What's the right 401(k) contribution rate?

Commentary: The most frequent question I receive from participants is, "How much should I contribute?". My answer is always the same, "As much as you possibly can.” That never seems to satisfy anyone, so I typically go on to explain the following.

The correct 401(k) contribution rate

T. Rowe Price, the mutual fund giant, recently completed a study which showed that participants should average 15% in contributions into their 401(k) plan accounts each year to achieve retirement readiness. A number of years ago, Alliance Bernstein conducted a similar study which came to basically the same conclusion.

The suggested annual 15% contribution rate includes employer contributions and should be maintained for a participant’s entire 40-year career. Since many employers provide matching contributions (typically at a 3% rate) the study assumes participants should contribute 12% annually.

How most of us normally contribute

Unfortunately most of us don't contribute at all at the beginning of our careers. Student loan debt, the need to save to buy a car or home and other priorities may cause many younger workers to forgo 401(k) contributions early in their careers. It is often not until our 30s that we begin to think about funding our retirements.

Also see: “Small employers have new retirement plan option with myRA.”

At that point, most of us contribute the minimum required to receive the maximum employer match. Since most employers have historically matched 50% of the first 6% of employee contributions, total contributions are generally around 9% annually. Applying some basic math to the average participant’s situation yields the following contribution short-fall:

Early career contributions (first 10 years): 0%

Mid career contributions (second 10 years): 9%

Mid career contributions (third 10 years): 15%

Late career contributions (final 10 years): 15%

Average contribution rate over 40 years: 9.75%

Required average contribution rate: 15%

Most participants are aware of this situation and feel they can fix it by contributing much more during their latter years to make up the difference. Continuing the example above, the contribution rate they would need to average during the final 10 years of their careers (to average 15% for 40 years) is 36%! Contributing at this level still leaves participants far short of the account balance they would have had if 15% contributions had been made during the first 20 years (due to the power of compounding).

What you can do to help your employees

Auto-enrollment at an employee contribution rate of at least 6% with auto-escalation of 1% per year is a good start. These plan design features won't help everyone, but with opt-out rates typically less than 15%, they will help the majority of your plan participants.

Robert C. Lawton, AIF, CRPS is president of Lawton Retirement Plan Consultants, LLC, a RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at bob@lawtonrpc.com or 414.828.4015.