Your Assumed Rate of Return, Know the Fees in Your 401(k) & Adjusting Your Financial Planning Timeline
Let's assume your financial planning is way ahead of your friends. You have saved, invested well and paid off your debts. And while it’s easy to pick your retirement date and maybe budget what you will need for retirement income, there are a ton of additional projections you need to make that could derail your plans completely. And one of the biggest ones is the assumed average rate of return on your portfolio.
Suppose your portfolio takes a hit when the market drops 20% like it did earlier this year or maybe 40% like it did back in 2008. But you are patient, you have a few years left to your goal and you don’t panic. The following year your account rebounds and is up 40%. That’s great, you’re back to where you started, right?
Not even close.
Let's assume your portfolio started with $1 million. After the first year's 40% decline, your balance would have dropped to $600,000. The next year’s 40% jump helps some, but your 40% only gets you back to $840,000. That’s a loss of 16%.
Sadly, many financial plans paint a false picture by relying on average rates of return. Of course we want to predict nice smooth, consistent rates of return, but if recent years have taught us anything, it’s that markets are anything but smooth and consistent.
One way to think about this is to recognize that yourportfolio is most sensitive to market swings during the five years before and after your target retirement date. Your savings are peaking and as such, a market correction can be devastating. You can delay retirement and hope for the best or you can retire anyway and reduce your standard of living.
A retirement plan should be designed to withstand volatility and provide income regardless of market conditions.
SPEAKING OF A 30% LOSS: FEES MATTER
Two most-asked questions about retirement accounts are:
After I leave my employer, should I stay in the 401(k) or roll it over into an individual retirement account?
How much should I save in my 401(k)?
One huge key is how much you pay in fees. Your money in both 401(k)s and IRAs is tax-deferred, meaning you pay no tax on it until you start withdrawing your money – and as a retiree, you may be in lower tax bracket when that time comes.
Trouble is, although you save in taxes, fees can eat away at your gains. One study by research group Demos found that fees could reduce the value of your 401(k) by over 30%. And it was summarized best by a Los Angeles Times article that said: “The average American couple could pay nearly $155,000 in fees for their 401(k) plans over their careers, reducing their eventual nest eggs by more than 30%.”
Here is a stark example: without any fees, a couple has $510,000 at retirement. After fees, their total is only $355,000. The fees include charges to manage the fund and indirect expenses, such as the cost of trading its underlying securities. Not counted here are the opportunity costs, which are the lost investment returns on that $155,000.
Staying in Your Employer’s 401(k)?
So, should you leave your money in your employer’s 401(k) plan? If your previous employer pays the fees or has a low-fee plan with good investment options, then it may make sense to leave it in the plan. Alternatively, when changing employers, rolling your 401(k) into your new employer plan is another option to consider. But if your employer is like many companies, where management does not understand the fees that 401(k) providers charge, then it may be a better idea to roll it over into an IRA that has low fees.
How much should you save in a 401(k)? The answer has two parts.
First, if your company provides a match to what you put in, you should contribute up to the match. After that point, it may not be in your best interest to put any more money into your plan.
While deferring taxes may sound good, it comes at a price. The fees discussed earlier should be a major concern. Tax deferral is not worth losing 30% of your nest egg. Second, there are government restrictions on your money. A 401(k) is one of the most restrictive types of investment accounts an individual can own.
You have penalties if you take money out too soon and penalties if you take too little out at a certain age. Yes, you have deferred your taxes, but there is no guarantee that taxes will be lower when you retire.
YOUR FINANCIAL PLANNING TIMELINE
Recent surveys have indicated that many of us are rethinking our retirement plans because of the recent stock market pull-backs of 2022. In fact, one survey from the nonprofit group Life Happens suggests that a whopping 45% of Americans say they plan to postpone and continue working past their retirement date.
And while it’s impossible to make blanket statements or give advice that fits the masses, there are three important questions you need to ask yourself before delaying your retirement.
Ask yourself:
How is your health? Did you know that 4 out of 10 current retirees said they were forced to retire earlier than planned because of health issues? Of course you don’t know what the future holds for you in terms of your health, but an honest assessment is a great investment in you.
How is your asset allocation? More specifically, if you were expecting to retire in say 3 years, were you invested 100% in equities hoping for one or two “great” years from the stock market? Not reallocating your portfolio away from equities the closer you get to retirement is actually a pretty common mistake. But it can be devastating too.
Did you alter your financial plan because of the stock market declines in 2022? Asked another way: did you change your investments because you were scared? Trying to time the market based on fleeting emotions is a dangerous game.
Intuitively, working in your retirement years and saving more will add to your retirement nest egg because you’ll be adding money versus withdrawing.
But, if your asset allocation remains inconsistent with your goals and risk profile, then you’re setting yourself up for disappointment.
SOCIAL SECURITY SHOULD ALSO BE PART OF YOUR FINANCIAL PLANNING
Planning is the key to creating your best retirement. You need to plan, save, invest, and plan some more. And despite the naysayers suggesting that Social Security will be bankrupt, make sure you plan for it (or not). Did you know that as of 2022 on average, retirement beneficiaries receive 40% of their pre-retirement income from Social Security? And do you really know how Social Security works? You know about the Social Security Credits?
From ssa.gov:
Social Security Credits
“You must earn at least 40 Social Security credits to qualify for Social Security benefits. You earn credits when you work and pay Social Security taxes.
The number of credits does not affect the amount of benefits you receive. We use the amount of credits you’ve earned to determine your eligibility for retirement or disability benefits, as well as your family’s eligibility for survivors benefits when you die.
We cannot pay benefits to you if you don’t have enough credits.
How Credits Are Earned
Since 1978, you earn up to a maximum of four credits per year. Credits are based on your total wages and self-employment income for the year. You might work all year to earn four credits, or you might earn enough for all four in much less time.
The amount of earnings it takes to earn a credit may change each year. In 2022, you earn one Social Security or Medicare credit for every $1,510 in covered earnings each year. You must earn $6,040 to get the maximum four credits for the year.
During your lifetime, you might earn more credits than the minimum number you need to be eligible for benefits. These extra credits do not increase your benefit amount. The average of your earnings over your working years, not the total number of credits you earn, determines how much your monthly payment will be when you receive benefits.”
Planning for Social Security
Of course, the amount of the Social Security benefits you or your family receives depends on the amount of earnings shown on your record, so it’s important to periodically check your Social Security earnings history to make sure it’s accurate. This will help you plan your retirement benefits so that there are no surprises.
YOUR FINANCIAL PROFESSIONAL
Complicated problems require professional advice.
Find a financial professional who knows how to deal with these types of issues.
Find a financial professional who models a reasonable assumed rate of average return.
Find a financial professional who understands how much fees can eat into your nest egg.
Find a financial professional who understands the benefit of time on your portfolio. Then make a decision about how to plan for your goals.
Important Disclosures
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
Asset allocation does not ensure a profit or protect against a loss.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by FMeX.
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