Recently, I read an article that questioned how some people could build million dollar plus 401(k) balances. Someone might need a $1 million plus balance depending upon assumptions about lifespan and budgets. However, I don’t believe that everyone needs to make the sacrifices required to attain a million-dollar balance. You should start with the question “How large of a 401(k) balance do I really need?”
401(k) balance or retirement nest egg
Let’s start by determining your strategy for creating retirement income. Do you want to have a chicken that produces eggs or are you planning on eating the chicken? I believe most people are much better off having a chicken that produces eggs that can be consumed on a regular basis. This strategy takes the 401(k) amount and converts it into some type of fixed annuity. Rather than you retaining the risk of running out of money, you transfer the risk to insurance companies you choose.
Let’s say you need $50,000 in addition to what you are getting from outside pensions and Social Security. An insurance company may provide that amount if you give them say $500,000 of your money. The downside is if you die the day after you give them the money, the money you’ve given them is forfeit. However, the upside is that if you live longer than expected, you may receive more than what you would have gotten by pulling $50,000 out of the principal for 10 straight years.
You may ask, “What happens if the insurance defaults?” You can diversify the risk of default by divvying up your money to multiple insurance companies.
Another retirement income strategy is to systematically spend your nest egg. You could simply pull the money out of your account as needed or go with a strategy of only pulling out a percentage. If you go with the “spend as you need” approach, you expose yourself to the risk of running out of money with no hedge. You could also choose to pull out a percentage from the accounts while maintaining the principal. Much research has said that number is likely around 4%, but that comes with no guarantees. In layman’s terms, that means that if you need $40,000, you would need a million-dollar 401(k) balance. The problem is that you still need to grow your money to ensure you have the capital necessary if you have a longer than expected life. That means exposing yourself to the risk of the market. If the market goes down to $500,000, 4% means spending only $20,000. Determining which one of these withdrawal strategies best fits your comfort level and finances gives direction on the 401(k) balance size issue.
Calculating your 401(k) balance need
Financial planning is about balancing multiple goals and needs such as your children’s education, mitigating the financial risk to your family because of premature death, retirement planning, emergency funds, etc. while you determine what balance is right for you. You may determine that one of these withdrawal strategies emerges as the one that best suits you. How might this work? Let’s assume:
- You want to live on $75,000 at the start of retirement
- Social Security will pay $25,000 at the start of retirement
- You have no pensions
- Inflation will hover around 4%
- Your 401(k) balance needs to provide $50,000/year and 4% annual raises
- Your risk comfort suggests a portfolio that is half stock and half bonds
You like the strategy of passing the risk onto an insurance company, and target a 401(k) balance that can be converted into a fixed annuity with a 4% cost-of-living adjustment at retirement. Let’s say that will likely cost you somewhere in the neighborhood of $600,000 to $800,000 at the start of retirement. (There are several factors that might vary that amount. As you get closer to retirement, you and your advisory team can make adjustments.)
What is your plan for growing your 401(k) balance?
If you’re like most people, you have not had a Certified Financial Planner™ or other credentialed financial planning professional help you calculate your savings need. Adding a retirement spending strategy (how you will withdraw your money) likely adds a new wrinkle into that calculation. While plans are great, implementing them is even better. For most of us, the challenge comes with implementing the key inputs of the plan–saving, getting consistent market returns and sticking with your plan.
That’s why I believe it is imperative that you work with a credentialed financial planner, like a Certified Financial Planner professional. Research by Unified Trust uncovered that savings is 45 times more important than investment returns in helping savers reach 401(k) balance targets. Investor behavior is known to sink many an investment plan. Research from Charles Schwab found that 401(k) savers who work with a financial professional generally save more and get better returns.
Don’t you owe it to yourself and those that you love to get help?