When it comes to making investment decisions regarding your 401k, the choice between a fixed 7% return and diversification is not a simple one. Both options have their advantages and disadvantages, and understanding them is crucial in making an informed decision.
Firstly, it’s important to understand what a 401k is and how it works. A 401k is a retirement savings plan offered by employers to their employees. It allows individuals to contribute a portion of their salary on a pre-tax basis, meaning the contributions are deducted from their paycheck before taxes are calculated. The contributions can grow tax-deferred until withdrawn during retirement.
Now, let’s examine the concept of a fixed 7% return. This option implies that your investments within your 401k will consistently yield a 7% return every year. This may sound enticing as it offers a predictable and guaranteed return on your investment. However, it’s essential to be aware that a fixed 7% return is not typical in the investment world. Investments come with various levels of risk, and higher returns often come with higher risk. A fixed 7% return may be achievable with low-risk bonds, but it is unlikely to be sustainable over an extended period of time.
On the other hand, diversification refers to spreading your investments across a variety of asset classes, such as stocks, bonds, and mutual funds. This approach aims to reduce risk by not putting all your eggs in one basket. By diversifying your investments, you can potentially benefit from a mix of asset classes that perform differently under various market conditions. For example, while stocks may have higher returns in a bull market, bonds tend to perform better during a bear market. Diversification helps smooth out fluctuations in your overall portfolio, potentially reducing the impact of a single investment’s poor performance.
While a fixed 7% return may offer stability and a guaranteed return, it is essential to consider the long-term effects of such an option. Inflation is a critical factor to consider, as a fixed 7% return would need to outpace the rate of inflation to truly grow your savings. If the rate of inflation exceeds 7%, your purchasing power would erode over time, potentially leaving you with a diminished retirement fund. By diversifying your investments, you have the opportunity to potentially outpace inflation with higher-yielding assets while still managing risk through a well-balanced portfolio.
Another aspect to consider is your risk tolerance. Some individuals are more risk-averse and prefer the stability of a fixed return. Others may be more comfortable with taking on higher risk to potentially achieve higher returns. Understanding your risk tolerance is crucial in determining whether a fixed 7% return or diversification is the better option for you.
It is also important to note that past performance does not guarantee future results. While a fixed 7% return may have been achievable at certain times in the past, it does not necessarily mean it will continue to be the case in the future. The investment market is constantly changing and influenced by various economic, social, and political factors. Diversification can help mitigate the risk of relying solely on a fixed return by spreading your investments across different asset classes and potentially reducing the impact of a single investment’s poor performance.
Considering all these factors, it is generally recommended to opt for diversification rather than a fixed 7% return on your 401k. By diversifying your investments, you can potentially benefit from a mix of asset classes and manage risk effectively. A diversified portfolio allows you to capitalize on opportunities in various market conditions and potentially achieve long-term growth. It provides the flexibility to adapt to changing market dynamics and maximize the potential returns while managing risk.
However, it’s crucial to remember that every individual’s situation is unique, and what works for one person may not work for another. It is always advisable to consult with a financial advisor who can evaluate your specific circumstances, investment goals, and risk tolerance to provide personalized guidance.
In conclusion, the choice between a fixed 7% return and diversification for your 401k can be a complex decision. While a fixed 7% return may provide stability and the allure of a guaranteed return, it may not be sustainable or adequately protect against inflation. Diversification, on the other hand, offers the potential for higher returns and reduced risk through a well-balanced portfolio. It allows you to take advantage of different asset classes and adapt to changing market conditions. Ultimately, consulting with a financial advisor is essential in making an informed decision that aligns with your specific circumstances and long-term goals.
I am skeptical that a municipality, funded by taxpayers, would guarantee a 7% return rate against a market that may dictate way less. Are you sure you don’t mean a 7% match?
You can see past history of the returns here:
https://www.trsnyc.org/memberportal/Investments/HistoricalDataInvestmentReturns
Not really sure how the fixed return is always 7%, I’d be curious to know how they never go above or below that with market fluctuations.
Assuming they can actually deliver on the 7% returns, this is actually a pretty solid deal. It makes your retirement planning very easy since you can literally work out exactly how much money you will have in your 401k by the time you retire.
If you want to do things kind of like how target date funds do things, you would start off more heavily in stocks and gradually transition over to the fixed 7% returns as you get closer to your retirement date (depending on your appetite for risk).
Since you already have a Roth IRA, though, you could just let that be your riskier, high growth retirement vehicle and leave the 401k more conservative.
My municipal gov’t pension is based off a mandatory contribution from me of 7%. They match me 2:1, and they guarantee 7% returns on all of it.
It costs them anywhere between 11-14% of payroll to achieve this for all employees.
Some caveats: you don’t vest with their money until year 5. So there’s a lot that they put aside but gets left behind from people who leave prior to year 5. This money left on the table by departing employees is used to keep costs down for funding everyone else.
Their target returns for their investments is 8%. 1% goes to fees and/or reserves, then 7% goes to the employee. Any year they do better than 8%, that gets banked to offset lean years in the future, and/or to decrease the contribution rate of the employer in the next year.
I was with the organiztion on and off for 20+ years starting in the mid-1990s and the plan was solid throughout all that time.
*(Next day edit: When I posted this, the top comments were assuring OP she was confused or naive, and all her replies were deep in the negative. But now she’s gotten some good advice and context.)*
ITT: The top comment is someone snarkily denying this could be real, and OP is getting downvoted to oblivion
But this is a very real option in the NYC teachers’ deferred compensation plan. Here’s a detailed read on the history and mechanics of it:[https://cbcny.org/research/expensive-and-risky-benefit](https://cbcny.org/research/expensive-and-risky-benefit)
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>In 1988 the State Legislature added a unique feature to the TDA: a guaranteed fixed return fund investment option. TDA participants could designate some or all of their contributions for the fixed return fund, guaranteed to return 8.25 percent. The guaranteed rate was pegged to average returns in the QPP over previous years and was close to returns on federal government bonds at the time.
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>In 2009 the guaranteed rate on the TDA fixed fund option was lowered from 8.25 percent to 7.0 percent for most participants. This State legislative action followed a collective bargaining agreement between the Mayor and the United Federation of Teachers (UFT).
I’m in my 30s and I do 50/50 fix and the diversified large cap. I treat the fix as a bond allocation that returns much better than average.
I often take a conservative 6% ROI when forecasting my investments performance until retirement, so personally I think I would lean heavily towards choosing that guaranteed return
>25f
Personally I would go in for far more riskier stocks/etfs at this age for the higher return, since retirement is so far away there is no reason to be so conservative, but that’s just me. Fixed rate of return of 7% is still pretty damn good.
I interact with employers that offer a ‘similar’ deferred compensation benefit. They have legal language where if the contract is terminated, the participants will experience a ‘market value adjustment’ or MVA. the rates on those contracts are between 2-6% and the MVA if exercised is around 10-25%.
While I don’t work at all with TRS, just doing napkin math, largest holding is core bonds at TRS, likely with a yield of around 3.1%. You can then divide 3.1% by current rates of like 4.75% and get an MVA of around 65% – so in this example someone would lose 35% of their account if the MVA was exercised today.
what employers do to get around this, if they have to exercise these things is either extend the duration of the contract, or place a put on distributions, limiting only 15% of all the money for all employees to be transferred/withdrawn each year, or to pay out all your funds automatically over like a decade.
TRS doesn’t appear interested in exercising this, so this would just be doomsday math, in case the legislature changed the laws, or lots of participants died at once and all the beneficiaries tried to quickly make a distribution.
you could compare this bad scenario with a bad scenario of OP’s other investment choice, the diversified index, which has a standard deviation of 16.74% – which means that in 95% of scenarios it won’t drop by more than 33.48% in a short time frame – but it would likely eventually recover, whereas the fixed fund would not.
meanwhile, if you are continuing to outperform the risk free return by .8%, then over 20 years the difference (assuming $20,000 annual contributions) would be 819,000 vs 895,000 (or 9.1% more money, if you are saving a different amount)
TRS seems to only use indexes, so you can’t use require rate of return or CAPM formulas to determine other investment choices – but if you were using individual securities in your Roth IRA with betas different than 1.0 you can use an RRR or CAPM formula to see if it’s worth it.
Now, OP claims that they have access to a 401k, but I was under the impression that TRS is a 403b. I don’t know if that changes any of the rules on this. lots of 403b employers have annuity options, where there might be a 7% guarantee, but it also might not have the liquidity options that TRS in particular offers.
Fellow NYC teacher, I would look at other options especially with your age. You can diversify. The TRS newsletters we get mailed to us have the funds listed with rate of return for each fund over different time periods. I wish this was tax free growth but it’s better than nothing, I have a ROTH also.
Take it. That is close to 10% (based on your income tax bracket) on an after-tax equivalent basis.
7% is the inflation adjusted average return of the S&P500 over the last 100 years.
Many people think that means that is a reasonable number to expect the S&P500 to return in the future. It might over the next 100 years but almost certainly the number will not be 7% over the next 10 or 20.
The thing that really matters is the valuations at the start of the period you are concerned about. One metric that is highly correlated with future returns is the “Cape P/E ratio”. It is currently at around 30. No single 10 year period starting with a Cape P/E of 30+ has ever returned more than 5% and usually a lot less.
Take the 7%. I would if it was an option.
At your young age I would
* put 100 percent of future contributions into SPY / VOO
* every 2 weeks move 2 percent of your fixed rate balance to SPY / VOO