401(k)s: Failure to Raise Debt Ceiling Would Mean What?

July 7, 2011 -- If Congress fails to raise the U.S. debt ceiling, what will be the consequences for U.S. savers and investors? Two economists at the Center for American Progress, a progressive advocacy group, believe the consequences could be dire.

The stock market, they say, could drop by 20 percent to 30 percent. And 401(k)s, which in the past two years have rebounded from losses suffered earlier in the recession, could see those gains largely erased.

Gloria Moss, 65, an educator in Florida, lost about half the value of her 401(k) in 2008, when the economy turned sour and the stock market fell. By this May, thanks to a stronger market and the help of a financial planner, she had recovered about 75 percent of what she'd lost.

A report by financial services company Fidelity Investments found that by the end of the first quarter, the average 401(k) balance had surged past where it had been before the recession. It's exactly these gains, said the two economists, that are in jeopardy if the nation's debt ceiling isn't raised.

Heather Boushey and Christian Weller expressed their views, respectively, in testimony before Congress in July and in a May white paper.

Boushey predicts that allowing the economy to "slam into the debt ceiling will undoubtedly create an immediate economic shock," with disastrous consequences for the job market. Government, unable to borrow, would need to reduce spending immediately by 40 percent. The same shock, she believes, would trigger a sharp fall in the stock market. "Families with 401(k)s would likely lose all the gains they have made in 2010 and much of their gains in 2009, moving them further below where they were at the end of 2007 after the stock market fell sharply."

The blow would be felt most painfully by baby boomers of retirement age, since this generation, unlike previous ones, is more dependent on market-sensitive 401(k) savings than on fixed pensions. "These families are more vulnerable to what goes on in the financial markets," she told ABCNews.com.

The hit to 401(k)s, coupled with what she said would be a further decline in home prices, will deal the middle-class a double whammy. Near record-breaking unemployment rates would make it difficult for older, unemployed boomers to work their way out of their retirement hole.

Of the ongoing struggle in Congress over what to do about the debt ceiling, Boushey's colleague Christian Weller wrote: "What may seem like an esoteric debate far removed from people's lives could in the end become a major setback for families' economic security." Given that almost 60 percent of 401(k) money, he said, is invested in stocks, a 20 percent market drop would cost the average saver $7,911; a 30 percent drop would cost almost $12,000.

How much any individual's 401(k) would be affected by a market drop would depend, of course, on how the money had been invested.

"It all depends on what you have your money in," said James Sorrell, a self-employed travel industry executive whose company, New York TAB, promotes tourism in New York City. Though Sorrell's 401(k) took a hit at the start of the recession, it's rebounded 28 percent in the past two years. "That's because I shifted a lot of money to Fidelity's defense and aerospace fund," he explained. "It's done marvelously for me, so long as we're at war."

Likewise, savers who had put their 401(k)s into gold would have done well the past two years, and might continue to in the future, against the backdrop of a falling stock market. A 401(k) heavily weighted in U.S. Treasuries would also come out ahead, said Weller, if Treasuries were held long-term.

Sorrell 's worries are mitigated by his youth. "I'm 39. If my 401(k) plummets, of course I'd be concerned. But longer term, I think the stock market will have recovered by the time I need to tap my savings for retirement." A crash actually could represent a buying opportunity, he said, with temporarily depressed stocks available on the cheap. "If you'd bought Bank of America nine months ago," he noted, "You'd have made a tidy profit."

Sorrell's greater worry is how a default might affect the tourist business, and how a worsening U.S. economy might discourage foreigners from coming to New York. "Look at Greece," he said. "The travel business there is just bleeding away. If we, here, defaulted, then some tours from abroad would be canceled. My business could be very badly hurt. Professionally, that's my real worry."