Taking the Slow Road to a Comfortable Retirement

Call it the ultimate get-rich-slow scheme or how to make a heavyweight fortune on a lightweight salary. Either way, 401(k) savings plans--the terrific company benefit with the terrible name--have become a crucial tool for a comfortable retirement.

Admittedly, spending time preparing for retirement can seem like an absurd exercise for workers in their 20s or 30s. At those ages, the notion of some day being as old as your grandparents can seem pretty unlikely. But if you’re lucky, it actually happens, so you might as well have enough money when you get there to live comfortably.

“This is one of those benefits that you might not appreciate when you’re younger but it really is one of the most important things you can do during your working lifetime,” said Steve Merritt, author of the book “How to Build Wealth With Your 401(k).”

Several trends have made 401(k) retirement savings and investment plans, which are named for the tax code that covers them, increasingly important, experts say.

Federal legislation signed into law last month is expected to persuade even more companies to offer the plans. The new rules, effective in 1997, will simplify the administrative burden of 401(k) plans for companies with 100 or fewer employees.

The same legislation allows some nonprofit groups, such as trade associations, to make the plans available to their employees for the first time.

The second issue propelling 401(k)s is the uncertainty surrounding the traditional retirement scenario: Your company pays you a set amount each year after you retire and Social Security will account for most of the rest of the money you need to live on.

That picture has changed dramatically. The most pessimistic prognosticators predict that Social Security will go belly-up early in the next century. Even if that doesn’t happen, it’s a pretty safe bet that future retirees will receive fewer benefits than they anticipate or be forced to work longer before retiring.

Additionally, far fewer companies now offer the traditional pension plans that guarantee a certain monthly payment at retirement. Only about 120,000 companies provide these defined-benefit pensions today, about half as many as in 1984, according to Access Research of Windsor, Conn. That number is expected to continue to decline.

“401(k) plans are the most popular plans out there right now,” said Roy Oliver, the partner in charge of compensation and benefits for accounting and consulting firm KPMG Peat Marwick in Los Angeles.

The basic premise of a 401(k) is this: A little pain early in life--setting aside a small portion of your paycheck--can make for a big gain later--a large pot of cash when retirement arrives. That will probably be sometime after you reach 59 1/2, the age the government allows you to begin withdrawing your 401(k) funds without major tax penalties.

To make people more willing to swallow the pain, the government provides an important sweetener and employers often add one of their own.

The government allows you to contribute pretax money to your 401(k)--which lowers your taxable income--and then allows you to avoid paying taxes on the money and the returns it earns until you withdraw it for retirement. Many employers match some of your 401(k) contributions. It’s sort of like getting a raise without having to beg for it.

So just how much can you save through a 401(k)?

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Take a 25-year-old worker earning $30,000 a year who sets aside 8% of her paycheck before taxes are taken out, and is in a plan where her employer matches 50 cents on the dollar and her investments earn 10% a year. Even in the unlikely event she never gets a raise during her career, she would be looking at $1.6 million in retirement savings when she hits 65, based on annual compounding, not exactly chump change.

Without the benefits of a 401(k) plan, that same worker would have about half that amount awaiting her at retirement.

With that kind of extra money in the wings, you’d suspect that everyone eligible for a 401(k) would take advantage of it. While about 22 million people are enrolled in the plans, according to Access Research, surveys show that 25% of people who could be in the plans are not--about 7 million people. A substantial portion of those are believed to have no other pension plans to fall back on, meaning they are making no financial preparations for retirement.

The reasons people don’t join vary from an unwillingness to plan for something that seems so distant to falsely assuming that their employers provide some other type of pension.

Other reasons people give for not joining include not being able to afford even a small slice taken from their check to not understanding investments enough to feel comfortable participating in the programs.

Workers who think they are unable to afford it should try to adjust their budget so that they can manage a small paycheck reduction or join when they next get a raise, experts suggest.

When you figure taxes and matching contributions into the equation, someone willing to forsake $20 of his paycheck each week would gain $40 or more in his 401(k) plan.

“It’s important that people put something into their plans, even if it’s only a little,” said Harold Loeb of Buck Consultants in Los Angeles. “The bottom line is that you can’t afford not to do something.”

And it pays to start early.

“It’s important that people understand that they can’t afford to wait until they’re 45 to start planning their retirement,” said KPMG’s Oliver. “They’ve got to start as soon as they can.”

If our hypothetical $30,000 wage earner started saving 8% of her wages at age 45, for example, her nest egg would amount to just $206,190, assuming the same rate of return and the same employer match.

For people reluctant to join because they feel intimidated by the intricacies of 401(k) plans, here are some basics to be aware of:

* Your contribution: You decide what percentage of your paycheck you want to contribute, although each plan will have some maximum limit. A good rule of thumb is to contribute as much as you can comfortably afford but to be sure that you put in enough to get all of the company match.

For example, if your company will give you 50 cents for each dollar you contribute, up to a maximum of 3 percent of your pay, make sure you contribute at least 6% of your pay. That way you’ll get the full 3 percent from the company.

Keep in mind that the maximum limit on your pretax dollar contribution is $9,500 annually, although in some cases it will be lower depending on your compensation or the level of participation by others at your company.

* Company contribution: This is the amount a company will add to go along with your 401(k) contribution. Although a handful of companies offer no matching funds and another handful will match more than a dollar for each of your dollars, the typical range for a company match is from 25 cents to a dollar.

* Where to invest: Usually, you will have a choice of investments for the contributions coming from both you and your employer. Choosing the best investments is the most critical decision you will make after deciding to join a 401(k) plan.

A few companies offer only a single investment choice but the more typical number of options is from three to seven.

Author Merritt points out, though, that it’s the quality of the choices you have, not the quantity, that’s important.

A good plan will include a range of investments, from conservative money market accounts to potentially more risky, and rewarding, international and aggressive-growth stock funds. Obviously, funds that have consistently outperformed the market are best.

A rule of thumb is that the younger you are, the more risk you should be willing to take. To get an idea of each fund’s level of risk and past performance, ask your company for the fund’s prospectus, a pamphlet outlining a fund’s strategies, goals and history.

If you are not comfortable selecting your investment options, talk to a trusted friend or relative about it. It may even pay to sit down with a financial planner to go over your choices.

A big mistake, particularly among people new to investing, is to pick the most conservative fund. A little risk can frequently pay off in the long run and a difference of even a few percentage points can make a big difference.

For example, putting $5,000 a year into a fund that earns 8% a year will give you $566,416 after 30 years. That same investment earning 12% would generate $1,206,663. The difference, $640,247, could pay for quite a few rounds of retirement golf.

Keep in mind that aggressive investing is needed to keep ahead of inflation. At first glance, that $1.2 million might seem like a lot of cash, but if inflation continues at the current rate of about 3% a year, that nest egg in 30 years would be worth $497,138 in today’s dollars.

(For more tips on making the most of your 401(k) investments, please see accompanying story.)

* Vesting: To encourage an employee to stay with a company and to reward longevity as a traditional pension plan would, many firms set up their 401(k) plans so that it takes a certain number of years before an employee owns the company’s contributions to the employee’s 401(k) account. In most plans, employees are vested in a certain percentage of their funds each year and become fully vested after three to five years.

Legally, it can take up to seven years.

The money you put into a 401(k) plan, and the investment return it earns, is always yours and cannot be taken away.

One of the beauties of the 401(k) plan is that it’s portable. In other words, when you leave your company, you can take your 401(k) funds with you and set up an Individual Retirement Account with a brokerage firm or mutual fund company and still enjoy tax-deferred benefits.

Another option is to take your 401(k) funds to your new job, if that is allowed in your new employer’s plan. A third choice is to leave your funds in your previous employer’s plan.

* Other issues: There are several other aspects of your 401(k) that you should be aware of.

Many plans allow you to borrow money from your account. It’s a practice frowned upon by many financial planners because it slows the creation of a retirement nest egg but it’s a handy option that many people take advantage of anyway.

Additionally, plans vary on how frequently you can change your investment options. While it’s not a good idea to constantly switch your choices chasing the latest hot trend, it’s important to know when you can make a change.

Each of these issues and others are addressed in your company’s Summary Plan Description document. Your human resources department should have a copy.

Finally, if your company has a 401(k) plan that you don’t think is up to snuff, you and your colleagues should lobby for changes. Companies are not required to offer 401(k) plans, so if they do make one available there’s a good chance they’ll be willing to consider improvements.

“If you’re not happy with the investment choices offered, show your company that they don’t measure up to the indexes over a period of time and they’ll probably be willing to add some more choices,” said author Merritt.

The bottom line is that 401(k) retirement savings plans are an essential part of your company benefits package. When the time comes, you don’t have to be happy about hitting retirement age but you might as well be financially comfortable when you do.

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How Does Your 401(k) Stack Up? Do you have “the Dream Plan” or does your company offer just the bare bones? It pays to know because your 401(k) plan is likely to be a key source of your retirement savings and income.

But few employees realize that companies have wide leeway in setting up these plans. There are dramatic differences, for instance, in how much, if any, companies contribute toward workers’ savings, how many investment options they offer and even how often they tell workers the value of their 401(k) accounts.

Use the checklist below to determine the attributes of your own plan, then compare your plan to the three hypothetical plans we have created based on the results of a survey of 401(k) practices and policies at U.S. companies by Buck Consultants of New York. You may find that you want to ask your company to boost its offerings. Or if you’re looking for a job, use the checklist to evaluate prospective employers’ plans. The differences between plans could amount to thousands of dollars when you retire.

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A CHECKLIST

* Fill out this checklist, then compare the answers with our three hypothetical plans. The results may be eye opening and could help you decide how better to build your retirement nest egg.

1. What’s the waiting period before you can join the plan? .........

2. How much of your salary can you contribute? .........

3. How much will your employer match for each dollar you contribute?

4. What is the maximum percentage your employer will

match? .........

5. How does your company match your contributions? .........

6. How many investment options do you have? .........

7. How frequently can you switch your money between investment options? .........

8. Can you borrow money from your 401(k)? .........

9. If so, what’s the interest rate? .........

10. How frequently is the value of your 401(k) calculated? .........

11. Can you get that information over the phone? .........

12. Are hardship withdrawals permitted? .........

13. How often are your contributions deposited into your account?

14. Who pays the plan’s administrative fees? .........

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THE DREAM PLAN

* The creme de la creme of current 401(k) plans.

1. Waiting period: None.

2. Your maximum contribution: 20% of pretax salary.*

3. Employer match: Dollar for dollar up to a designated maximum.

4. Maximum employer contribution: 10% of your pretax salary.

5. Type of company match: Cash.

6. Investment options: More than 15, including a variety of mutual fund categories.

7. Investments can be switched: Daily.

8. Loans available: Yes.

9. Interest rate: Less than the prime rate.

10. Value of plan calculated: Daily.

11. Telephone valuation available: Yes.

12. Hardship withdrawals available: Yes.

13. Statements mailed: Monthly.

14. Your contributions are deposited: Every pay period.

15. Administrative fees paid by: Company.

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THE MIDDLE-OF-THE ROAD PLAN

* Many plans will fall into this range. Not bad, but there is room for improvement.

1. Waiting period: Six months.

2. Your maximum contribution: 15% of pretax salary.*

3. Employer match: Fifty cents for each dollar you contribute, up to a designated maximum.

4. Maximum employer contribution: 3% of your pretax salary.

5. Type of company match: Cash.

6. Investment options: Five (various mutual funds and company stock).

7. Investments can be switched: Quarterly.

8. Loans available: Yes.

9. Interest rate: Prime rate plus 1 percentage point.

10. Value of plan calculated: Monthly.

11. Telephone valuation available: Yes.

12. Hardship withdrawals available: Yes.

13. Your contributions are deposited: Monthly.

14. Administrative fees paid by: You and your employer split the cost.

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THE BARE-BONES PLAN

* Because a 401(k) plan offers such a tremendous opportunity to leverage your retirement savings, even a threadbare plan shouldn’t be ignored. But a plan in this category may play a smaller role in your overall retirement savings strategy.

1. Waiting period: One year.

2. Your maximum contribution: 6% of pretax salary.*

3. Employer match: None.

4. Maximum employer contribution: Not applicable.

5. Type of company match: Not applicable.

6. Investment options: One or two.

7. Investments can be altered: Twice a year.

8. Loans available: No.

9. Interest rate: Not applicable.

10. Value of plan calculated: Once a year.

11. Telephone valuation available: No.

12. Hardship withdrawals permitted: No.

13. Your contributions are deposited: No sooner than the federal law now requires, which is 15 business days after the month in which the money is taken out of your paycheck.

14. Administrative fees paid by: The employee.

* Actual amounts vary based on your income and the structure of your 401(k) plan.