Will 401(k) Miracle Help All Investors?

Those who were in school in the 1940s and 1950s had teachers who lived through “The Great Depression.” They focused their lectures on various government programs for unemployment insurance, the willingness to run a peacetime deficit, and a more enlightened tariff policy that would prevent another Depression. Why then on November 20th, 2008 did stock market measures set the record for the largest annual decline (50%) since the beginning of recorded market history in the 1870’s?

The economy is in a period of contraction and official unemployment is in the mid single digit range. (The most credible pessimistic estimate for the future is in the high single digit range.) Perhaps, a more important statistic is the under-employment total, which measures those who want to work full time for an employer other than themselves, and is now just shy of 12%. I have not seen any under-employment estimates of the future over 15%. In the Depression, excluding farmers, the low point was calculated to be 28%. If the market is tied to the perception of the future economy, the current market decline is overdone by perhaps 50%. But as traders know and investors too often forget, the only real indication of value is the current price.

I believe the current price is more a measure of how bad we feel than an estimate of what the future will provide. There is a good reason for this pessimism, but not about the economy itself. The reason for the pessimism is that having surpassed record declines, we have lost all of our historical yardsticks.

In the US Marine Corps, we were trained the best defense was an offense. In a similar manner at the race track one learns that the percentage of winning favorites multiplied by their odds, most often produce a loss if one bets an equal amount on each race every day. This suggests that it pays to bet selectively against the crowd. With the perspective of these two schools of great learning, I have a positive outlook for the market long term.

One of the many reasons to bet against the pessimistic crowd is the miracle of the 401(k), 403(b), and 457 plans that allow and often encourage employees to defer a small part of their current wages into a tax deferred savings plan. These plans did not exist in 1929 and in the 1930s. As of 2007 there were $4.5 trillion in defined contribution plans and another $4.7 trillion in Individual Retirement Accounts (IRA), with over half invested in equities. The Total Retirement Capital last year stood at $17.6 trillion, again with a significant portion invested in equities.

Why do these figures make me optimistic? With US Treasuries’ yields below the actuarial requirement for Defined Payment plans, with endowments’ planned spending rates above these miniscule yields, and with the expected investment income of many 401(k) plans, the current income generation of bonds will not help enough, therefore they will buy equities not bonds.

In addition, with Defined Contribution plans needing to invest hundreds of billions of dollars, I foresee steady buyers of equities each and every year. With the sellers currently capitulating and the buyers waiting, the mid-term the outlook is good for the stock market. Therefore, my answer to the question, “Will 401(k) help all investors?” is YES.

In the near future I will use this forum to discuss whether 401(k) and similar plans should be investing for capital preservation (after inflation) or for capital appreciation. As the answer to this question is largely a function of individual facts and circumstances, I appeal to our readers to pose specific questions (no names of funds, please) that focus on investment strategy for them.