The stock market decline undercuts retirement savings

The shift from defined benefit (DB) plans to defined contribution (DC) plans in the private sector means that non-state workers have the majority of their retirement savings in 401(k)-style plans or individual retirement accounts (IRAs) (see Figure 1). It’s important to include IRAs in the calculus as they are mostly rollovers of 401(k)s. (Most state and local workers are still primarily covered by defined benefit plans.) To the extent that the money in these private sector accounts is invested in stocks, workers bear the full risk of stock market fluctuations.

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Vanguard reports that 72% of the 401(k) plan assets the company manages were invested in stocks in 2020. Given the COVID-19 stock market boom, the percentage could be slightly higher in late 2021. My best guess is that the asset allocation for IRAs would be about the same. This means that a significant part of the retirement savings is at risk.

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One question is who holds these assets? Again, the data comes from Vanguard. In terms of income, high-income participants were more likely to take market risk—that is, invest more in stocks—than their lower-income peers. However, with the increasing use of cut-off money and automatic adjustment, lower-income participants actually have a slightly higher proportion of their wealth in equities (see Table 1).

It is also important to understand which age groups are exposed to fluctuations in stock market values. If younger employees hold most of the stock, they would have time to recover and recoup losses before retirement. In terms of age, while stock holdings decrease as participants age, those over 65 still hold almost half of their portfolio in stocks (see Figure 2). To the extent that these older people are forced to reduce their retirement savings, they have no chance of recovering.

How much have people lost in their retirement plans during this market downturn? Let’s say markets are down about 20% since January. Participants would have lost 20% of $6.8 trillion ($9.5 trillion x 72%) or $1.4 trillion in their 401(k)s; and IRA owners would have lost 20% of $10.0 trillion ($13.9 trillion x 72%), or $2.0 trillion, in those accounts. Keep in mind that IRAs are mostly 401(k) rollovers and should therefore be counted in the total.

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It could be argued that these recent losses simply wipe out the exceptional COVID-19 gains, so participants aren’t actually worse off than they were before the pandemic. But it’s human nature for people to feel like past gains are theirs, so recent losses are painful.

People — mostly the wealthier ones — also hold stocks outside of retirement savings accounts. In 2021, those stocks totaled $32.2 trillion. Applying the 20% drop means people lost another $6.4 trillion in direct holdings. However, these individuals are much less likely to be forced to sell and can wait out the drop to recoup their losses.

We all know that the shift from defined benefit to defined contribution pension plans has shifted longevity and investment risk from employers to employees. It’s easy to forget that when the market is booming; hard to ignore when the market is tanking.