Financial Planning, Retirement

How Dollar Cost Averaging Helps Employees Manage their 401Ks

9/28/15 7:30 PM

401k

When it comes to retirement planning, the sooner your employees can get started, the better. Between student loans, home buying, having kids and everything in between, would-be investors may have little left over for their retirement funds — and those who do have to navigate investing strategies, market fluctuations and more.

Saving for your later years with the help of a 401(k) plan is a smart way to invest for the long term, but where and how much to invest are questions to which there are few easy answers. An investment strategy known as “dollar cost averaging” can help employees to better manage their 401(k)’s, helping to ensure investment success. Here's how:

A (Deceptively) Simple Plan

Investors who use dollar cost averaging invest the same amount of money into a particular portfolio on a recurring basis, as opposed to varying amounts in order to hit a future target (value averaging) or simply investing it all at once (lump sum investing).

Those who attempt to “time” the market correctly with large investments fail more often than not. Dollar cost averaging is, on the other hand, a sound strategy because by design it allows investors to put their money into both rising and falling markets, therefore ensuring that more shares are bought when the market is low but that enough are still purchased when markets increase. By accepting the good days with the bad, most investors stand to gain a lot more.

Those enrolled in 401(k) plans through their employers can easily make regular contributions to their funds through tax-deferred payroll deductions, which allow employees to avoid the need to funnel investment funds through their bank accounts or calculate income tax deductions.

How Dollar Cost Averaging Works

In a 401(k) plan that purchases mutual fund shares, using a dollar cost averaging strategy will result in a greater number of shares being bought when prices are down and fewer shares when they are up.

Let's say your employees invest $100 each month towards their 401(k)’s. Shares cost $20 each during the first month. That’s five shares.

The next month prices drop to $10 a share, netting them 10 more. Over a two-month period, employees have accumulated 15 shares at a total cost of $200. The average cost-per-share was $13.33.

Example #1: 2-Month Dollar Cost Averaging Strategy

1st Month:

$100 invested

$20/share

= 5 shares

Total Cost = $200

Total Shares = 15

Average Cost/Share = $13.33

2nd Month:

$100 invested

$10/share

= 10 shares


Dollar cost averaging has advantages over a strategy in which investors purchase the same number of shares from month to month. In the next example, employees purchase the same total number of shares over a two-month period but lose money against a dollar cost averaging strategy.

Example #2: 2-Month Strategy of Buying Equal Shares

1st Month:

7.5 shares × $20/share

= $150

Total Cost = $225

Total Shares = 15

Average Cost/Share = $15

2nd Month:

7.5 shares × $10/share

= $75


Moving Employees in the Right Direction

Employers have a responsibility to ensure that their employees are prepared for their post-occupational lives. Part of that responsibility entails nudging them toward viable investment strategies. For employers to understand the benefits of dollar cost averaging is one matter; getting their employees on board is quite another.

Employers can help first by educating employees about what's at stake: Saving for retirement isn’t just a good idea, it’s a necessity. Nearly half of retiring Americans will lack the savings to maintain their living standards after they stop working, according to a 2014 prediction by the Center for Retirement Research at Boston College.  

Employers can also provide additional incentives, such as offering 401(k) matching programs that encourage employees to adopt dollar cost averaging strategies.

Looking Ahead Together

Successful 401(k) management is achieved through attention and care over long period of time. While no single strategy works for all investors, dollar cost averaging helps most employees to avoid some of the guesswork and risk associated with other strategies while also pursuing a reasonable rate of return.

Prioritizing retirement savings allows for a more comfortable future; sticking with a consistent investment plan leads to rewards; and 401(k)’s are the most popular vehicle to get people there. If employers can help their staffs to navigate that long and winding path, why shouldn’t they?