How Much Could Your 401(k) Lose In The Next Market Crash?

by: Ronald Surz
Summary

Recent stock market losses have refocused investor attention from wealth building to wealth protection: Win by not losing.

Based on previous market crashes, investors in stocks could lose as much as 80%, but not many are 100% invested in stocks.

I examine the risk exposures of target date funds in the face of various market crashes that could repeat.

Based on the U.S. history of previous market crashes, investors who are currently entirely in stocks could lose as much as 80% of their savings if the 1929 or 2001 crashes repeat. If we have a repeat of the 2008 crash, the loss would be “only” 56%.

But most 401(k) investors are not 100% invested, and the next crash might not be as bad as 1929, 2001 or 2008, so in the following we look at all the previous U.S. market crashes and at asset allocations for target date funds (TDFs), the most popular investment in 401(k) plans, at $1.5 trillion. Some will recover from the next crash but many will not. Those near retirement will probably not recover, including lots of our 75 million Baby Boomers, and it’s a shame.

Target date fund allocations

Until now, most of us had forgotten the devastation of 2008 when the typical IRA and 2010 TDF lost more than 30%. Target date funds are not all built alike. There is a wide range of risk at the target date among TDFs, ranging from 10% equity to 70% equity, with a cluster near 60% equity. In the following I examine the average TDF and the safest TDF. Although it went unnoticed, the SMART TDF Index, which is the safest, defended quite well in 2008, with only a single digit loss. The following graph summarizes this TDF and the industry.

The average TDF is about 60% in equities near the target date while the SMART Fund is less than 20%. Also most of the balance in the typical TDF is in long term (risky) bonds while SMART is in T-bills and TIPS. Note that these differences are all about risk management rather than timing. More on this distinction follows.

Possible losses in 2020 target date funds

It’s worth noting that when the 2010 TDFs lost more than 25% in 2008 they were 2 years away from the target date; beneficiaries in these funds were expected to retire in 2 years. That’s precisely where the 2020 funds are today – 2 years away from the target date.

The following table shows the history of U.S. stock market crashes and how much investors in 2020 funds stand to lose if history repeats itself.

How much will 2020 TDFs lose if a market crash repeats?

As you can see, potential losses on the typical 2020 TDF are at least 16% and could be as high as 50%, but the maximum loss on the low risk 2020 SMART fund is capped at 16%.

So you’ve been alerted. Some will recover but many will not. Those near retirement will not recover.

The promise of target date funds is that they help protect older beneficiaries from losses, but as you can see this protection is not adequate in the typical TDF. Most importantly, 75 million Baby Boomers are currently in the Risk Zone that spans the transition from working life to retirement. Losses in the Risk Zone are not recovered; they’re paid for with reduced standards of living. Some confuse this warning with market timing, but it is quite different.

Risk management is not timing

Many confuse risk management with timing, but timing has little to do with investor vulnerability and everything to do with market outlook. In the current market run-up, where U.S. stocks have earned more than 250%, there is great demand for crystal balls that will tell us when to get out of harm’s way, but that’s not risk management. Risk management is called “Tactical” asset allocation, while timing is called “Strategic.” The idea is that risk management is independent of market outlook and designed to protect when investors are most vulnerable, whereas timing is short term and all about market forecasts.

Sometimes risk management is easy

Age Risk

Risk management and timing are both usually very hard, and require different skill sets, but there is a time in every investor’s life when risk management is easy and obvious, although most don’t see it. It’s a time when a special kind of risk is at its highest and that risk could ruin our lifestyles for the rest of our lives. Unless we feel extraordinarily lucky we really should move to safety during the Risk Zone that spans the transition from working life to retirement when Sequence of Return Risk peaks. Baby Boomers have $30 trillion in the Risk Zone. At this stage in their lives they should be protecting their savings and figuring out how to make them last a lifetime.

Win by not losing

The arithmetic of financial losses is complex and emotional, so an example will help. In 2008, the 2010 SMART Target Date Fund Index lost 5% while the industry lost 25%. As a result, SMART investors were wealthier than other TDF investors for the next 6 years, when the riskier Industry funds caught up. But – and this is the important point – when the next crash happens, the whole scenario will reset, and SMART will shine again.

Investors win by not losing. It’s a safer course.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a sub-advisor of the SMART TDF Index and the originator of the 1st and only Robo Analyst that integrates Age with Risk. Age Sage builds better asset allocation models that help Baby Boomers transition through the Risk Zone that spans the 5-10 years before and after retirement. Implementation of these models can be done for less than 6 basis points. Boomers are poised for a sucker punch that they’ll never shake off.