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Six Simple Ways to Retire Rich
By Mary Beth Franklin
Retirement savings plans are undergoing an extreme makeover. After decades of trying to teach Americans how to save and invest for their own retirement -- with mixed success -- employers have come up with a simple solution: They'll do it for you.
Thanks to automatic enrollment in 401(k)s and other retirement plans, plus streamlined investment options, saving is so effortless that you can't help but succeed. And that's true whether you're starting your career, switching jobs or planning your exit.
To help their employees compensate for disappearing pensions and declining Social Security benefits, more than one-third of large companies have already embraced the new reality of retirement saving: the automatic 401(k). That's up from just 19% in 2005.
More than half of all employers expect to offer automatic enrollment this year. The trend also applies to 403(b) retirement plans for teachers and employees of nonprofit organizations, as well as to the 457 plans that many state and local governments use. "Now you'll succeed at saving for retirement even if you don't do anything," says Jeff Maggioncalda, president of Financial Engines, a pioneer in providing investment advice to workers.
The most effective new plans pair automatic enrollment with an option to increase the amount you contribute to your account each year. When Nationwide Insurance added an automatic-escalation feature to its 401(k) plan last spring, employees Sean and Lisa Kennedy signed up, promising to boost their contributions by one percentage point each year until they reach the maximum contribution level.
"We can tie it to our annual salary increases," says Sean, 38. "We'll never see the extra money in our take-home pay, so we won't miss it."
Aside from adding to their already substantial nest egg, the Kennedys will also be able to cut their taxes -- a more immediate concern, says Lisa, 31. She and Sean, who live in Columbus, Ohio, contributed more than $25,000 to their retirement accounts in 2007, saving them more than $7,500 in taxes, assuming a combined state and federal rate of 30%.
The third piece of the automatic 401(k) model is built-in professional investment advice, whether in the form of target-date retirement funds, computer-generated model portfolios or managed accounts. Together, the changes amount to a total overhaul of 401(k) plans. "It reverses our assumptions about what individuals are willing and able to do," says Maggioncalda. "It makes inertia work in their favor."
1. Sign Up
Although auto 401(k) plans are a major step forward, they have a downside. Pamela Hess, director of research for consulting firm Hewitt Associates, worries that some employees may be lulled into complacency, accepting default contribution levels as implicit savings guidelines when they can and should be saving more. Most employers set the initial deferral rate at 3% of salary, and many plans with automatic-escalation features top out at 6% of pay. That's well below the 15% of gross income (including employer matching contributions) generally recommended as a target for retirement savings.
The Kennedys, who are approaching that recommended 15% target, are well on their way to a secure retirement, even if their plans to start a family may force them to scale back future contributions. An early start on saving, coupled with the power of compounding, will work its magic over time. But if you're a late bloomer, don't despair. By starting now and increasing your contributions a little each year, you could still reach your goal.
2. Get Help From The Pros
Still, even a weak stock market can be good news for investors in the long run, says Finra chief executive officer Mary Schapiro. Buying shares of mutual funds when prices are low positions you for big gains when the market rebounds. And most employees benefit from matching contributions from their employer -- often 50 cents on the dollar up to the first 5% or 6% of pay. A guaranteed 50% return on your investment is better than any fund can promise. With regular contributions, most newly enrolled workers will see their account balances grow, even in a down market.
Although automatic 401(k) features tend to target new hires and younger employees, you may benefit even if you are already enrolled in your company plan. Many employers now offer all workers access to personalized financial advice or all-in-one investment solutions, such as professionally managed accounts or target-date funds that invest in a diversified mix of stocks and bonds that grow more conservative as you near retirement.
A recent study by John Hancock compared the account balances of 401(k) participants who invested in funds with those of employees who selected their own investments from 2002 through 2006. Researchers found that after five years, 81% of workers who picked their own investments would have accumulated higher balances -- about two percentage points more, on average -- if they had invested in a single life-cycle fund instead.
Broad-based enrollment in a company's retirement plan also benefits high-income employees (those who earn $105,000 or more), who are sometimes prevented from contributing the maximum amount to their 401(k) plan because too few lower-income workers participate. When auto enrollment is extended to existing workers who are not already in the company plan, participation rates can jump to as high as 95% of those eligible, according to the Retirement Made Simpler study, compared with an average 78% of eligible workers who currently participate in 401(k) plans.
3. Check Your Progress
Frazier and his wife, Ann, gathered all of their financial documents -- including life-insurance policies, Social Security statements and IRA information -- and met with a Principal adviser to review their entire financial picture. "I was a little nervous," says Frazier. "I was afraid they might say I could never afford to retire." Instead, the adviser told him that he was on track to quit at 62 and encouraged him to bump up his 401(k) contributions from 7% to 10% of his salary just to be safe.
At 51, Frazier is eligible to add an extra $5,000 in catch-up contributions to his 401(k) this year, for a total of $20,500. With two kids in college, however, cash is tight. "I can't contribute the maximum now, but once the kids are out of school, I may try to save more -- probably in a Roth IRA."
4. Consider a Roth
Roth 401(k)s, however, have no income-eligibility limits. And now that Congress has made these plans permanent, more employers are starting to offer them. Fewer than one-fourth of employers surveyed by the Profit Sharing/401(k) Council of America offered Roth 401(k)s in 2007. But among the companies that didn't, more than 60% said they would consider adding a Roth 401(k) option in the future. Roth 401(k)s have the same maximum contribution limits as traditional 401(k) plans -- $15,500 in 2008, plus $5,000 in catch-up contributions for those 50 and older.
Younger workers, such as Chance Webre, are prime candidates for a Roth 401(k) because they will benefit from decades of tax-free growth. Webre, 21, a unit operator for Placid Refining, in Port Allen, La., also wants to minimize paying taxes today, so he splits his contributions between a traditional 401(k) and a Roth 401(k). (That's okay as long as your total contributions to both don't exceed annual limits.)
Together with his employer's whopping 8% matching contribution, Webre is saving an impressive 24% of his salary. "Being young and single and living at home, I can afford to stack up all this money right now," he says. "I'm planning for an early retirement at 55." Webre has a good shot at reaching his goal. If he continues to save aggressively at his current rate for just five years -- and never puts away another dime -- he would have more than $1.2 million by the time he's 55, assuming an 8% annual return.
But Roths aren't just for the young. Older workers who earn too much to qualify for a Roth IRA can still take advantage of tax-free income in retirement through a Roth 401(k). And so can retirees like Bill Griffith of Dumfries, Va., who converts a little of his traditional IRA to a Roth IRA each year. Although Griffith must pay income taxes on the amount he converts, he thinks the advantages are worth it. He'll avoid mandatory distributions after age 70 -- a requirement for traditional IRAs -- and he'll be able to leave a tax-free legacy to his heirs. Currently, your annual income must be $100,000 or less to convert to a Roth IRA, but that restriction disappears in 2010.
5. Roll It Over
The one option you'd do well to skip is to cash out your 401(k), which nearly half of all workers do, according to a 2005 study by Hewitt Associates. That's because you could lose as much as half of your account balance to taxes and penalties, as well as sacrifice all future tax-deferred growth on your savings. Let's say you have $50,000 in your account when you switch jobs. If you are in the 25% tax bracket and decide to take the money and run, you would lose $12,500 off the top. If you are younger than 55, you'd sacrifice another $5,000 in early-withdrawal penalties, leaving you with just $32,500. If you invested that money and earned an 8% annual return, you'd have about $108,000 after 20 years, after deducting for annual taxable gains. That would be less than half of the balance you would have accumulated had you left the money in a tax-deferred retirement account.
When Rob Falcone left his job as a financial analyst with PNC Bank in Philadelphia late last year, he knew he wanted to maintain the momentum of tax-deferred retirement saving. But there were so many rollover options that he had a tough time deciding what to do with his money. He liked the low-cost index funds offered by the Vanguard Group, where he already had an IRA. But he also enjoyed the suite of interactive Web tools and broad investment choices available through Fidelity.
Falcone, 51, also didn't want to give up shares in one of his favorite funds, Dodge & Cox Stock, if he rolled over his savings. The fund is available through his PNC 401(k) account, but it's closed to new retail investors. So he was relieved when he learned he didn't have to cash out of his investments to roll over his account. Instead, he could make in-kind transfers of stocks and most fund shares to a new IRA custodian. As long as you have at least $5,000 in your account, you can leave your 401(k) with your old employer, as one-third of employees do, and take your time deciding which move is best for you.
6. Sell Company Stock
Employer stock presents a unique challenge to 401(k) participants and plan providers. Many employers use their stock to match contributions, but individual stocks can be much more volatile than mutual funds and don't fit easily into recommended asset-allocation models or target-date-fund portfolios.
Thanks to the sweeping Pension Protection Act of 2006, employers must now allow workers to cash out their company stock within three years to diversify their 401(k) investments, and many employers now allow their employees to transfer out at any time. By the time Falcone left PNC last November, he had reduced the company stock in his 401(k) to 14% of his portfolio, which was more in line with the 10% to 20% asset allocation normally recommended.
In late 2007, the U.S. Department of Labor issued guidelines for appropriate default investments in company retirement plans. For employers to qualify for liability protection if their plans include company stock, the Labor Department said companies would have to offer managed accounts. Maggioncalda, of Financial Engines, a leading provider of managed accounts, calls that "an elegant solution."
It allows employers to continue to match contributions without fear of liability, and it lets employees hang on to a portion of their stock while the rest of their investments are managed around it. If an employee has a heavy concentration of a single stock, as Falcone did, Financial Engines would gradually reduce his position but limit portfolio turnover to no more than 20% a month.
If you would like to learn more about the advice contained within this article and how it could benefit you, please contact the professional who provided your subscription.
Reprinted with permission. All Contents © 2008 The Kiplinger Washington Editors
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