Index funds aren't too exciting, but they deliver reliable long-term results. Not everyone will reach millionaire status with the S&P 500, but the index still offers a pathway to a seven-figure nest egg. Keep the following in mind as you plan the investment strategy for your 401(k), IRA, or other retirement account.
This chart should look familiar for most investors: It's the S&P 500's performance over the past 30 years.
The index offers no guarantees -- there are plenty of significant, temporary declines as you can see above. However, history has shown us the S&P 500 rises as the global economy grows long term. Even during the worst possible stretches, the index was never negative over any 15-year period. Historically, the market's average rate of return is just under 10%.
Growing to $1 million
We can use this information to figure out how the S&P 500 can make you a millionaire retiree. If you have $100,000 in your retirement account today, it will take 30 years of 8% compounding annual returns to surpass $1 million. If you only have 10 years, then you'll need to start with about $465,000 to hit $1 million.
The best way to maximize growth is to start saving early and keep doing it systematically. A household that contributes $12,000 per year to a 401(k) will need a little over 25 years of 8% growth to hit $1 million.
Of course, these neat little linear growth models aren't realistic. The market goes through cycles of bull and bear markets. This means $241,000 invested in the S&P 500 in 2002 would have been enough to hit $1 million today, but only $263,000 was necessary if you started a decade later in 2012. Average returns obviously can vary substantially from period to period, so there's a lot of uncertainty in any sort of forecasting.
With all that in mind, we can conclude the S&P 500 can make you a millionaire retiree. Index funds are enough to get many people there -- you just need the right combination of savings and patience.
Outpacing index funds
Other strategies can certainly deliver better growth, but they also come with additional risk.
Some people have successfully picked stocks and outperformed the market over the long term. Exchange-traded funds (ETFs) that focus on economic megatrends also have a chance to deliver big returns by capitalizing on the fastest-growing portions of the global economy.
There are many examples of successful long-term active strategies. However, studies repeatedly show that active investors -- both professionals and individuals -- usually fail to outperform the S&P 500. It's difficult to pick winners, and it's even more difficult to avoid the self-sabotage that can be caused by panic and greed. Make sure you have the knowledge, mindset, and time to dedicate to an active strategy before adopting one.
Don't forget about expenses
Investing expenses are impossible to avoid, so investors need to understand where costs are incurred. You have to account for them to understand the returns you'll eventually realize.
First and foremost, the net returns on your index funds will always be lower than the average rate for the S&P 500. Certain annual costs reduce your rate of return each year. Mutual funds and ETFs all charge management fees, which are measured by the expense ratio. For simple index funds, it's a good idea to find the lowest expense ratio available. The fund managers aren't doing anything too complicated or proprietary, so they don't require an expensive team.
Mutual funds carry additional expenses related to taxable transactions that occur when shares are redeemed. If you use an advisor, they'll charge a fee as well, so make sure that they create enough value to justify the cost.
Individual investors also incur transaction expenses. The bid-ask spread and commissions eat away at returns when shares are bought or sold. You'll also have to pay capital gains tax on any investment returns in your brokerage account.
Finally, some retirement accounts carry embedded tax liabilities. Distributions from your 401k or traditional IRA are taxed as ordinary income, so $1 million in a qualified account might actually be closer to $800,000 net of taxes. If you have $1 million in a Roth IRA, it can be withdrawn tax-free.
Be sure to account for all these periodic and embedded expenses. Being a millionaire retiree is way less appealing if you can only spend a fraction of that money.