CHAPTER 4: “SHOW ME THE (FREE) MONEY!!!!”
Status Check
Whether by way of Chapters 1-3 or other routes, if you have 1) lived your budget + 2) taken control of your spending (eliminated credit card debt) + 3) at least started or finished buying your umbrella (built your Rainy Day Fund) then you are ready for the next best financial pay-off after the “guaranteed 21% return” achieved by eliminating credit card debt.
Free Money Does Exist
If you were in a business relationship with a counterparty and they offered you 50 cents for every dollar you saved for yourself, what would you do? And what if this counterparty would make that match up to a given level of your contribution, say 6% of what you make. And – AND – for every dollar you contributed you reduced your taxable income by that amount. Would you maximize your contribution to gain the highest level of match? If you answered an unequivocal, resounding “YES!!” then come on down, you are ready to play in the free money gig created by Qualified Retirement Plans like 401(k)’s.
Free Money Does Exist, But Only Certain Ways
The catch to this entire gig is that you must work for an employer that offers what are called Defined Contribution Retirement Plans (DCRP’s – my abbreviation). Congress passed legislation in the late 1970’s that created DCRP’s as a supplement to the existing Defined Benefit Retirement Plans (DBRP’s) that most companies offered. 401(k)’s are just 1 type of DCRP and are considered Qualified Retirement Plans because employee contributions can be made from pre-tax income (with taxes on the contributions and gains on those contributions deferred until the funds are used for retirement income).
What’s the Diff?
The key difference between DBRP’s & DCRP’s is where the responsibility for funding retirement income lies. With DBRP’s, this liability lies with the company as they define what benefits they will provide their retired employees, and since they define the benefits they own the responsibility of how to fund those benefits. With DCRP’s, the liability lies with the employee because in these arrangements the company defines only what contribution the company will make to the plan; the employee owns the contributions once made (within rules) and subsequently the responsibility to manage them for their use in retirement.
Simultaneously Frightening….
The introduction of DCRP’s revolutionized saving for retirement in many fundamental ways. From the employee standpoint, every participant now needed the moxy and discipline to replace the legions of retirement plan administrators and analysts used to manage DBRP’s. Over time DCRP’s have in many places outright replaced DBRP’s rather than supplemented them, creating a seismic shift of liabilities from companies to employees. So: with the free money comes much responsibility.
… And Liberating
To say everything lies on the employee is not wholly true as many companies do an admirable job curating cost effective investment options across the entire risk spectrum so an employee can build an appropriately diversified portfolio of investments within that company’s DCRP. This can be liberating as each employee can utilize the plan to build a fund meeting their individual needs and risk profile. It can seem daunting when an employee is not an experienced investor, but most companies offer lots of support and educational resources for gaining knowledge.
Grab Your Free Money Early and Often
The only way to enjoy the free money gig is to participate in a DCRP. The typical company match rate today is 50% dollar-for-dollar of employee contributions up to 6% of pre-tax wage. Ranges on match rate run from 0% to 150%, and match on employee contributions from 0% to 10% of pre-tax wage contributed. If you have the good fortune to work for a public company (401(k)’s), private company (SEP’s or similar), non-profit or government agency (403(b)’s) that offers a DCRP, start contributing as soon as you are vested to do so (typically after 1 year of employment). The “free” money insures the return on this investment will exceed that of a similar investment made without a match.
Time Can Be Your Friend
Getting started with a 401(k) or similar DCRP is a fantastic way to build a nest egg as it utilizes 2 fundamentals: regular & consistent deposits (usually from payroll deductions, which make the inputs automatic) and compounding of those inputs over time. The compounding can very much be a mixed blessing – the more time you are invested, the less you need to invest to hit a goal; however, the opposite is true for a situation with a shorter investment timeline. Skipping the math for a moment, consider 2 cases A & B. A is someone in their mid-20’s and B is someone in their mid-40’s; both want a $1MM nest egg at 65 and both are starting with $0 saved. Assuming an 8% return and compounding monthly, the required savings rate/month for each are: $285 & $1695. That’s almost a 6X difference!! And it comes solely from the compounding effect across the difference in the investing timeline.
Show Yourself the Free Money
You must join a 401(k) or similar plan to access to the company match, the “free” money. Today many companies automatically enroll employees and establish them in low risk portfolios starting Day 1 upon their joining the plan. Other companies still require employees to initiate the enrollment. Either way, if a 401(k) option is available to you take maximum advantage of this awesome benefit by making regular contributions as soon as possible. Consider contributions exceeding the company match since these are tax-deferred (maximum annual limits do apply). Assemble a mix of investment options to create a diversified portfolio with appropriate risk profile for your specific personality and goals. Regardless of how you proceed, the key is to start taking the free money.