Regularly contributing to a 401(k) plan is one of the best ways for most people to build wealth. If you have a job that includes access to a 401(k) or a similar plan, you probably know that you shouldn’t neglect these plans.
But simply transferring cash into your 401(k) isn’t enough, as cash loses value over time due to inflation. You also need investment returns. An average rate of return of about 6% to 8% is considered good in most cases. However, your portfolio’s returns will depend in large part on how the money is invested.
To fully answer this question, we must understand what affects 401(k) returns and how you could realize the best returns based on your situation and goals.
What is a good return on a 401(k)?
A good 401(k) return is not easy to pinpoint because the investments you choose may differ from other investors’ choices. While we mentioned 6% to 8% interest rates, that is a rule of thumb. However, we do have some data that gives us an idea of typical 401(k) returns.
For example, a 2022 report from Vanguard provides some data on typical returns:
- The average 5-year return is 12.2%.
- The average 3-year return is 16.7%.
- The average 1-year return is 13.6%.
The report also includes returns on portfolios with bonds. For example, a portfolio with 60% stocks and 40% bonds has a 12.3% average 1-year return, and a portfolio with 70% stocks and 30% bonds had a 14.7% average 1-year return.
Another article from Vanguard shows that between 1926 and 2019, a portfolio consisting of 60% stocks and 40% fixed income investments such as bonds had an average annual return of 8.77%. The report shows several portfolios, and as they are weighted more heavily toward stocks, average returns improve. But so, too, do the worst years for those portfolios look increasingly bleak.
While these figures could serve as a point of reference, you might have different results. After all, past performance does not guarantee future results.
In addition, the investment options you have might vary depending on your employer. Employers usually offer a selection of mutual funds and Exchange-Traded Funds (ETFs) for their employees.
Mutual funds are investment funds with a manager who oversees the buying and selling of securities. An ETF is a basket of securities that is usually linked to a stock or bond index, such as the S&P; 500. ETFs tend to have lower expense ratios (fees).
How 401(k)s work
401(k)s are known as defined contribution plans. That is in contrast to pension plans, which are defined benefit plans. Employees make contributions to defined contribution plans, typically on a tax-deferred basis. In many cases, employers offer matching contributions, where they contribute to the plan alongside employees up to a certain percentage of the employee’s salary.
For example, your employer might offer a company match of up to 3% of your salary. That means your employer matches your contributions up to 3%, effectively doubling the amount you’re contributing. If you contribute more than 3%, it still gets added to your 401(k), but your employer wouldn’t make a matching contribution.
Money in 401(k)s can be invested, often in mutual funds and ETFs, and grow tax-free. You only owe taxes on your 401(k) investments when you take withdrawals.
In some cases, employers might offer a Roth 401(k) retirement account. The main difference between a Roth and traditional 401(k)s is the tax treatment.
Traditional 401(k) contributions are made with pre-tax funds, while Roth 401(k) contributions are made with after-tax funds. This means potentially lower taxes when you withdraw the funds in retirement. If you anticipate being in a higher tax bracket in retirement, you may want to consider contributing to a Roth 401(k) if it’s available to you because the amount of tax you pay now could be less than the amount you may pay in retirement.
Tip: 401(k)s also have a limit to how much you can contribute each year. The contribution limit for 2022 is $20,500. Those age 50 or older can make additional catch-up contributions of up to $6,500.
What affects your 401(k) return?
There are many factors that could influence your 401(k) return, so you shouldn’t necessarily be worried if your returns don’t match the figures mentioned earlier. Also mentioned earlier is the fact that different plan providers offer different investment options, and different mutual funds and ETFs may perform differently. There are a few other factors that could affect your 401(k) returns, though.
Your asset allocation heavily influences your 401(k) returns. For example, you might have noticed that investment portfolios consisting of 30% bonds and 40% bonds have different returns than the overall averages mentioned in Vanguard’s report. Specifically, the 70/30 stock/bond portfolio has a higher 1-year return than the 60/40 portfolio.
In general, portfolios with higher bond allocations tend to be less volatile, which is useful for some investors, such as those nearing retirement. However, bond-heavy portfolios also tend to have lower long-term returns.
Economic conditions and market performance also have a big influence on returns. For example, consider the S&P; 500, which is a stock index. The S&P; 500 fell sharply in March 2020, only to rise steadily until the end of 2021.
Then, the index began to fall once again, though not as sharply as in 2020. Portfolios with higher stock allocations will rise and fall more dramatically during these periods of volatility in the stock market.
Another thing to consider is fees. When we invest, fees that might seem small could have a big impact. Mutual funds, for example, could have fees of 1% or higher. These fees could cost thousands of dollars on a portfolio that is invested for 30 or 40 years.
Measuring your 401(k)’s performance
Knowing whether your 401(k) investment account is on track can be tricky because there are many variables and many benchmarks to which you might compare your portfolio. For example, if your portfolio is invested entirely in a target date fund, then comparing its performance to that of the S&P; 500 won’t be very useful.
Other comparisons make more sense. For example, VTSAX, a total stock market index fund, will tend to have performance similar to the S&P; 500. If we add bonds to our portfolio, volatility will be reduced, but long-term performance will likely be less. One way to test different scenarios is to run a portfolio backtest, which will show how portfolios with different allocations would have performed based on historical data.
We can also use Vanguard’s data from the report mentioned earlier. The report includes millions of portfolios and provides ranges of returns:
- 1-year return: 11.2% to 22.3%.
- 3-year return: 5.0% to 24.2%.
- 5-year return: 3.3% to 18.0%.
Notice the much wider variance for longer timeframes, which highlights the variation in portfolio composition. The report also shows ranges for investments such as target date funds, which have a range of 9.3% to 13.7%.
Choosing the right investments for your 401(k)
Just as gauging your portfolio’s performance can be tricky, so, too, can choosing the right investments. There are an infinite number of ways you could potentially invest your money, which could make it difficult to settle on one strategy. However, there are a few guidelines that could inform how to invest money in your 401(k).
Age minus 100 rule
Your 401(k)’s asset allocation will usually vary based on factors like your risk tolerance and how close you are to retirement (also known as your time horizon). However, the age minus 100 rule could serve as a guideline to address both of those issues at once. The rule is simple:
Your age - 100 = your portfolio’s stock allocation
For instance, if you are 30 years old, you subtract that from 100 to get 70, so you would allocate 70% of your portfolio to stocks. The remaining 30% would consist of bonds. At age 35, then, you would have 65% stocks and 35% bonds, and so on.
This rule is nice because it’s easy to follow and the math isn’t complicated. But some financial advisors have recommended changing the rule to be 110 minus age for fear of investors running out of money. After all, 35% is a relatively high bond allocation for a 35-year-old who still has a lot of earning years left. Making it 25% instead (and 75% stocks) will give their money more time to grow.
Again, this is just a rule of thumb. A higher stock allocation will generally increase your portfolio’s long-term rate of return. However, it will also increase the risk that your portfolio will lose value, which is why the typical recommendation is to reduce your stock exposure as you move closer to retirement.
Target date funds
If you don’t want to worry about managing your investments all the time, one option to consider is a target date fund (TDF). A TDF is an investment fund that roughly corresponds to the year you plan to retire (usually in 5-year increments).
A fund manager will adjust the asset allocation over time, adding more bonds as the retirement date approaches. The fund manager also handles tasks like rebalancing. Generally, no work is needed from you once the money is invested.
Your retirement goals
Your investing strategy should also align with your retirement goals. Some anticipate needing a modest amount of retirement income, which might mean investing more conservatively. Others might envision traveling extensively and staying in luxury accommodations, which will require more income. That means you may want more risk in your portfolio to meet your goals.
You should also keep any other retirement income in mind when you’re considering how much you’ll need. How much will you receive in Social Security benefits? Do you or your spouse have a pension? Keep your overall financial picture in mind as you consider how to invest your 401(k) contributions.
Consider meeting with a financial advisor
Whether you are confident in your investment strategy or not, meeting with a financial advisor for investment advice is a move that could pay off in the long run. They could help you develop a retirement plan that meets your financial goals.
If you are worried about the cost, or that a financial advisor will try to upsell you, then you could meet with a fee-only fiduciary financial advisor. These financial advisors make their money based on a predetermined fee rather than earning on commission. And if they are fiduciaries, it means they are obligated to act in the client’s best interest.
You could also meet with a financial advisor on a consulting basis. In other words, they could help you put together a retirement savings strategy that you will uphold for the remainder of your career.
They could help you avoid taking too much (or too little) risk and avoid unnecessary investment fees. These investment decisions will set you on the path to success, and, thanks to the power of compounding, they might make the nominal fee worthwhile.
How much do you need to save for retirement in your 401(k)?
A good rule of thumb for saving for retirement is to save 20% of every dollar you earn. This could be part of the 50/30/20 budgeting method, where 50% is spent on needs, 30% on wants, and 20% on savings.
Keep in mind that if you have other savings vehicles, such as an IRA you opened through a brokerage account, this 20% figure includes the money that goes there, too. Thus, the exact percentage of your income that should go to your 401(k) depends upon your complete savings picture.
What is a healthy rate of return on a 401(k)?
Typically, a return of 6% to 8% is considered good for a 401(k). You might be able to achieve higher returns, but that tends to come with increased risk.
Investing your 401(k) in a diversified portfolio of stocks and bonds is key to building wealth long-term. In doing so, you can grow your money over the years and decades. This is especially important because cash tends to lose purchasing power over time due to inflation. Your 401(k) is a powerful tool to help combat inflation.
But the 401(k) isn’t the only vehicle we have for saving and investing. Other accounts, such as traditional and Roth IRAs and high-yield savings accounts, also have their places in helping us save. This is why it might help to meet with a financial advisor as they can work with you to put a plan together to help you save, invest, and grow your wealth as you move closer to retirement.
More from FinanceBuzz: