Are 401(k) Plans Setting Up Millennials for Pain?

Are 401(k) Plans Setting Up Millennials for Pain?


Rob Arnott, one of the investment world’s Big Thinkers, has advanced a worrying argument: that an investing approach devised to help us more safely and sensibly steer toward retirement may actually backfire.

The argument concerns target-date retirement funds, whose allocation shifts away from stocks and more in favor of bonds as the specified date grows nearer. Those funds have become the default choice for many 401(k) investors. Arnott’s analysis suggests the combination of target-date funds, the IRS and a bear market could be particularly toxic to millennials who are only just starting to save for retirement.

Related: 3 Strategies for Making Your Retirement Money Last

Here’s the backstory: In 2006, Congress permitted employers to designate target-date funds or other mutual funds offering a mix of stocks and bonds as a default option in 401(k) plans. Employees would automatically have their contributions directed into those specified funds unless or until they picked a different fund option.

The policy change has been a windfall for the mutual fund companies that offer target-date funds. Within two years, 75 percent of plan sponsors were offering target-date funds, and by 2016, Vanguard estimates, 55 percent of 401(k) participants will have their entire account invested in a target-date fund.

Sounds pretty smart, right?

Well, there are downsides. Target-date funds can carry hefty fees relative to other investment vehicles, and there is no consistency among them. Funds from T. Rowe Price, Pimco, Fidelity or others may have the same date but wildly different portfolios reflecting very different philosophies. Then there’s the problem of what happens if your target date happens to coincide with a market downturn, as folks discovered in 2008. Target-date funds nosedived with the rest of the market, and proved to be anything but a safe haven.

Related: Retirement Savings Fears Grip Americans: ‘I Don’t Have Enough’ 

Which brings us back to Arnott, founder of Research Affiliates, based in Newport Beach, Calif. He has spent some time looking at what happens if, as is increasingly likely, young investors have virtually all of their savings in a target-date retirement fund. Given their youth, that fund’s portfolio is almost certain to be loaded up to the brim with stocks. Any stock market selloff would therefore leave their portfolio disproportionately battered.

On top of that, Arnott notes a Fidelity study showing that 41 percent of those aged 20 to 39 cashed out some or all of their 401(k) plans when they switched jobs. Even if the job switch is voluntary, if it happens after the market has taken a beating, the accountholder is going to take three separate hits:

  • First, they’ve lost the opportunity to let those savings grow, tax-sheltered.
  • Second, there’s a chance that thanks to the market selloff, what they are withdrawing may actually be less than they had contributed in the first place.

Ouch, ouch, and ouch. If the reason for dipping into the 401(k) is that they have lost their job, you can add a fourth and even more painful “ouch” to that list.

The conventional wisdom is that younger investors can tolerate more risk because they have more years to go before they will no longer be earning, meaning that if anything goes wrong, they have more time to “fix” a mistake. Perhaps, Arnott suggests in his brief analysis, conventional wisdom has got it wrong this time. Isn’t there a risk that young employees will become “risk-allergic” if their first experience with investing “ends with the triple whammy of a lost job, necessary liquidation of their 401(k) at a loss, and a tax penalty to boot?”

Related: 8 Smart Ways to Lower Your Taxes in Retirement 

Arnott has built an entire career around challenging conventional wisdom (his company designs investment products built around a radically different kind of index, known as a fundamental index), so it’s hardly surprising that his solution involves turning the tried-and-true approach to 401(k) investing on its head.

Millennials should shun target-date funds, and their outsize allocations to equity, until they have built up what Arnott refers to as a “starter portfolio,” and what most of us might recognize as a safety cushion: an account holding the equivalent of six months’ of income that they can tap in the event of a job loss or other unexpected emergency. This rainy-day fund shouldn’t rely heavily on stocks, but should be a more hedged portfolio. It’s about safety, not returns, because it’s more important that it’s all there when it’s needed than that it generates big returns.

Only once that rainy-day allocation has been filled should millennials start pondering what to do with the rest of their 401(k) assets. Perhaps target-date funds, the “set it and forget it” option, will still emerge as their favored choice. Or in the process of building their rainy-day nest egg they may acquire enough insight and confidence to ask questions about what other options are available, and consider the risk/return tradeoff and the impact of higher-than-average fees on their long-term returns.

Arnott certainly makes a compelling case, especially in light of the fact that young workers already know that their career paths are likely to be tricky and volatile. Why add to their anxiety by making their first encounters with retirement savings costly and potentially painful?

“We can continue pretending that 401(k) portfolios are used only as intended — for retirement savings,” Arnott writes. “Or we can face reality.”

Of course, the task of facing reality will be left up to individuals. It won’t be in the interests of the investment management firms like T. Rowe Price and Fidelity to encourage any further changes to the way target-date funds are used or 401(k) plan options are selected. And employers find the current system to be enough of a headache, too often leaving their employees struggling to make sensible decisions, without enough education or information about the consequences of their actions.

Arnott’s suggestion may be aimed at younger investors, but there’s food for thought for anyone with a 401(k) and a target-date fund in their portfolio.

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