Early retirement is fantastic. There’s only one problem. Most early retirees no longer contribute to their 401Ks unless they start a business. Not only that, early retirees lose employer 401K match and profit sharing. I just took a look at my final year’s employer 401K profit sharing plus match and it came out to $27,000. There’s much more to your job than just your salary!
My 401K makes up a minority portion of my stock exposure as I’ve been aggressively investing through structured notes and after-tax accounts. Furthermore, I’ve been receiving more deferred company stock than desired. Although $400,000 is not a lot to retire on, it’s the best I could do after maxing out for 13 years after college. It should serve well for illustrative purposes to see how a portfolio can grow under different assumptions.
With the way the government loves to spend our money, I wouldn’t be surprised if the retirement age for distribution without penalty increases beyond 59.5 or the government imposes a “distribution tax” to take more of our money. That said, we can hope for the best by reducing our mutual fund expenses and creating different scenarios to better prepare for our future.
The best way to increasing our odds for retirement success is to run various investment scenarios. I will run three investment scenarios (Conservative, Realistic, Blue Sky) using the free 401K investment analyzer by Personal Capital. Regardless of whether you are retired or not, I encourage everybody to perform at least these three scenarios and write down some notes. Early retirees need to be extra diligent given we are more dependent on our investments to survive. If you have years to go before retirement, I suggest you pretend you are retired now so you can develop a fire to be all over your money!
CONSERVATIVE 401K PORTFOLIO SCENARIO
General Instructions: It looks like plenty of you have signed up already so this will be a good tutorial. For those who haven’t, once you have signed up for Personal Capital and linked your 401K, go to the “Investing” tab on the top right and then choose “401k Fee Analyzer.” This is the page where we plan to do all the analysis to get an idea of how different assumptions make big differences.
Base Assumption: The 401K alone is not enough to provide for a comfortable retirement. A 401K needs to be coupled with Social Security and other after tax investments to give ourselves a chance for financial security. We will use my 401K balance at the end of 2016 as an example. After reading this post you should input your own. I assume no contributions and no employer match or profit sharing forever. Portfolio growth assumption is 4% per year with 0% additional fees. 4% annual growth is conservative given the average return for the S&P500 since the 1950’s until now is roughly 7%. The 2009-2010 economic downturn helped bring the average down.
The Good: Despite not contributing anything to the 401K, even a conservative assumption of 4% allows the 401K to grow by $754,920 to $1,160,000 by the time I’m 65. $1,160,000 is OK if I were to live abroad or in cheaper US locations, but it won’t go far in San Francisco or New York City.
The Bad: In 30 years, things will be much more expensive thanks to inflation. Honda Civics that now cost $20,000 will probably cost closer to $40,000. I expect all prices to at least double in 30 years if inflation runs at 2.3% a year using the rule of 72. Hence, the buying power of $1,160,000 is more like $580,000 in today’s dollars after fees. Let’s subtract another 20% income tax on $580,000 (spreading the distribution out), and I’m left with only $464,000. The figure is kind of depressing after starting off with $1,160,000.
Conclusion: Once you’ve built a decent sized nut, investment performance is the #1 criteria for portfolio growth and not contributions. The key is to build that nut. With ~$464,000 in buying power after taxes, fees and inflation, I could probably only live comfortably for 5-8 years in retirement before the money runs out. As a result, I need to rely on the government’s good graces, which is always a crap shoot. By now, I hope alarm bells are ringing in your head as to why it’s so important to max out your 401K and IRA.
REALISTIC 401K PORTFOLIO SCENARIO
Portfolio Assumptions: I assume $10,000 total annual 401K contributions (includes employer match) and a 1% higher 5% per annum investment return for 30 years. In my case, the contributions come from a self-employed 401k plan. If you are working, contributions will just come from your paycheck and employer.
The Good: By just contributing $10,000 a year and performing 1% better, the total gross 401K figure after 30 years grows by $1,551,642 to $2,429,266, or more than double the conservative case scenario. Meanwhile, the percentage lost to fees goes from 17% down to 14% or two years of retirement lost compared to four years lost. $2.4 million should be enough for most people to live comfortably in retirement.
The Bad: I’m still paying $262,693 in fees based on my existing portfolio largely due to a Fidelity Blue Chip Growth Fund that has a 0.74% expense ratio vs. 0.35% or lower for similar Vanguard Funds. We should all run the mutual fund fee analyzer on our 401Ks and see where we can optimize.
Conclusion: A little effort goes a long way. When you combine multiple improvements to your portfolio (increased contribution, increased employer match, and 1% increase in annual growth), you end up with explosive long term results. Let’s cut the $2,429,266 in half due to inflation to account for today’s dollars. We get $1,214,633. Take 20% tax and we’re left with $971,706 in buying power. I can live comfortably for the next 11-20 years just off my 401K. Unfortunately, I plan to live longer than age 72-80, which means the 401k is still not enough or I have to cut down on my lifestyle.
BLUE SKY 401K PORTFOLIO SCENARIO
Portfolio Assumptions: Let’s contribute $17,000 a year, receive a $17,000 match/profit sharing from our employer, and earn a 7% annual return. Please note for 2013, the maximum contribution is $17,500. We aren’t Warren Buffet or Bernie Madoff, so 7% will have to do to account for large double digit returns and losses throughout the years. Remember, it’s still better to be conservative in a Blue Sky scenario because you don’t want to come up short in retirement.
The Good: We don’t have to financially worry in retirement anymore! By maxing out our 401K ($17,500 for 2013), receiving a 100% employer match, and returning a reasonable 7% a year thanks to good research and good luck, our 401K has now grown by $4,821,749 to $6,844,000. The Blue Sky scenario leads to an amount 2.5X greater than the base case scenario. Furthermore, we’ll probably earn at least $30,000 a year in Social Security. Note that you can contribute up to $51,000 in your self employed 401K up to 25% of profits.
The Bad: $647,216 in fees is an incredible amount that equates to 10% of my entire 401K balance. Think what you can do with $647,216? I’m imagining a $147,000 Range Rover 2013 Super Charger with $500,000 left over to go on 10 world cruises! Even a half percent in fees really drags down returns over time. Furthermore, we are assuming we’ll have the desire to work until age 65. I thought I was going to work until 40, but got tired and wanted to pursue my online endeavors. Things are always changing.
Conclusion: Maxing out our 401K, working for a company until 65, and doing due diligence on our investments pays off big time. A lot of folks hop around firms, resulting in a temporary stoppage of compounding and contributions since it takes a while for shares to vest. If we can stick it out with a company long enough, while diligently saving by adjusting our lifestyles accordingly, there is no doubt we will become multi-millionaires by the time we are 65.
Take half of $6,844,000 for inflation and 30% off for taxes and you still get around $2,400,000 in today’s dollars for retirement. With $2.4 million and no mortgage at 65, life is easy. We can book first class tickets to Bali and stay in a waterfront bungalow for a month. We can eat and drink until our heart’s content. We can pay for our children’s education and help the poor. The best thing is that during all our years, the markets did most of the work and we probably didn’t even notice the pre-tax savings pinch.
SMALL DIFFERENCES + CONSISTENCY MATTERS
To achieve financial security in retirement you must:
1) Take a proactive step in analyzing your portfolio. If you don’t have any idea what you are investing in, how much in fees you are paying, and how much you have, it’s hard to build wealth.
2) Run multiple scenarios based on different savings, matching, and investment returns. I only introduced three, but you can and should put in your own assumptions in the 401K Investment Analyzer section. We all have different 401K amounts, risk tolerances, and investing prowess.
3) Estimate the net present value of your retirement savings and account for taxes. Inflation is a real killer, which is why you should consider investing in real assets that inflate over time e.g. real estate.
4) Draw some conclusions after each scenario analysis. Conservative portfolio scenarios generally require extra after tax savings and/or alternative income streams to fund retirement. You don’t want to end up short in retirement so it’s best to keep your forecasts low.
5) Set realistic return goals and consider rebalancing when such goals are achieved. It’s important to have discipline during extreme market swings.
I’ll be the first to admit I love doing scenario analysis in practically everything I do e.g. comparing jobs, choosing schools, buying a car, picking a vacation, battling opponents in sports etc. Ever since I was a kid, I’ve been a dreamer. Even today, I enjoy dreaming about what I would do if I won the World Series Of Poker or the Powerball lottery. When a free tool like Personal Capital makes it so easy to test different assumptions, why not do a little dreaming?
To replicate the charts in this post with your own figures simply sign up for Personal Capital, link your portfolio(s) on the left hand side of the dashboard, and then click Investing tab on the top right to see the results. The process only takes a a minute to sign and is completely free. I recommend running your 401k and investment portfolios through the Retirement Fee Analyzer tool as well. The software found $1,700 in 401k fees I had no idea I was paying. Finally, you can easily track your net worth in one place automatically.
About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond. It’s now more important than ever to be diligent about your 401k and investments. We’ve gone through a huge recovery and there is usually a period of volatility and consolidation.