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April 15, 2003


A recent article in the Wall Street Journal chronicled how, after three years of continuous stock market losses, many workers are now abandoning their 401(k) retirement plans.  A recent Buck Consultants survey confirms this trend, indicating that only 73% of employees participated in their employers’ 401(k) plans in 2002, down from 77% in 1999.  A separate survey by Vanguard Funds also indicates that those who are continuing to participate in 401(k)s are contributing less than in the past.

I can understand not participating in a 401(k) if a spouse has been laid off or other hard times have occurred.  However, the idea that employees would stop participating in their 401(k) retirement plans simply because of poor investment results strikes me as illogical.  That is, until I started getting e-mails from readers asking me whether they should drop out of their 401(k) plan because of recent poor results.  The answer is NO, by the way.

The psychological effect of losses strikes each person differently.  However, the way 401(k) plans work, losses in your account are not necessarily the end of the world, especially if you are middle-aged or younger and have many years to make them up.  In this edition of the Forecasts & Trends E-Letter, I am going to go over some of the basics of 401(k) plans and why they are beneficial, even in times of depressed stock prices.

The Basic 401(k) Plan

401(k) is nothing more than a section of the Internal Revenue Code that, in a nutshell, allows participating employees to shelter part of their income from taxes until retirement.  Participants in 401(k) plans do not pay current income taxes on the amounts they contribute, and investment earnings grow tax-deferred as well. This compounding effect is one of the greatest advantages of tax-qualified retirement plans (more about this later).

The worker is always fully “vested” in the money he or she contributed to the 401(k), as opposed to certain other types of plans, meaning that there is no way this money can be forfeited.  It is subject to investment gains/losses, but participants cannot lose their right to the 401(k) contributions they have made, and also any gains on those contributions, even if they are terminated or choose to leave the company sponsoring the plan.

Yet that is only part of the good news.  401(k) plans are also structured so that employers can “match” employee contributions, and most employers do so (to varying degrees).  Some employers match employee contributions in cash, while others match in company stock.  Either way, the employer matching contribution is a major advantage of this type of plan.

Instant Returns

Employer matching contributions are a huge benefit, in that they represent an immediate return on money saved by the employee.  Let’s say that an employer matches 50% of all contributions made by employees into the 401(k), as we do at my company.  That means that employees contributing 6% of their pay would be eligible to get a match equal to 3% of their pay, for a total of 9%.  This amounts to an immediate return of 50% on amounts contributed.

Some employers require employees to work for a minimum number of years before all employer matching contributions become non-forfeitable (vested).  Even in this case, the matching contributions stay in the participants’ accounts and are invested right along with the employees’ contributions.

Unfortunately, some larger employers have recently announced that they are going to either reduce or temporarily eliminate employer matching contributions in the name of cutting costs.  While this does remove one advantage of participating in a 401(k), an employee should not stop participating simply because the employer chooses to reduce or eliminate matching.  The other advantages of 401(k) plans make them a great way to save for retirement, even without an employer matching contribution.

Investment Options

In most 401(k) plans, participants have the ability to direct the investment of their own account balances.  This includes both their contributions and employer matching contributions, unless such matching is made in the form of employer stock. 

Most 401(k)s offer a variety of mutual funds in which to invest.  Typically, there are several stock mutual funds, ranging from conservative to aggressive, one or more bond/fixed income funds and a money market fund.  Most 401(k)s also have relatively risk-free investments such as CDs, fixed annuities, etc.  In most 401(k)s, the participants are allowed to choose the funds they want and make changes frequently if they wish.

In addition to various mutual funds, many companies also offer shares of their own stock to participants as one of the investment choices in their 401(k) plan.  In some cases, employees have been known to invest all or a large part of their 401(k) in their own company’s stock.  Some employees feel that if they don’t purchase the company’s stock, it might look like they aren’t loyal.  Caution: it is not wise to be too heavily concentrated in any stock, including the employer’s stock.  


Another major advantage of 401(k) plans is the fact that you place a regular amount of money into the market on a monthly basis.  In investing terms, this is known as “dollar-cost-averaging.”  It simply means that you purchase shares of stock or mutual funds at various prices over the course of your working lifetime.  When fund prices are high, you buy fewer shares, but when markets are down and prices are lower, you buy more shares. 

This is extremely important because depressed markets actually provide an opportunity to purchase more shares than when prices are high.  As share prices rise and fall, the value of your account is determined by the number of shares you own times the prevailing share prices.  Whether your account gains or loses depends on the share prices you paid for each of the shares you own.

This may be better explained by a short example.  Let’s assume that Employee A contributes $100 to his 401(k) plan each month.  For sake of simplification, we’ll assume there is no employer matching contribution.   Over the course of three months, Employee A purchases shares at $10.00 per share the first month, $5.00 per share the second month and $8.00 per share the third month.

At the end of the third month, you might think that A’s account is at a loss, since the price of the shares he purchased is less than the original $10.  Not true.  In the first month, A’s $100 contribution purchased 10 shares at $10.00 each.  The next month, he purchased 20 shares at $5.00 each, and then 12.5 shares at $8.00/share the final month, for a total of 42.5 shares.  The total invested is $300, but the total value of the account is 42.5 X $8.00, or $340.  Thus, the drop in share prices allowed A to buy more shares, and when these shares rose in value, A’s total account gained as well.

The Psychology of Losing

In the 1990s, “participant-directed” accounts, such as 401(k)s, were all the rage, because it was almost impossible NOT to make money in the stock market.   Each account statement was greater than the last, and double-digit annual growth came to be expected by participants. 

However, since the beginning of the bear market in 2000, participants have become increasingly reluctant to manage their own accounts.  Some continue to hold onto aggressive mutual funds in hopes they will return to their past glory.  Others are paralyzed, not knowing what action to take.  Still others have decided to stop participating at all, thus putting their comfortable retirement in jeopardy.

Almost certainly, the psychological effect of continued losses is what is contributing to the dropping participation rates in 401(k) plans.  While much attention is now being paid to these psychological factors, one thing is clear:  Losses in relation to a long-term 401(k) plan are very different than losses in one’s non-tax-deferred investment portfolio.

Many non-tax-deferred portfolios are started with a lump sum that is invested at one time.  The initial amount could come from an inheritance, sale of an asset, an insurance policy, maturing CDs, a large bonus, etc.  In these lump sum cases, the number of shares is often fixed in the beginning and only infrequent additions are made.  Therefore, when losses occur in these types of portfolios, it can be psychologically devastating because there may be no other source of funds for continued contributions.

In contrast, 401(k) accounts start with a zero balance, and principal plus earnings gradually pile up as monthly contributions are added to the total.  Shares are purchased at various prices over time.  When losses occur on the monthly 401(k) statement, savvy participants know that this represents an opportunity for them to purchase more shares per dollar contributed.

Unfortunately, many 401(k) plan participants approach losses to their 401(k) accounts in the same way they would losses in their regular portfolios.  Only through continued participation and education can the psychology be “turned around” to see that down markets can be a good opportunity.

Taking Control of Your 401(k) Account

As I discussed above, most 401(k) plan participants are able to direct the investment of their own accounts.  If you have a 401(k) account, that means YOU are in control of your financial destiny.  You can maximize your 401(k) by taking advantage of the following benefits that 401(k) plans provide:

1.   The Power of Compound Interest.

Compounding is one of the primary benefits of 401(k) plans.  As noted earlier, your contributions grow tax-deferred as your money is in the plan.  With many employees having 20, 30 or even 40 years until retirement, the power of compound earnings can truly be phenomenal.

For example, let’s assume that Employee A has 40 years until retirement.   We’ll also assume that he puts $100 per month into his employer’s 401(k) plan, and receives a 50% matching contribution.  Over A’s working lifetime, he will contribute $48,000 and the employer will kick in another $24,000 for a total of $72,000. 

If we assume that A earns a return of just 6% per year on these contributions, his retirement nest egg will grow to $287,544.28!  Not bad for a $72,000 total investment.  Just think what kind of account balance A would have if he doubled or tripled his contribution.

2.  Long-Term Time Horizon.

I acknowledge that this doesn’t apply to all readers, but most of you probably have many years until retirement.  If so, the bear market of the last three years is just a drop in the bucket as compared to the total years of participation you will have in your 401(k) plan.  Even though the past few years have been bad for the market, the very long-term trend in stocks is expected to continue upward.

You should not focus too much on the short-term results in your 401(k) plan, but rather keep your focus on your eventual retirement.  No one knows for sure what market conditions will be in 10, 20, 30 or 40 years, but historic trends would indicate that the stock market will be higher than it is now.

Unfortunately, the recent surveys show that those who are not participating in 401(k)s are the very ones for whom compounding works best – young, new employees.  Many “new hires” are associating 401(k) plans with a falling stock market and increasingly want nothing to do with them.  However, as I described above, the current lull in the market allows these young participants to purchase more shares than they would be able to if the stock market were still at record levels.

Continuing the example of Employee A above, let me illustrate the “cost” of waiting to sign up for the 401(k).  If we assume that A opted out of his company’s plan for 5 years, he would have only 35 years until retirement rather than 40.  At the same assumed rate of return of 6% per year, A would accumulate $207,043 at retirement rather than $287,544.  That’s a difference of over $80,000!

3.  Participant Direction.

I stated above that most 401(k) plans allow you to direct the investment of your own account.  Employers are required to provide you with investment information designed to help you make informed choices.  If your employer does not provide this education, contact your human resources department to see why not.

If you have the ability to direct your own investments, don’t drop out of the plan.  Just  change your investment directions, if the current downtrend in prices is too much to handle.  Virtually every 401(k) program I have ever seen has at least one conservative, fixed-rate investment such as a Certificate of Deposit, Guaranteed Investment Contract (GIC), fixed annuity and/or a money market fund.  These options provide very little return right now, but at least your principal will be safe.

Many investors have been switching from stock funds to bond funds in their 401(k)s because of the drop in the stock markets, and because most bond funds have done well over the last few years.  Many investors think bond funds are safer than stock funds, but this is not necessarily true.  Depending upon the type of fund, they can be just as volatile as stocks, or even more so, especially if interest rates begin to rise.  I fear that investors who have joined the migration from stocks to bonds have set themselves up for another round of losses when interest rates begin to rise and the prices of bonds fall.

4.  Invest for the Long Haul.

While directing your 401(k) account into conservative investments will preserve your principal, it might not generate enough returns to provide a meaningful retirement.  At present, short-term interest rates are actually below the rate of inflation.  This means that the returns you may get from a fixed-rate “safe” investment could actually result in your money losing purchasing power.  Sure, the total dollars you have at retirement will be greater than your contributions, but the purchasing power of those dollars may actually be significantly less.

The solution is to invest for the long haul.  That means developing a diversified portfolio with different types of stock and bond funds that avoids concentrating too much of your account in one asset type.  Will you suffer occasional losses along the way?  Sure, but a diversified asset allocation can help to moderate these losses while still providing the potential for meaningful growth.


The moral to this story is that you should never delay participation in your employer’s 401(k) plan, or stop participating once you have already started, unless you have encountered such a financial hardship that makes it impossible to continue making contributions.  The combination of tax-deferred growth, compounded returns, dollar-cost-averaging and, in many cases, the presence of an employer matching contribution makes these plans a great way to save for your retirement.

I acknowledge that a lot of the advice in this E-Letter applies to younger participants with many years to retirement.  Those of you who are near retirement and have suffered losses in your 401(k) are in a different position, but my advice stays the same.  You should continue to participate in your 401(k).  In fact, you should consider increasing your contributions to make up losses since time is not on your side.  Re-evaluate your investment choices and avoid very aggressive investments that could actually make your situation worse.

Finally, I also recognize that many of you reading this are not in a 401(k) or similar retirement plan, but I’m sure you have friends or relatives who are wondering what to do with their plans at this point.  You are free to pass this E-Letter on to your children or grandchildren or friends who may be having second thoughts about participating in a 401(k) or similar retirement plan.


Since 1977, I have been writing a monthly newsletter called Forecasts & Trends.  Each month, I write 6-12 pages with analysis on the economy, the investment markets and world events that can affect both.  I also include analysis by several of the very expensive research publications I subscribe to.  My newsletters are provided free of charge to our clients.  You can sample my latest April newsletter at the following link CLICK HERE.

All the best,

Gary D. Halbert


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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