Revitalize Your Retirement Savings with a Mid-Year Checkup
Making regular contributions to an employer-sponsored plan can supercharge your journey to financial independence.
But, you already knew that, right?
And, you likely already know about the benefits of “free money” that you could receive from your employer match and how pre-tax contributions to a qualified retirement account like a 401k, 403b or other employer-sponsored account can give your financial independence savings goals a major boost.
But, did you know that there are things you need to do periodically throughout the year besides putting money into your employer-sponsored plan to ensure that your financial independence goals are on the right track?
To be sure, some of you may be asking yourself, “isn’t contributing to a 401k, 403b, or other employer-sponsored plan account enough to secure my retirement?
Well, the short answer is: no.
That’s because getting money into a retirement account is a crucial first step toward securing your path to financial freedom, but it’s not the only step.
Indeed, throughout the year, there are some specific actions that you should take to 1) ensure that you’re putting your money to work in the most efficient way possible, 2) that you’re not taking more risk than necessary, and 3) that you’re not leaving any money on the table.
So then, with the mid-year upon us, there’s no better time than the present to log into your employer plan website and follow along as we review key factors that can help or hinder your financial independence goals.
Check Your Asset Allocation
According to various studies out there, asset allocation is one of the most crucial decisions you can make when it comes to growing and preserving your retirement savings for the long-term. And to put it simply, asset allocation refers to the mix between stocks, bonds, and real estate held in your portfolio.
Now, when we think of asset allocation, we tend to think of it in terms of aggressive versus conservative. And what do we mean here?
And an aggressive asset allocation could hold a higher weighting to stocks, while a more conservative portfolio holds more bonds. Aggressive allocations tend to take more risk, but also tend to get higher returns over the long-run. On the other hand, a conservative portfolio tends to take less risk, but also receives a lower return over the long-term.
To be sure, growing and preserving your savings has less to do with timing the markets or choosing the best performing security or mutual fund. Rather, it has to do with ensuring that you’re putting your money to work in a way that matches your risk tolerance, investment goals and time horizon.
The Risk of Being too Conservative
And why does this matter? Well, let’s assume that you’re still saving for retirement and have about 15 years to go before you’re ready to walk away from your job. If your asset allocation is too conservative, meaning that you’re not taking enough risk, you could end up saving less than you had initially planned.
For example, let’s assume that you have half a million dollars saved in your employer sponsored plan. We’ll also assume that you’re maxing out your contributions, and, to simplify our illustration, we’ll leave out any employer matching for the time being. If you have an aggressive investment profile, you could assume to expect to receive an investment return of around 6.5% under normal circumstances. Given this set of assumptions, your portfolio could grow to $1.9 million by the time you’re ready to walk away from your job.
Alright, so far, so good, right? Well, what happens if we keep all of the assumptions the same, but this time, we change the return assumption to be more consistent with a conservative investment portfolio that is expected to return 3.5% annually over the long term. Well, in this case, your portfolio would still grow, but at the end of 15 years, you’d have $1.3 million saved, which is nearly half a million dollars less than in the aggressive asset allocation profile!
This illustration shows how essential it is to ensure that your asset allocation aligns with your tolerance, goals and time horizon. And the truth is that, all too often, individuals who have the room to take more aggressive stances in their retirement portfolios play it too safe, which ends up costing them over the long-run.
So then, if you have well over a decade before you need to begin drawing down on your savings, you may want to take a moment to ensure that you’re not being too conservative with your asset allocation.
The Risk of Being too Aggressive
Another critical moment to check your investment allocation is if you’re five or fewer years away from needing to take distributions from your retirement savings. And why’s that? Well, what we’re trying to do is get ahead of what we call sequence of return risk. Now, sequence of returns risk is particularly important to individuals who are less than five years away from retirement because it directly impacts the value of your retirement savings during a critical period.
Here again, this risk refers to the order and timing of investment returns, which can significantly affect the overall portfolio performance and the sustainability of retirement income. In fact, here’s why sequence of returns risk is of concern to individuals nearing retirement.
First, when you’re transitioning to retirement, you’ll typically start relying on your investment portfolios to provide regular income. Now, if there’s a sequence of poor investment returns early in retirement, it can deplete your portfolio faster than expected, leaving fewer funds available for the remainder of your retirement. This situation is particularly detrimental because, if you choose not to return to work, you’ll likely have limited time to recover from significant losses.
Next, if you’re approaching retirement, you have a shorter time frame to replenish your savings compared to those who are earlier in their careers. So then, if you experience a series of negative investment returns just before or during retirement, you may not have the opportunity to recover those losses through additional savings or a prolonged investment horizon.
That’s because the compounding effect of investment returns becomes less impactful as your retirement approaches. In fact, even small losses in the final years leading up to your retirement can have a substantial impact on your overall retirement nest egg, as there is less time for the compounding effect to work in your favor.
Now, another point to consider is that, as you’re nearing retirement, you may have already made decisions about your retirement income strategy, such as setting up systematic withdrawals. Now, if poor investment returns coincide with the initiation of these income streams, the negative impact can be long-lasting, potentially leading to lower income throughout retirement.
Indeed, the impact of sequence of returns risk is more pronounced for if you’re close to retirement because you have fewer years to recover from a market downturn. Again, a significant loss in the final years before retirement may force you to delay retirement or make drastic adjustments to your planned lifestyle.
So how do you get around this? Well, again, this is where your asset allocation strategy comes into play. And at this point, you may want to consider gradually shifting towards a more conservative investment allocation to minimize the potential impact of market volatility. And you’ll also want to take a second look at your comprehensive financial plan to help you manage your savings effectively during the transition into retirement.
Regardless of whether you’re in the accumulation stage and have years to save, or nearing the distribution stage and are preparing to draw down on your savings in just a few short years, the first thing you’ll want to do as you’re reviewing your employer-sponsored savings plan is ensure that your investment holdings align with your overall asset allocation decisions.
Choosing the Right Investments
Alright, now that you have a good understanding of why it’s essential to know how much you should have allocated between various asset classes, let’s talk about where you should be putting your money to work.
The fortunate thing is that in a world of tens of thousands of investment options, your employer sponsored plan may limit your available investment options to less than a few dozen choices. Now, while its’s arguable whether this limitation is a good thing or not, it does reduce the analysis paralysis aspect of putting your money to work once you’ve identified your ideal asset allocation framework.
Asset Class Purity
So, where should you start when it comes to evaluating your investment options? Well, first things first, take time to ensure that the funds held in your retirement savings account align with the asset classes defined in your asset allocation strategy.
For example, let’s say that your goal is to allocate a quarter of your retirement savings to large cap stocks. And let’s also say that your employer has given you the option of a Total Stock Market Index Fund and an S&P 500 Index fund. Which should you go with? Well, if you decided to choose the total stock market fund, you would not only gain exposure to large cap stocks, but also to mid and small caps at the same time.
Now, while this may not seem like a big deal on the surface, the point here is that if you’re serious about adhering to a disciplined asset allocation approach, then you need to choose funds whose investment profiles match the asset class that you’re selecting them for. We call this using asset class purity.
Now, when you, select funds that are “asset class pure,” it means that you choose funds that focus exclusively on a specific asset class or category. Here again, asset classes refer to different types of investments, such as stocks, bonds, real estate, commodities, or cash equivalents.
By opting for asset class pure funds, your aim is to maintain concentrated exposure to a particular asset class, rather than investing in a diversified fund that includes multiple asset classes. This approach allows for a targeted investment strategy and can be beneficial if you have a strong conviction about a specific asset class or want to align your investment choices with a particular investment theme or strategy.
For example, if you believe that the stock market will outperform other asset classes in the near future, you may choose to allocate funds exclusively to equity-focused funds, which primarily invest in stocks. By doing so, you concentrate your investments in a single asset class, potentially maximizing returns if your prediction proves accurate.
Now, it’s important to note that investing in asset class pure funds carries certain risks because when your portfolio is concentrated in a single asset class, it may be more susceptible to fluctuations and volatility specific to that asset class. And that’s why diversification across multiple asset classes is a common strategy to mitigate risk and smooth out investment performance over time. Therefore, selecting asset class pure funds should be carefully considered and aligned with your risk tolerance, investment objectives, and overall portfolio diversification strategy.
Now, if you’re not sure which asset class a particular fund tracks, you can always look up the benchmark that the fund is measuring itself against in the fund prospectus, or you can go online and use a tool like Morningstar.com to evaluate the asset class style for that particular fund.
Fees and Expenses
Another point to take into consideration when choosing which funds to hold in your retirement account is fees and expenses. Here again it comes back down to the old adage of it’s not how much you make, but how much you keep.
Now, not all employer sponsored retirement plans are created alike. Therefore, the fees and expenses you’re likely to pay will vary depending on your program, but the three main expenses you’ll want to pay attention to are individual service fees, administration fees and investment fees.
Of these fees, you’ll want to pay particular attention to the investment fees related to your fund holdings. And why do investment fees matter? Well, let’s assume for a moment that you’re considering three funds that track large cap stocks, and they all seem like reasonable investments.
Now, if you’re not paying attention, you could be giving away much more of your investment returns in the form of fees than you expected. Indeed, depending on your situation, investment fees in your employer sponsored retirement account can range between 0.5% to 2.0% per year!
Now, at face value, this might not seem like a lot, but a half percent difference on a half million dollar portfolio invested over 15 years could mean forgoing over $100,000. And in the case where the fee is 2% for a given fund, that could cost you well over $400,000 in potential returns. That’s why, when you’re choosing between various fund options, your best bet is to go with the fund that is the lower cost option given your specific asset class constraints.
Putting Away Enough Money
Alright, now that you’ve ensure that you’ve dialed in your asset allocation decisions to your risk tolerance, and have chosen low-cost, asset class pure investments to go along with those allocations, one last thing that you’ll want to do is to ensure that you’re setting aside enough money in your retirement account.
But, now, how much is enough? Well, because everyone’s situation is unique and there is no one right answer, here are some general guidelines to consider as you go about putting your money to work:
Take Advantage of Your Employer Match
First, many employers offer to match a percentage of your 401k contributions up to a certain limit. And in many ways, when your employer matches your contribution, it’s essentially free money being added to your retirement savings.
In fact, this is an immediate return on your investment, which is something few other investment opportunities can offer. And is a sense, not taking advantage of this match would be like turning down a pay raise.
What’s more, the employer match can accelerate the growth of your retirement savings. That’s because this extra contribution not only increases the principal amount being invested but also compounds over time, which could significantly increase the total amount you have saved by the time you retire.
Again, what we’re talking about here is essentially free money and provides an immediate return on your investment. That’s why if your employer provides this benefit, you should consider contributing at least up to the maximum matching limit.
Balanced Contribution Amount
Next, it’s crucial to strike a balance between saving for the future and maintaining a reasonable quality of life in the present. That’s because your ability to contribute to your retirement savings account will be influenced by your current income and your ongoing living expenses.
Now, as it stands today, the contribution limit for employees who participate in 401k, 403b, and other employer sponsored plans is $22,500. And if you’re over the age of 50, you have an option to drop in another $7,500 annually as a catch-up contribution.
So then, as you go about considering how much to contribute to your employer sponsored plan, maxing out your contributions should be your priority in most cases. That’s because most contributions to employer sponsored plans are made on a pre-tax basis, which allows you to put more of your money to work before Uncle Sam gets his fair share of your earnings.
Targeted to Your Retirement Goals
Alright, so as you’re evaluating your contributions, if you’re making the bare minimum to take advantage of your employer’s match, but not willing to max out your pre-tax contributions, then what should your do to find the right balance?
Well, if you find yourself in this situation, then your likely focus should be on setting aside enough money to cover your projected lifestyle expenses in retirement. Here again, how much you need to save will largely depend on the kind of retirement lifestyle you want. That’s why you should consider factors like where you want to live, what kind of activities you want to participate in, and potential healthcare costs.
Now, in previous posts, we spent some time discussing how to use exponential returns to calculate your retirement need. But if don’t have a financial plan and are looking for a quick and easy way to figure out your savings need, then online calculators and retirement planning tools can help you estimate how much you’ll need to save to meet your retirement goals.
Consider Auto Escalation
Now, as you’re going about reviewing your employer-sponsored plan, another option to consider is setting up your plan contributions to automatically rise each year as you earn more money. Now, automatically increasing your contribution each year is often called “auto-escalation,” which could work in your favor in several ways. For starters, it’s a straightforward and effortless method to regularly boost your savings.
To be sure, since the contribution increases happen automatically, you don’t have to remember to make the adjustments yourself every year, which means there’s less chance you’ll forget or keep delaying it.
Another benefit to consider is that as your salary grows over time, there’s a tendency for spending to increase along with it. This is known as “lifestyle inflation.” If you’re automatically increasing your contributions every year, you’re effectively channeling some of the extra income that might have gone into spending, into your savings instead.
And, naturally, by contributing more to your employer-sponsored plan, you’re speeding up the growth of your retirement savings. Indeed, every incremental increase in your yearly contribution accelerates this process, potentially allowing you to reach your retirement savings goal much sooner than expected.
The bottom line is that while these annual increases might seem insignificant in the short term, they can significantly impact your total savings over time, thanks to the power of compounding.
Either way, as you’re reviewing your employer sponsored plan, you’ll want to make sure that you’re contributing enough to take advantage of your employer’s match. And, if you can, max out your pre-tax contributions to enable your savings to grow for maximum effort. And, when possible, turn on auto-escalation within your plan to make higher contributions much more effortless.
Revitalize Your Retirement Savings with a Mid-Year Checkup
No matter where you are in your journey to financial independence, ensuring that your retirement savings are on the right track requires more than just contributing to an employer-sponsored plan. While it is a crucial first step, there are additional measures you need to take on a regular basis to maximize the efficiency of your savings and minimize unnecessary risks.
Indeed, when it comes down to it, managing your employer-sponsored retirement account involves three key aspects. First, you should assess your asset allocation to align it with your risk tolerance, investment goals, and time horizon. This will help you strike the right balance between risk and return, ensuring your savings grow optimally.
Second, carefully evaluate the investment options available within your retirement account. Consider the concept of asset class purity, selecting funds that correspond to your desired asset classes. By doing so, you maintain a focused investment strategy and potentially capitalize on specific asset class performance.
Additionally, pay close attention to fees and expenses associated with your fund holdings. Even seemingly small differences in fees can significantly impact your long-term returns. That’s why, when you can, opt for lower-cost options that align with your asset allocation decisions to preserve more of your investment returns.
Lastly, make sure you’re contributing enough to your retirement account. Take advantage of any employer match offered, as it is essentially free money that can boost your savings. Strive to maximize your pre-tax contributions and consider utilizing auto-escalation to gradually increase your savings over time. By finding the right balance between saving for the future and your current lifestyle, you can ensure a more secure retirement over the long run.
And by addressing asset allocation alignment, investment selection, fee management, and contributions you can ensure that you’re taking one step closer to becoming the master of your own financial independence journey.
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