Stress Tests

No, not those stress tests...the ones that show which major financial institutions are under capitalized under stressful economic times. But rather the tests consumers feel in these uncertain times.

A recent article in the Wall Street Journal on emergency 401k withdrawals got me to ask colleagues in the tax preparation world if this was in issue this year. By and large the answer as yes, and the stories they told profound.

One site here in Madison did taxes mostly for University employees as part of the IRS Volunteer Tax Assistance Program (VITA) and served low-income individuals. The thing about many VITA sites is the tax forms are not that complicated--few clients have to fill out schedules for small businesses or rental properties, or even Schedule A for itemized deductions. Getting through Child and Earned Income Tax credits is much of the work. But this year an employee with around $25,000 in income came in who had cashed out an 401k or IRA tax deferred account. It had at one point risen in value to more than $35,000--a lot for a low-wage worker under 40 years of age. Then by November/December has dropped to $14,000. For this client seeing this drop in value was too much. The media was talking about banks failing and scams where investors lost all of their money. This was not an FDIC insured account and the client feared the worst. The only defensive move in this client's mind was to get that money back ASAP before it was all gone.

He panicked. But it is not hard to put yourself in his shoes and realize in that context, if you don't believe markets will come back, and the media is buzzing about the collapse of the economy, you might have the same thoughts.

Of course finance theory tells us to ignore cyclical swings, dollar cost average, and invest for the long-run, especially for a retirement account that won't be needed for a decade or more. But knowing that and believing that when you and everyone around you is under stress is another matter.

This story is not that uncommon among VITA sites. Sometimes people sold for an emergency expense; some sold in a panic. Either way they sold at what now looks like a bottom of the market. Plus remember they have to pay all the deferred taxes on the initial IRA/401k contributions, plus a 10% penalty. In the anecdote above the client ended up owing about $4000 in taxes and penalties to pull out $14,000. Mind you $14,000 is still more than half his income. If there as an emergency use it might even avoid some tax implications. But most likely that money won't be reinvested at a reasonably long-run rate of return (eg it will go in a savings accounts versus an S&P 500 Index) and will lose value. Or even more likely it will be spent on everyday costs of living and consumption.

A lot of savings "policy" and programs aimed at boosting financial literacy or investing focus on getting in, but not what to do when the market drops 30% in less than one year. When it looks like the bottom is falling out people respond in predictable ways. One implication is that we need to better understand this consumer behavior under financial stress. Maybe this could lead to more supportive products and services to prevent people from letting today's stress get the better of their financial future. Financial insecurity comes from more than just a spreadsheet, but is a state of mind.