A recent study by the Center for Retirement Research at Boston College looked at how defined contribution plan participants responded to changes in the economy. The study found that plan participants responded to an economic slowdown by reducing their contributions to plans such as employer sponsored 401(k) plans. These results were not too surprising -- during tough economic times folks have less money to allocate to retirement savings. More interesting is the effect the lower contributions have on the long term health of their retirement plans and their final wealth.
During the booming times from 1992 through 1999, the real median contribution increased by 2.5% a year for a cumulative 19.1% increase. Contributions continued to grow about 1.8% per year in 2002 through 2004. Then the slowdown in the housing sector pinched household budgets and from 2004 through 2009 contributions dropped by 2.5% a year. The levels remained unchanged in 2010 and 2011 but resumed their decline in 2012 and 2013. The Great Recession crimped people's ability to save for retirement.
The Federal Reserve just reported that the average contribution rate in 2013 was 9.2% with roughly 6% coming from employees and the balance from a 50% employer match. Contribution rates had averaged 10% through most of the previous decade according to data from Vanguard funds.
The slower economy also made investors more conservative in their portfolio allocations. The percentage of participants investing in bond funds increased with the slow economy in 2001 and 2008 and decreased when the economy recovered. The Great Recession led investors to increase their allocation to bonds from 38.0% in 2006 to 54.8% in 2009. Clearly tough times led people to choose safer investments.
Long term effects of the changes
The Boston College researchers looked at the long term effects of decreasing the contribution rates during the economic slowdown. If a typical 30 year old worker reduced his contribution rate by 6% between 2007 and 2010 in response to the slower economy and then resumed a more normal contribution rate increasing it by 1% annually for the remainder of his career, and for the balance of his career his account earned just a 3% rate of return, then at age 62 he would have $11,907 or 8.9% less in his account. The four years of lower contributions would have cost him almost 9% of his wealth when he reached retirement. The researchers found that the younger the plan participant and the further away from retirement the more significant the penalty to final wealth.
The economic slowdown which we recently experienced caused 401(k) plan participants to reduce their contributions to their savings plans and to choose safer but lower yielding investments. The wealth effects of this will be felt for a much longer time than we ever expected -- not just by those about to retire, but also by those just starting their careers.