Should young retirement savers load up on stocks? Maybe not
(The writer is a Reuters columnist. The opinions expressed are his own.)
By Mark Miller
CHICAGO, March 27 (Reuters) - Millennials don't seem to buy the traditional wisdom when it comes to investing. They're the most risk-averse investors since the Great Depression, with the average portfolio 52 percent in cash, according to a recent report by UBS Wealth Management Americas.
That runs counter to what most investment experts will tell you - that young people need the greatest exposure to riskier stocks to meet long-range goals, and that equity allocations should decline as retirement approaches. That philosophy underpins the fastest-growing retirement savings product in the market today, the target date fund (TDF).
TDFs automatically adjust your risk exposure to your age bracket, and they are growing explosively: Some $618 billion was invested in TDFs at the end of 2013, up from $160 billion in 2008, according to the Investment Company Institute. Most of that was in defined-contribution plans, which held $5.9 trillion last year.
Rob Arnott thinks the TDFs have it all wrong. A respected investor and academic researcher, Arnott is chief executive officer of investment management firm Research Affiliates in Newport Beach, California. In a recent paper he co-authored in the Journal of Retirement, he found that investors come out ahead by starting conservative and taking more risk as they age.
The paper analyzed more than 140 years of historical returns, simulating hundreds of outcomes over three portfolio strategies. One begins 80-20, stocks to bonds; the second rebalances annually to a 50-50 allocation; the third starts with 20-80, stocks to bonds, and moves to an 80-20 equity-centric allocation over time. Arnott and his co-authors conclude that an investment of $1,000 over 40 years finishes an average of 11 percent better in a balanced fund than in a TDF; the inverse glide path beats the TDF by 22 percent.
One of Arnott's key points is that retirees with low equity allocations miss out on stock market rallies in the out years when they are older and have the largest portfolios and hence the largest potential gain. But I asked Arnott recently about high equity allocations for young people after seeing some eye-popping data pointing to a fundamental problem with the assumption that young investors can take the long view with their money.
Fidelity Investments reported recently that 41 percent of workplace retirement savers in their 20s cashed out their accounts when they left their jobs. Cash-outs before age 59 1/2 are subject to a 10 percent penalty in most cases, and the funds are taxed as ordinary income in the year of withdrawal.
Most important, the Fidelity numbers suggest that for many young workers, retirement accounts aren't "long view" money. Twenty-five percent of all 401(k) accounts are terminated after three years, according to Federal Reserve data, and 50 percent are gone after seven years. Some of those are rolled over, but many are cashed out.
"If young adults early in process of saving are that skittish about risk, why put them into something that is 80 percent stocks, where they could suffer huge losses if we have a repeat of 2008 and 2009," Arnott says. "Half of their liquid wealth could disappear, and they'll shun risk for the rest of their lives.
"Having their early money invested in a less aggressive fashion would make this feel more like a savings plan than a speculative coin toss. If it feels more like a savings plan, they might have more desire to stay with it, rather than cashing out when they change jobs."
Arnott suggests starting young people in a beginner's portfolio with broad diversification and much less risk. "I'd structure it so you have very low volatility and can never lose more than 20 percent of your principal. Keep it there until you have maybe $50,000, and then move it into a target date fund."
Most experts draw a different lesson from the cash-out figures - that young people should be encouraged to build up emergency funds outside their 401(k)s that will help them avoid tapping retirement accounts when they hit a rough patch or change jobs.
"It's troubling to see people taking out funds instead of rolling them over or keeping it in the plan," says Wei Hu, vice president of financial research at Financial Engines, which provides financial planning services to employees enrolled in workplace plans. "The smart thing to do is make sure you have enough emergency money available outside of your tax-deferred account that you can get to quickly and easily and keep it invested conservatively."
That sounds good - in theory. But for many younger households, financial pressures make any saving difficult. Sixty percent of households participating in a 401(k) plan added more debt to their family balance sheet than they contributed to retirement savings from 2010 to 2011, according to a study by Hello Wallet, another workplace financial guidance firm.
Most investment managers reject Arnott's view that equity exposure should begin low and increase as retirement approaches. And Jerome A. Clark, portfolio manager of the T. Rowe Price Retirement Funds, adds that constructing retirement investment products around less-than-perfect investor behavior wouldn't make sense.
"With any retirement product, you're trying to solve a specific problem. With TDFs, the problem is how to accumulate savings in an appropriate way, and then provide lifetime income in retirement. We know there will be a wide range of behaviors by investors in a plan - and that there will be suboptimal behavior. But for most plan sponsors, it's about providing an asset allocation that gives people the best chance of meeting that objective."
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