If I was a financial planner, what is the first investment I would look to make for my client?
The answer to this question isn’t the stock of the latest technology company or a commercial property in a very prestigious location. The answer is that I would first ask my client, “Does your employer offer a 401K for its employees?” A 401K would be the first investment I would look to get my clients invested in not because of what investments (stocks, bonds, REITS) go into this account, but because of the employer match.
The employer match gives you essentially “free” money or a “free” return. I put “free” in quotations because it isn’t exactly free because your employer is paying for it, but IT IS CERTAINLY FREE TO YOU, the employee.
Warren Buffett is pretty much the unanimous best investor of all time, and he has compounded money at about 22% a year. Most employers will match 50% of the money you contribute into a 401k plan up to 6%. This means that for the first 6% of your salary that you contribute to a 401K, the employer is paying you 3% of your salary, or in other words a 50% return. A 50% return! That is double the return that Warren Buffett has been compounding money at.
Now to bring this point home let’s use an example. Let’s say that you are earning $100,000 a year at your company and your employer offers a 401K plan that matches 50% up to 6% of your salary. You just read this article and decide that it is a great idea to participate. So every year $6,000 is taken out of your salary before taxes - you pay no taxes on this 6% of your salary ($6,000), but you will eventually pay the taxes later on - and the employer gives you $3,000.
Instead of having just $6,000 in your 401K account, you now have $9,000 and this $9,000 will get invested mostly in exchange traded funds, mutual funds, bond funds etc. If I was a financial planner I would very much be interested in what the $9,000 is being invested in, and I would prefer to see exchange traded funds as opposed to mutual funds, but that is a topic for a whole new blog post. I am mainly focused on the 50% return that you are getting just for participating.
There is a lot of psychology that goes into why so many people would not take this free money, and it’s more than just not knowing about this “free” money that is transferred from the employer to the employee just by enrolling. I will let the authors of Why Smart People Make Big Money Mistakes - a book I finished reading a couple of months ago and where the idea for this blog post originated from - touch upon the psychology in the two paragraphs from chapter 3 of their book below:
“One of the most costly and regrettable examples of how the endowment effect leads people to ignore opportunity costs occurs in connection with retirement savings plans at work. First, a little background. Some 29 million U.S. workers are eligible to participate in 401(K) retirement plans, which (as you may very well know) are tax-deferred savings vehicles funded mostly by workers themselves. However, the typical employer matches fifty cents to each dollar contributed by plan participants, up to 6 percent of the employee’s salary. In other words, someone who makes $50,000 a year and contributes $3,000 will receive an extra $1,500 from his or her [employer]. That’s right: $1,500 free of charge. But according to a 1996 survey by Buck Consultants, roughly 12 million people a year who are eligible for this free money choose not to accept it, either because they don’t contribute to their 401(k) plan at all or because they don’t contribute enough to qualify for a full employer match."
"Certainly some people fail to contribute because they don’t know how the plans work or because they absolutely cannot spare a dime from their salary for their retirement. Mostly, though, this mistake – which, according to a Money magazine estimate, costs employees $6 billion a year in missed employer matches – can be blamed on loss aversion and the endowment effect. Parting with money today is experienced as a loss, or out-of-pocket cost, and is therefore hard to do. At the same time, the future benefits from doing so are experienced as foregone gains and therefore relatively easy to ignore. Stated differently, people overvalue what they have (today’s salary) and fail to properly value what they could have (the employee matches and the benefits of tax-deferred savings.)"
This has prompted employers to automatically enroll their employees in 401K plans. Automatic enrolling is a very useful form of persuasion for a company to help their employers realize this 50% gain. This is due to the fact that once something is automatically chosen for someone they are less likely to switch to something else because switching takes effort and time.
This demonstrates the power of the default options, or in other words, options that are automatically chosen for someone. The default option in this case is to automatically enroll employees in a 401K plan knowing that the employees will be less likely to opt out of the plan because that will mean that the employee will have to find the correct paperwork to complete, then go through the trouble of filling it out, and then finding out where to send it.
The power of defaults was highlighted in studies done on the drastic differences of certain countries to get their citizens to become organ donors, and is now being used effectively to help employees invest in the best investment vehicle today, and the number one investment I would look to get my clients in if I was a financial planner: the 401K plan.