Average 401(k) Rate of Return: What You Can Expect

If you’ve been diligently contributing to your 401(k) account, you may wonder about your investment portfolio’s potential returns. As such, understanding average 401(k) returns — and how to plan for the unexpected — can significantly influence your future financial security. This is especially true given Social Security benefits may not be enough to cover all of your expenses in retirement.

Each 401(k) plan, like every IRA, is as unique as the individual investor. The average annual return can vary significantly (with a middle range of around 3% to 8%) based on how you allocate your funds across stock, bond, and cash investments. This variation in outcomes depends mainly on how your allocate your account balance, but also depends on how the broader economy performs as a whole.

For instance, many Americans use services like Vanguard to manage their 401(k)s and enjoy reasonable returns year after year. However, average market returns vary greatly from year to year: in 2021, broad markets rose by double-digits, while last year, in 2022, markets fell precipitously. Retirees and those nearing retirement must consider this variability when coming up with an asset allocation of their own.

In this article, we’ll explore the basics of 401(k) returns so you can start to anticipate your account balance and personal finance strategy as you plan for your retirement years.

Basics of 401(k) Plans

The 401(k) plan is an employer-sponsored retirement savings account that often comes as a standard employee benefit. Essentially, it’s a type of investment account you contribute to straight from your paycheck before taxes are taken out.

One attractive feature of most 401(k) plans is employer matching, where your employer will contribute to your 401(k) account up to a specified percentage of your total compensation. Your company match is essentially “free money” added to your retirement savings.

The IRS identifies contribution limits each year. For 2023, plan participants under 50 can contribute up to $22,500 in employee contributions, while those 50 and over can add on a catch-up contribution of $7,500 (for a total of $30,000 in elective deferrals).

Your employer’s plan administrator will outline your investment options within your 401(k), and they will usually include mutual funds, company stock, target date funds, and potentially even ETFs — depending on the brokerage.

Investing in a 401(k) can help you reduce your income tax burden in the present while building a reliable nest egg for later in life, boosted by employer matches along the way.

Asset Allocation and 401(k) Returns

The asset allocation strategy within your 401(k) is crucial in determining your expected investment returns. For example, investing primarily in real estate mutual funds or actively-managed ETFs might offer potentially higher returns but will also come with increased volatility. The risk-return tradeoff is a key concept here, as higher potential returns often come with a higher level of risk.

Making strategic decisions about your asset allocation, like the relative proportions of stocks, bonds, and cash in your portfolio, could lead to substantial growth over time. However, ensuring your asset allocation aligns with your investment goals, risk tolerance, and time horizon is essential. Otherwise, you may wind up with a more uncertain account balance that could leave you worried about your ability to take timely withdrawals in retirement.

Risk Tolerance and Investment Strategy

Your risk tolerance, or your ability and willingness to lose some or all of your original investment in exchange for greater potential returns, is critical to shaping your investment strategy.

Your risk tolerance is influenced by age, income, financial goals, and personal attitude towards risk.

Whether you self-assess or consult with a financial advisor, understanding your risk tolerance is important in crafting your investment strategy.

Balancing Risk and Returns

Balancing risk and returns in your 401(k) is crucial to achieving your retirement goals. Depending on your risk tolerance, financial goals, and retirement timeline, you might choose a moderately aggressive, aggressive, or conservative portfolio. Various asset allocations would be available through your plan provider — Fidelity Investments, for instance.

• The aggressive portfolio strategy, generally with 70% equities, 25% fixed income, and 5% cash, is ideal for individuals with higher risk tolerance. This might include younger investors who have a longer time horizon to retirement and can therefore withstand more short-term volatility in exchange for the potential of higher long-term returns. These portfolios can see the higher end of 8%-10%+ returns, with a higher potential for significant losses as well.
• A moderately aggressive portfolio, typically composed of about 60% equities and 40% debt or cash investments, is a common choice for individuals seeking a balance between risk and return. This strategy is particularly suitable for individuals who can tolerate some market volatility in pursuit of higher returns. These portfolios can expect around 5%-8% returns on an annual basis, but of course, this may vary from year to year.
• A conservative portfolio strategy, often comprised of 75% debt or fixed-income investments, 15% equities, and 10% cash, aims to protect investment principal while providing modest growth. This might be suitable for individuals nearing retirement who focus more on preserving capital than achieving high returns. These investors often gravitate towards stable options, accepting lower investment returns in exchange for less risk. This strategy may only yield 2%-3% returns over time.

It’s important to remember that no strategy guarantees a specific average rate of return, and all investing involves a degree of risk.

Target-Date Funds in 401(k) Portfolios

Target-date funds can be a valuable tool in retirement planning. They automatically adjust your investment mix over time based on your selected retirement year. For instance, if you’re younger and your retirement date is far off, the fund will likely allocate more to riskier investments like stocks.

You might invest in a fund called the 2050 or the 2065 fund—a name indicating your projected retirement year. As you approach retirement, the fund will automatically shift to safer investments to preserve the wealth you’ve accumulated.

It’s crucial, however, to monitor your target-date fund’s performance and make adjustments as needed, as they won’t necessarily be a “set and forget” solution if your preferences or personal financial circumstances change.

Monitoring Your 401(k) Performance

Just as you’d keep a close eye on any valuable asset, it’s essential to regularly monitor your 401(k)’s performance. This could involve comparing your investments to similar funds or benchmarks, understanding how fees can affect your returns, and conducting periodic reviews and adjustments of your investments.

Despite the stock market’s fluctuations (given the Fed’s recent decisions to rapidly change interest rates), a well-managed 401(k) can offer substantial returns over time. Still, you should take the time to monitor and adjust your account as your circumstances change.

Opt for strategies that reduce fees (especially investment expense ratios) and invest in assets that track well with the performance of standard indexes to avoid repeated transaction costs.

In Summary

Understanding average 401(k) returns is crucial for retirement planning. By considering various factors such as asset allocation, risk tolerance, and investment strategy, you can make informed decisions about your 401(k) investments and ensure your portfolio performs to a high standard. Continuing to contribute regularly and avoiding an early cash out will help set you on track for retirement.

Everyone’s financial situation and retirement goals are unique, so what works for other savers may not work for you. Remember this as you plan for your future, and always seek investment advice from a qualified financial planner if you run into more complicated trouble.

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