- Social Security is insufficient for many Americans.
- Retirees rely heavily on retirement savings to bridge the gap between income and expenses.
- Bear markets allow you to buy the stock on sale, potentially increasing long-term returns.
Stocks historically go up and to the right, but they don’t do it in a straight line. Inevitably, there are corrections and bear markets like we have now. When the market pulls back, contributing more to retirement plans is something long-term investors should consider.
Unfortunately, too few take advantage of lower prices when the market goes “on sale”, making it harder to achieve their long-term goals.
Why pension plans?
Social Security is designed to replace only about 40% of the average person’s pre-retirement income. Unfortunately, it is not enough money to support many retirees, so they are afraid to achieve the lifestyle they had hoped for in retirement.
According to the Social Security Administration, Social Security represents more than 50% of the monthly income for more than a third of men and 40% of women. The ratio is even higher for singles, many of whom rely on Social Security for more than 90% of their income. Retirees get annual cost-of-living adjustments, but the average retired worker still pocketed just $1,827 in monthly Social Security benefits this year — nearly a penny when you consider the average annual outlay for Americans 65 and older were $48,872, according to the Bureau of Labor Statistics.
As a result, retirees need other sources of income to make up the shortfall between income and Social Security expenses. In some cases, a pension covers the gap. However, pensions are becoming increasingly rare, so retirement plan savings make the difference for most.
In particular, retirees rely heavily on workplace retirement plans, including 401k and 403b plans. Fortunately, most employers offer these plans to employees, and they are especially valuable because they have a higher annual contribution limit than a traditional IRA or Roth. Self-employed people often use SEP-IRAs to save for their retirement because they have a high contribution limit.
In 2023, workers can contribute $22,500 to their 401k or 403b plan, up from $20,500 by 2022. SEP IRA contributions can total a minimum of 25% of compensation or $66,000 for 2023, from $61,000 in 2022. If these options are not available, or if your income qualifies, you can contribute up to $6,500 of earnings to a traditional or Roth IRA, from $6,000 last year.
What makes retirement plans so valuable is that contributions to these plans are tax-advantaged, so more money can compound annually. Contributions to Roth accounts are made with after-tax dollars, but they grow tax-free. Traditional IRAs and retirement plans are funded with pre-tax money, so taxes are deferred until the money is withdrawn in retirement, often at a lower tax rate than when the individual was working. .
Earning interest on interest, or compound returns, on more money because of these tax advantages makes it incredibly attractive for long-term savings.
A good time to systematically buy stocks
It’s tempting to think you can time the market perfectly. However, the stocks top and bottom before the economy, many Investors mistakenly buy too high and sell too low due to extrapolation bias, the tendency to overweight recent events when making decisions.
Investors who regularly contribute to a retirement plan through periodic payments are less likely to fall victim to this bias, however.
Regularly investing a predetermined amount of money, or dollar cost averaging, means you buy fewer stocks when prices are high and more stocks when prices are low. As a result, investments during bear markets, when stock prices have fallen, decrease the average cost of the investor, offering opportunities for greater gains over time.
While it is historically true that every bear market has preceded new highs on the S&P 500, many investors shy away from stocks during bear markets. In effect, these investors short-change their financial future because they ignore the possibility of lowering their average cost. This can hamstring returns while slowing down the recovery speed of account balances.
For example, suppose an investor bought $10,000 of the S&P 500 ETF SPY on October 31, 2007, the average dollar cost of $100 monthly at the end of the month through 2012.
In all, $16,200 was invested (the initial $10,000 plus $6,200 in additional monthly contributions), resulting in 154.36 shares. At an adjusted dividend price of $104.95 on December 31, 2012, these shares would be worth $18,212, a gain of 12.4%.
Alternatively, suppose she had invested the same $10,000 on October 31, 2007, but added $100 monthly to a shoebox in her closet instead. She also booked $16,200. However, she just defeated. The savings was only $16,448, about 10% less than if he had continued to invest monthly in the S&P 500.
It’s not hard to imagine how much bigger his portfolio would be if he had contributed even more money to his retirement plan during the Great Recession.
The Smart Game
Extrapolation bias is dangerous and difficult to resist. We tend to weigh recent events more than past ones, making decisions more likely to reflect short-term headlines than long-term thinking.
Instead, zoom out and remember your long-term investment goal. Has your financial plan been structured to provide you with the best savings to get the retirement you want? If so, changes based on inevitable bear markets and corrections could cause myopia.
Remember, stocks do best at the start of a bull market. The S&P 500’s average return in year one of a bull market is 38%, much better than the 6% average annualized return over 10-year periods, according to CFRA. The more money invested during the bear market, the better able to take advantage of those robust first-year gains, and the more likely account balances will return to pre-bear market highs the faster.
Of course, individual stocks may never recover to past highs, but historically, every bear market has been a good buying opportunity in the S&P 500 index. Why? Because the S&P 500 is a momentum index that only owns the largest stocks. The index allocates less money to stocks as they decline, eventually replacing stocks if they are too small. As a result, buying the index is very different from buying individual stocks during a bear market.
It pays to sell the first half and buy the second half of a bear market, but no one rings a bell that signals half time. As a result, dollar cost averaging can be the best way to take advantage of discount prices during a bear market.
Since retirement plans provide tax savings, allowing more money to compound over time, now is the perfect time to reconsider your retirement plan contribution rate. Raising your rate even by a percent or two during a bear market could be the difference between living the way you want or struggling financially in retirement.