How to Be a 401k Decamillionaire (A ConocoPhillips Case Study)

Bloomberg recently did an analysis of the best 401k plans offered by the list of S&P 500 companies.  They created a scoring system based on: matching contributions, additional automatic contributions, fund availability, vesting requirements, and automatic enrollment.  They also looked at special restrictions such as requiring matching contributions to only be in company stock (this subtracted from the overall score).  Overall, it looks like they have a pretty good methodology.

I was amazed at some of the very best 401k plans at the top of the list – check out ConocoPhillips right at the top.  There’s some major opportunities for saving up a big chunk of cash for retirement without a lot of sacrifice.  It’s almost as if these companies simply shifted their pension obligations over to profit-sharing via 401k matches and contributions.  Check out the list of the top ten:

best401ksTo the astute investor out there it should be no surprise that a lot of the companies at the top of this list pay hefty dividends out to their shareholders.  ConocoPhillips, Boeing, McDonald’s, Altria, and Phillip Morris International stand out in particular.  However, there are others like Google, who don’t pay a dividend, but have a lot of free cash flow they can give back to their employees.  Citigroup barely pays a dividend as of this writing, but that’s likely to increase in the future, especially if interest rates rise.

One thing that came to mind when I looked at this list was thinking about an average employee who had a goal of stashing away a lot of retirement cash – how could they maximize their 401(k) plan?  What do you get when you couple significant sums of retirement savings on both the employee’s side and the company’s side?  The answer: a lot of money 🙂  But how much is possible?  What is the potential here?

Let’s imagine a fictional guy named Treyvon.  He’s a smart dude, and he’s 22 years old.  He just graduated from engineering school and snagged a job at ConocoPhillips as an entry level reservoir engineer.  His starting base salary is around $100,000.  Man, look at this guy.  Already so young and he’s raking it in.

reservoirengineer

Being a wise young man, Treyvon decides not only to contribute the 1% needed to get the 401k match from the company, but to max it out entirely.  He just got out of college so, what the heck, he’s been living in poverty anyway, what’s $18,000 of unseen money?

At this point let’s look at the breakdown of ConocoPhillips’ retirement package.  It looks like they offer:

  • 9% match on the first 1% contributed to the 401k
  • 6-9% of employee compensation, based on age, placed in a cash account
  • a wide collection of stock and bond index funds
  • immediate, 100% vesting of all contributions

Let’s assume average 3% raises throughout Treyvon’s career.  Let’s also assume that even though the cash account contributions are credited with interest based on the U.S. 30-year Treasury rate, they earned no interest whatsoever so that it is truly a “cash” account.  Also, I assume that the full $18,000 contributed each year never increases.

His money compounds at an average rate of 10% annually over a 40 year period, net of fees.  I also assumed that all 401k contributions are using the Roth 401k option, which ConocoPhillips offers.  Although all company match contributions will be pre-tax, there is still a lot of money that is going to be saved in future taxes, as I demonstrated in this post where I talked about my wife and I’s decision to switch our 401k contributions from pre-tax to Roth.

Here’s what happens after 40 years of consistent contributions and compound interest:

ConocoPhillips401k_1
This is possible because of consistent contributions made from both Treyvon and ConocoPhillips over a long period of time.  Getting an average of 10% returns helps too, of course, but even if the returns were 5% annually, we’re still looking at over $4,000,000 in 401k wealth.  At the end of 40 years, our faithful petroleum engineer will be a decamillionaire.

This doesn’t account for stellar performance on the job, which would mean even higher raises than the 3% assumed.  This doesn’t take into account raised limits on 401k contributions over the years.  This doesn’t account for interest earned on the cash account.

Treyvon could have never saved another penny.  He could have taken the rest of his earnings and, after taxes and basic expenses were accounted for, gone out every weekend for beers with the boys.  He could travel to Europe every year.  Give large donation checks to his church.  Buy a house and comfortably support a family of five.

Ok, ok, you get it.  If you’re reading this, you’ve likely heard some version of it before.  Save lots of money and do it as early as possible and eventually you’ll wake up with boatloads of cash.  But what about an extreme case?  What if we pushed the limits of our assumptions even further?  What if our fictional engineer, at the age of 21, looked at his life and decided to tweak all of the variables he could in order to ensure the highest amount of wealth in his 401k account at 60 years old?

Let’s adjust our assumptions.  Let’s say there are 5% raises because of hard work and recognition among our guy’s management.  This will directly affect the company match as well as the amount contributed to the cash account over time.  Let’s also assume that the 401k contribution limits rise $500 every year.  This is typically in line with what has happened historically.  Here’s what happens to the numbers:

ConocoPhillips401k_2

That’s almost an extra $4,000,000.  Those increased IRS contribution limits make a difference.  Higher salaries over time make a difference.  Sometimes people complain because of seemingly small 2% or 3% raises at work, or maybe even shrug at the thought of the IRS increasing annual contribution limits by a whopping $500 per year.

I get it, I’ve been there.  But there are many worse things in life.  That seemingly small increase in income and seemingly small increase in tax-sheltered contributions means real wealth over long periods of time.  That extra $4,000,000, given an average dividend yield of 3%, could be pumping out an extra $120,000 per year in passive income.  Just as in the lesson of compound interest we cannot despise the day of small beginnings, neither can we be ungrateful for the days of small pay or savings increases.  Over time, they really do make a difference.

Let’s summarize the list of advantages that made this $18.6 million 401(k) account possible:

  1. To start, make as much money as possible, maybe even six figures, right out of college in order to  provide investment capital.
  2. Work for a company that has a generous matching program, and maximize it’s benefits.
  3. Maximize the IRS guidelines for contribution limits.
  4. Utilize a Roth 401(k) if it is available to significantly cut future tax liability (matching contributions will still be taxed under current rules).
  5. Invest every year without fail, and without taking loans out of the account and ignoring market fluctuations.
  6. Utilize low-cost index funds in the 401(k) in order to reduce fees.

By stacking advantage on top of advantage, before long a lollapalooza effect occurs, where you have multiple various reinforcing each other, which results in exponential returns over time.  Although this is great in an ideal world, the first example proves that you don’t have to get everything right to have outstanding results.  Just putting together a few key variables can make things work out just fine.  Here, the most important variables are the high starting salary, the generous matching program, and the passage of time.  The other variables simply amplify the results further.

I was excited to write about this case study because it helps psychologically reinforce decisions my wife and I are making in our own lives.  Over time, habitually making small good decisions can yield fruitful results, and it’s one of the reasons I’ve grown to love the process of investing.

Applied Skill is the Foundation of Wealth

As I drive to and from work everyday, I pass by a McDonalds off to the side on one of the corners of the road.  As someone who worked in food service at one point, I empathize with how some of the workers probably feel with regards to the pay that they receive.  It can be really frustrating when you work hard and then, after Uncle Sam takes his cut, you sit there looking at your paycheck bamboozled at how low it is.

News regarding pay within the food service and retail industries has been good lately, however.  McDonalds recently increased their minimum wage by about 10% at company owned stores, and expanded their benefits to employees (GED program, PTO accrual, etc.).  Wal-mart and T. J. Maxx also raised their minimum pay for workers.  This definitely looks like a way to temporarily quiet the storm that is brewing among the lower classes.  The middle class is almost extinct if you look at any recent data sets.

In fact, check out this snippet of a table from the Survey of Consumer Finances’s most recent report.  Look at the 2013 data for mean income.

The inequality of income between Americans continues to increase.

The inequality of income between Americans continues to increase.

This shows that median income decreased over a period of three years for all but the top 10%  – and this was in a period of slow (but still existent) economic recovery!  I think it’s great that McDonalds and other companies are raising wages, but let’s not kid ourselves.  What do you think is going to happen?  Companies will slowly start raising prices as well.  This is natural inflation.  Sure, food service and retail workers may psychologically feel like they are making more money, but on an inflation-adjusted basis over the long term it is more like treading water.  It’s clear that the gap of income is growing greater between the classes, and it’s only going to increase.

Let’s dive a little deeper into that concept.  Why would the gap increase so much?

At the Foundation, All Wealth Comes From Applied Skills

Simply put, the majority of those who are growing wealthier and wealthier have become more adept at providing value to other people in some form.  Sure, there will always be those out there who are crooks and swindlers.  Some people take what is not theirs, and lie, cheat, and steal to exploit others.

By and large, however, most people who have attained wealth in capitalistic societies did so because they were able to provide more value to more people throughout their lives.  This is evidenced by the data from the late Dr. Tom Stanley who discovered through his research that the majority (90%) of millionaires in America are self-made, and that they are virtually all small business owners, well-paid professionals, blue collar workers, and people who simply lived frugally and invested a modest amount over a long period of time.

Think about every dollar that exists.  Somebody earned it from something.  The cashier at McDonald’s earned it by smiling, ringing up the register, and taking orders for customers.  The manager of a hedge fund earned it by helping vigorously studying the markets and providing a satisfactory return to their clients, which could then be used for vacations, new clothes for the kids, and gifts to charity.

Since almost the beginning of time, mankind has recorded this value in the form of currency, which is then used as a trading mechanism for goods and services.  When you pay for groceries at the store, you are breaking off a piece of the value you created for someone else through your job or assets.  The grocer (as a company) gets a piece, the person who rang up your food gets a piece, the food distributor gets a piece – and then they all purchase things to sustain their own lifestyles.  It’s all value being traded for value.

In a way, it is such a beautiful system.  People are rewarded, over the long term, based on how much they can serve other people.  Folks who get wealthier with each passing year have simply figured out how to serve people more than those who do not.  This could be in the form of financial capital (investing), knowledge capital (white collar job), knowledge plus physical capital (many blue collar jobs), etc.

The Ways Applied Skills are Utilized and Packaged Determines the Amount of Wealth that is Ultimately Produced

The way I see it, there are two primary ways that skills are applied to create wealth:

  1. Direct application of skill
  2. Inventoried skill

Direct application of skills is active effort to accomplish something, with value being recognized for a  specific amount of effort.  When a bodybuilder lifts a heavy weight at a competition, they get paid for the physical effort they exert.  The same goes for professional football or basketball players.  When I walk into my office in the morning and engineer something, that’s a direct application of skill because I’m performing a service and getting paid a salary for it.  If I don’t perform the service then I won’t get paid.

The same thing goes for people who sell products and services of any type.  They exert their skills of communication and knowledge to potential buyers, and then when buyers do make a purchase, they get a commission check.

I am not necessarily referring to people paid on an hourly basis, although all work that people do get paid hourly for does fall within this category.  For example, a famous artist might be commissioned to produce a new sculpture for a college campus.  They don’t get paid for their time directly, but rather for the finished product itself.  (There may be a deadline on the project, but you see the big picture)

The next type of skill is inventoried skill.  This is skill that has been created through direct application, but is eventually contained in some kind of asset.  Assets provide recurring value and are thus an expression of past skill.  An asset like a house in a growing neighborhood will continue to provide value after decades, while something like an industrial tractor will provide a lot of value at first, but then start to produce decreasing amounts of value as the usefulness of the asset decreases and the tractor breaks down.

I say that these assets are inventoried skill because someone had to come up with the idea for these things and create them.  A group of builders designed the house, and a group of developers and contractors built it.  A team of people designed the tractor, while a different group of people provided the raw metal that was then shaped into various parts.

All businesses are inventoried skill because they are organized systems of people and tools used to deliver a product or service.  A patent is inventoried skill because it is intellectual property that describes the details of how a product works and functions – its value is recurring because many millions of that product could conceivably be created from it.  Likewise, a best-selling book is a form of inventoried skill because it is a person’s best ideas concentrated into written form, providing value for many people each time they turn a page.

A Framework is Necessary for Understanding the Impact of Any Applied Skill

Looking at the larger picture, these two types of skill can be applied within the backdrop of two abstract concepts:

  1. Time
  2. Leverage

Looking at the time over which a skill is applied determines it’s usefulness.  If you and I were at the top of a mountain and used a fire-hose to spray a river of water down its side, we’d get bored quickly.  Nothing would seem to happen.  However, imagine that we were immortal so we didn’t care about wasting a few millenia.  Say it’s 10,000 years later – that mountain would have substantially decreased in size!  Given enough time, the water from the fire-hose would erode away the surface.

The same concept applies to investments.  Those bi-weekly 401(k) contributions don’t seem like much for the first few years, but once a critical mass is reached, the results can be awe-inspiring.  Time can have an exponential effect of the value that is created (or destroyed) by applied skills.

The next backdrop to view skills from is leverage.  Imagine two businesses: an online magazine and a traditional newspaper company.  Both cover the same subject matter, hire the same amount of writers, and start out with the same amount of capital.  Which do you think will immediately be able to reach more people?  Of course, the online magazine.  The ability to leverage technology is this case provides a supreme advantage over the traditional method of delivering the same product.

Creating positive associations of wealth, status, and youth with a product are forms of psychological leverage.

Creating positive associations of wealth, status, and youth with a product are forms of psychological leverage.

Aside from technology, leverage can be thought of in terms of human psychology.  Think about ads for liquor companies touting the latest brand of vodka.  What is the ad likely to feature?  Surely it isn’t a bunch of average looking bums sitting on the couch and pouring each other shots.  No, it’s likely a group of handsomely dressed men and woman at a club, laughing and having a good time.  The ability of marketers to leverage the emotions of those who are exposed to their advertising enhances the usefulness of their applied skills (the collective liquor business) because people are more likely to buy more vodka when they see ads like that.

Another form of leverage is the collective human potential of teamwork.  When people work together toward a common goal, they can accomplish far more than they ever could if they approached the same goal as an individual.  If you’ve ever been a part of a sport’s team and had one of those “in the zone” moments, you know exactly what I mean.  We can apply skill far more effectively and efficiently when we work with other people and are in sync with them.

In Summary, Applied Skill Determines Levels of Wealth at both Microscopic and Macroscopic Levels

Coming back to the example of McDonald’s, we can look at the issue of income inequality and wealth generation at different levels.  While the worker at the cash register of McDonald’s is applying certain skills directly and is getting paid relatively low wages for it, the franchise owner or the stockholder is receiving profits commensurate with the combined and leveraged skills of other people.  The franchise owner depends on both the inventoried skills of his or her assets (the building housing the restaurant, the cooking equipment, the McDonald’s brand name) as well as the directly applied skills of the employed workers.  Simply, the franchise owner gets a bigger paycheck because they are the one organizing and managing the system that is their McDonald’s restaurant.

At an even higher level, since McDonald’s is a publicly traded company, people all over the world part with their cash to collect small pieces of ownership of the entire business.  In doing this, they entitle themselves to a portion of the earnings that the business creates (in the combined form of dividends, share buybacks, and retained earnings used for growth).

When you become an investor and a business owner, you essentially elevate yourself to a different part of the path that money flows up to.  Those who are in the top 1% of income and net worth in America receive only about half of their compensation from active earned income (wages).  Instead, they have designed their financial life such that they receive a significant percentage of their income from business profits as well as from investments.

By focusing on building future profits and other streams of cash for ourselves, we can begin to avoid being left behind by the inevitable class separation that is occurring in our country.  It would behoove us to learn to not only apply skill directly for higher wages (i.e. graduating high school and college and becoming a well-paid professional in our trade), but also to learn the skills of business and investing, if only at a basic level.  Properly owned and understood forms of inventoried skill – assets, coupled with the right leverage and enough time to compound, will help sustain us and our families financially for years to come.