Every so often here, there's a diary discussing how terrible the 401(k) is. These diaries inevitably bring up some good points, such as how the average worker is underpaid (true) and financially illiterate (also true) that don't really have much to do with the suitability of the 401(k) as an investment tool. Unfortunately, they may discourage people from saving the money they need to be able to retire. Let's take a look at what the 401(k) can do for you, and how you can use it effectively.
For this diary, I will assume the following:
1) You have a steady job
2) Your employer offers a 401(k)
3) You can afford to put away a few bucks each month (even if it's only $50).
If #2 doesn't apply to you but the other two qualifiers do, most of what I'm going to say also applies to IRAs. An IRA is very similar to a 401(k), but is not tied to employment (you set it up yourself) and has much lower contribution limits. Many people choose to roll their 401(k) into an IRA after leaving a company.
What is a 401(k)?
A 401(k) is named for the section of the tax code that defines it. This is a retirement account, set up by your employer, that allows you to save money for retirement in tax-efficient manner. In a traditional 401(k), money is invested pre-tax, grows tax-deferred, and then is taxed as ordinary income when you withdraw it; think if it as getting an interest-free loan from Uncle Sam. In a Roth 401(k), you invest with after-tax dollars (just as if you had opened your own taxable investment account) but all earnings are tax-free. In both cases, there are penalties if you withdraw money before reaching retirement age (with some exceptions). You're allowed to have both types of accounts, and can contribute a maximum of $18,000 per year total across all of your 401(k) accounts (this is a $500 increase from 2014). If you will be 50 or older by the end of the year and are maxing out your contribution limit, you may also make an additional $6000 "catch-up" contribution.
Many employers who offer 401(k) accounts also offer a 50% or 100% match on your contributions, up to some limit; for example, the employer might contribute an extra 3% of your salary if you put in 6%. If you have a Roth account, the employer contribution must still go into a traditional account (which is one reason why you might have both). One advantage of the Roth is for people fortunate enough to be able to max out their account - $18k in after-tax dollars is quite a bit more than $18k in pretax dollars!
One common misconception about the 401(k) is that they always come with limited choices and high fees. This is something that depends on your employer, who is responsible for selecting the plan options; a good 401(k) will let you invest in low-cost index funds, as we'll discuss below.
One thing that a 401(k) is NOT is any kind of guarantee. Can I promise you that if you use one, you'll be able to retire? No. Can I promise you that you won't lose money? No. Can I honestly tell you that a 401(k) is one of your best options for saving for retirement? Absolutely.
What is the Stock Market?
Many people consider the stock market to be just one big casino, and it's hard to blame them. In the short term, the market is totally irrational. Stock prices go up and down for no particular reason. Lots of people think they can figure out how to beat the market, and almost all of them are wrong.
So why would you even consider putting any money into stocks? The thing to realize is that when you buy a stock, you're not just betting that you'll be able to sell it to someone else for more than you paid; you're actually acquiring part of a company. If I buy stock in Costco, I am now a partial owner of Costco. This is a tangible asset, with a real value. People might not agree on what the real value of the company is, and as a result the stock price could jump all over the place, but the company itself - which I now own part of - retains its real value. As Costco continues to make money, we expect both the real value of the company and the average value of its stock to continue to grow; even if people decide they don't like Costco stock anymore, the only way it can become worthless is if the company itself fails. If Costco makes more money than they need to expand, then they may opt to pay out a dividend - returning that money to shareholders. Even if nobody else wanted to buy Costco stock ever again and I kept that share for the rest of my life, any dividends they pay out is money back in my pocket (or in this case, back in my 401(k)).
Diversification
But what if Costco itself fails? If all my money is invested in Costco stock, I could lose everything. That's why I need to be invested in many different companies. Some will lose value or even go bankrupt, but others will increase in value; if I choose reasonably well, I will make money. Unfortunately, most people won't choose reasonably well; additionally, it costs money to buy and sell stocks, so buying too many is a quick way to spend down your portfolio.
Thus, we have mutual funds: instead of buying individual stocks, you purchase a mutual fund, which holds many stocks for you. This lets you avoid the stock purchase fee and also avoid having to figure out which stocks to buy. Unfortunately, mutual funds have two problems that are very similar to the ones you had as an individual stock purchaser: many of them charge high fees to manage your money for you (and even worse, while the cost to buy stocks is generally a flat charge - say $8 for any size purchase - a mutual fund charges a percentage of your account balance each year), and most mutual fund managers aren't all that good at picking stocks either! In fact, due to the nature of a mutual fund (needing to show activity to justify the fees and often having more money than can be easily invested in a good opportunity), a mutual fund manager may very well do quite a bit worse than an informed investor.
Eventually somebody noticed that while the market as a whole (which, remember, reflects the overall profitability of businesses in the US (and the world, but we'll ignore international stocks for now)) tends to do quite well over time, almost all investors do considerably worse than the market. So the question was: why not just buy the market? This is what an index fund does: it holds either the entire stock market or a well-defined subset of it (such as the S&P 500). Fees are minimal (Vanguard's Total Stock Market fund, for example, charges 0.05%), because there's no need to research which stocks to buy; the fund just buys everything. This fund will never beat the market, because it IS the market; instead, it guarantees that you get the same return that the market does.
Assessing Risk
Of course, you don't necessarily have to invest in the stock market. Aside from several dozen mutual funds selected by my employer, my 401(k) offers a brokerage account, which lets me purchase any mutual fund, stock, or bond (including government bonds) I desire. Opening one requires clicking a button on Fidelity's website confirming that you really, really want to do this - unlike the funds that your employer (at least theoretically) selects to be reasonably low risk, the brokerage account has no such safeguards. If you screw up and put all your retirement savings into a stock that then tanks, it's your own fault.
So if you can put your 401(k) money into safe government bonds, why would you ever risk investing in stocks? You can even buy government bonds for free (that is, with no commission)! Let's take a brief detour into the nature of risk.
When saving for retirement, there are two types of risk:
1) The risk of losing money
2) The risk of not having enough money to retire
Risk #1 is much more immediate. If you invest in the stock market for the long term, there will days, weeks, months, and even years in which you will lose money. Read that again - you WILL lose money. In the course of 1 1/2 years - 10/9/07 through 3/9/09 - the stock market lost over HALF of its value. As in every crash, many people panicked and withdrew their money (either fearing future declines or to replace income after a job loss), thus locking in the loss of years or even decades of saving. For those people, this was a disaster from which they will never recover. If your response to a crash would be to withdraw your money, then you should not invest in the stock market.
But what if you left your money alone? Let's say you had $100,000 in your account at the start of the decline and neither added nor removed money after that. By the time the market bottomed out, you were down to $45,100. As of the time of writing this article, less than six years later, your account would have recovered to $163,181 - a return of 63% over less than a decade, including the Great Recession. (Technically, a little less as this neglects the impact of fees, which will cost us several hundred dollars per year)
On the other hand, let's say we don't care for that risk, so we'll put all our money in US government bonds. Ted Cruz aside, this is pretty safe; if we ever reach the point where the US government actually defaults on its debt, we'll have bigger problems than worrying about our 401(k) balances. Over the last few years, interest rates on government bonds have been extremely low; so low, in fact, that after adjusting for inflation you're actually paying the government to hold your money for you! But before the crash, rates were a bit higher. So let's say that in October 2007, we take our entire $100,000 and put it into 30-year government I bonds. A year later, we're looking pretty good - while our friends in the stock market have lost half their money, we're up over $5k! Fast forward to now, however, and things aren't looking that great - while the index fund has more than tripled from its 2010 low, our savings bond has improved to only $130k - approximately $30k less than the amount in the index fund account.
Dollar-Cost Averaging
But let's take a step back - if people were selling off their stocks during the crash, somebody must have been buying them! Two groups of people will buy during a crash:
1) Experienced investors who have cash available and see a crash as a giant flashing SALE sign at their favorite store.
2) Anybody using dollar cost-averaging.
Dollar-cost averaging (DCA) is a fancy way of saying that instead of trying to figure out the best time to enter the market (you won't), you just invest the same amount of money every month. A 401(k) makes this easy, because when you sign up you just select the amount or percentage that you want to have deducted from your paycheck and that much automatically goes into your account. What the averaging bit means is that, because you're spending the same amount every month, you will automatically buy more shares of stock when prices are low and fewer shares when prices are high; as a result, your average price per share will be closer to the low end. If that sounds confusing, think of it like this: if you drive 50 miles at 10 mph and 50 miles at 50 mph, your average speed over that 100 miles will be less than 17 mph. This means that market crashes are a great thing for you if you are in a position where you can continue to invest money and are several years away from needing to withdraw any, as it gives you the opportunity to buy more shares at a discount.
What If I Need My Money?
Two somewhat contradictory criticisms of the 401(k) are that it allows you to take money out, and that you get hit with penalties if you do so (in most cases) before retirement age, defined as 59 1/2. While there are hardship provisions that allow you to withdraw money early without a penalty, doing so is almost always a bad idea as that money is no longer able to grow for your retirement.
So What Should You Buy?
First off, if anyone (online or off) gives you a hot tip on a stock that will absolutely go way up in value next month - run in the other direction. In the short term, nobody knows what the market is going to do, and very few people have an accurate idea of what a given stock is going to do.
That said, given a long investment horizon (that is, assuming you're able to park your money for a few decades and NOT TOUCH IT), it's hard to go wrong with a combination of an index fund and a few government bonds. One thing to watch out for is that this assumes you're doing monthly investments, as described above; I wouldn't just move a big chunk of change into stocks right now, because if we're near a peak (which I suspect we very well may be), moving a lot of money into stocks right before a decline is likely to be quite upsetting!
Summary/Conclusion
1) A 401(k) is just one means of investment, and can be used to hold stocks, bonds, and mutual funds in a tax-advantaged way. Aside from saving you money, this allows you to invest more efficiently because you don't have to worry about generating short-term capital gains.
2) Your investments have the potential to lose value, particularly in the short term. If you're going to need your money in the next 5 years, it should not be in stocks. Social Security is a guarantee (at least until Paul Ryan gets his hands on it) to keep you from starving; an investment account, done properly, gives you a very good chance of having a decent retirement, but there are no guarantees.
3) There are lots of very smart people trying to beat the market. Odds are, you're not smarter or better informed than them, so don't try. Settle for the same return as the market.
So how much money DO you need to put away for retirement, and is it still worthwhile if you can only save a few bucks per month? And just how much IS the average market return, anyway? Check back for part II...