3 Key Ways to Boost Your 401(k) Returns

The First Commandment of 401(k) Success

In point of fact, there are four keys to 401(k) success, but I am skipping the most critical one: Save more! I omit that overwhelmingly important mandate not solely because it is obvious, but because I previously discussed that topic at length, in “What Is the Right 401(k) Contribution Rate?” That article gave the required savings rates for middle-income workers to achieve their retirement goals, assuming varying levels of 1) portfolio returns and 2) replacement rates.

That leaves three remaining methods for improving one’s 401(k) fate: 1) earning more, 2) catching up with contributions, and 3) good timing.

Key 1: Earning More

This directive is also obvious. (There aren’t many secrets with 401(k) plans.) Stronger investment performance leads to higher account balances. You knew that. Nevertheless, it’s instructive to measure those specific effects.

The details: The base case for all calculations in this column considers two employees, each of whom opens a 401(k) account on her 23rd birthday and then contributes for the next 42 years, until age 65. The first participant, who we will name “Median,” personifies the average US worker. Her salary starts at $48,766 and rises modestly until age 45, where it peaks at $64,116. The second participant, labeled “Wealthy,” represents the 90th percentile of income, with an initial salary of $81,818 that eventually reaches $160,000.

The computation posits that each employee contributes 8% of her salary (including the effect of company matches) to her 401(k) account, throughout her working career. Each year’s investment return is 5%. That assumption may appear conservative, but all figures in this article are presented after inflation. Since my birth year of 1961, the average annualized real gain on a balanced portfolio has been just that: 5%.

Those assumptions make for final 401(k) portfolio values of $645,000 and $1.42 million, respectively. (If those numbers look scanty, I can fatten them by assuming an annual 3% inflation rate, leading to $2.32 million and $4.91 million nominal totals.) For convenience, I translated those figures into annual spending amounts, using a 4% withdrawal rate. The results are $25,800 and $56,800.

The exhibit below shows what happens to those expenditures if the average annualized investment performance shifts by 1 percentage point.

Small but mighty changes! Improving the annualized return by just 1 percentage point, to 5% from 4%, leads to a 30% boost in spending ability, with a similar raise coming from the increase to 6% from 5%. The green-bar employees invested no more into their 401(k) accounts than did their red-bar peers, but they can withdraw almost 70% more per year. That must be nice.

Of course, achieving higher returns is easier said than done. My counsel: Trim the fat! There’s no room for extra costs in 401(k) plans for participants of any age, and for younger investors there shouldn’t be room for bonds or cash, either. They should own dirt-cheap equity funds, period. Participants closer to their retirement dates will add fixed-income securities—but they should not be overly cautious. Equities have outgained bonds in 80% of rolling 10-year periods. And when they have trailed, they usually have not done so by much.

Key 2: Catching Up

The IRS permits workers aged 50 or over to invest an additional $7,500 in their 401(k) accounts each year above the legal maximum. This is termed the “catch-up” provision. Strictly speaking, this article does not measure the effect of that rule, as the annual 401(k) contribution limit of $23,000 exceeds any amount stipulated in my model. Rather, I observe the spirit of the law by showing what occurs if employees boost their savings rates as they near their retirement date.

For simplicity’s sake, I will stick with that $7,500 amount. Beginning at age 50, each employee raises her annual 401(k) contribution by $7,500. That strategy is perhaps unrealistic for the Median employee, but it should be attainable for her Wealthy counterpart. After all, older high-income workers typically reap the twin economic benefits of owing home equity and being empty nesters. Given those conditions, they should be able to hike their savings rates.

Here are the results.

An improvement, to be sure, but the gain from making catch-up contributions nonetheless failed to equal that of the 1-percentage-point rise in total return. With that exercise, the Median employee’s retirement income rose to $33,800 instead of the catch-up figure of $31,800. The advantage for the Wealthy employee was much bigger yet: $76,700 as opposed to $62,800. The larger the 401(k) account, the greater the dollar effect of even slightly better returns.

To put the matter another way, a 45-basis-point increase in annual after-inflation performance to 5.45% from 5% would have profited the Wealthy investor more than would have 15 years’ worth of $7,500 catch-up savings! Such is the magic of compound interest. The result reinforces the lesson from the previous section: Squeeze every ounce of return from 401(k) plans.

Key 3: Good Timing

I have also written before about this subject. The performance of a 401(k) account is determined not only by the size of the investment return, but also on its timing. Early in an employee’s career, performance is immaterial. There aren’t enough assets in the account to make a meaningful difference. As the retirement date approaches, though, returns become increasingly important. Better that they are high during the later years than they are low.

The effect is surprisingly big. The illustration below depicts three return scenarios: 1) the base case with steady 5% annual real returns; 2) a fast start, with the participant receiving 8% real returns during the first 14 working years, then 5% for the next 14 years, then 2% for the final 14 years; and 3) a slow start, which reverses the fast start by returning 2%, 5%, and then 8%. (These examples do not incorporate catch-up contributions.)

The bars closely resemble those of the first exhibit. That is, the effect from receiving the same overall rate of return, but in different sequences, almost exactly matches the effect of receiving a percentage-point change in that overall rate. When things happen can matter as much as what things happen.

For this factor, I can offer no advice. One cannot alter one’s birth date. I will note, though, that 401(k) participants who are about to retire hit a timing triple if they invested in a balanced fund, as such portfolios have gained about 6.5% per year after inflation over the past 15 years. And if they were brave—or rash enough—to own only US equities, they hit a grand slam, as the real 15-year return on that investment exceeds 10%. May we all be so fortunate!

Postscript

Two weeks ago, I criticized a chart that has circulated throughout social media, in the lightly read “No, Casino Gambling Isn’t More Lucrative Than Day Trading.” (It was one of my better efforts, but there’s no accounting for taste.) In that column, I mentioned that I could not locate the chart’s original source.

Well, he found me. Jeremy Schneider, purveyor of a website called personalfinanceclub.com, informed me that he had created that graphic. We had a pleasant exchange. We did not change minds, as he still believes that the essence of his message—the danger of day trading—was more important than its details, while I continue to think otherwise. But we listened. In this day and age, that counts as a small miracle.