The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (36 page)

It’s our job to help you understand why it will.

The truth is that retirement plans are in big trouble. Many pension plans throughout the United States have been notoriously underfunded and poorly managed. There are protection levels in place, but those were designed to handle individual failures, not widespread multiple pension plans going bad en masse. In fact, each level of protection has serious vulnerabilities.

Let’s start with managers. While many pension managers are chosen for their qualifications and judgment, in practice these people rarely outperform market indexes. And if they haven’t outperformed the market in the past—under stable conditions—why would they be able to keep their pension funds afloat in the case of a serious market crash?

Next are asset categories. Being invested primarily in bonds doesn’t help much because we know that rising inflation and rising interest rates will be poison to the bond market. Ratings? The ratings agencies showed catastrophically poor judgment in the recent past, when they contributed to the 2008 financial crisis. They haven’t changed much about how they operate, yet people still expect them to deliver good results. (What’s that line about the definition of insanity?)

If and when bond issuers go bankrupt, bondholders will still have a high priority in liquidation proceedings, but if many companies go belly up at the same time, there will be a lot of sellers and very few buyers. Their assets will bring in only pennies on the dollar. Bad news for bondholders. Corporate backing for pensions is the same story—corporations will face failed pensions and collapsed earnings at the same time. Bankruptcy will be the only option.

Last is the federal government, which will certainly do its part—at least for a while—in making sure pensioners get what they need. But the PBGC is not well funded to begin with and will quickly be overwhelmed. The government can still step in and help for a few years, but eventually there are simply too many guarantees to cover—not just with pension plans but everywhere—and the Fed can’t keep printing money forever. And down goes the last line of defense for pension plans.

Of course, long before a company goes bankrupt or the federal government has to step in, bonds can lose an enormous amount of their value as interest rates rise, as detailed in Chapter 5. Stocks and real estate are also very vulnerable, as described in Chapters 4 and 6. So, even if there were no corporate bankruptcies or no need for government bailouts, pensions can lose much of their asset value and, hence, their ability to pay those pensions.

Unfortunately, defined contribution plans like 401(k)s aren’t in much better shape. Because most offer relatively few options based on traditional investing strategies, they make it very difficult for an individual to beat a total market failure while also protecting against inflation. When stocks, bonds, and real estate all fall, 401(k) plans will fall with them. In 2008, for example, 401(k) plans fell in value by 40 percent. This is just a taste of what’s ahead.

With such an ugly outlook for pensions and other retirement plans, it’s hard to know how to proceed. Unfortunately, the simple answer in most cases is to get out of your employer’s plan, so you have more control and can put it into assets that will hold up in the Aftershock. However,
when
and
how
to get out are crucial questions. Because of the tax advantages in most retirement accounts, you often face steep penalties if you pull your retirement money out early. In addition, as we write this, stocks and bonds are still doing okay—not great, but okay—and you need to strike a balance between maximizing your portfolio for the next few years and making sure your retirement savings will hold up in the Aftershock.

To determine your best option, we’ll break down each category of retirement plan and the best way to protect yourself as much as possible.

Many defined benefit plans offer a lump sum at retirement as opposed to an annuity. This is great news for those approaching retirement in the next few years. Taking a lump sum and putting it into Aftershock investments—which you actively manage, of course—is an easy way to minimize the risk of ever-shrinking payments down the road. Better yet, you can put the lump sum into an IRA account and enjoy the benefits of tax-deferred growth. (See the section on IRAs for more information on this approach.)

For those who don’t have the option of a lump sum payment and are instead forced to take regular payments, the situation is more grim—especially for people near retirement or already retired. Remember, those are fixed payments, so when inflation kicks in, it will eat away much of their value. Market crashes, widespread bankruptcies, and an eventual government default will make the situation worse. The truth is that you can’t depend on these pension payments to provide living expenses indefinitely. When things get really bad, you can expect the federal government to step in and provide hardship payments, with pensioners among the first in line. But those payments will be limited—probably not much more than $2,000 per month (in 2012 dollars)—since the government will have to rely on tax revenues to cover their cost. But it will be better than nothing. People facing this scenario may need to plan on reducing living expenses as they approach their retirement years.

Younger readers with defined benefit plans may not be as concerned about retirement, but it’s worth looking into your options now regardless of your age, so you know what your options are. Does your plan allow for early withdrawals? Paying a relatively small penalty now or in the next few years is almost certainly better than being wiped out later. What about early retirement? What are the costs and the benefits? If you’re thinking about changing jobs, or if you lose your job, can you roll over your retirement benefits into a self-directed IRA?

No matter how close you are to retirement, if you’re covered under a defined benefit plan, you need to know the choices your employer is making on behalf of your future. And if you work at a small company, you can always request changes to the plan. Even if your employers aren’t sold on the Aftershock—and many employers are resistant to these ideas—they might be willing to offer options for employees who want to protect themselves with alternative Aftershock investments, such as gold.

As we said above, the biggest problem with 401(k)s and other defined contribution plans is that they limit your options. If you can only invest in traditional stock and bond funds, your retirement account is going to suffer when the stock and bond markets collapse. In most cases, employees with 401(k) plans have no good Aftershock options.

At some point, obviously, you’ll need to get out. But not so fast. There are some mitigating factors that can make holding onto a 401(k) worthwhile, at least in the near term. First of all, you can always ask your employer for more diversity in investment options, including a gold or foreign currency fund that is more likely to hold its value in the Aftershock. If you work at a smaller company and several employees feel the same way, you might have enough sway to convince your employer to make a change.

Even if you are stuck with limited options, there are still legitimate reasons to continue making contributions to a 401(k)
in the meantime
, before the Aftershock. For one thing, if your employer offers matching contributions, that alone may be reason enough to keep making the minimum contribution to get that match for the next few years, while things are still relatively stable. After all, employer contributions are free money. Another factor to consider is whether you are close to being fully vested in your plan, or at least will be more vested than you are now. Employees in that situation should stay with their current plan, as the increased vesting could mean a substantial difference in potential income down the road.

If you’re going to remain, what should you invest in? In the immediate future, cash-type investments, such as money market funds and short-term Treasury funds, are the safest options. These funds still may lose value as inflation and interest rates rise, but the declines will be mild at first, and your employer’s matching contributions should easily cover the difference. Better yet, investing in TIPS, or Treasury Inflation-Protected Securities, will give you some protection against inflation in the short term.

Of course, sooner or later, if your 401(k) plan doesn’t offer options that will hold up in the Aftershock, you will need to get out before things get too ugly even if you have to take some penalty. Borrowing from your 401(k) fund is one option, but it’s not a particularly good one. Theoretically, you could invest the borrowed funds wisely and come out ahead, but this strategy can be very risky, given short-term fluctuations. If you leave your job
for any reason
, the repayment term for 401(k) loans shortens dramatically. That’s a pretty big gamble, and it could leave you on the hook for ordinary income tax on the borrowed amount, plus a 10 percent penalty on any borrowed funds if things don’t work out as you expected.

Hardship withdrawals are also available, but they also come at a steep price, and they are not available for those looking for other investment opportunities (except, in some cases, for buying a home).

For older workers, the choices are a little easier. If you’re already older than 59½, or will be soon, some 401(k) plans will allow you to take an in-service withdrawal based on your age, even if you’re not ready to retire. That way you can simply take a lump sum payment, preferably rolling it over into an IRA account, where you can invest as you wish.

Even if an age-based withdrawal is not allowed, early retirement may be the right option for you, depending on your financial situation and life plans. In fact, 401(k) plans even allow you to retire as early as 55 and begin withdrawals without penalty. (One caveat: If you roll these funds into an IRA, you’ll still have to wait until you turn 59½ to begin taking withdrawals without a penalty.)

For younger employees, the answers aren’t as simple, but you still have some solid options. First, some employers offer a partial rollover, allowing you to take out a portion of your 401(k) funds—usually not more than 50 percent—and put it into a qualifying IRA of your choosing. This may not solve all your problems, but it’s a pretty good start.

Second, if you change jobs, you can roll over your 401(k) funds into an IRA. For some people who are on the fence about their current employer, this may be enough to help them make their decision.

Note
: You can also take this option if you’re fired or laid off. While that’s certainly not an ideal situation, the silver lining is that you can invest your retirement wisely and perhaps come out richer for it in the long run.

If none of these options is available, you can always simply withdraw your 401(k) funds early. You’ll face a 10 percent penalty for the amount you take out, and the funds will be treated as ordinary income. If it’s a significant amount, it could easily push you into a higher tax bracket for the year. But if the alternative is to lose nearly all of your retirement savings, this may be a price you’re willing to pay. Like we said, you likely have a few more stable years between now and the Aftershock, giving you some time to preserve and even grow your portfolio. This is a big step, so it’s worth looking into all the ramifications ahead of time so you’re prepared to get out when the time comes. You can easily make up for the losses if you invest wisely.