Recently, I came across an advertisement on Facebook where a financial advisor (a Certified Financial Planner or CFP no less!) argues against putting money into a 401(k) (or other employer-sponsored qualified plan) mainly due to market volatility. According to the author, using your 401(k), "Exposes your money to 50% losses," citing 2008 as a prime culprit. Note: The official CFP curriculum calls for advisors to encourage clients to take advantage of employer matching contribution within the retirement plan. Most (but not all) employers will "match" contributions the employee places inside the plan as a payroll deduction, usually dollar-for-dollar up to a certain percentage of the employee's salary. For example, ABC Company offers Jane Client a 100% match up to 3% of her salary. That means if Jane makes $100,000 per year, and she deposits $3,000 annually into her 401(k), the employer will also deposit $3,000 on her behalf for a total of $6,000 going into the plan each year.

Why is an employer match amazing? Most people say because it's free money, which is definitely true. The other reason is because YOU GET A 100% RATE OF RETURN DURING THE FIRST YEAR. Nowhere else can you reliably earn 100% on your money within a single year of investment: not a bank, not an investment company, nowhere. If you want anything close to 100% RoR, you will need to accept a lot of risk. There is, of course, an opportunity cost to putting money into your qualified plan, but hastening the compounding effect on your retirement funds is an excellent way to save.

Now, the advertisement (like many financially-related ones) doesn't specify the product or strategy being sold. Its author, however, is correct about a couple of things. First, the S&P 500 lifetime average is around 5.5%. Unfortunately, when it comes to investments, simple averages fails to account for a lot. For one thing, it doesn't realistically depict the volatility in the market. When you lose money in the market, you must earn double what you lost just to get back to even. This reality is captured by what's called the geometric return (as opposed to the arithmetic return, which is the one we commonly use in our everyday lives). Second, even if you were to use the geometric average rate of return, you still face sequence of returns risk--the risk of the lowest (often negative) returns affecting your portfolio when it has the most money in it. I plan to write a separate post on sequence of returns risk, but suffice to say that if you are going to encounter a bad market year like 2008, you want to do so either when you're just starting out or when you have exhausted most of your retirement funds. A 30% loss will affect a $1M portfolio much more than a $1,000 one.

As one of the commenters to the Facebook ad pointed out, just because you put money into your 401(k) doesn't mean you must be invested in the market. But, does it make sense to do that? Lately, cash only pays 1% in a money market account, and jumbo certificates of deposit these days only approach 3%. Compared to the stock market, those are pretty meager. Nevertheless, it's an interesting question.

To test whether it's a waste to take the match or invest in another vehicle outside of retirement, I created an Excel spreadsheet using time value of money calculations across 10, 20, 30, and 40 years of accumulation periods. I considered three different choices: taking the match of 100% up to 10% of salary, assuming a $100,000/yr salary; somehow managing a 6% average rate of return, purportedly in an indexed life insurance or annuity product where the S&P 500 averages 6% with upside-only gains and no downside risk; and being fully invested in the market with no match (some people don't like the strings attached to retirement plans and would rather pay taxes along the way). It's important to realize that I do not consider taxes in these calculations.

My results are shown in the following table:

You will notice that cash (also known as the match) overtakes both the 6% average as well as the market returns at some point from 1% to 7%--that's the rate of return earned on keeping your cash somewhere, whether it's a CD, money market, bond fund, etc. The point is, there is no volatility in the cash account while there is in the market account. After 10 years, cash overtakes the market even at the 1% level, mostly because of the 2008 crash. Cash is even with the average account at, you guessed it, the 6% mark. Cash outperforms the other two accounts at 1% and beyond. For 30 and 40 year accumulation periods, however, it takes a higher return percentage for cash to "catch up" to the other accounts.

This shows the raw power of compounding with greater payments. In fact, one can argue that payments probably do more to hasten the compounding effect than rate of return does. There have been some articles written on this subject within the financial planning literature; It's ironic that people focus much more on rates of return than other important elements within the TVM equation such as present value and the number of compounding periods.

For those who like graphs, here is the above table presented in a combination chart:

The vertical axis represents the account values in $500,000 increments. The horizontal access depicts a combination of the number of years in which the participant is accumulating retirement assets and the rate of return percentage of the cash account. This is why all the values within the orange and grey groups, respectively, are the same number. Unfortunately, Excel does a poor job of depicting three-dimensional charts while illustrating four or more dimensions is nearly impossible within that program.

Several additional points are worth noting from this graph. First, the historical S&P 500 returns do better over a longer period of time. This is due to the law of large numbers when the observations revert to the mean. Second, the particular set of market returns matter. If instead of 10-40 years, each cluster was a separate set of 10 years, the interaction with the blue line (which is the cash account performance) would appear random. For instance, the single 10-year period leading up to the dot-com bubble burst or during the roaring 20s fared much better than the respective decades that followed them. Third, and probably least surprising, the slope of the cash account curve as it moves from 1% to 7% annual rate of return steepens with longer accumulation periods.

Admittedly, the best possible outcome, given market volatility, is to take full advantage of the match, for the longest possible period, and invest in the market despite the oscillations. Undoubtedly, it would take some impressive numbers for the cash account to overtake the market account if the 401(k) participant were investing the funds (employee + match) in the stock market. Yet, it should be clear that any discussion of contributing to an employer-sponsored qualified plan ought to include employer contributions as well. Considering the Facebook ad author is a self-proclaimed, "One of the top 100 most influential advisors in the US," it's unfortunate that she left out the employer match.

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