It doesn’t take an advanced degree in finance to know that the more money you put into your retirement account, the more you’ll have to spend later. But when it comes to contributing to that retirement fund, how much should you be putting away annually? According to a recent study, the difference a few percentage points can make over time, is dramatic.
A study by the Putnam Institute, "Defined Contribution Plans: Missing the Forest for the Trees?" contends that while a number of variables, such as fund selection, asset allocation, portfolio rebalancing, and deferral rates all contribute to the effectiveness of a defined contribution plan( aka 401k/403b plans), the one variable that had the biggest impact was the deferral rate. In other words, the rate and amount of contribution to an individual’s plan was the most significant factor in boosting retirement saving success.1
As part of its analysis, the research team created a hypothetical scenario in which an individual's contribution rate increased from 3% of income to 4%, 6%, and 8%. After 29 years, the final balance jumped from $138,000, to $181,000, $272,000, and $334,000, respectively.
Even with a just a 1% increase from a 3% to a 4% deferral rate – an individual’s final accumulation balance would have been 30% greater than it would have been using a fund selection strategy defined as the "Crystal Ball" strategy, in which the plan sponsor (i.e., employer) uses a predefined formula to predict which funds may potentially perform well for the next three-year period. Furthermore, the 1% boost in income deferral would have had a wealth accumulation effect nearly 100% larger than selecting agrowth asset allocation strategy, and 2,000% greater than rebalancing. Of course, these results are hypothetical and past performance does not guarantee future results.
So, the bottom line is: increasing your deferral rate could be the best and easiest way to grow your retirement assets. But, this is just one component of your “Retirement Planning Map”. There are many other issues to consider such as: Where and when do you plan to retire? How much income will you need? Have you identified all of your retirement income sources? Does your plan take into account the possibility of increased longevity? We’ll expand on those topics in future articles. In the meantime, remember that by contributing more, you stand a better chance of achieving success in your overall retirement planning process. At the very least, contribute enough to receive the full amount of any employer's matching contribution. It's also a good idea to increase contributions annually, such as after a pay raise or a bonus.
Retirement will likely be one of the biggest expenses in your life, so make it a priority to calculate your savings goal at least once a year. Reviewing these points at least annually and/or when there has been a financial or life changing event will help you to stay on top of your planning process.
1Putnam Institute, Defined Contribution Plans: Missing the Forest for the Trees? May 2014.
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