Suppose you are a participant in a 401(k) plan. You probably are if you are reading this. Then, it wouldn't be surprising if your plan's recordkeeper (by the way, they may also hold the majority of the funds in the plan) gives you online access to some sort of retirement modeling tool. This is a good thing.
OK, so why is this idiot blogger wasting your time? There is a little problem here. On any of these sites, either the site makes assumptions for you, or, sometimes within a set of constraints, you get to choose assumptions for yourself. This can be dangerous.
Consider your best friend. Is he or she a smart person, financially savvy? Let's assume the answer is yes. And, you, of course, are financially savvy? Would you trust that best friend of yours to be able to pick your annual return on your 401(k) balance? Would your best friend trust you with guessing a return on their balance. Probably, the answer is no, so why would you think you can guess your own rate of return. And, even if you can, is that an average return, or a constant return. And, if it's an average return, what does that mean?
Oh, come on, idiot blogger, everyone knows what an average is.
Not so fast, there may be more than meets the eye.
I'm going to consider four scenarios as follows:
- In the first, I am going to assume to assume that you have 10 years to save, that you are currently earning $50,000 per year, that 5% of that will go into a defined contribution (DC) plan every year (on the first day of the year), that you will get a 3% pay raise every year, and that those funds will earn a constant 5% rate of return.
- In the second, you still have 10 years to save and you are still currently earning $50,000 per year. You are still going to get a 3% pay raise every year and you are still going to put 5% of your pay into your DC plan. And, on average (arithmetic mean), you are still going to get a 5.5% annual rate of return on your money, but I am going to throw some volatility into the mix. I am going to give your annual investment return a normally distributed standard deviation of 11%. In simple terms, this means that about 69% of the time, your actual annual return will be between -5.5% and 16.5%. Further, about 95% of the time, your actual annual returns will be between -16.5% and 27.5%.
- In the third, I will keep all of these assumptions the same, except that your average annual return will be 6% and your standard deviation will be 18%.
- Finally, in the fourth scenario, your average annual return will be 6.5% and your standard deviation will be 26%, with all other assumptions kept the same.
Before I give you the results of this analysis, I need to explain a few more of the details here. In scenario 1, since there is no variability, I need not perform more than one simulation. In the other scenarios, however, I have normalized the annual returns so that the arithmetic mean return over the 10-year period is, in fact, the intended arithmetic mean. Additionally, I have done this simulation 10 times each and then taken the average (arithmetic mean) of the 10 account balances after 10 years.
What do you expect the relationship between the four ending account balances to be? What do you expect will be the range of results in each scenario after 10 years?
Average account balance after 10 years: 37,403
Highest account balance after 10 years: 37,403
Lowest account balance after 10 years: 36,403
Average account balance after 10 years: 36,387
Highest account balance after 10 years: 42,024
Lowest account balance after 10 years: 29,106
Average account balance after 10 years: 38,641
Highest account balance after 10 years: 48,640
Lowest account balance after 10 years: 28,022
Average account balance after 10 years: 38,662
Highest account balance after 10 years: 57,439
Lowest account balance after 10 years: 26,411
The volatility is essentially offsetting the improved investment returns. So, when you go to your recordkeeper's website and use their modeling tool, what rate of return are you going to assume? Do they give you a place to input assumed volatility? I'll bet they don't.
I'm sure your recordkeeper means well. They don't want to confuse you. But, are they really helping you to win the race to retirement? Or, does slow and steady win the race?
It's your retirement. You make the call.