How Much Should I Contribute To My Deferred Compensation Plan?

As a government employee, you have access to the 457(b) plan, one of the most powerful retirement tools available. However, there’s a key decision you face that will shape your retirement savings strategy: Should you contribute a percentage of your income, or should you lock in a fixed dollar amount?

It may sound like a small question, but in the context of long-term retirement planning, the implications are substantial.

In my work as a financial advisor for 457(b) participants, I’ve often encountered clients who are unsure about how to structure their contributions. Should they keep it simple and contribute the same amount every paycheck, or should they adjust their contribution to reflect their growing income? The answer isn’t always obvious, and the choice you make can have a lasting impact on how well-prepared you are for retirement.

But here’s the problem: many government employees start their 457(b) contributions with a fixed dollar amount in mind, without revisiting that amount year after year. They may not realize that inflation, salary increases, and compounding returns all have the potential to outpace their contribution strategy if they don’t adjust it regularly. As a result, the fixed dollar amount that worked early on may not be sufficient as their salary grows or as inflation eats into the purchasing power of their savings.

Personal Experience with the Problem for Relatability

I vividly remember working with a client, John, who had been contributing $100 per paycheck to his 457(b) plan for over 15 years. At first, this amount was a manageable percentage of his salary, and he was on track to retire comfortably.

However, after multiple promotions and raises, John’s income had increased by 50% over the years. He had successfully increased his savings rate in other areas of his finances, but his 457(b) contributions remained stagnant. As a result, his retirement savings weren’t growing in line with his increased income.

When we sat down to review his retirement goals, John was surprised to see that his fixed contribution amount was no longer sufficient to meet his desired retirement standard of living. Even with market growth, he wasn’t saving enough to fully fund his retirement lifestyle. After analyzing the impact of adjusting his contribution rate to a percentage of his income, John realized that switching to a percentage-based strategy could unlock significant growth potential, given the power of compounding.

This experience is common among those who fail to adjust their contribution strategy over time. Without regularly revisiting your plan, you may unknowingly limit your retirement growth, despite having a higher income and greater potential to save.

The Difference

Before diving deeper, it’s crucial to understand the two main approaches to contributing to your 457(b) plan: fixed dollar contributions and percentage-based contributions.

• Dollar-Based Contribution: This is a fixed dollar amount you contribute each pay period, regardless of how much you earn. For example, you might decide to contribute $500 every paycheck. While this gives you clarity on how much you’re saving, it doesn’t account for changes in your income.
• Percentage-Based Contribution: This means contributing a fixed percentage of your income, such as 5% of your salary per paycheck. As your income grows, your contributions increase accordingly. This approach naturally adjusts for raises, promotions, and inflation over time, which can help you stay on track for your retirement goals.

So, What Should I Do?

Now that we’ve established the basics, let’s break down how you can make the most effective decision for your retirement.

Understand the Advantages of Percentage-Based Contributions

The primary advantage of percentage-based contributions is that they scale with your income. As your salary increases, so do your contributions. This helps ensure that you’re saving a proportionate amount of your earnings, which is critical for keeping pace with inflation and lifestyle changes over time.

For instance, let’s say you earn $50,000 and contribute 5% to your 457(b) plan. That’s $2,500 per year. But if your salary increases to $60,000, your 5% contribution automatically adjusts to $3,000 per year—an increase that directly correlates with your higher income. This keeps your retirement savings rate consistent with your increased standard of living.

Moreover,  when you contribute to your 457(b), this allows you to take advantage of compounding growth. As your contributions increase, the potential for your money to grow accelerates, especially when you stay consistent and allow for years of growth. This strategy essentially ensures that your savings grow as your financial situation improves.

Well, what percent should I contribute? Rule: Aim to save at least 15% of your gross income (before taxes) each year for retirement. 

Saving 15% of your income is a good target to ensure that you’ll have enough to retire comfortably, when you start early enough. This percentage can be a combination of your contributions to a 457(b), 401(k), IRA, and other retirement accounts. This can be adjusted for forced pension savings, if desired.

Assess Your Current and Future Income

If you’re starting with a lower income, a fixed dollar amount might feel more manageable. For example, early in your career, contributing a specific dollar amount (say, $200 per month) may seem like a reasonable starting point. However, as you receive raises and promotions, the gap between your actual savings rate and your future retirement needs will begin to widen. If you don’t revisit your contribution rate regularly, you may find yourself under-contributing as your salary increases.

For those already earning a substantial salary, sticking to a fixed dollar amount might lead to missed opportunities for maximizing savings, especially given the higher contribution limits for 457(b) plans. A percentage-based approach becomes crucial to stay on track for larger retirement goals.

Use Percent-Based Contributions to Account for Inflation

Over time, inflation erodes the purchasing power of your money. In 30 years, a dollar today won’t buy you the same amount of goods and services. By increasing your contributions in line with inflation, you can help protect the purchasing power of your retirement savings.

For instance, if inflation averages 2% annually, your future retirement income needs will be much greater than they are today. By contributing a percentage of your income, your contribution automatically increases with inflation, helping you stay on track to meet your future retirement needs.

Take Advantage of IRS Contribution Limits

The IRS sets annual limits on how much you can contribute to a 457(b) plan. It’s essential to periodically assess whether you’re taking full advantage of these limits, especially if you’ve received salary increases.

Reevaluate Your Strategy Annually

Finally, it’s essential to periodically review your 457(b) contribution strategy. Regardless of whether you choose a fixed dollar amount or a percentage of your income, your financial situation and retirement goals will evolve over time. Annual reviews allow you to make adjustments and keep your retirement savings strategy on track. If you receive a raise, increase your contribution by the same percentage. If your salary plateaus, ensure you’re still contributing enough to meet your goals.

What Next?

The decision to contribute a percentage or a fixed dollar amount to your 457(b) plan is a fundamental one that can greatly impact your retirement security. While a fixed dollar contribution might work in the short term, a percentage-based approach offers more long-term growth potential, scalability, and inflation protection.

Ultimately, your retirement plan should grow with you, not remain static. Regularly increasing your contribution rate in line with your income ensures that you’re always saving an appropriate amount, making full use of tax-deferred growth, and staying on track to achieve your retirement goals.