Millennial investors who can take advantage of a 401k plan in their twenties give themselves a great opportunity to retire young and wealthy.
While it’s never too late to get started saving for retirement, it’s never too early either. In fact, the earlier the better, because the biggest impact on the size of the retirement nest egg is time.
A majority of people don’t start saving for retirement until their thirties or forties; they think there’s time to “catch up” by increasing their savings and investing more aggressively. While savings rate and investment selection are primary aspects of saving for retirement, time is the most important because of the power of compounding interest.
For millennial investors fortunate enough to start saving in a 401k plan in their twenties, the combination of savings rate, investment selection and time can add up to millions saved by retirement age.
With those key aspects of retirement success in mind, here are crucial steps for any millennial managing a 401k.
The Millennial’s’ Guide to 401k Management: The Savings Rate
When completing the 401k enrollment forms, there are two primary decisions to make: The first is how much you want to save each pay period, which is called a “deferral,” and the second is how you want to invest that money.
So let’s cover that first decision: How much is an ideal amount to save in a 401k plan? There is no magic number, but the short answer is to save as much as you can afford without hurting other areas of your finances.
One key factor in deciding the savings rate, or deferral percentage, is to make sure you’re taking full advantage of any matching contributions made by your employer. A common 401k match is at a rate of 50% of the employee’s contribution up to a maximum of 6% deferral. So if you contribute 6% of your pay, your employer will contribute an amount equal to 3% of your pay, which adds up to a total of 9% compensation.
Also, keep in mind that it’s easier to adjust your deferral percentage to a lower amount than it is to adjust higher. Therefore, start as high as possible. For example, try starting at 10%, and if that’s too high you can adjust it lower.
The Millennial’s’ Guide to 401k Management: The Amount of Risk
Once you’ve decided how much to contribute to your 401k retirement fund, you’ll need to make the best investment selections for you.
You may have already heard that it is wise to invest aggressively in your early saving years and then gradually shift to a more conservative mix of investments as you get closer to retirement age. While this is generally true, the best investments for retirement also depend upon how much risk you can tolerate.
Put differently, there are two basic risk measurements for young investors to consider before choosing investments:
- Risk Capacity: This is a measure of how much risk you can afford to take. When you’re in your twenties, you can afford to take more risk, because you presumably don’t need to touch your retirement nest egg for 20, 30 or even 40 years. So when your investments decline in value during market corrections, there’s no real threat to your financial security because you don’t need your 401k or IRA savings for many years.
- Risk Tolerance: This is a measure of how much risk you are comfortable taking. So, even though it is true that younger investors can afford to take more risk, you don’t want to lose sleep at night worrying about falling stock prices and potentially jeopardize your investment objectives by selling your 401k mutual funds in a down market.
After you have assessed your risk tolerance, you can choose the best 401k investments for you. If you’re still not sure how to invest, you might try a moderate allocation of roughly two-thirds stock mutual funds and one-third bond mutual funds.
Above all, be sure to diversify your investments by allocating your 401k money to several different funds. Somewhere between three and five funds should do the trick.
The Millennial’s’ Guide to 401k Management: Time Value of Money
Time makes the biggest impact on retirement savings because of compounding interest, which is essentially interest (or dividends and gains) that go to buy more shares of investments, such as stocks and mutual funds, which will then grow and earn more interest, as the process repeats itself.
Consider this example of two different investors:
- Investor No. 1 starts contributing $5,000 per year in a 401k at age 25 and continues with the same savings rate for 10 years. She stops saving but allows her portfolio to continue growing another 30 years, to age 65. Her total savings amount is $50,000. Assuming a 7% rate of return, Investor No. 1 ends up with $585,000.
- Investor No. 2 starts saving $5,000 at age 35 and continues the same savings rate until age 65. That’s a total of $150,000 savings for him. Assuming the same 7% rate of return, Investor No. 2 ends up with about $508,000.
Therefore, thanks to the power of compound interest, Investor No. 1 ended up with a much bigger nest egg, even though she only saved for 10 years, whereas Investor No. 2 was never able to catch up, even after 30 years of saving, because he started later.
As you continue saving in your 401k plan, the basic maintenance requirements are only to periodically rebalance the portfolio and increase your 401k deferral percentage whenever you get a pay raise. Rebalancing effectively returns the mutual fund balances to their original target allocations. Once per year is sufficient frequency for rebalancing.
To summarize, there are only two real mistakes you can make with a 401k plan:
- Not contributing.
- Putting all of your money in just one fund.
So contribute as much as your finances can withstand and diversify your portfolio!
Kent Thune is a freelance writer the owner of an investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent a recommendation to buy or sell securities.