There’s been a lot of press in the last year dedicated to asking whether or not we’re in a recession. Because the National Bureau of Economic Research (NBER) calls recessions retroactively, we could be living in one now and not realize it. Many experts still maintain that a recession will be announced in 2023, though 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. Should you slow down on your contributions? Invest more? Or make your investments more conservative?
Here are some key things to consider when managing your 401(k) through a recession.
- Recessions don’t necessarily coincide with bear markets, though bear markets present a unique growth opportunity for investors.
- Investing through a recession or a bear market highly depends on your time horizon.
- Long-term investors can find relief in the fact the market has always rebounded from recessions, reaching even greater market highs over more extended periods.
What Happens to Stocks During a Recession?
The stock market is not the economy. Just because you’re sitting 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 do coincide.
Historically, when the stock market has decreased during a recession, it has always rebounded and gone on to achieve new highs. For example, during the last recession in early 2020, the S&P 500 hit a low of 2,304.92. On Oct. 7, 2022, even in its downward slump compared to the end of 2021, the S&P 500 sat at 3,639.66 – up compared to its February 2020 high of 3,380.16.
That means if you’re a long-term investor, you shouldn’t count the temporary low as a loss – the long-term value of your investments is highly likely to go up as long as you don’t cash out.
2022 was a particularly rough year for the stock market, with the Russian invasion of Ukraine causing global uncertainty and high inflation leading the Federal Reserve to institute a series of aggressive rate hikes. The downward pressure hurt corporate profits, many tech companies laid off employees, and discretionary spending decreased generally.
Right now, it’s unclear if we’re in a recession, but markets have been on a slow march upward in recent months. After a relatively volatile March, mainly due to the collapse of Silicon Valley Bank, experts are hopeful markets can continue to improve in April.
Defensive and Dividend Stocks
Many financial advisors recommend looking into 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 options for investment because they offer regular interest payments and don’t fluctuate as much during volatile economic times. Dividend stocks provide similar benefits in that they can produce steady income but are still subject to market volatility.
Learning about defensive stocks can be another strategy for investors planning for retirement. Some stocks like utility companies, grocery chains, and discount retailers won’t be as affected by market volatility.
Evaluate Your Time Horizon
Time horizon is the amount of time you need 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’ll need to withdraw any money. As you age, your time horizon gets inherently shorter as retirement draws near, and you will need to liquidate your assets to continue living.
20+ years until retirement
If you invest over a longer time horizon, you can view market downturns as a generally good time to invest. This is because stock prices typically decrease, allowing you to buy in cheaply.
While the market may go down further, there are high odds it will recover and then some by the time you need to access your investments in retirement.
The adage tends to be true: more time in the market tends to beat trying to time the market. That’s why one of the wisest ways to invest is dollar cost averaging, investing a fixed dollar amount in steady increments over a long period.
10 to 20 years until retirement
If you have ten to twenty years until retirement, you’re more likely to want a mix in your asset allocation. Maybe half or a little more than half of your portfolio is made up of stocks, which are higher risk but also offer the potential of higher returns.
You could allocate the remaining portion of your portfolio towards more conservative investments, like bonds. Some investments, like target date funds, make these allocation changes automatically for you as you age.
Less than a decade until retirement until retirement
As you move towards retirement, it’s generally a good idea to make your portfolio more conservative. You can do this by putting a more significant proportion of your investments into shorter-term bonds and high-grade bonds, which tend to be less volatile than stocks.
Most people will want to aim for ample cash reserves at retirement. It is a smart idea to do some income planning to decide where you will get your income at retirement. For example, if you have a Roth IRA, a 401(k), social security, and cash reserves, which source of income does it make sense to draw from first?
For example, one advantage of delaying drawing from 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 reach their maximum – you can earn more income later in life.
Investing During a Recession
One of the surest ways to successfully save for retirement is putting away at least 10%-15% of your income throughout your career. Make those contributions directly via paycheck deductions to ensure you don’t get cold feet about investing when the market is down.
If you are sitting on some extra cash and wondering if a recession is a good time to invest, the answer is usually “yes.” When the stock market dips down, that dip has never historically been permanent. Over a longer time horizon, your investment’s value will likely 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 cash for too long before investing and then buy as stocks are on the rise again, losing the gains you would have incurred had you put your money in earlier.
Rather than trying to time the market, consider contributing at least 10% -15 % to your 401(k). Remember that one of the most significant benefits of having a 401(k) is reducing your taxable income whenever you move money from your paycheck into that account. Because the US uses a progressive tax system, less taxable income means you pay fewer taxes.
401(k) vs. Roth IRA
When planning for retirement, you must decide what kind of tax-advantaged 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, meaning 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, like a 401(k). You deduct contributions toward a traditional IRA from your taxable income and pay taxes on the money after retirement.
The most significant difference between a Roth IRA and 401(k) is that the latter is employer-sponsored. This means you don’t have to be as hands-on with your account, and that eligibility depends on whether your employer offers this savings option.
A Roth IRA is a handy option for people who think they’ll be in a higher tax bracket after retirement. This is because Roth IRAs are funded with after-tax money, meaning your withdrawals were already subject to taxation. However, Roth and traditional IRAs typically have lower contribution limits than 401(k)s.
Lower-Risk Places to Hold Your Cash
If you’re inching closer to retirement, you may want to move more of your assets into more conservative investments like:
- Short-term bonds
- Money market funds
- Treasury bills
Only some of these vehicles are immediately liquid, but they are a safer space to stash your cash than the stock market.
Remember that 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’re investing in have longer to recover and grow.
The Bottom Line
Hopefully, you started investing young to give yourself an adequate time horizon to take on 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. When you have 10 or 20 years left until retirement, you typically want to start making your portfolio more conservative but maintain enough risk to enable further growth.
Suppose retirement is less than a decade away. In that case, you’ll probably want your investments to be much more conservative overall, and you may even start strategizing how to move them into cash reserves.