Retiring: New ways to save

Don't refrain from saving

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

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Question: People have been telling my husband and me that we should increase the percentage of pay we put in our 401(k) account so that we can make a lot of money when the market rebounds. What do you think -- should we up our contributions or keep them the same? --Dawn Bennett, Dwight, Illinois

Answer: I've been getting emails from a lot of people lately who are considering reducing or eliminating their 401(k) contributions because the balance seems to keep going down.

I think taking such a short-term view of the long-term process of building a nest egg is a big mistake, so I'm glad to see that there are people out there like you and your husband who are thinking about saving more for retirement instead of less.

But even though I think it's a good idea for most people to at least consider boosting their 401(k) contributions -- particularly if their employer has scaled back matching contributions -- I don't advocate it for the reason you're being encouraged to do it, i.e., to capitalize on a market rebound.

Why? Well, I don't see the logic in tying the size of your contributions to how you expect the market to perform over the short-term. I mean, if you believe it makes sense to boost contributions to take advantage of the higher returns that often come as the market recovers, would you then lower your contributions to avoid losses if you think the market is heading south? It seems to me that you're getting into the same guessing game that market timers play, except that instead of moving in and out of stocks, you're toying with the amount you contribute to your 401(k).

That said, there is a more compelling reason to consider plowing more dough into your 401(k). I'm not talking about a temporary increase. I'm talking about re-thinking how much you need to save in light of the market's lousy performance recently.

Let's say that someone is 35 years old, makes $40,000 a year and will receive 3% annual pay increases during his career. If that person contributes 10% of salary each year to a 401(k) and earns an annual return of 10%, he would have a 401(k) balance of just under $900,000 at age 65.

But what if those 10% annual returns don't materialize? What if his 401(k) investments earn 7% a year? Well, instead of a balance of almost $900,000, he would have about $535,000, or about 40% less. If you were counting on something close to $900,000 and ended up with an account balance under $600,000, you would probably have to make some serious adjustments to your lifestyle in retirement.

So what could this person do to avoid a radical downsizing of his standard of living in retirement?

Clearly, we have no say over what size returns the financial markets deliver, and we have limited control over how much of the returns the markets generate end up in our 401(k). So even if our hypothetical 401(k) owner began to sense at some point that he was falling short of earning 10% a year, it's not as if he could simply revamp his investing strategy to get back to double-digit returns and avoid ending up with a stunted nest egg. Indeed, if he tried, he'd have to take on a lot more risk, raising the possibility that he could suffer big losses and end up with an even smaller amount.

But there is another way he could enter retirement with a hefty nest egg even if he earned the lower return of 7% a year. He could save more. Specifically, if boosted his annual 401(k) contribution to 17% of pay, he would end up with $900,000 even at the lower annual return of 7%.

Of course, in the real world we don't have the luxury of knowing what returns we'll earn over the next 30 years, or even the next few days. So we can't calibrate our contribution rate to end up with precisely as much money as we would like at retirement.

And even if we did have some magic crystal ball that predicted returns, we might not be able to save as much as is necessary to get the same size nest egg in the face of lower returns. Going from 10% of pay to 17% might not be manageable for many people.

But the point is that to the extent you can boost your contribution rate, you'll end up with a larger 401(k) balance at retirement time than you otherwise would. For that matter, you'll also be in better shape if the markets take a big hit, as they have recently, just before or after you retire.

Of course, the extent to which you can or want to boost the amount you contribute to your 401(k) or other retirement accounts depends on your situation -- how much you earn, what other obligations you have, how much you're willing to rein in spending now so that you have more security in the future. So I can't give you a specific percentage to shoot for.

But I can suggest this exercise.

Go to a retirement calculator like our Retirement Planner or Fidelity's myPlan Retirement Quick Check and plug in how much you've saved and how much you're contributing to 401(k)s and other accounts. You'll get an estimate of what size nest egg you might have and how much retirement income you're on track to receive.

Then ask yourself how you would feel going into retirement if you had 20% or 30% less than those amounts and whether or not it would crimp your style to live off the smaller figure. If you think you might have a problem getting by, run some scenarios in which you boost your savings rate by different amounts.

If this sort of number crunching isn't your thing, you can ask an adviser to do it for you. Or, you can take a seat-of-the pants approach and simply boost your savings rate a couple of percentage points each year (or sign up for the automatic contribution increase option, if your 401(k) offers it.)

To put it simply, the investing experience of the past 10 years and the market plunge of this year have proven that the notion of retirement-planning that held sway in the 80s and 90s -- that you could save relatively little and count on outsized investment returns to build a big nest egg -- was dangerously flawed. Yes, smart investing still counts for a lot. But I think there's a growing realization that saving is just as important as investing, if not more so.

So by all means boost the percentage of pay you contribute to your 401(k) to capitalize in the eventual market rebound. But hold your contribution rate after the market has regained its lost ground. You might even want to consider boosting it again later on. Because in the end, saving more is your best defense against the possibility of lower-than-expected returns.