Opinion: Now Is Not The Time To Invest In Your 401(k)

For young professionals, one of the most common pieces of financial advice is to begin saving and investing early, often via a 401(k) plan. But what if investing in a typical stock/bond portfolio today meant that over the next 10-12 years, not only would you not make a positive return, but instead stand a chance of losing money?

In that case, you might look for an alternative benefit with a guaranteed return, one not subject to the whims and gyrations of capital markets. For an increasing number of employees, there is such an alternative: student loan repayment.

In 2019, an accelerated pay-down of student loan debt could be preferable to investing for retirement over the next decade. To understand why, we need to look at three things: the risk inherent in today’s asset markets, the nature of opportunity cost and the concept of the option value of being debt-free.

The Peril of Investing at a High Valuation

Over longer cycles (10 or more years), the single biggest driver of returns for stocks is valuation. The standard measure for this is the price-earnings (or P/E) ratio. After a nine year period of gains in the stock market, today’s 10-year smoothed P/E is 30.1. How high is this? In the last 150 years, the market has been more highly valued only once: during the dot-com bubble. Why is this important? Because secular bear markets typically begin when valuations are high.

Using historical data, market analysts can project a range of future returns based on today’s valuation. According to fund manager John Hussman’s calculations, over the next 12 years, a balanced stock/bond portfolio will likely produce less than a 1 percent annual return.

In the chart below, the blue line represents the estimated 12-year projected annual return of a stock/bond/cash portfolio. The projected annual return is below 1 percent! The red line is the actual subsequent 12-year total return. Their correlation is strong.

An Alternative To The 401(k): Student Loan Debt Repayment

In student loan repayment plans, employers will pay a monthly amount to reduce the principal of the employee’s outstanding student loan debt. Because these payments go entirely to principal and not interest, they can have a profound impact on reducing both the time to paying off the loan, and the total interest paid.

Let’s say an employee has $30,000 of student loan debt paying 6 percent interest, with a 10-year amortization, or payoff term. Under the new benefits plan, an employer pays $150 a month to reduce the principal as long as the person is employed.

Here is the result of such a plan:

• The employee’s student loan is fully paid off in just over six years instead of ten.
• The overall cost savings (principal and interest) for the employee is $15,220.

Let’s compare this to 401(k) contributions of the same amount over six years. Based on Hussman’s projections of 1 percent annual returns, at the end of six years the employee would have a portfolio worth $11,183.

To compare apples to apples, let’s subtract the total employer contributions:

• Student loan payoff benefit (savings) = $4,420
• 401(k) investment benefit (earnings) = $383

Why is the loan payoff so much better? Because of the relative rates of interest and return: 6 percent vs. 1 percent. This difference is magnified over time as the loan principal is paid down.

In short: Loan principal pay-down is the magic of compounding — only in reverse.

To be fair, the employment contributions to debt principal payment are taxable under current law (which may change in the future) where 401(k) contributions are not. To account for this difference, we can estimate what a tax burden might look like for the employer contributions. For an employee in the 22 percent tax bracket, it would be $2,376. The net post tax benefit is $2,044, which is still more than five times the ROI of the 401(k) contributions over six years.

The Option Value Of Being Debt-Free

From a purely financial perspective, it’s easy to see how paying off student debt is a good idea because today the opportunity cost associated with not investing is essentially zero, and will remain that way until markets adjust significantly. The higher the interest rate on the debt, the more advantageous it is to have one’s employer pay down the principal.

But what about other benefits that are not purely financial?

Having debt obligations limits people’s options. If you didn’t have any debt, you would be much freer to entertain all kinds of options – switching industries, moving to new countries, even starting your own business. In addition, lowering personal debt increases one’s credit score, which results in lower borrowing costs. Perhaps the most valuable “real option” created by being debt free is the ability to purchase a home earlier in life.

For the 70 percent of college graduates with student loan debt, the currently low opportunity cost of not investing means that debt principal pay-down is a more advantageous benefit than a 401(k) plan. This is true both in purely financial terms, and in terms of real-life options. Fortunately for today’s workers, more and more companies are adopting student loan plans every day.

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