We have all now, unfortunately, been introduced to the power of compounding. Not in the sense of compound interest, but in the mathematics of how a virus, like Covid-19, can spread among an unprotected populace. We are learning that introducing small changes, like social distancing, sooner, rather than later, can have big effects in slowing the spread of the disease.
The current economic environment is forcing many Americans to make some difficult decisions. Many younger Americans who were already in debt, particularly student loan debt, are having to prioritize cash flows amidst a surge in unemployment. Other Americans who remain employed are facing whether they should stop contributing to their retirement accounts to preserve cash for other more pressing needs.
Some companies are beating them to the punch by delaying, or suspending altogether, contributions to 401(k) plans. Unfortunately many employees take this a signal as well. Meghan McCarty Carino at NPR writes:
She’s [Teresa Ghilarducci] also found workers pick up on signals from their bosses. When companies hold back on matching retirement money, employees often decide to cut what they put in, too. That means they don’t benefit as much when markets eventually recover.
Even before this current crisis, so called ‘401(k) leakage’ was an issue. This economic crisis, along with the new CARES Act, which makes penalty-free withdrawals from 401(k) and IRA accounts available, will also lead to more money leaving the retirement savings system. Getting people to save on a regular basis is hard enough without the issue of big negative externalities intervening.
As Ben Carlson at A Wealth of Common Sense notes, the contributions made during the depths of a bear market end up being the most valuable in the long run. Which is in some sense is obvious, but the math of markets eventually recovering makes it so. This is the cruel irony: the best investment opportunities come when the average American is stressed financially and emotionally. Simply being able to make already scheduled investments into 401(k) accounts and having your employer match them is no small thing.
These moves will in all likelihood exacerbate the wealth inequality problem in the US . As Michael Batnick at the Irrelevant Investor notes:
During this current downturn, some people’s finances won’t be affected, for others it will feel like a recession, and for others it will feel like a depression. Wealth inequality is only going to be exacerbated by the decline in economic activity.
While it is great that billionaires are stepping up to help offset some of the issues involved in the pandemic, it does not substitute for a system that leaves fewer workers behind. William Bernstein at Efficient Frontier writes:
Today, the top quintile of the population owns 92% of stock wealth, and the bottom four quintiles own 8%. This discrepancy is likely to grow in the coming decades as the upward distribution of equities towards their “rightful owners” plays out, most of the time gradually, but sometimes in paroxysms.
Over the past generation, as ever fewer American workers participate in defined benefit schemes that provide a reliable stream of retirement income, ever more have become their own portfolio managers via defined contribution plans such as 401(k) plans.
Better financial literacy certainly couldn’t hurt. A mandatory retirement savings program like that seen in Australia could also help. Spain is in essence rolling out a system of universal basic income. Whatever the solution, it is not going to be available to help American workers today. The (negative) power of compounding is already rolling downhill. Here’s hoping that by the time this crisis well in the rearview mirror and the economy is back on its feel that we will have taken some steps to avoid the disruptions seen today.
