I remember the day when I accepted my first real job as an optometrist. There was a lot of excitement because I would finally be making some real money. Also, I was kind of excited about having the ability to contribute to a 401k account. I know, not the most traditional thing to get excited about when getting a new job, but a few months before is when I started reading personal finance books which all extolled the wonders of the 401k. I read that it was the best retirement account around and had great tax advantages as well. I had to wait 3 months on the job before being able to start contributing, so I used that time to read up on 401k’s and investing in general.
My all time favorite book on investing is The Bogleheads’ Guide to Investing, which expounds upon the investing ideas of John Bogle, the founder of Vanguard. Vanguard heavily emphasizes the importance of low investment fees and simple asset allocation. Meaning you shouldn’t pay a lot to invest your money and you shouldn’t have to think about it too often either. I’m naturally a conservative person, so this mode of thinking is right up my alley. I thoroughly enjoyed this book and took its values to heart. After reading other great investment books like A Random Walk Down Wall Street and heeding the words of investment gurus such as Warren Buffett, I was comfortable with the ideas of simple asset allocation, low investment fees and buy and hold investing being the core of my investing strategy.
The 3 months were finally up, and I was able to create my account, look at the investment choices and start contributing! After reading about something theoretically for a few months, you can’t wait to apply it no matter how mundane it might be. After logging in I found out that our 401k plan had 33 investment choices. Not too many but enough for some variety I suppose. I looked at the 5 year returns of the various mutual funds and didn’t find anything great. In fact, a lot of them had negative returns. Why do most of these investments suck? No matter I thought, as I already know from my research that past performance does not dictate future results. It was only a couple of years back where we had the financial crisis so that was understandable as well.
Next, I checked what is arguably the most important aspect of keeping more of your own money when investing. And that is fees! I specifically checked the expense ratios of all the available funds. I was surprised (once again) to see that the expense ratios were higher than I would have expected. The lowest expense ratio was .5%, not bad but not near the Vanguard levels of .1-.3 I was accustomed to seeing. Many of the funds had expense ratios above 1%, which is much higher than the Vanguard average (though it seems like every fund’s expense ratio is higher than the Vanguard average.)
On top of all that, there wasn’t a very wide variety of funds to choose from. I learned all about large cap, mid cap, small cap, bonds, income etc. The vast majority of the mutual funds were invested in domestic large cap funds with only a couple of bond funds. The rest were target date funds with pretty high expense ratios. Nothing seemed to be matching up to my idea of the perfect retirement account.
I eventually realized it’s not really worth it to stress about those factors I couldn’t control. The firm that runs our company’s 401k was not one of my choosing and either were the investment options it contained. This was all decided by my company’s HR department years ago and unfortunately there was not much I could do to change things. This is the account my company offered and I had to make the best of it. I had to focus on what I could control and simply forget about what I could not. There are two main variables I could control which are also two of the most important variables for retirement success: contribution amount and investment fees.
I believe the best thing you can do with your retirement accounts is actually contribute to them. I have talked with people who have 401k accounts available to them yet don’t contribute because of lack of knowledge on the subject or because they don’t want to take home a little less money. The fact is, saving early and saving often is the most important factor contributing to a healthy retirement account. Sure, investment returns are important, but the theme of this post are things you CAN control, and investment returns aren’t one of them. Also, deciding to contribute 5% of your income doesn’t mean you take home 5% less money. That 5% contribution is tax deferred, meaning you won’t pay taxes on it until you withdraw it decades from now. What that means is if you decide to contribute $100 and you get taxed 30%, you’re actually only reducing your take home pay by $70 not $100, because that’s how much you would have gotten anyway after taxes. Ideally, but in now way is this guaranteed, you will likely be paying less taxes when you retire so that tax bite shouldn’t be too bad.
Another factor that can guide your contribution amount is whether your company gives a matching contribution. A “401k match” simply means your company will contribute to your retirement account up to a certain threshold, which is decided by the company. A typical employee match is a 100% match up to a 3% contribution rate. This means if a 3% contribution for you equals $1000, your company will contribute $1000 to your account as well. This sounds like free money. That’s because it is. This is a great way to optimize your 401k contribution, as no other retirement accounts will give you extra money just for contributing. If you can’t decide how much to contribute, contributing up to the match amount is a GREAT start.
The next most important thing you can control is the fees your investments charge. All mutual funds are now required to clearly reveal their investment fees, so there is no excuse not to pay attention. Now, while you can’t control what fees the investments charge, you can simply pick the investments with the lowest fees. Lower fees mean no matter what your investment returns are, a lower percentage will be eaten up by the mutual fund company. This may not be too big of a deal early on, but if you have a $50,000 account balance with a mutual fund that charges 1% for yearly maintenance, that’s $500 you lose. A .5% charge means you lose $250. And it gets more glaring the higher your balances get. Fees matter, and choosing the investment options with the lowest fees is almost always a great move.
You’re not guaranteed to make money with a 401k. In fact, you can lose money if you’re not careful. Contributing an appropriate amount and keeping your fees low will not assure huge gains, but they certainly will help. My parting advice is that even if your 401k is not the greatest, contributing up to the employer match amount and choosing low cost funds will be the best thing you ever did. If you have some money left over you still want to invest, that is wonderful. You can use it to invest with Vanguard and their awesome mutual funds with .1% expense ratios I read all about. Which is exactly what I did.