Taking advantage of your employer’s savings plan is one of the most powerful and effective tools available to investors planning for retirement. But be wary of “setting and forgetting” the contribution amount you make each year: It may not be enough to meet your goals.
Consider the following case of a young professional in the US who decided to give his contribution schedule some more thought.
Robert is 30 years old and single. He earns $100,000 a year pretax at a large company and expects his salary to increase 5% a year until he retires at age 65, even if he doesn’t receive a major promotion.
Robert has a growth-oriented asset allocation in his 401(k), with 80% invested in global stocks and 20% in intermediate-term taxable bonds. He expects to adopt a moderate asset allocation, with 60% in stocks and 40% in bonds, when he retires.
Until now, Robert has contributed 6% of his pretax salary, or $6,000, each year to the 401(k), in order to receive the full employer match. But a friend contributes the maximum: $18,000 in 2015. Robert asked us how much doing that would increase his long-term wealth? Would it allow him to retire comfortably?
We estimated that at his current 6% contribution rate, after 35 years of average market returns, Robert would have inflation-adjusted wealth of $1.5 million. But if he maximized his contributions from now on—and took full advantage of catch-up rules that allow him to contribute an extra $6,000 a year (adjusted for inflation), after age 50—his inflation-adjusted wealth would be almost 50% greater, or $2.1 million!
Not too shabby, you might think. Clearly, maximizing his contributions would make a big difference. But would it be enough to support his current lifestyle in retirement?
Probably not. We estimate that if Robert retires at 65, he will be able to spend only $61,300 a year in inflation-adjusted dollars from his 401(k) without running the risk of depleting his account if markets are hostile, as the Display shows. (In typical or great markets, he would still have significant assets after 30 years.) But Robert’s final inflation-adjusted salary would be $190,000, so his retirement account would replace only 32% of his final salary. That wouldn’t come close to supporting the same lifestyle in retirement, even with Social Security.
Using a Roth to Improve the Odds
Robert asked what else he could do. His advisor suggested taking advantage of his employer’s Roth 401(k) option. The maximum contribution for a traditional 401(k) and a Roth 401(k) is the same, but the tax treatment of the two is different.
With the traditional 401(k), Robert would contribute pretax dollars, and the growth of the portfolio wouldn’t be taxed. When he retires, however, his withdrawals will be taxed at ordinary-income-tax rates. With the Roth, Robert would contribute after-tax dollars but pay no tax on portfolio growth or withdrawals.
If his tax rate doesn’t change, the tax treatment shouldn’t make a difference. However, an after-tax contribution of $18,000 is, in effect, much larger than a pretax contribution of the same amount.
If Robert maximizes his contributions, the Roth 401(k) will support sustainable retirement spending of $77,000 a year, inflation-adjusted—a hefty 26% more than the traditional 401(k).
The downside is that contributing $18,000 after taxes is equivalent to contributing $25,000 before taxes, for someone in Robert’s tax bracket. That’s a lot to save from $100,000 in annual salary. (For someone in the top tax bracket, $18,000 after taxes is equivalent to $30,000 pretax.)
If Robert isn’t willing to save that much, he could contribute somewhat less than the maximum to the Roth 401(k) account and monitor how his account balance grows. He could increase his contribution rate later, if markets are poor. If they are very poor, he could defer retirement until age 70.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.