March 23, 2020
In the current financial market conditions, this question is trickling into retirement plan call centers, Human Resources teams, and discussed amongst friends: “Should I stop contributing to my 401(k) plan?” The easy answer for most is no. The why behind the answer is very powerful and could bring comfort in these difficult times. As markets normalize in the future, sticking with your 401(k) contributions could be the most critical decision you make on your journey to retirement.
It Seems Logical
When retirement account balances decline and the bears run rampant in the market, it is logical to question whether you are making the right decisions with your money. As a result, a common consideration is to stop your payroll deductions to your 401(k) plan. It is easy to feel you are throwing good money after bad. Flushing money down the proverbial toilet by making 401(k) contributions when the market is down. Or, some might find it more productive to light their money on fire. None of these are good feelings, especially if this is the first time you are experiencing a significant decline in the market. However, so long as you are still receiving a paycheck and are not in financial distress, don’t stop your 401(k) contributions.
A Few Thoughts About The Markets
On a day to day basis, the financial markets move up and down. Sometimes the short term trend is more down than up as we have seen recently. While declines of more than 20% in stocks happen, it is not very often. Since 1928, the S&P 500, a broad measure of the stock market, has finished a year with a 20% loss or more only seven times. Smaller market fluctuations are more frequent and expected. The good news is that the stock market has also recovered after these downturns.
Another way to rationalize this is by looking at periods of rolling returns. In a given year, the market can be very volatile. The S&P 500 has gained as much as 53% and lost as much as 43% in a single year. As you extend the amount of time you stay invested in the market, the range of returns tightens and skews more positive. Your probability of a better investment outcome also increases if you diversify your investments between stocks and bonds.
In the short term, no one knows where the market will finish on a daily, monthly, or yearly basis. This unpredictability and volatility can be maddening. However, if you are making consistent payroll contributions to your 401(k) plan, it can actually work in your favor. It may actually improve the long term growth of your retirement savings.
A key advantage of 401(k) plans is hiding in plain sight. The simple process of making a contribution every paycheck means you are buying into the markets at different prices throughout the year. Sometimes the markets increase in value, sometimes they decrease, every now and again they are virtually the same between your contributions. As your payroll deductions are invested at different prices, your actual investment cost basis becomes the average of the purchase prices from one payroll period to the next. Counterintuitively, during times of market volatility, this works to your advantage. To illustrate, let’s take a look at Consistent Courtney and her last ten contributions to her 401(k) plan.
At the end of these ten contributions, Courtney does not feel great about how things have gone. She has several concerns about continuing her contributions:
- In paycheck #1, her first contribution was made at a price of $10
- Her investment went as low as $7 in paycheck #6, a 30% decline from where she started
- At paycheck #10 it stood at $8, a 20% decline from where she started
At first glance, at the end of these ten contribution periods, it looks like she has a 20% loss from where she began. However, despite the decline in her investment, she is actually at the breakeven point on her contributions. Courtney, who is now understandably confused, needs some more information to support this claim.
Thanks to her consistent contribution of $100 a paycheck into her 401(k) plan, as the value of her investment declined, she was able to purchase more shares. In total, Courtney contributed $1,000 to her 401(k) plan, and at the end of this period, she owns 125 shares valued at $8 a share and they are worth $1,000. By using the concept of dollar-cost averaging, Courtney’s average cost on her investments was lowered and improved her rate of return. Taking this one step further, if her investment appreciates back to where she started at $10 a share, she will have a 25% gain on her contributions. After learning about dollar-cost averaging and how it can help during volatile markets, Courtney decided to keep her 401(k) contributions flowing.
Light A Match
It is easy to make poor financial decisions that feel good at the moment but can hurt you in the future. One more concept to keep in mind, many employers match some or all of your 401(k) contributions. If you decide to stop your 401(k) deductions, the company match ends as well. Short term volatility in the financial markets is challenging for anyone to stomach. The long-term trends of the stock market and the hidden power of dollar-cost averaging are two compelling reasons to keep your 401(k) contributions going.