Retire aggressively!

More and more we're moving away from a pension ("defined benefits") system to an individual retirement account ("defined contribution", ex: 401k) model. While many are unhappy about this, it's actually better: you are protected against your former company collapsing and no one paying your defined benefit anymore. Since you own your 401k funds, you are free to move between companies without fear of not building up "pension credit".

The downside is that you have to manage your 401k: decide how much to put away, how to invest it, and when retirement rolls around, how to disburse it. While I can't speak for the latter from personal experience, I've decided an aggressive approach is right for the first two options.

There is a federally defined maximum personal yearly contribution (somewhere around $17,000 currently). Get as close to that number as you can afford to do. Do that every year. Make it one of your known expenses, don't plan to use that money. Your employer may match part of your contribution, this is allowed to take your total over that defined limit (to repeat, only your personal contribution counts against the limit). Why do the maximum? Assume you work 35 years, and assume the limit stays the same. Even with zero growth and no employer contribution, you'll have stashed away almost $600,000 of pre-tax money, which you can disburse in smaller amounts and therefore get taxed less. Realistically the limits go up about $500 each year, so contributing the max and getting a typical match from your employer should get you around $1,000,000 into your fund.

Now for that growth component ....
You have lots of investment options and probably no clue what to do next. Your 401k fund's firm likely offers several "package funds". For example, I can invest in "large cap growth" or "European small cap" funds, as well as long-term plans like LifePath 2040 (which gets progressively less risky as 2040 and my planned retirement approach). Your best bet is probably something that tracks a major market index such as the Dow or S&P 500. These have reasonable returns each year and are cheap for the fund manager to run. In my case, "large cap growth" is roughly the same as the Dow, so that makes up a substantial portion of my portfolio. LifePath is likely to be less volatile, but has lower returns over time because it's more managed and more diversified... this is bad: a rate difference of a few percent per year, compounded by management costs can affect your final balance by a factor of 2 (in this case, millions of dollars!). If you have 30 years until retirement, let that "over time" work for you.

The rules for your 401k and your personal investment fund are very different. Your personal stock portfolio is at your fingertips anytime you want it. Ideally you buy a stock today, tomorrow it doubles in value and you cash out big. This is not an option in a 401k. You can't just cash out your winnings (or not as easily anyways), at most you can re-balance your invested assets. Also, you are contributing smaller amounts to your 401k each pay check instead of buying a big bundle of shares once and then maybe idling for 6 months. Pop quiz, which of these prices per share/unit over time results in the best outcome for your 401k when you retire:
1. Steady growth: $1.00, $1.10, $1.20, $1.30 ... $3.00, retire
2. Bust and boom: $1.00, $0.50, $0.50, $0.50, ... $0.50, $3.00, retire
3. Boom and hold: $1.00, $3.00, $3.00, ... $3.00, retire
Think hard about this, it's critical to understanding the aggressive approach to 401k.

But eventually, I want to retire and know how much money I have to live off of, right?
Yes. LifePath and similar funds do this by gradually shifting your money out of the stock market and into super-safe investments like bonds and cash. The issue here is that your money stops growing, and you still plan to live another 20, 30 or infinity years (or plan to pass down the money, or leave it for a spouse, ... ). However, leaving your investments in a stock index fund could lead to some pretty big swings that you no longer want to put yourself at risk for. Enter the Rule of 5.

An observant person noted that, approximately speaking, the major indices are always higher in value 5 years from now than today. This allows for arbitrary volatility in between, of course, but says that given a 5-year window, money invested in an index fund will not be worse off. While most how-to's recommend the uber-safe approach, I believe that only the next 5 years' worth of money needs to be conservatized. In other words, every year you can move the money you'll need to use in 5 years into a conservative portfolio, allowing the remaining money to continue working for you, over time! If the market takes a dive, just delay taking the next batch of money out until it recovers! We can look at 3 scenarios for the expected trends (a more complete look would bracket 'reasonable' upper and lower bounds, and of course you wouldn't want to follow a plan whose lower bounds put you at risk), assuming you have amassed $2,000,000 and wish to spend $100,000 a year:
1. all in cash: money will run out in 20 years.
2. all in low-yield bonds (3% per year): you have about $844,000 left after 20 years
3. all but the next 5 years' in an index fund (7%): you have about $2,305,000 left after 20 years! Your money has grown. Note that aside from an initial $500,000 earmark, the remaining $1.5M are generating slightly more than the next $100,000 you need to cash into your safe bucket.


Quiz Answer:
The answer to the pop quiz is 2. Bust and boom is ideal for you because it allows you to purchase the most units of fund over time. You'll have way more units than in steady growth or boom and hold. The opposite is true for conventional [buy-at-once] investing. Here, bust and boom is actually painful because you are stuck with underwater stocks, until the boom happens, and can't put that money to use in the meantime.