What Matters Most

Eight Options
I'm looking at a spreadsheet sent to me by Tom Kmak, who runs a company called Fiduciary Benchmarks that serves 401(k) plan sponsors. The spreadsheet gives the case of a hypothetical 42-year-old employee who makes $40,000 per year, is growing her salary at 3% annually, has no current 401(k) balance, and has started to contribute 6% annually with a 50% employee match. Her company's 401(k) plan carries funds with an average annual expense ratio of 0.72%. (There are no additional plan costs). Those funds will gain 7% per year before expenses. She will retire at age 67.

What would help her the most?

1)      Early start: Find a time machine, go back four years, and start her plan at age 38

2)      Higher salary: Get an immediate 25% raise, to $50,000 in annual salary

3)      Salary growth: Increase her salary by 4% annually rather than 3%

4)      Contribution rate: Invest 8% annually instead of 6%

5)      Company match: Receive a 75% company match instead of 50%

6)      Cheaper plan: Switch to Vanguard and pay 0.22% in fund fees rather than 0.72%

7)      Better funds: Own funds that gain 8% per year before expenses*

8)      Retire later: Wait two more years and retire at age 69, not 67

*  Easier said than done, but we'll assume that Jessica can pull this off.

Jessica fully controls three of the eight items--the first (choosing when to start investing), fourth, and eighth. She partially controls the seventh option, as she might be able to improve her investment results by researching funds and taking a more aggressive investment approach. Her company is in charge of the remaining four options.

This exercise, therefore, is not specifically about what Jessica can do to improve her situation. Rather, it concerns the broader subject of what can be done by all relevant parties: participants, companies, plan sponsors, and providers. The United States, we are told, faces a retirement crisis, with 401(k) plans being a big part of the problem. All right, fine. Let's see how to get better 401(k) results.

All eight steps would be in the right direction. Which, however, would take our hypothetical Jessica the furthest?

Not an easy question. Two things should be clear to Jessica if she thinks through the issue. One, raising the contribution rate by 2 percentage points will lead to a larger balance than the 1.5 percentage points gained if the company raises its match rate to 75% from 50% (particularly as the effective gain from her higher contribution rate is 3 percentage points, as the existing company match chips in a percentage point of its own). Thus, option number 4 outranks number 5. Similarly, gaining an extra percentage point per year by owning more-aggressive funds beats saving half a percentage point by having a cheaper plan. Thus, number 7 outranks number 6.

After that, the predictions get tricky. I have a sense that investing for a longer time will help the most, so that the first and last options, those of starting earlier or retiring later, will finish near the top. But only a sense, and no intuition really about the remaining options.   

Let's see. The spreadsheet's baseline amount is $1,086, which represents the expected monthly income that will be generated from Jessica's 401(k) plan at the time of her retirement, under her current plan. This $1,086 figure is nominal as opposed to real, but that distinction is unimportant for the purpose of this exercise. The same holds true for the rate of annuitization. We don't need correct predictions from the spreadsheet. We merely need consistent, reasonable assumptions so that we can compare the size of the benefit of each option.

Here are the results, accompanied by the order that I predicted, and by the expected percentage increase of Jessica's final balance (and thus her monthly annuity):

Good news! The three most important items, at least as this exercise was constructed, are all under Jessica's control. She could have invested earlier, she can retire later*, and she can save more.

* Again, please suspend your disbelief. I think it unlikely that corporate America will willingly take on legions of workers, at their peak salaries, as they extend their retirement ages. However, this is often proposed as a solution for retirement funding, so we'll treat this approach as feasible.

Of course, she doesn't particularly wish to do those things. Jessica likes the remaining five options much better than the first three. She would be delighted if the company paid her more, gave her larger raises, and boosted its match rate. She would also enjoy the painless benefit that comes from owning funds that perform better, and she'd like the company to lower the plan's costs.

For their part, financial-services companies don't control what plan sponsors do, so they're not much interested in Jessica's salary, wage growth, or company match. They do, however, care very deeply about investment performance, so they're keenly interested in offering funds that have higher returns than the next company and in convincing 401(k) participants that they are receiving top-of-the-line performance. They also care about costs and are delighted to talk about the advantage of costs if it is a competitive advantage.

The intersection of interests between the participant and financial-services companies, therefore, occurs with two of the eight options: owning better funds and having lower plan costs. Not surprisingly, those are also the topics that receive the most ink in articles about 401(k) plans. Revisit, for example, Helaine Olen's piece in Salon.

On plan expenses--that 7% figure in the table looks awfully low, doesn't it? There are four reasons that costs didn't appear to be relatively important in this exercise. First, this plan, presumably offered by a large company, doesn't have particularly high expenses. A small-company plan might benefit from a steeper cut. Second, this participant started saving at a relatively late age. Had she started when younger, with more of her assets working for a longer time, costs would have played a larger part. Third, the spreadsheet ends at the age of retirement (with the assumed annuitization), rather than extending into retirement. That also reduces the time span of the analysis. Fourth, Jessica continues to grow her salary late into her career, which means that she's putting a relatively large amount of money into the plan as she approaches retirement. This shrinks the time horizon for the effect of compounding. 

All that said, the spreadsheet's result does touch on an important aspect of 401(k) investing--the inflows come throughout the employee's career. The typical illustration on the power of costs, such as in Olen's article, implicitly measures the effect of costs on an employee's early investment. The illustrations don't show the effects for three years or seven years or even 15 years, when the effects are less dramatic. But those are 401(k) assets, too. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.