Invest better? Sure, but savings are key

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).

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(Money Magazine) -- Given the havoc the market has wreaked on your 401(k) over the past year, you may be wondering what you might have done differently to stay in better shape for retirement.

Many of these wouldas, couldas and shouldas focus on investing. Ah, if only I'd picked better funds, stashed less money in company stock or taken less risk with my retirement portfolio.

No doubt there's room for improvement in all of these areas. But if you're many years from calling it a career, there's another issue that you need to consider: finding ways to stash more money into your retirement account. That's right. Save more.

Granted, that message is a tough sell now. A recent AARP survey of people 45 and older found that far from boosting retirement savings, 36% say they have stopped putting money into a 401(k), an IRA or other retirement account. I'm not surprised. I've been getting lots of e-mails from readers of my Ask the Expert column whose impulse is to save less, not more. They see their 401(k) balances shrinking and worry that contributing more will just expose additional sums to a sinking market.

That's an understandable but misguided reaction. The real retirement planning lesson to be drawn from this market is that you can no longer rely on double-digit annual stock gains to build your nest egg for you - as investors did throughout the 1980s and '90s.

Saving more will be particularly important if you work for one of the growing number of firms - such as FedEx (FDX, Fortune 500), GM (GM, Fortune 500) and Motorola (MOT, Fortune 500) - that have recently eliminated or cut their 401(k) match, which threatens to set you further back.

But even if your match is safe, here's why saving more is so important:

Saving more softens the impact of market setbacks. Some older 401(k) investors have just seen their account balances drop 20% or more at the worst-possible time - right before they're set to retire. Well, pumping up your savings rate during your working years is a form of insurance against ending up with a dangerously inadequate nest egg because of a market downturn, weaker-than-expected long-term returns or having to leave the work force earlier than you had planned.

Consider how a last-minute loss could hamper your plans. Let's say you're 40, earn $100,000 a year and have $200,000 saved already. You'd be on target to amass nearly $2 million by age 65, assuming you receive 3% yearly salary increases, contribute 10% of your pay and your portfolio grows 7% a year.

But let's say that just as you're about to retire, your portfolio sustains a 20% loss. In that case, your expected 401(k) would fall almost $400,000 short. That amounts to having about $16,000 less in annual income in retirement (see table, above right).

Now think about what would have happened if at 40 you started saving 15% of your pay, which many advisers recommend. Instead of going into retirement with a $1.6 million nest egg, you'd retire with roughly $1.9 million even after a 20% plunge.

In other words, by saving an extra 5% of your pay, you would be close to the same position you would have been in had you saved 10% and the market stayed healthy. In order to see how boosting savings can increase your nest egg, check out the Retirement Planner tool.

Savings will boost your 401(k). If the past decade taught us anything, it's that banking on big stock returns is fraught with uncertainty. But here's one thing you can be sure of: Whatever the rate of return you earn on your investments, saving more can substantially increase the size of your 401(k).

Say you're 30, make $70,000 a year and contribute 10% of your pay, which grows 3% annually. If your 401(k) investments earn 7% a year, you'd have about $1.4 million by 65. Not bad. But if you increased your savings rate by just two percentage points, to 12%, you could have a nest egg of $1.7 million. Boost it to 15% and you'd have more than $2.1 million.

That extra cash can make a huge difference to your retirement lifestyle. An additional $700,000 in savings, assuming a conservative initial 4% annual rate of withdrawal, could generate an added $28,000 in inflation-adjusted income each year in retirement.

Saving more might not be as difficult as you think. Of course, recognizing the need to save more and actually being able to do it are two different things, particularly in this challenging economy. After all, going from a 10% savings rate to 15% will require you to set aside another $5,000 a year, or $417 a month if you earn a $100,000 annual salary.

But 401(k) contributions reduce your taxable income, which means the government will help you save. In this example, assuming you're in the 25% federal tax bracket, Uncle Sam will give you another $1,250 in tax breaks for saving more.

If you're committed and resourceful, there are smart ways to save more. One idea is to raise your 401(k) contributions gradually by a percentage point or two over several years - either on your own or by signing up for an automatic-increase option if your plan offers one. Similarly, you could time an increase in your contribution rate to coincide with a raise so it's less disruptive to your lifestyle.

And if you're already maxing out on your 401(k), funnel extra savings into an IRA - or, if you don't qualify, into tax-efficient funds in a taxable account. To stay disciplined, sign up for the automatic-investing plans most fund companies offer that directly transfer cash from your checking account to the fund.

Who knows, maybe the Obama administration's stimulus plan will quickly get the financial markets humming again. Or perhaps one of the many proposals to revamp the nation's retirement savings system will get your nest egg back on track.

But just in case, remember that it never hurts to save more.

For more retirement and investment advice from Updegrave, including videos and his twice-weekly Ask the Expert column, go to cnnmoney.com/expert. E-mail him at longview@moneymail.com.