Why Your 401k is at Risk if the U.S. Defaults

27 July 2011 One Comment Print This Post Email This Post

People wonder how to protect their 401K from the debt ceiling crisis. The real problem is not simply that a 401K’s assets could go down in value, rather it is that there is a problem with the country’s finances: if the unsustainable deficit is not fixed then one of two scenarios will occur: either government programs will be cut by about 45% or else taxes will rise very significantly.

Scenario I: How will your 401K investments be damaged by a massive cutback of government programs?

If a massive cutback in government spending is enacted (possibly a 45% cut) that would be a reason for the economy to fall into a deflation or recession due to reduction of demand. Beneficiaries of government spending would have less money to spend and that would decrease demand, leading to an economic crash.

Scenario II: How will your 401K investments be damaged by a massive federal tax increase? If a massive tax increase occurred that was aimed at balancing the federal budget, with no cuts in spending then tax rates might rise by 20 percentage points. So moderate income person (a single person earning over $33,000 a year) in California who is now in the 25% bracket would pay 35% in federal income tax, plus an additional 10% of Medicare payroll tax (up from 1.45%), plus state income tax of 9.3%, plus Social Security of 6.2%. His employer would have to match the Social Security and Medicare taxes, which would dampen employer’s desire to create jobs and incentivize employers to reduce jobs.

These taxes would be very deflationary. Econ 101 textbooks say “raise taxes to cool off the economy, cut taxes to stimulate the economy”. A deflation would make stocks go down to retest the SP’s low of 666 of March 9, 2009 and probably stay there.

People may wonder what about a third scenario where the Federal Reserve simply prints money and donates it to the Treasury. There is no legal provision for this happen. People wonder will Congress simply keep expanding the Federal deficit and simply have the Federal Reserve Bank buy all the new issue of T-Bills? This is unlikely because Congress does not want to increase the deficit. Further, the government has an incentive not to create inflation because most of their costs are indexed to inflation: Medicare, Medicaid, college education, short term interest rates all go up with inflation and could go up faster than the CPI rate of inflation.

Conclusion: Deflation and soft Depression, like in Japan, are coming. There is no way to get extra stimulus to get out of the recession, instead the recession will be made worse by a cutback in government spending or by a massive tax increase. Therefore, the proper investments regardless of whether or not they are in a 401K are conservative, high quality investments that have the characteristics of low risks.

For example if you insist on buying stocks (which I don’t recommend) then get stocks with all of the following: low debts, high corporate moat, steady and growing profitability, above average retained earnings, good management, and above all don’t overpay for any type of asset. My preference is to ride out the storm by holding the asset class of investment grade quality bonds. Avoid low quality bonds. Be careful about Mortgage backed bonds because of variable duration risk. Beware of Muni bonds as a Federal austerity program means that the federal government may not bail them out and a deflating economy means less tax revenue for Muni governments.

  • Kathryn

    Should I transfer my 401k into the bond market. Will this be a safer way to ride out this whole debt mess?