How can a debt crisis affect your 401(k)?

The high-stakes battle over Washington’s debt ceiling spills over into financial markets.

Stock values ​​have fallen and bond yields have risen in recent weeks as Wall Street has grown increasingly fearful of a federal default.

Experts say the damage could be minor and eventually reversible if lawmakers can avoid default.

But the battle poses serious risks to retirement accounts — especially for Americans who are about to leave the job market.

“The timing of the stock market’s big drop is crucial for about 10 years [million] To 20 million Americans, said Teresa Gilarducci, economist and director of the Retirement Equity Lab.

The threat is greater for baby boomers, Gilarducci said, who are reaching the end of their working years and have less time to recover from damage to their retirement accounts than younger workers will.

She added, “If the debt limit policy causes the stock market to drop, even for two months this year, that could have the effect of the sharp drop in the stock market in 2008.”

The resumption of talks between the White House and House Republicans has allayed some concerns on Wall Street. But lawmakers still have a lot to cover before the US runs out of cash early next month.

Treasury Secretary Janet Yellen warned earlier this week that the country is already experiencing “the effects of brinkmanship,” referring to changes in the bond market in recent weeks.

Borrowing costs rose as investors became increasingly concerned about the federal government’s ability to repay its debt after June. Yellen warned lawmakers this week that the US could default as soon as June 1 and cause a “catastrophic” financial meltdown.

“Investors are becoming more reluctant to take on government debt due in early June,” Yellen said on Tuesday at a conference hosted by the Independent Community Bank of America.

“The impasse has already increased the debt burden for American taxpayers.”

Why is the fight against debt shaking the markets?

US Treasury Secretary Janet Yellen, right, and Federal Reserve Chairman Jerome Powell speak before a group photo session of the G7 meeting of finance ministers and central bank governors, at Toki Messe in Niigata, Japan, Friday, May 12, 2023. Photo/Shoji Kajiyama)

Yellen cited reports from the White House Council of Economic Advisers which showed that a prolonged default could “lead to a downturn as severe as the Great Recession”.

In his simulation, more than 8 million Americans would lose their jobs. Business and consumer confidence took a huge hit. The stock market value fell by about 45 percent — wiping out years of retirement and other savings for families, Yellen said.

High interest rates are hitting the bond market hard, draining another source of growth for retirement accounts.

The uncertainty around debt limit discussions could help raise interest rates on a long-term basis, said Richard Johnson, a senior fellow in the Center for Income and Interest Policy at the Urban Institute.

“Then higher interest rates lower the value of bonds, so for those people, that can be a very big blow,” he said. “And if bond prices remain high after that, that would be worrisome.”

He added that while higher rates can lead to better results in funds in interest-bearing bank accounts, it is those who have invested in long-term bonds “who will be hurt”.

Ghilarducci cautioned that market volatility poses serious risks for 401(k) and Individual Retirement Accounts (IRAs).

She said, referring to the market — stifling the impact of price hikes.

“These are retail products that are run by workers themselves,” Gilarducci said, referring to 401(k) plans and IRAs, “and they don’t have the kind of hedge that an endowment fund or defined benefit plan might have.”

The long-run costs of brinkmanship

Traders work on the floor at the New York Stock Exchange in New York, Monday, March 13, 2023. (AP)

Experts also worry about the possibility of a mass exit from financial markets and retirement accounts if a debt battle — or worse, a default — sends panic among Americans.

“One of the concerns is that if this volatility — does it scare people away from saving from investing in the stock market because they don’t want to lose their capital,” Johnson said.

“Then that becomes a concern and that could have a long-term impact even if this volatility does not persist in the event.”

The latest internal survey showed “people worried about volatility and, therefore, didn’t feel comfortable about retirement,” said Craig Copeland, a senior research fellow at the Employee Benefits Research Institute (EBRI).

“People who are approaching retirement age or making that decision… those people are going to be in a very difficult position,” Copeland said.

“If they are already scheduled, they could be in a situation from which it will be very difficult to recover.”

EBRI is a nonprofit research institution funded by a wide range of investment managers, pension funds, and AARP.

There is a risk, Copeland added, that Americans will start to “anticipate a default or start selling immediately if there is a default before really understanding its impact,” particularly younger workers.

He continued, “Responding in a way that just moves everything out, because of that one issue, would be shortsighted because you won’t know when to jump back in.” “And you might miss out on some of the biggest gains.”

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