Welcome to Part 3 of Your 401(k) Workshop: Develop a Wealth-Building Plan for Your 401(k).
Your 401(k) is an incredibly powerful tool to help you build wealth, but it’s not perfect. Many people have expressed confusion and frustration with how to choose their investments, how much money they need in their 401(k), and an array of other issues. In addition, there are probably some unknown elements of your 401(k) that are working against your financial success!
This series provides a step-by-step process for evaluating your 401(k)’s purpose (it’s about more than just “save up a bunch of money”), understanding how your current financial situation affects your 401(k)'s future growth, and developing a plan for getting the most out of your 401(k) to better provide for your financial future.
In Part 2 we evaluated our current financial status by showing the importance of creating a simple budget, optimizing cash flow, and creating a Personal Balance Sheet. In Part 3 we’ll develop an investment plan based on your financial status in Part 2 and your financial goals in Part 1.
Keep in mind that when I say "investment plan" I'm not talking about your actual investments, but rather the plan to fund those investments. This is critical, as there are too many 401(k)s out there with good investments but far too little money to last through one's retirement.
First, Find Your Retirement Number
We first need to answer a glaring question you’ve probably wondered about already: How do I know how much money I’ll need for retirement?
A simple calculation is to divide your annual expenses by .04, or 4%. Why 4%? It’s based on something called "the Safe Withdrawal Rate" in retirement. Your Safe Withdrawal Rate is the amount you can withdraw from your retirement account each year while maintaining a strong chance of not outliving your money--the biggest fear of retirees. Research shows that if you plan to be in retirement for 30 years you can safely withdraw roughly 4% of your nest egg.
This formula has many assumptions, the biggest of which is that your current and future cost of living will stay the same (adjusted for inflation), and you’ll therefore want to maintain a similar income. While there is an argument that your costs will decrease in the future (assuming your home is paid off and your taxes are lower), the case can also be made for a cost increase, as medical expenses rise and discretionary spending, like travel, also increases.
Using the Safe Withdrawal Rate is not an exact science, but it can help you determine a number to work toward for retirement savings.
Connect Your Goals, Financial Status, and Your Retirement Number
With your financial goals, financial status, and retirement number figured out, you can tie these pieces together to capitalize on your 401(k)’s potential. Start by asking yourself this question: Based on my current financial situation, how close am I to meeting my financial goals? Let’s assume you have the following goal:
Retire by age 60, live on my investments for 30 years, and maintain my current standard of living at $75,000 per year.
Let’s first determine how big your nest egg should be:
$75,000 / 0.04 = $1,875,000
Given your stated goal and assuming a Safe Withdrawal Rate of 4%, you need $1,875,000 by age 60 to provide for a 30-year retirement. That’s almost two million dollars! This may sound like an unreachable sum of money, but I assure you it is not. Compound interest and disciplined saving in your 401(k), even with seemingly small amounts, will play an important role, as you’ll see.
How much money do you currently have working toward this goal? This value is found in your Personal Balance Sheet. Any funds you currently have in your retirement account(s) are working towards this goal.
Suppose you’re 35 years old, you have $40,000 in your current employer’s 401(k), and you’re contributing 10% of your $75,000 salary with a 100% company match up to 4% of your salary. Let’s plug this information into a financial calculator to see how close you are to your retirement goal using a simple, free 401(k) calculator from Bankrate.
After plugging in the numbers, here’s where you would be at age 60 (assuming an 8% average annual rate of return):
Total employee contributions to your 401(k): $225,000
Total employer contributions to your 401(k): $90,000
Total amount available at retirement: $1,642,918
Not too bad! You’re making good progress toward this goal given our assumptions, but you can see that based on the inputs you’ll be short about $200,000. Remember, though, that there are several assumptions here that could change such as your contribution percentage, your annual salary (due to an unexpected job loss or promotion), and an annual salary increase.
By manipulating the tools’ inputs, you can see what changes you could make to your investment behavior to reach your goal.
- How does your total available at retirement increase if you contribute an additional 3% to your 401(k) each year?
- How does your total increase if you receive a salary bump to $85,000? How does this also affect your employer contributions to your 401(k)?
Please note: I highly recommend NOT adjusting the annual rate of return beyond 8%. History has shown that the stock market has averaged 8-10% over time, and I believe you’re better off selecting the low-end of that average. Adjustments to other values, such as your percent to contribute, annual salary, and annual salary Increase are much more within your control.
Develop Your 401(k) Investment Plan
With the 401(k) calculator information, you can start creating your 401(k) Investment Plan. It doesn’t need to be complicated. It’s simply a statement showing how much you need to save, how much you anticipate having based on your current savings rate, and how you plan to make up the difference in order to have enough money to achieve your savings goal.
Your 401(k) Investment Plan (Sample)
How much I need to save: $1,875,000
How much I’ll have at my current saving rate: $1,642,918
My plan to change my current savings and reach my goal:
Work toward and receive a 5% raise next year
Increase savings rate by 3% next year, from 10% to 13%
Increase my employer match (automatic, due to salary increase)
Ultimately, filling the gap between what you’ll have and what you’ll need in retirement comes down to two options: save more or change your retirement goal. If you plan to save more rather than change your goal, you can either cut expenses, increase income, or do both. Remember, we won’t tamper with rate of return assumptions beyond 8%, since we have no control over them.
Let's explore a few ways you could potentially make up the difference.
Optimize Cash Flow
Calculating your budget in Part 2 showed that you have either positive or negative cash flow each month. Any consistently positive cash flow you see month after month could be directed into your 401(k) by increasing your 401(k) contribution percentage.
Cut Expenses or Increase Income
If your cash flow is consistently negative, you’ll need to either cut expenses or boost your income. Here are some approaches most people can take.
Cut High-Interest Debts
Look for expenses that you know you shouldn’t have, but do. One example is high-interest debts, like credit card debt. Put a plan together for how to pay this down quickly. There are a countless variety of debt payoff tactics out there. My typical advice is to first attack the debt where you're paying the highest interest rate. Once you’re free from the grips of credit card debt, don’t spend the excess! Direct those funds into your 401(k).
Cut Big Ticket Items
Look for big-ticket expenses that are consistently eating into your paycheck. These might be a high rent payment or large monthly payments on a car. I’m convinced that expensive cars and costly homes are two of the biggest retirement killers out there.
As a general rule, aim to keep your essential expenses under 50% of your total salary. If you’re serious about saving for retirement, consider trading in your new car for something older but just as reliable, at possibly a half or a third of the monthly cost. For home renters, consider re-negotiating your lease or relocating to a more affordable area.
Boost Your Income
When was the last time you asked for a raise? The biggest way to get a boost to your cash flow is to increase your salary. Don’t be afraid to ask your manager to lunch and discuss your career goals. Let them know where you want to improve and where you’d like your salary to be. Create a one-year plan for how to make it a reality.
As pay raises and promotions come, it’s typical for expenses to go up as well. This is called lifestyle creep. Little by little your salary goes up and your lifestyle follows suit. Resist the urge by directing at least a portion of pay raises into your 401(k) until you're on a path to filling the gap in your retirement plan.
Give Your 401(k) a 1% "Raise"
A clever trick to contribute more to your 401(k) is by giving your 401(k) a 1% “raise” each year. This works well because 401(k) contributions are made before they ever appear in your paycheck. The money is harder to miss when it never hits your checking account in the first place. Plus the amount is relatively small. The tax-reducing advantages of your 401(k) contributions will make the impact even less severe.
I hope you’ll put Part 3 to work by creating an investment plan for your 401(k). Remember, the biggest driver for your retirement success is how much you contribute towards it and how much time your money has to grow in the market. Part 3 has focused on how to maximize your contribution. In Part 4 we’ll discuss the actual selection of your investments and getting them to work for you.