Protecting your 401(k) during a recession (2024)

Key points

• A recession is a time of significant economic slowdown.
• You’re likely to see the value of the investments in your 401(k) decline during a recession.
• Most equities will eventually recover from a recession-induced pullback.

For someone who is experiencing their first recession, it can be scary and disappointing to watch your retirement balance shrink. Even if you’ve been through it before, it’s natural to wonder whether economic events will harm your ability to retire comfortably and on time.

A workplace 401(k) is many people’s first exposure to investing. When you start contributing money to your 401(k) — and, if you’re lucky, your employer starts contributing — it can be exciting to see your balance grow. But if you’ve lived through a recession as an investor, you know that account balances also go down.

Generally, the best course of action during a recession is to hold onto your investments and not make fear-based decisions. Staying invested in the stock market usually allows you to buy shares at bargain prices during a market downturn.

Since the stock market has historically recovered from a recession, the value of your investments should eventually bounce back in time over a longer horizon.

When deciding what to do with your 401(k) during a recession, it can be helpful to understand why recessions happen in the first place. A few reasons include:

• An overheating of the economy when it’s expanding at an unsustainable rate.
• Asset bubbles, similar to what we saw leading up to the Great Recession.
• Economic shocks or unexpected negative economic events, like the COVID-19 pandemic.

As we go further into 2023, financial experts and regular consumers alike fear a recession is on the horizon. The recession may come — at least in part — as a result of the Federal Reserve’s efforts to combat inflation through its tool of hiking interest rates. As the Fed increases interest rates, spending goes down and causes most sectors to contract.

Recessions can have several negative impacts on the economy. Because of the reduced economic output, some businesses may be forced to close their doors. Others lay off employees, which leads to increased unemployment. Finally, there’s often a decline in asset prices, including those in your 401(k).

So let’s explain what’s likely to happen to your 401(k) during a recession and how you can protect it.

Read more: How much money do you need to retire?

What is a 401(k)?

A 401(k) is a type of employer-sponsored retirement plan offered by many private sector companies. Employees who have access to a 401(k) can defer money from their paychecks into their 401(k) accounts.

The money you contribute to a 401(k) plan is taken from your paycheck pretax, meaning it reduces your taxable income for the year. Investments will grow tax-free in your account. Funds will be subject to ordinary income tax when you withdraw them during retirement.

In 2024, the IRS will allow individuals to contribute up to $23,000 per year to their 401(k) plans, with an additional $7,500 allowed for workers 50 and older. Many employers also contribute to their workers’ 401(k) accounts, usually matching an employee’s contribution up to a particular percentage of their salary.

Once you’ve deferred money to your 401(k), you can invest based on a menu provided by your employer. Most employers offer their employees the choice of mutual funds and target-date funds.

If you’ve contributed to your 401(k) without making a specific fund choice, most likely your funds have been allocated to a target-date fund. A target-date fund is a simple investment solution, with an asset allocation mix that becomes more conservative as it nears the target date (for retirement).

What can happen to your 401(k) in a recession?

Unfortunately, a recession can hurt asset prices, and therefore your 401(k) balance.

According to CFRA Research, an investment research firm, the S&P 500 has lost an average of 8.8% of its value during the four recessions since 1990. So if you had a balance of $100,000 before the recession, an 8.8% loss would drop your balance to $91,200.

The tables below show the length of prior recessions and stock market performance during each of those recessions, as well as before and after, according to an October 2022 report published by HBKS Wealth Advisors.

Of course, not all recessions behave the same. In 2008, during the height of the Great Recession, the stock market fell by more than 38%. The effect on your 401(k) would have been far more noticeable.

One thing worth noting is that by the time something has been declared a recession, the economy has often been on a downward trend for about several months. As a result, you probably saw losses in your 401(k) before you knew you were in a recession.

“Stock recoveries may begin soon after recessions commence. Over the last half-century, the earliest recessionary recovery in stocks began just two months into the brief economic downturn of 2020,” according to investment management firm Vanguard.

While any sort of economic downturn can be scary, especially when your retirement savings are at stake, they are only temporary. U.S. stock markets, dating back to the early 20th century, have recovered from every downturn in history.

Financial advisors say it’s tough to get the timing right for a market recovery, which is why day trading is only lucrative for a small few. But if you keep your money on the sidelines, you’re also betting against the odds. That’s why you always hear the sage advice of staying in the market for the long haul.

How to protect your 401(k) in a recession

When you see your 401(k) balance declining or hear that a recession is coming, it’s natural to wonder what you should be doing to protect your retirement savings. You might be surprised to learn the answer: nothing. At least, nothing different from what you’ve been doing.

“That’ll take some grit because it’s certainly not easy to see a drop in your life savings,” says Eric Phillips, a chartered financial analyst and senior director of partnerships and strategic insights at 401(k) provider Human Interest. “Money can be emotional, and it’s hard to manage the fear, anxiety, and other emotions that have you worried about your financial picture today and tomorrow.”

The Fed has eased past recessions by cutting interest rates, but right now its focus is on the opposite.

During the pandemic, the Fed cut interest rates to their lowest interest rates ever to encourage buying and relieve economic stress. But throughout 2022, inflation reached a concerning level. The consumer price index peaked with a 9.1% year-over-year increase in June 2022. Core CPI, which excludes food and energy prices, climbed to a 5.9% year-over-year increase that month.

Even before that devastating CPI report card, the Fed was trying to rein in inflation. Since March 2022, the Fed has made several rate hikes to slow economic growth and inflation.

Unfortunately, it’s this effort to slow inflation that could also contribute to our next recession.

If you stop contributing to your retirement account (or worse, sell off your investments), you’ll be doing so when prices have dropped. As a result, you won’t see the benefit of your stocks rising in value as the market bounces back.

“Ideally, you’re invested with a long-term strategy in mind and, when the market returns, you’ll see the gains and growth,” Phillips says. “To get a chance at those gains, you’ll need to stay invested. If you pull your money out, you could miss out entirely.”

5 steps to protect your 401(k) investments

The following steps could help you make the best of a recession and protect your investments while still planning for future growth.

1. Continue contributing to your 401(k) plan

First and foremost, don’t abandon your retirement planning during a recession. Many people invest using a strategy called dollar cost average, which is when you invest a specific amount regularly, such as having $100 from each paycheck contributed to your 401(k) plan.

There’s no reason to pause these contributions during a recession.

2. Maintain a well-diversified portfolio

Diversification is one of the most important principles for long-term investing. It involves having many different assets in your portfolio to ensure you aren’t putting all your eggs in one basket. An easy way to diversify your 401(k) portfolio is to invest in a target-date fund.

3. Consider investing in defensive stocks

Defensive stocks are those that typically perform well during recessions and other economic downturns. These companies tend to fall within sectors that people must spend money on, regardless of the economy.

Examples include consumer staples, health care, and utilities. While the S&P 500 Index, a proxy for the health of the overall stock market, was down year over year by 20% in 2022, the health sector was down a comparatively light 4% for the year. The utilities sector was up 1.22% for the year.

4. Opt for value over growth stocks

Generally speaking, value stocks, meaning those that are priced relatively low relative to their earnings, tend to outperform growth stocks, those that are growing faster than the market overall.

Part of the reason for this is value stocks are often more affordable, which is an attractive quality during a market downturn. Another reason is growth stocks tend to require more capital for growth, and that capital might be more difficult to secure during a recession.

5. Make room for income-producing assets

Income-producing assets like bonds and dividend stocks can be a good option during a recession.

Bonds tend to perform well during a recession and pay a fixed income. Similarly, dividend stocks pay regular income regardless of how the stock market is performing. The caveat, however, is that a dividend-paying company may suspend or reduce its dividend.