More 401K Peril: The Budget Deal

by: James Shell

For those readers that managed to miss the events of the last two months, here is a summary:

The federal government was about to shut down because it was approaching the limit at which it was allowed to borrow money. Because of the insistence of various political factions, including the president of U.S., who wanted to use the deadline as an excuse to get benefits for their constituents, a deal was struck to defer any major tax increases or spending cuts until after the 2012 election.

Standard and Poor's, the famous rating agency that underestimated the risk of the mortgage backed security market in 2008, determined that the failure to solve the problem was justification for lowering the nation's credit rating.

The reaction of the stock market and investment community was negative. There was a correction, somewhere between 10 and 13%, between that time and now, depending on which stock price index you care to use:

The loss in wealth for Baby Boomers could be somewhere approaching $1.5T of our $15T total 401K investments.

There are two prevailing theories at the moment as to how all of this will shake out.


The theory is: since the current path we are on is mathematically and politically unsustainable, our elected officials will naturally be strongly tempted to pick the painless third choice: inflate the currency and pay back the loans with cheaper dollars with poorer purchasing power.

By my calculation, using the current officially announced inflation rate of 3.6%, savers will be losing the equivalent purchasing power of this month's major stock correction every three years, for cash, or six years, if we can get the best CD rate in town which is 2.02%.

Side question: How meaningful is the officially published inflation rate to the Baby Boomers, since we already have all of the furniture and other items we need, but need to keep buying food which is inflating at 4.7% per year?

Hopefully you are not one of the substantial percentage of people who have significant indebtedness, or are planning to live solely off of Social Security.

People in the old-fashioned pension system are not out of the woods; many of these plans are underfunded and vulnerable.

Investors who waited too long to transfer from higher-risk investments to lower risk during the collapse of 2008 may have sold at or near the bottom, and their portfolio never got back to the 2008 level during the 2010-11 rally. Rebalancing and reducing risk, like all 401K transactions, ought to be done with a plan, in a methodical way.

Maximize your Safe Return

In May, William Gross, founder of PIMCO and manager of its biggest fund, exited the U.S. Treasury Bond market in favor of higher-yielding but still safe corporate bonds. This was strictly defensive, since even the corporate bonds will not keep up with inflation. Also, it is not without risk, since any interest rate increase will cause bond prices to fall. But, his example is noteworthy because of its sheer scale and the conservative reputation of the company.

A similar move for the 401K holder might be to switch between a Federal Bond Fund (such as VMFXX or FBIDX) and a broader corporate bond fund (such as VBTSX or FTBFX). If an investor's Roth or Simple IRA contains similar ETF's, such as Direxion 7-10 year Treasuries (NYSEARCA:TYNS), it can be redistributed toward something like Barclay's Scored Corporate Bond Fund (NYSEARCA:CBND) to try to get a little better return.

Look for sectors that are going to do well in times of inflation

Examples: Commodities, Energy, Health Care. Most 401K accounts have limited sector fund choices, but if possible, some shifting into these areas might be in order. Examples of individual stocks that fall into this group: Monsanto (NYSE:MON), ExxonMobil (NYSE:XOM), and Humana (NYSE:HUM), all of which are still up substantially year-on-year and are well thought of in their respective sectors.

Diversify out of the Dollar

Most mutual fund groups and many 401K plans allow some diversification into Europe and Asia. Europe is not without peril of its own, in light of problems with the euro. Asia is also not without peril, because in many countries, business operates outside the Western accounting, legal, and intellectual property systems. Also, the markets there were also beaten down in the last few weeks, and the investor might be well advised to stick to the mutual funds and leave the stock selection to the professionals.


The theory is: The current resistance to government spending is coming at exactly the wrong time, and if spending is reduced, it will take money out of the economy at the exact moment that it needs it. There is a school of thought that this is what happened in 1937.

As evidence, we need only look at the real estate market which this spring showed property values still declining in much of the country, and also the current unemployment rate, both of which indicate that the economy is still very weak, and may even be contracting.

Cash is King

In a deflationary environment, cash is king. A conservative approach would be to transition to short term US Government Bond funds, thought to be risk-free. An example of this might be the Vanguard Federal Money Market fund (VMFXX) or the Fidelity US Treasury Fund (FDLXX) which despite having a current return of essentially zero, have still outperformed the major stock market indices since 2008.

A non-401K investor may wish to move to an equivalent ETF, such as Barclay's 7-10 year Treasury ETF (NYSEARCA:IEF)

Stay long the Dollar

In a deflationary environment, debt is destroyed. Since most debt is denominated in dollars, it represents a decrease in the supply of dollars, and the dollar will rally. This is the opposite of the inflation scenario, but allow a conservative investor to avoid peril with the euro.

Avoid Debt and Real Estate

The residents of South Florida are experts on the topic of what happens when the underlying price of an asset decreases, while the value of the debt used to purchase the asset remains the same. This is one of the reasons that our elected officials are so terrified of deflation, and have gone to great lengths to avoid it.

Be a Lender

Deflation is the transfer of wealth from borrowers to lenders. Therefore, high quality corporate bond funds are still attractive, provided the borrowers are able to protect their pricing, and have a strong underlying business.

Note that this is the only strategy that is consistent in both the inflation and deflation strategies.

As we are so fond of saying, the world is full of chaos and there are no guarantees on anything. Even worse, for most of us 401K holders, we have no training on how to be portfolio managers, and at the same time, we are in an environment when some of the fundamental assumptions of the last generation are in question.

Disclosure: I did switch between VMFXX and VBTSX, and am a holder of energy, health care, Asia Pacific and European mutual funds. My main 401K peril is the stock in one of my former employer, which has greatly underperformed the market since 2008.