New data indicates that more Americans are accessing their retirement accounts to make ends meet in recent months. That could be a stern warning sign with important portfolio management implications. It also highlights a few noteworthy lessons that households can embrace to build the best possible financial plan.
Consumers need new sources of liquidity
One of the obvious conclusions to draw from this news is that consumers are turning to new channels to access liquidity. This suggests that demand for goods and services is still generally strong. However, the public is clearly starting to feel strain induced by tricky macroeconomic conditions.
High inflation rates squeezed consumers in 2021. Prices surged throughout the economy thanks to a potent combination of government stimulus, a rapidly expanding money supply, supply chain disruptions, and other factors. Wages didn't keep up with peak price inflation, eroding consumers' buying power.
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The Federal Reserve took action to combat price inflation over the past two years by hiking interest rates. High rates increase borrowing costs, making people less eager to buy expensive items and discouraging businesses from hiring and investing in growth.
In general, this is bad news for consumer sentiment and employment. A wave of high-profile layoffs in the tech sector and weakness in the housing sector were noteworthy examples of these forces in action.
The Fed's actions effectively cooled the rate of inflation, but prices aren't reverting to previous levels -- they continue to rise, just at a more manageable pace.
Meanwhile, people have been forced to contend with high interest rates, limited access to credit, and a weaker job market. This creates a sort of squeeze on many household budgets. People are still dealing with sticker shock and a dollar that won't go as far, while they're also facing a slowing economy and high borrowing costs.
The number of hardship withdrawals and 401(k) loans increased in 2023 relative to the prior year, and it's easy to see why many families had to source cash from their retirement accounts to navigate this rough patch.
Accessing retirement funds early is often an indicator of cyclical weakness. Optimists will hold out hope that the Fed's anticipated rate cuts later this year could relieve strain on consumers. The elusive soft landing that regulators are targeting could send the economy back into growth mode, and this might just be a temporary lean period.
If things aren't resolved so smoothly, this could be an early sign of consumer distress that is likely to spill into other sectors. A stock market correction is possible if consumer health declines.
This has important ramifications for investors. The current uncertainty underlines the importance of balance and long-term strategies. Investors should maintain an allocation that balances growth with volatility in accordance with your time horizon and risk profile.
401(k) accounts are an important savings tool
One positive observation coming from the recent data is that 401(k) accounts are clearly an important wealth-building tool. People accessing retirement savings ahead of schedule might be an ominous sign, but it would be even worse for households to have no liquidity at all.
Employer-sponsored retirement accounts are essential components of many families' financial plans. It's impossible to know what the future holds -- life can throw serious curveballs, from job loss to unexpected expenses. When surprises inevitably arise, it's important to have access to liquidity to address those events. Therefore, assets held in a 401(k) can act as a lifeboat to get through tough times.
Make sure that you're saving enough to have a buffer. Automatic contributions are helpful for imposing discipline to keep earnings out of your checking account. Employer contribution matches are a great perk to boost your savings rate. Take advantage of the tools at your disposal.
There might be more efficient options
All that said, a 401(k) is rarely the most efficient source of liquidity. It's often beneficial to use various tools in conjunction.
Loans against the accounts carry interest rates, along with fees and potential restrictions in the event that your employment status changes. Hardship withdrawals generally don't come at any significant cost, but these often coincide with macroeconomic issues that can accompany stock market volatility. If your retirement fund is allocated for growth, there's a good chance that you'll be selling when the market is down to free up cash. Volatile assets aren't ideal for short-term liquid needs.
Even worse is accessing a volatile account without a penalty exemption. Withdrawing from your 401(k) early can be a taxable event that incurs an additional 10% penalty. That's a disaster from a financial planning perspective.
You need to set yourself up with flexibility and options in order to avoid these inefficiencies. If you're already taking full advantage of an employer contribution match, it might be wise to consider building wealth in other accounts. A Roth IRA or brokerage account are funded with post-tax dollars, so they're often accessible with less risk of penalty or taxation.
It's also worth considering stashing three to six months' worth of expenses in a low-volatility vehicle, such as a savings account, CD, money market account, or short-term government bond. This gives you a safety net that won't force you to raid growth assets at inopportune times.
