What Does 1% Annual Increase Mean with 401k? [2024]

What Does 1% Annual Increase Mean with 401k? A 401(k) plan is an employer-sponsored retirement savings account that allows employees to contribute a portion of their paycheck pre-tax to save for retirement. Many employers also offer to match a percentage of the employee’s contributions up to a certain limit as an extra retirement benefit.

When signing up for a 401(k), one of the key factors to understand is the annual increase percentage. This refers to the expected annual rate of return on your 401(k) investments. While past performance does not guarantee future returns, the annual increase percentage provides an estimate of how quickly your contributions may grow each year.

Even a small difference of 1% in your annual increase can have a big impact long-term. This article will break down exactly what a 1% 401(k) increase means and the power of compound growth over time.

What is a 401(k) Annual Increase Percentage?

The annual increase percentage for a 401(k) plan refers to the expected yearly rate of growth for your investments within the account. This includes investment returns in the form of dividends, interest, and capital appreciation.

401(k) plans offer various investment options, usually mutual funds, that are designed to provide diversification and compounding growth. The projected annual increase for each fund is known as the fund’s average annual total return.

When you choose the funds to invest your 401(k) contributions, the weighted average annual returns across all your fund selections make up your portfolio’s annual increase expectation.

For example, if you invest 60% of your 401(k) in Stock Fund A with a 10% annual increase, and 40% in Bond Fund B with a 5% annual increase, your total portfolio annual increase would be:

60% x 10% = 6% from Fund A
40% x 5% = 2% from Fund B

Total Annual Increase = 6% + 2% = 8%

The Power of a 1% Higher Annual Increase

While 1% may seem like a small difference, the power of compound growth in a 401(k) over decades can make a 1% variation in your annual increase tremendously impactful.

Here’s why:

• Your contributions and investment returns stay invested and grow year after year
• Returns compound upon prior-year returns, accelerating overall growth each year
• Small variances today become major differences over 30+ year time horizons

To demonstrate, let’s compare two hypothetical 401(k) savers with identical starting balances, monthly contributions, and timelines, but with a 1% difference in annual increase.

Saver 1 401(k):

• Starting Balance: $5,000
• Monthly Contribution: $250
• Annual Increase: 7%
• Time Horizon: 35 years

Saver 2 401(k):

• Starting Balance: $5,000
• Monthly Contribution: $250
• Annual Increase: 8%
• Time Horizon: 35 years

Although their inputs are mostly the same, Saver 2’s ending balance is 16% higher! This is thanks to the power of compound growth applied over decades.

Here is a detailed year-by-year breakdown:

Year 1

• Saver 1 Balance: $6,633
• Saver 2 Balance: $6,750

Year 10

• Saver 1 Balance: $39,097
• Saver 2 Balance: $42,333

Year 20

• Saver 1 Balance: $135,275
• Saver 2 Balance: $163,064

Year 30

• Saver 1 Balance: $394,797
• Saver 2 Balance: $501,297

As you can see, the longer the time horizon, the greater the impact a 1% annual increase differential has thanks to compounding.

Key Takeaways:

1. Focus on your expected annual increase when making 401(k) investment selections
2. Small short-term differences compound over long periods into tremendously different outcomes
3. Maximize 401(k) contribution rates and returns to benefit from compound growth

How Much Could 1% Higher Annual Returns Really Make?

Based on reasonable assumptions, here is additional detail on how impactful a 1% higher annual 401(k) return could be for savers at various ages:

For a 25 Year Old

• Over 40 years, an extra 1% per year results in 30% higher ending balance
• On a $500,000 portfolio, 1% greater returns adds $4,000 more growth per year

For a 45 Year Old

• Over 25 years, an extra 1% yearly return leads to a 20% bigger ending balance
• On a $750,000 portfolio, 1% higher returns adds $7,500 more growth per year

As you can see, thanks to decades of compound growth, small return differences have huge impacts. This demonstrates the value of maximizing 401(k) annual returns.

What Drives a 401(k) Plan’s Annual Increase Percentage?

Now that you have seen the power of compound growth and how small return differences have big long-term impacts, you may be wondering – what factors actually influence my 401(k) plan’s annual increases?

The key drivers are:

1. Asset Allocation
2. Individual Investment Selections
3. Fees & Expenses

Let’s explore each of these in more detail:

Asset Allocation

Asset allocation refers to what types of investments make up your overall 401(k) portfolio – specifically, the percentage breakdown across stocks, bonds, and cash equivalents.

Stocks tend to provide higher long-term returns than bonds and cash, but with higher volatility. Bonds generate consistent interest income with medium risk profiles. Cash is very low risk but provides minimal returns.

Finding the right equity/bond/cash allocation ratio for your risk appetite and time horizon maximizes returns while properly managing risk. Typical 401(k) allocations may shift from 80/20/0 stocks/bonds/cash in your 20s to 50/40/10 by retirement.

Individual Investment Selections

Within each asset class – like stocks, bonds or stable value funds – there are many individual investment options. Selecting funds with experienced managers, disciplined strategies, and histories of strong risk-adjusted returns is key.

Two funds in the same category can vary widely in their holdings, geographic focuses, size exposure, and ultimately, performance. Picking winners matters.

Fees & Expenses

All investments charge annual fees to cover their operating costs, usually expressed as “expense ratios.” These include mutual fund management fees, recordkeeping fees, etc.

While fees may only total 0.5-1% per year, this directly reduces annual increases. Over decades, high fees can consume 20-30% of a portfolio’s value. Seeking low-cost index funds and institutional share classes adds up.

The Bottom Line

A 401(k) plan’s annual increase projection is no small detail. The compounding impact over 30+ years is so powerful that even a 1% extra return each year results in vastly greater retirement savings.

Be sure to factor in expected annual returns when making asset allocation and investment selections. While past performance cannot guarantee future results, understand what drives returns in your 401(k)’s underlying investments so you can maximize this key contributor to retirement income.

FAQs

Here are some commonly asked FAQs about what a 1% annual increase means for 401(k) plans: