We hate to drag out that old hedge-y phrase, "it depends." But it does. Your 401(k) plan's rate of return is directly correlated to the investment portfolio you create with your contributions, as well as the current market environment. Although each 401(k) plan is different, contributions accumulated within your plan, which are diversified among stock, bond, and cash investments, can provide an average annual return ranging from 5%-8%.
Let's review the basics a bit. An employer-sponsored retirement plan such as a 401(k) can be a valuable tool in accumulating savings for the long-term. Each company that offers a 401(k) plan provides an opportunity for employees to contribute money – a percentage of wages – on a pretax basis, through paycheck deferrals. Often, employers provide a match on employee contributions, up to a certain percentage, creating an even greater incentive to save. While they vary according to the company and the plan provider, each 401(k) offers a number of investment options to which individuals can allocate their contributions. Employees benefit not only from systematic savings and employer matching, but also from the low-cost nature of 401(k) plans and their investment options.
OK, back to that 5%-8% range we quoted up top. It's an average rate of return, based on the common moderately aggressive allocation among investors participating in 401(k) plans that consists of 60% equity and 40% debt/cash. A 60/40 portfolio allocation is designed to achieve long-term growth through stock holdings, while mitigating volatility with bond and cash positions. It is important to note that performance within a 401(k) plan is not guaranteed based on past returns, and investors experience different results dependent on the investment options and allocations available within their specific plans. For instance, if you invest in a more aggressive portfolio, you may expect higher returns over time. However, the volatility within your account may also be much greater.
Your asset allocation should be determined based on your specific appetite for risk, also known as your risk tolerance, as well as the length of time you have until you need to begin withdrawals from your retirement account. Investors with a low appetite for risk are better served by placing investments in less volatile allocations that could result in lower rates of return over time. Conversely, investors with a greater risk tolerance are more likely to choose investments with more potential for higher returns but with greater volatility.
It is common for an individual with a long time horizon to take on more risk within a portfolio than those who are near retirement. Target-date funds have become a popular choice among 401(k) plan participants. These mutual funds allow investors to select a date near their projected retirement year, such as 2025 or 2050. Funds with a further-out target date focus investment allocations in a more aggressive manner than funds with a near-term target date. Rates of return on target-date funds vary from company to company, but these one-fund allocations offer a hands-off approach to retirement savings within a 401(k).
It is not possible to predict your rate of return within your 401(k), but you can use the basics of asset allocation, risk tolerance and time horizon to create a portfolio to help you reach your retirement goals. Also, look carefully at the fees different choices entail. Each of these factors influences the overall rate of return within your 401(k) account and should be reviewed regularly to ensure that your account meets your investment preferences and nest-egg accumulation needs.