Young workers should consider investing in a safe 'starter portfolio' within their DC plans.
Most target date fund (TDF) products—also known as glide path investing—start our youngest employees with a heavy equity allocation and slowly shift their portfolio holdings into bonds as they age. With growing use of automatic enrollment in 401(k) plans, and the prevalence of TDFs as the default choice in defined contribution (DC) plans, we’re seeing an ever-higher equity concentration in young workers’ DC portfolios.
A recent Fidelity (2014) study reports that, among 12.5 million DC participants, 41% of those between ages of 20 and 39 cashed out part or all of their DC assets when switching jobs, incurring tax penalties along the way. A rhetorical question: Do they lose their jobs more often in a bull or a bear market? Maybe a high-risk profile is unwise for young savers. When some of them lose their jobs in a bear market, and find that they need to dip into their DC reserves while looking for another job, it’s a triple-whammy. If their 401(k) is their only serious savings:
- they may have to cash out to meet basic living expenses,
- their assets may be less than the money they set aside from their paychecks, and
- they have to pay the IRS a stiff penalty for early withdrawals.
The literature of consumption finance suggests—and tangible evidence corroborates—that people try to smooth their lifetime consumption by overspending when young, long before their income peak, then saving more and more aggressively as they approach their peak earnings years. Many young adults are establishing their financial self-reliance, starting families, and saving down-payment money for their first homes, often while burdened with student loans. As a result, young adults have different saving incentives from those who are further along in their careers: their savings are precautionary (to offset income uncertainties), not for retirement.1
Work is less stable among young adults, as demonstrated by the higher unemployment rates. Figure 1 (left axis) shows the monthly unemployment rates, seasonally adjusted, for different age groups. From January 1990 to mid-2014, workers between ages of 20 and 24 experienced an average unemployment rate of 10%; the average unemployment rates for those age 25–34 and 35–44 drop to 6% and 5%, respectively. The older age groups, those above 45, seem to have a better chance of staying employed, experiencing the lowest average unemployment rate (4%) among all age groups.