Back in the Spring of this year, good news came out of CNBC regarding average 401k returns when they published an article titled Big Surge in 401k Balances, but Workers still not Saving Enough. The news out of this article was that the average 401k balance had grown $42,400 or nearly doubled from five years ago. Sounds great and it looks like Americans achieved a super awesome return on their 401k balances (finally).
Only, it didn’t happen that way.
At First Glance…
Simply calculating the compound annual growth rate for this result leads us to assume that average 401k balance grew just a hair under 14% per year–awesome!
But, truth is that didn’t happen. While most of the growth was due to the market, a not so insignificant amount of that growth came from 401k contributions. Once we factor that in, the results change…a lot.
Using data from Bloomberg and Zero Hedge the average 401k contribution just a year prior was calculated at $2,733 per participant per year. Since nothing happened recently that would suggest average contributions have gone down we’ll assume they’ve remained the same and add this contribution number back into the calculation for annual return.
This brings the annual return down to 8.91%. Not bad, but not 14% either.
This result seems agreeable since, after all, 8% is the magic number we hear about quite a bit when estimating stock market returns. But I’m afraid the actual stock market fared much much better of the same period of time. By Vanguard’s reporting, the S&P 500 has grown 18.83% over the last five years.
Now that number represents a lump sum investment made five years ago and growing for the entire five years, and since we know that’s not what’s going on we have to make an adjustment for the systematic investment.
Once we’ve adjusted for the systematic investment by taking the actual returns of the S&P500 using a systematic investment of $2,733 over the last five years we come to an annual return for the last five years of 14.01% (coincidence to the 14% mentioned above).
So Americans have, on average, done a good bit less.
How do you Expect to Actually Achieve that Return?
I bring all of this up simply to make the following point. For years investment salespeople have used historical stock market performance to support the argument that you should be in the market. The move is one that plays on greed. Even Dave Ramsey admits he does this, but pointing out the ”motivation” he has created by showing people the money they could have. But DALBAR has shown consistently for the last couple of decades that American investors don't achieve these returns, and–sadly–nothing has changed lately.
Since we’re talking a 401k, the money inside the majority of them (excluding Roth 401k contributions, which are still relatively rare) include money that is fully taxable once it makes its way out into the other side.
What’s the net of taxable yield on this money?
Well if we assume a 15% effective tax rate (somewhat low since the effective federal income tax rate for a married couple filing jointly would be a tad higher than 15% on this sum of money) and completely ignore state income taxes, the yield drops to 5.15% per year if the balance (the average balance held by a 401k participant) were liquidated all at once.
Now, I realize it’s somewhat unlikely that one would liquidate their entire 401k balance and pay taxes on it. Although, maybe not all that uncommon, since the Washington Post told us that more than 1 out of 4 Americans raid their 401ks. Still, we’ve asked for years, why one would paint themselves into a corner where their only option regarding their money was to systematically withdraw it or else pay hefty taxes.
Average 401k Returns tell us to Plan Accordingly
Many Americans have failed mimic the returns the stock market brings and under-perform it a great deal. This is okay, after all the 8.91% that was achieved for the past five years is still pretty good. But we can't pretend like investing in stocks will necessarily yield the results that we see from hypothetical scenarios often quoted by investment salespeople as most investors fail consistently to achieve those results.
I'm not trying to demotivate stock market investing. My major concern here is more in setting adequate expectations. As I've mentioned numerous times in the past, underestimating is way better than overestimating returns when it comes to projecting future retirement balances, and empirical evidence for average 401k returns has certainly supported this position.