How Auto-Saving in your 401(k) Could Leave You Looking Like a Football Player Who Celebrated a Touchdown Too Early
Major football fans over here at SGWM so this post felt right for the start of a new season! Now that summer is unofficially over, it’s also a good time to take a look at your finances and get things in order before the end of the year. Hopefully this silly analogy will help get our point across.
First off I’d like to say that that if you have set up auto-contributions to an account like a 401(k) or IRA, congratulations! You have taken a great step towards financial freedom and are setting yourself up for success. You’ve caught the pass and are beginning to pick up yards as you make your way down the field towards the end zone.
Soon you begin to see your account balance grow each quarter and you start to feel pretty great. You speed past the other players on the field and can see nothing but green in front of you.
You assume that you’re in the clear and if you just keep on keepin’ on, you’ll reach your goal of saving enough for retirement. You start to get a little cocky, raise your hands in the air in celebration of the presumptive touchdown when, seemingly out of nowhere, you are tackled by a 300-pound defensive line man on the 10-yard line.
The name on his jersey? Allocation.
You forgot to finish through.
While contributing to a 401(k) (or any retirement plan) is a great move, a big mistake you could be making is not paying attention to how that 401(k) is allocated aka how it is invested. Let’s look at this common scenario.
Imagine you begin working full-time at the young age of 22 and right away start investing in an employer sponsored 401(k). You know the right thing to do is sign up for the plan so you elect to defer 5% of your salary. Easy so far.
Then comes time to pick the actual investments in the account. You might be thinking “WTF” when looking at your options. The part you do figure out is that you need your investment selections to total 100%. Other than recognizing a few terms in the fund titles, like “bond” or “stock” it might as well all be written in Latin. So you decide to just spread out 25% here, 10% there, and so on until you hit 100%. Boom, done.
Well years later you’ve learned a bit more about money and investing and now you’re in your 30s. You take a look at your 401(k) and you finally understand exactly what type of funds you picked 8 years ago. All this time you’ve been heavily invested in bonds and even a money market fund. *Face palm!*
You know now that no investment-sane person would allocate a 22 year-old’s retirement portfolio to be heavily based in bonds. You have just lost almost 10 years of aggressive compounding growth! Seriously, what a waste! Your money could have been working for you all of these years. Instead, while yes you did indeed at least save up a nice sum, you missed out on a really big game-changing opportunity that was just within reach if you only stayed focused for a few more steps. You settled for 3 points instead of 6.
Bottom line is don’t just check “save in 401(k)” off your list without making sure you are truly all set. Granted the hardest and most important part is to just save in the first place. I applaud anyone who has taken responsibility for their financial lives and future and has begun to save and invest. Once you decide to do that, take the final step and finish it off! Allocate properly! Don’t know how to allocate? Don’t stress, just keep it simple. Follow some of these below.
Choose a Target-Date Fund
This is basically a set it and forget it type situation. A Target-Date Fund usually has a year in the title. For example, Target-Date Fund 2055. This means that between now and year 2055 the fund will change its allocation in preparation for the owner’s retirement. Assuming a retirement age of 65, a 2055 fund would be good for someone born around the year 1990. (1990+65 = 2055). The fund will be more heavily weighted in equites (stocks) and then grow more conservative (bonds, etc.) as the year 2055 approaches. The fund company takes care of all of the allocation changes and rebalancing for you.
Something I hear often is “but I don’t know what year I will retire in” or “what if I need the money before year 20xx?” The year of the fund doesn’t actually have any rules associated with it. You can totally use a target-date fund for non-retirement investments and accounts, but they are really branded for retirement investments with the easy to pick date right in the title.
In terms of a retirement account (401(k), IRA etc.), the date in the title of the fund does not set forth any rules or regulations. Any rules are set by the IRS and are based on the type of account you are holding investments in. You should always be aware of penalties for early withdrawals.
Your employer plan may offer you investment funds from Vanguard, Fidelity, and an array of other financial institutions. Always make sure to check the fees and ask questions if you are unsure. Also just because most of the heavy lifting in your account is done for you doesn’t mean you shouldn’t check in every once in a while. Take a peak at a funds of different dates than yours to see what you can expect over the years in terms of portfolio allocation. Remember: the further the date out is, the more heavily invested in stocks. The closer the date, the more heavily invested in bonds. It should be red flag if this shift isn’t occurring over time.
Though there are arguments against Target-Date Funds they really are a useful tool for a novice investor and for one who really doesn’t have the time or interest to research individual funds and reallocate every few quarters. My advice? If you are in your 20s or 30s pick the furthest out date, as of 2023 that will probably 2070 (see VSVNX). Always continue to read and ask questions.
Keep in mind the NEW Rule of Thumb
You may have heard the old rule of thumb before. This was to subtract your age from 100 and you get the percentage of your portfolio that should be invested in stocks. For example, 100-27 = 73%. Personally I find that far too conservative and it sounds like many financial planners agree. We are living longer and therefore need our money to last longer.
Try using the new rule of thumb. This time use 120 and subtract your age to get the percentage of your portfolio that should be invested in stocks. Using the same example, 120-27 = 93%. This is a much more realistic number if you are investing for the long term (25+ years) and want to be as reasonably aggressive as possible to take advantage of time and compounding.
You can use this rule of thumb to build your own portfolio by selecting individual funds at the percentage you’d like to allocate to each. You could take this route as opposed to using target-date funds to have more control over your investment selections. It will require just a bit more activity on your part though. So continuing with the above example, you would select an array of equity funds to total 93% and an array of fixed income funds (bonds) to total 7% with a grand total of 100%.
You are also responsible for re-balancing your portfolio and shifting the allocation as you get older and your risk tolerance changes. No-one is going to do it for you.
*Note: There are many different types of investments besides just stocks and bonds. This article is focusing on the idea of equity vs. fixed income with the purpose of making it easier to understand and therefore take action.*
Finally, something I like to reiterate, is to always keep in mind fees. Please check what you will be charged as high fees can eat away at a portfolio over the years. Companies like Vanguard are known for their extremely low fees. Some funds charge only 5 basis points (.05%) which is one of the lowest figures you’ll see! Other favorites of Gen X, Y and Z are Betterment and Ellevest. They charge a bit more than Vanguard, but are really tech-centered, and user friendly; especially for beginners. Still their fees are much lower than traditional brokerage firms.
Also keep in mind your own personal risk tolerance. If you honestly cannot handle swings in the market then maybe a 93% equity portfolio isn’t right for you. The idea for investing in a retirement account (401(k), IRA, etc.) is that it is for the long-term! You should not be logging in every day placing trades and making rash decisions any time the market goes up or down.
Remember, not allocating properly, whether that be too conservative as a 20-something or too risky as a 60-something, can cost you. For gen Y and Z, take advantage of being young and commit to save and invest from an early age.