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How the stock market affects retirement plans

With the market seesawing daily, you may have seen your retirement savings — that money you've been counting on, and expecting to grow — shrink to disturbing levels in recent months.
/ Source: The Associated Press

With the market seesawing daily, you may have seen your retirement savings — that money you've been counting on, and expecting to grow — shrink to disturbing levels in recent months.

Retirement funding has been tied very closely to the stock and bond markets in an effort to provide the potential for significant growth, but now a lot of Americans are learning the realities of the downside of investing.

Here are some questions and answers about how the stock market affects your retirement savings.

Q: How are retirement accounts and the stock market linked?

A: The whole thing started in the 1970s when the government began tinkering with retirement plans. By the end of the decade, Congress had created the Internal Revenue Code section 401(k), from which many of our current retirement plans take their name.

The section authorized paycheck deductions as a way to save for retirement. The accounts grow larger as you contribute part of your salary and your employer puts some money in each year. In addition, the money is invested in stocks, bonds or other investments to help the value of your retirement fund grow.

Q: Why is it necessary to tie my retirement account to the stock market?

A: The idea behind investing retirement money in the stock market is to make the account grow faster.

The money could be invested in a bank account or safer investment products like U.S. Treasury bills or long-term Treasury bonds, which would offer annual returns in the 3 to 4 percent range. Over time, though, the stock market has outperformed any other investment in the United States. For example, a stock market return of 7 percent would not be unusual over a 10-year period.

The idea is that your retirement money is a long-term investment, so you're taking advantage of that higher return to have more money when you stop working. Compounding the investment over years — reinvesting the earned money to earn even more — has proved to offer significant growth.

The downside: There are no guarantees when you invest in the stock market, which can drop significantly during economic downturns — as we've seen recently. To get the faster growth in your account, you're accepting some risk that a downturn may sweep away some of your money.

Q: Are there less risky alternatives?

A: Most advisers would say the best way to control your risk level begins with becoming involved in deciding where your money is invested within your 401(k) plan. Most 401(k) plans offer a variety of funds to invest in, typically ranging from higher risk choices that invest in volatile stocks to safer funds that put more money in bonds.

Basically, you need to strike a balance between earning potential and security. And there's no such thing as a perfect balance — only you can know how much risk you're comfortable with.

There's one principle most advisers would agree on, though: The younger you are, the wiser it is to consider riskier investments, since the stock market tends to rise over the long run and you'll have plenty of time to recover from any steep drops.

On the other hand, if your money is in high-risk stock funds when you're nearing retirement, you stand the chance of losing a large amount of money just when the time comes to start withdrawing — a situation many investors find themselves in now.

Q: What kind of impact has the meltdown had on company pension plans?

A: It's hit them hard. Since most companies invest about 60 percent of their pension plans in stocks and about 40 percent in fixed-income assets such as bonds or money market accounts, they've lost significant money.

Adrian Hartshorn, an actuary with business consultant Mercer, a division of Marsh & McLennan Companies Inc., has been tracking the pension accounts of companies in the S&P 1500. At the end of 2007 the companies collectively had a surplus in their accounts of $60 billion. As of the end of September, the combined value had fallen to a deficit of $35 billion because of stock market losses.

Without a recovery in the stock market, he said, that deficit could balloon into the hundreds of billions.

Q: Could a company's financial security be at risk if pension plans suffer from market losses?

A: Yes — in fact, the losses are already starting to hit some companies' profits.

Take defense contractors, for example. Lockheed Martin Corp., the nation's largest defense contractor, has 128,000 retirees covered by its pension plan. The plan provided a $160 million windfall to the company this year, but the stock market losses will result in a loss of $60 million next year.

At Northrop Grumman Corp., Chief Financial Officer James Palmer told analysts Wednesday that the October market dive has led to a loss of roughly 20 to 21 percent in the company's return on investment of its pension assets.

Q: Is there any chance the federal government might take over private pension plans to protect retirees, as Argentina is considering?

A: Some in Congress have begun discussions about how U.S. workers could be guaranteed more security but still see some growth in their retirement funds. The House Committee on Education and Labor is holding hearings on the issue.

On Oct. 7, they heard testimony from Teresa Ghilarducci, an economics professor from The New School for Social Research in New York. She proposed a radical, short-term fix, where 401(k) plans would be turned over to a guaranteed retirement account composed of government bonds earning a 3 percent annual return, adjusted for inflation.

When workers begin collecting Social Security, the account would pay them an inflation-adjusted annuity, based on the accumulated funds. For example, a 55-year-old worker with $50,000 in a 401(k) account in August would swap out the $50,000 for a guarantee of $500 per month in retirement.

Q: What about a long-term solution?

A: Chilarducci proposed the creation of universal guaranteed retirement accounts in which the federal government invests $600 for every worker. Workers would put 5 percent of their pay in and the account would earn a guaranteed 3 percent rate of return, plus inflation. The cost of this plan would be offset by doing away with most tax breaks currently offered on 401(k) accounts, so the government wouldn't have to pay any more than it does now. The accounts would be safer and guarantee all workers an income during retirement.

Q: What are the chances one of these proposals will be implemented?

A: That's probably not very likely right now — but if they get backed by enough political will, who knows? There certainly is a groundswell of concern over the current system, considering that many workers have lost half of their retirement funds in the stock market.

Something to keep in mind, though: In the current system, trillions of dollars are invested in accounts managed by some very large companies — and they'll fight any attempt to take away their retirement fund business.