As an investment advisor who has worked with the retirement plans of Apple, IBM and AT&T, I often receive questions from participants about how much in 401k contributions they should make. I typically respond by saying, “At least 20%.” They usually laugh and say, “No, really.” And I repeat, “Really, at least 20%.”
What the experts advise
Many experts, including Vanguard, suggest that most of us need to add 12% to 15% of our compensation to our 401k plan accounts every year we work. Money magazine indicates that the average 401k participant adds 10.9% to 12.9% to a 401k account each year (employee 401k contributions plus employer contributions). That seems to be right on track. However, if we look at the way most of us make 401k contributions, that range is way too low.
How most of us normally make 401k contributions
In real life, most of us don’t make 401k contributions in a uniform way. Early in our careers, when we are just getting started, most of us battle with competing saving and spending priorities. We are trying to pay off student loans, buy a car or save for a down payment on a home. Or, surprise, we may end up having kids!
As a result, during that first 10 years of our 40-year careers, most of us contribute very little (or nothing) to our 401k plans. At that time in our lives, retirement seems pretty far off anyway and those student loans look pretty scary. We often change jobs frequently as we try to figure out what we want to do with our lives and, unfortunately, many of us end up taking distributions of our 401k balances rather than rolling them over.
Generally, most of us are in our 30s when we begin to consider saving more seriously for our retirement. We now own homes, are a little more established in our careers and are earning more. Typically, we contribute the amount that will allow us to collect the maximum company matching contribution. The most common employer matching contribution is 50% of the first 6% of employee contributions. So we end up adding 9% on average to our 401k accounts during our 30s.
During the last 20 years of our careers, we begin to panic as we realize that we haven’t been contributing enough. Retirement is no longer a distant thought but is moving closer to reality. For these years, we may contribute as much as we possibly can. If we look at our contribution history and apply a little math, many of us end up with the following:
Early career contributions (first 10 years): 0%
Mid-career contributions (second 10 years): 9%
Mid-career contributions (third 10 years): 15%
Late career contributions (final 10 years): 18%
Average contribution rate over 40 years: 10.50%
Required minimum average contribution rate: 12.00%
I can hear what you are thinking, “Not much of a difference Bob, what’s the point?” There are two problems with how we contribute. First, the problem that can’t be fixed.
Back-loading rather than front-loading
All of us understand the power of compounding. That’s when your savings magically increase over time because of interest on interest. Well, that is not what we are experiencing when we make 401k contributions as outlined above. We are back-loading contributions into our accounts rather than front-loading, contributing a lot at the end of our careers and very little at the beginning. As a result, we are missing out on all of that compounding that takes place over time. So we end up with a 401k account balance that is way too low.
But I am going to catch up
Most of us know we didn’t contribute enough early in our careers. We rationalize that we can fix things by contributing as much as possible during our later years to make up the difference. So during that last 10 years of our careers, what would we need to add to our 401k accounts each year in the example above to average 12% for our entire 40-year career? More than you might think — 24% per year. Given that the average employer matching contribution is 3%, that means that our contribution rate for the last 10 years of our careers would need to be 21%.
As someone who has worked with 401k plans for more than 30 years, I can tell you that none of us are close to making 21% in contributions each year.
Regardless of what stage of your career you are in, all of us likely need to contribute more. Take a look at your 401k contribution rate today.
Lawton Retirement Plan Consultants, LLC (LRPC) Monday Morning Minute is crafted to provide decision-makers with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly $475 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges, and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.