Financial Planning Insights
Why are 401(k) plans essential to your retirement planning?
3 minute read time
With many large, lump‐sum payout pensions turning into a thing of the past it is becoming critical to your retirement success that you:
- Contribute to a tax‐advantaged retirement plan; and
- Have a plan to maximize those retirement dollars.
There are a number of retirement accounts that you can choose from and for this discussion I will concentrate on the employer‐sponsored 401(k). The maximum amount that you can contribute to your 401(k) is $19,000 in 2019. If you are age 50 or over at the end of the calendar year, you can contribute an additional $6,000 for a total maximum contribution of $25,000 However, even with the tax advantage of contributing to a 401(k), Forbes magazine reports that an estimate shows that the median retirement savings account balance for workers between the ages of 50‐60 is $15,000.
Since a 401(k) is tax‐advantaged, meaning all contributions and portfolio growth remain tax‐free until withdrawal, this can serve as the cornerstone of your retirement plan. If you aren't currently investing in your 401(k), or not allocating very much, I'd suggest you reconsider. Because your 401(k) may be the base of your future retirement income, you should consider what strategies you can use to maximize those 401(k) dollars. One big question may be, “How do I pick the right investments without putting my assets at risk... and protect my nest egg?” Answer: Asset allocation. A little background on that answer is in order. How can risk‐averse investors construct portfolios to optimize or maximize expected return based on a given level of market risk—knowing that risk is an inherent part of higher reward? The concept is rooted in Modern Portfolio Theory, which Harry Markowitz won a Nobel Prize for in 1990. In the simplest terms, this is the practice of not putting all of your eggs in one basket.
Modern Portfolio Theory tells us that, because no one knows which way and when an investment is going to move, combining certain investments and asset classes in a precise manner will give the greatest return with the least amount of risk. The relationship securities have with each other is an important part of what is known as the efficient frontier: Some securities' prices move in the same direction under similar circumstances, while others move in opposite directions. The more out of sync the securities in the portfolio are (that is, the lower their covariance), the smaller the risk (standard deviation) of the portfolio that combines them.
If you are interested in learning more about how to allocate your 401(k), or how to manage risk and help protect your nest egg, start by determining your risk tolerance profile.
1 Schwartz Center for Economic Policy Analysis, Policy Note, August, 2018
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