A version of this article originally appeared in 27east.com
Q. My employer recently stopped matching our 401(k) contributions and I'm wondering, given the state of the economy, what's the best course of action? Should I continue contributing? Should I increase or decrease my contributions? Or should I get out of the 401(k) altogether and pursue a different kind of investment plan?
A. Shhhhh, I am going to tell you the secret of all retirement planning – the sooner you start and the more you put away, the more you will have at the end of the road. And compounding (we’ll get to that in a minute) in a tax deferred environment is one of your most powerful tools to accomplish this.
Even if your employer has stopped matching, your best course of action is to continue your monthly contributions. In fact, you would be wise to make up the difference lost in your employer matching! You can continue these larger contributions to your 401(k) or you might set up another account outside of your 401(k), such as a traditional IRA or ROTH IRA. A ROTH can make sense if you believe your tax rate is likely to be higher in retirement than it is now.
Bottom line, you still need to save for retirement. Now, a mantra you will hear me say often is “there is no one-size-fits-all” answer to most issues of personal finance. If you are very close to retirement and have lost a decent amount of your nest egg over the last 18 months, your situation would require further examination. And despite all of what the experts espouse, you always have to ask yourself if your current strategy is passing the all important “sleep at night test.” Perhaps contributing, but allocating your funds to a guaranteed or fixed account would work for you. But besides taking money out of your 401(k), the second worst decision you can make is to stop contributing to it.
If your time horizon and aversion to risk are such that you can withstand this period of unprecedented volatility, then this is potentially a very good time to be investing regularly into the market. It remains that the aim is to buy on pessimism and sell on optimism. It is hard to recall a period in our history when there was such pessimism. And this often translates into buying opportunities for mutual funds into which your 401(k) funds are being invested.
A discussion of retirement savings would not be complete without illustrating the concepts of compounding and dollar-cost-averaging. When you invest regularly and leave those funds invested, you are actually earning interest and dividends on the prior interest and dividends. This dynamic, over the long run, in a tax advantaged investment, will supercharge the growth of your balance. Put another way, calculating your earnings on not only your principle, but on your prior earning will result in faster growth.
Now while you may not have realized it, if you have been consistently contributing to your 401(k) plan, you have been practicing the age old strategy of dollar-cost-averaging. Dollar cost averaging is a technique designed to reduce market risk through the systematic purchase of securities at predetermined intervals and at set amounts. By investing the same amount each month, regardless of the share prices, you will buy more shares when the prices are low and fewer shares when the prices are high. This, in turn, will drive your average share price lower and lower, thereby insulating you against drastic changes in market prices. This investment technique is different than other methods, in which investors might try to guess when market prices will be low and try to invest at the right moment. Instead, dollar cost averaging helps to take the guesswork out of investing. And, most investment firms make it very simple to set up regular investment schedule for your retirement vehicle.
Market weariness and anxiety about staying invested and participating in the market is understandable. However, it can be important to remove the emotion out of your retirement strategy. There are only three ways to make money: you earn income, someone working for you earns you income, or your own money works for you. By investing regularly in your 401(k) away despite market values and harnessing the power of tax-deferred compounding, you will be ensuring you’re capitalizing on two of those methods.