Home Investing Protecting your 401(k) During a Recession

Protecting your 401(k) During a Recession

Protecting your 401(k) During a Recession

Experiencing a recession for the first time can be a daunting and disheartening experience, especially when you see your retirement balance decreasing. Even those who have been through previous recessions may worry about the impact on their ability to retire comfortably and on schedule.

A workplace 401(k) is often the first exposure to investing for many individuals. Witnessing your balance grow as you contribute money, possibly with employer contributions, can be thrilling. However, recessions can cause account balances to decline, which is not uncommon for experienced investors.

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During a recession, it is generally wise to resist making fear-driven decisions and instead, hold onto your investments. By staying invested in the stock market, you may have the opportunity to purchase shares at discounted prices during the market downturn. Historically, the stock market has recovered after recessions, leading to a rebound in the value of your investments over time.

Understanding the reasons behind recessions can be helpful when deciding what to do with your 401(k). Some factors that contribute to recessions include an overheated economy expanding at an unsustainable pace, asset bubbles reminiscent of the pre-Great Recession era, and unexpected negative economic events, such as the COVID-19 pandemic.

Looking ahead to 2023, concerns about an impending recession are shared by financial experts and regular consumers. This recession may be partly triggered by the Federal Reserve’s efforts to combat inflation through interest rate hikes. As interest rates rise, spending tends to decrease, leading to contractions in most sectors of the economy.

Recessions have various negative impacts on the economy, including business closures due to reduced economic output and layoffs, resulting in increased unemployment. Additionally, asset prices, including those in your 401(k), often experience a decline.

Considering the potential impact of a recession on your 401(k), it is essential to understand what is likely to happen and how you can protect your investments during such times.

What is a 401(k)?

A 401(k) is a retirement plan offered by private sector companies. Employees can contribute part of their paycheck to their 401(k) accounts, which reduces their taxable income for the year. The money invested in the 401(k) grows tax-free, but it will be subject to ordinary income tax when withdrawn during retirement.

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The contribution limit for individuals’ 401(k) plans set by the IRS is currently $22,500 per year, with an additional $7,500 allowed for those aged 50 and older. Employers often match their employees’ contributions up to a specific percentage of their salary.

Once you’ve contributed to your 401(k), you can choose from various investment options offered by your employer, such as mutual funds and target-date funds. Target-date funds are a popular choice as they automatically adjust their asset allocation to become more conservative as retirement approaches.

It’s essential to make an informed decision when selecting your investment options in the 401(k) to align with your retirement goals and risk tolerance. Regularly reviewing and adjusting your investments may also be necessary to ensure you’re on track to achieve a comfortable retirement. Taking advantage of employer matching contributions is a smart way to maximize the benefits of your 401(k) plan.

Remember that the funds in your 401(k) are meant for long-term retirement savings, so withdrawing money before retirement age can result in taxes and early withdrawal penalties. It’s best to leave the funds untouched until you retire to fully enjoy the benefits of your hard-earned savings. By staying disciplined and making wise investment choices, a 401(k) can be a powerful tool in securing your financial future during your retirement years.

What can happen to your 401(k) in a recession?

Unfortunately, economic recessions can have a negative impact on asset prices, including those in your 401(k) portfolio, leading to a decrease in your balance.

According to CFRA Research, a reputable investment research firm, historical data reveals that the S&P 500 experienced an average loss of 8.8% of its value during the four recessions that occurred since 1990. This means that if you had a $100,000 balance before the recession hit, you would have seen your balance reduced to $91,200 after an 8.8% loss.

To gain more insight, let’s take a look at some specific examples. An October 2022 report from HBKS Wealth Advisors provided tables detailing the duration of past recessions and the corresponding stock market performance during each of those periods. Additionally, the report presented data on market performance before and after each recession.

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Recession startRecession length in years

Not all recessions are alike, and their impact varies. During the Great Recession in 2008, the stock market experienced a significant decline of over 38%, causing noticeable effects on 401(k) investments.

It’s essential to recognize that a recession is often declared after the economy has already been declining for several months. This means that you may have experienced losses in your 401(k) even before the official recession announcement.

Interestingly, stock market recoveries can begin shortly after the onset of a recession. For example, during the brief economic downturn of 2020, the stock market started its recovery just two months into the recession, as reported by investment management firm Vanguard.

Experiencing an economic downturn can be unnerving, especially when it affects your retirement savings. However, history shows that U.S. stock markets have bounced back from every downturn since the early 20th century, making these downturns temporary in nature.

Timing the market recovery accurately is challenging, and day trading is only successful for a select few. On the other hand, staying on the sidelines and not investing also means betting against the odds. That’s why financial advisors consistently advise investors to stay in the market for the long haul.

How to protect your 401(k) in a recession

When facing a declining 401(k) balance or news of an upcoming recession, it’s natural to worry about protecting your retirement savings. However, financial experts advise against making drastic changes to your investment strategy. Despite the emotional impact of seeing your life savings decrease, it’s crucial to manage fear, anxiety, and other emotions to maintain a long-term perspective.

During the pandemic, the Federal Reserve responded to economic stress by cutting interest rates to historically low levels. However, as inflation surged in 2022, the focus shifted to reining in rising prices. The consumer price index reached alarming levels, with a 9.1% year-over-year increase in June 2022. The Fed implemented multiple rate hikes since March 2022 to slow economic growth and curb inflation.

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Unfortunately, these efforts to control inflation may also contribute to the occurrence of the next recession. The possibility of a recession raises concerns about the impact on retirement savings and investments.

One critical piece of advice is to avoid halting contributions to your retirement account or selling off investments during market downturns. Doing so would mean selling when prices have dropped, which would prevent you from benefiting from the eventual rise in stock values as the market recovers.

5 steps to protect your 401(k) investments

The following steps could help you make the best of a recession and protect your investments while still planning for future growth.

Continue contributing to your 401(k) plan 

During a recession, it’s essential not to abandon your retirement planning. You can continue contributing to your 401(k) plan using a strategy called dollar-cost averaging, where you invest a fixed amount regularly. This consistency can be beneficial in the long run.

Maintain a well-diversified portfolio

Diversification is crucial for long-term investing. By spreading your investments across various assets, you can reduce risk. One way to achieve this in your 401(k) portfolio is by investing in a target-date fund.

Consider investing in defensive stocks

Consider adding defensive stocks to your investment mix. These stocks tend to perform well during economic downturns, as they are from sectors where people continue to spend money despite the overall economic situation. Examples of such sectors include consumer staples, health care, and utilities.

Opt for value over growth stocks 

When choosing stocks, favor value stocks over growth stocks during a recession. Value stocks, which are relatively affordable compared to their earnings, generally outperform growth stocks during market downturns. This preference can be attributed to the lower cost and increased attractiveness of value stocks during tough economic times.

Make room for income-producing assets

To safeguard your investments during a recession, allocate a portion of your portfolio to income-producing assets like bonds and dividend stocks. Bonds tend to perform well during economic downturns and offer a fixed income. Similarly, dividend stocks provide a regular income stream regardless of market performance. However, be aware that some companies may suspend or reduce their dividends during challenging times.

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