In a Dilbert cartoon, the boss is asked, “Why aren’t you signed up for the 401(k)?” His response: “I’d never be able to run that far.”
What the boss didn’t understand was that 401(k) is the section of the Internal Revenue Code that establishes employer-sponsored retirement accounts, and it’s a race worth joining.
Most likely your firm offers a 401(k) plan or similar retirement plan for its employees. As a young lawyer, you have the opportunity to start building your retirement nest egg. Here is some helpful advice to get you started.
Step one is to determine how much you can afford to save. After student loan payments, you may come to the conclusion that you can’t afford to save at all. But, consider this: many employers offer a “company match” (read: free money). This means your employer will match your contribution subject to a ceiling and vesting schedule. For example, if you contribute 4 percent of your salary, your company may add another 4 percent to your account. That’s a 100 percent return on your investment (ROI). With that type of ROI, you can’t afford not to contribute!
If that doesn’t convince you to save, then this might: any money you contribute (up to $16,500 currently) reduces your taxable income.
Solo practitioners can set up a 401(k) to enjoy these same benefits; but, they risk losing the advantages if they hire more employees, especially those paid much less or those who decide not to contribute. Another popular option for self-employed individuals is the Simplified Employee Pension, or SEP. This plan only accepts contributions from the employer, which are discretionary, making it ideal for those with unpredictable earnings. Both types of retirement plans can be opened at brokerage firms, with less administration required for a SEP.
Next, you’ll need to determine how to invest your money. The 401(k) plan will offer several investment options in the form of mutual funds. The goal is to select the right mix of funds to provide both diversification and the appropriate risk level.
Diversification helps smooth out the bumps in the market and ensures that all of your eggs aren’t in one basket. But, don’t be fooled: if your plan offers ten funds and you put 10 percent in each fund, that’s not diversification. A good asset allocation includes large-cap stocks, small-cap stocks, international stocks, emerging market stocks, bonds, and maybe even commodities. Your plan should offer some sample allocations to help determine how much to invest in each. A starting point is to invest your age in bonds, so a 30-year-old would have 30 percent in bonds and 70 percent in stocks.
An easy way to achieve diversification is to select an “age-based” fund. These funds provide diversification among stocks and bonds and will automatically invest more conservatively as you near retirement. In the words of Ron Popeil, you just “set it and forget it!”
If you decide to create your own mix of funds, consider the fund’s past performance and its expense ratio. Actively managed funds incur higher fees because they employ investment professionals who attempt to beat a benchmark, such as the S&P 500. But, they also risk underperforming the index when their stock picks don’t pan out. On the other hand, you can choose a low-fee index fund that will track the returns of an index such as the S&P 500 but will never outperform it.
To set expectations, according to Ibbotson Associates, the average annual return for large-cap stocks from 1926 to 2010 is 9.9 percent and 5.5 percent for government bonds. Assuming an average annual return of 7 percent, you’ll double your initial investment every ten years.
Annually, you should review your investment selections and contribution rate. You may want to adjust your allocation based on the performance and volatility of your investments. The more you can stash away in your early earning years, the more you’ll benefit from compound interest, or as Einstein called it “the 8th wonder of the world.”
As Dilbert’s boss recognized, the race to retirement can be long—slow and steady wins the race.