There has been a lot of press asking questions in the past year whether or not we are in a recession. Since the National Bureau of Economic Research (NBER) calls recessions retroactive, we may be living in one right now and not realizing it. Many experts still argue that a recession will be announced in 2023, although we have yet to see how severe it will be.
If your employer gives you access to a 401(k) — a defined-contribution retirement savings plan — you may wonder how a recession should change your contributions. Need to slow down with your contributions? Invest more? Or make your investments more conservative?
Here are some important things to consider when manage your 401(k). by a recession.
Key learning points
- Recessions do not necessarily coincide with bear markets, although bear markets offer investors a unique growth opportunity.
- Investing during a recession or bear market depends a lot on your time horizon.
- Long-term investors can find relief in the fact that the market has always bounced back from recessions and reached even greater market highs over longer periods.
What happens to stocks during a recession?
The stock market is not the economy. Just because you’re in the middle of a bear market doesn’t necessarily mean you’re also in the middle of a recession. But in many cases, the two coincide.
Historically, when the stock market fell during a recession, it always bounced back and hit new highs. For example, during the last recession in early 2020, the S&P 500 reached a low of 2,304.92. As of October 7, 2022, the S&P 500, even in its downward slump compared to late 2021, stood at 3,639.66 — up from its February 2020 high of 3,380.16.
That means if you’re a long-term investor, don’t view the temporary low as a loss – the long-term value of your investments will very likely increase as long as you don’t cash out.
2022 has been a particularly difficult year for the stock market, with the Russian invasion of Ukraine creating global uncertainty and high inflation, leading to the Federal Reserve a series of aggressive rate hikes. The downward pressure hurt corporate earnings, many tech companies laid off workers, and discretionary spending fell overall.
At the moment it is unclear whether we are in a recession, but the markets have been slowly moving up in recent months. After a relatively volatile March, mainly due to the collapse of Silicon Valley Bank, experts hope that markets can improve further in April.
Defensive and dividend stocks
Many financial advisors recommend looking at dividend stocks if you’re a retiree looking for passive income. Dividend stocks produce cash flow, which can replace your income once you retire.
Bonds are popular investment options because they offer regular interest payments and don’t fluctuate as much during volatile economic times. Dividend stocks offer similar benefits in that they can generate steady income, but that’s what they are still subject to market volatility.
Learning about defensive stocks can be another strategy for investors planning to retire. Some stocks, such as utilities, supermarket chains and discount stores, will not be as affected by market volatility.
Evaluate your time horizon
The time horizon is the amount of time it takes you to reach your financial goals. When you’re younger, you tend to have a longer time horizon with your 401(k). There are years, possibly decades, before you need to withdraw money. As you get older, your time horizon inherently gets shorter as you approach retirementand you will have to liquidate your assets in order to live.
20+ years to retirement
If you’re investing over a longer time horizon, you can view market downturns as generally a good time to invest. This is because stock prices tend to fall, allowing you to buy in cheaply.
While the market may fall further, chances are it will recover and then some by the time you need your investments in retirement.
The adage is mostly true: more time in the market is often better than trying to time the market. Therefore, one of the wisest ways to invest is dollar cost averaging, investing a fixed dollar amount in steady increments over a long period of time.
10 to 20 years until retirement
If you have ten to twenty years until retirement, you are more likely to want a mix in your asset allocation. Perhaps half or slightly more than half of your portfolio consists of stocks, which carry higher risk but also offer the potential for higher returns.
You can invest the remainder of your portfolio in more conservative investments, such as bonds. Some investments, such as target date funds, cause this allocation to automatically change for you as you get older.
Less than a decade to retirement to retirement
As you get closer to retirement, it’s generally a good idea to make your portfolio more conservative. You can do this by investing a larger portion of your investments in short-term and high-quality bonds, which are generally less volatile than stocks.
Most people will want to aim for adequate cash reserves in retirement. It’s a smart idea to do some income planning to decide where you’ll get your income when you retire. For example, if you have a Roth IRA, a 401(k), Social Security, and cash reserves, what source of income does it make sense to draw from first?
For example, one benefit of deferring Social Security is that the longer you wait to claim Social Security, the higher your monthly benefit will be. If you can rely on your 401(k) before you turn 70 — the age at which your Social Security benefits peak — you can earn more income later in life.
Investing during a recession
One of the surest ways to successfully save for retirement is to set aside at least 10%-15% of your income throughout your career. Make those contributions directly through paychecks to ensure you don’t get cold feet about investing when the market is low.
If you’re sitting on some extra money and wondering if a recession is a good time to invest, the answer is usually “yes.” When the stock market dips, that dip has historically never been permanent. Over a longer time horizon, the value of your investment is likely to increase.
However, waiting for the market bottom is rarely a good idea, as this point is difficult to predict accurately. You could hold onto your money for too long before investing and then buy it as the stock rises again, losing the profit you would have made if you had put your money in earlier.
Instead of trying to time the market, consider contributing at least 10%-15% to your 401(k). Remember, one of the main benefits of having a 401(k) is lowering your taxable income when you move money from your paycheck to that account. Since the US has a progressive tax system, lower taxable income means you pay less tax.
401(k) against Roth IRA
When you plan to retire, you need to decide what kind of tax break account you want to use.
A Roth IRA is an individual retirement account you can set up with a bank or other financial institution. You fund a Roth IRA with after-tax money, which means you can’t deduct contributions from your taxable income before retirement. Instead, you don’t have to pay taxes on the money you withdraw from your Roth IRA after retirement.
You fund a traditional IRA with pre-tax money, such as a 401(k). You deduct contributions to a traditional IRA from your taxable income and pay taxes on the money in retirement.
The main difference between a Roth IRA and 401(k) is that the latter is sponsored by the employer. This means you don’t have to be so hands-on with your account, and your eligibility depends on whether your employer offers this savings option.
A Roth IRA is a convenient option for people who believe they will fall into a higher tax bracket upon retirement. This is because Roth IRAs are funded with after-tax money, meaning your withdrawals were already subject to tax. However, Roth and traditional IRAs typically have lower contribution limits than 401(k)s.
Lower risk places to keep your money
If you getting closer to retirementyou may want to move more of your wealth into more conservative investments such as:
- Short-term bonds
- Money Market Funds
- Treasury bills
Few of these vehicles are instantly liquid, but they are a safer place to store your money than the stock market.
Remember, those with longer time horizons don’t necessarily need more conservative investments, even in a recession. Time is on your side, so the stocks you invest in have more time to recover and grow.
It comes down to
Hopefully you started investing young to give yourself enough time horizon to take risks. If you did, a recession wouldn’t necessarily upend your game plan.
Those with longer time horizons can usually afford to take on riskier stocks, even in a bear market. Typically, if you have 10 or 20 years left until retirement, you want to start by making your portfolio more conservative, but still maintain enough risk to allow for further growth.
Let’s say retirement is less than ten years away. In that case, you probably want your investments to be much more conservative overall, and you may even start thinking of strategies to turn them into cash reserves.