Setting Up Young Investors For A Triple Whammy

Target date funds, which start young investors off with a relatively risky portfolio and shift toward a more conservative profile as retirement approaches, have practically exploded in popularity in the last decade, growing from less than $100 million in industry AUM in 2004 to more than $600 million at the end of 2013 according to Ibbotson Associates. This strategy assumes young people will be able to keep adding to their TDF and ride out a rough business cycle, but unstable employment means that the theory doesn’t always work out.

“Current savings options blissfully ignore the fact the young use their 401(k) investments as their rainy day fund in case they have an unexpected and urgent need for cash. Often, this happens when they lose employment,” write Rob Arnott and Lillian Wu at Research Affiliates. “We can continue pretending that 401(k) portfolios are used only as intended—for retirement savings. Or we can face reality and offer our young investors a more prudent solution.”

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Employment risk is much higher for young adults

Arnott and Wu point out that, while unemployment goes up across the board during a bear market, younger people are affected at much higher rates, and as many as 41% of them will end up pulling cash out of their defined contribution plans to make ends meet in between jobs, selling assets when they are worth the least, and incurring tax penalties for early withdrawals on top of everything. Target date funds make sense for someone who never spends much time out of work, but it’s nearly impossible for most young people to know if that applies to them in advance.

unemployment v equities by age 1114

Building a rainy day fund before saving for retirement

Instead, they argue that young people should build up a low risk rainy day fund (made up equally of mainstream equities, mainstream bonds, and low volatility inflation hedges) before they start thinking about their retirement savings, perhaps equal to six months’ worth of pay. If workers can make it through the worst of a downturn without pulling money out of their TDFs then it can be a smart way to save for retirement, but the only way to be confident that will actually happen is to build up a reasonable cushion that they can fall back on.