“100 Minus Your Age”
Why do we subject our newest savers to the highest risk?
Too often, our industry is addicted to conventional wisdom and allergic to arithmetic and empirical testing. Conventional wisdom suggests a percentage allocation to equities which is “100 minus your age,” and the notion that the young can bear more risk than those of us who are middle aged (or older!). True, the young have more time to recover losses, but what losses are more insidious for retirees than inflation sapping the real income of a bond-centric portfolio? Until we published our “Glidepath Illusion” papers,2 was this conventional wisdom ever seriously tested?
Finance theory was then called upon to justify this untested conventional wisdom. Academia advanced the unexamined thesis that human capital is like a bond, so that, as we age, we should replace our diminishing human capital with bonds. Now we have an established literature which demonstrates that—assuming human capital resembles a bond—we should move from risk-tolerant to risk-averse as we age. Pardon me, but doesn’t employment income feel more like equities, with income typically growing at the rate of inflation plus a bit, and with ever-rising uncertainty the farther we look into the future? Which are more highly correlated with young adults’ income streams: The total returns and income streams for stocks or for bonds? Just asking.
Finally, we are told that the young are tolerant of risk and that, as retirement approaches, the average investor becomes intolerant of downside risk, fleeing after a serious drawdown. To be sure, we all know people of all ages who got out of stocks, including the stocks held in their 401(k) portfolios, at the 2002 and 2009 market lows. But are there studies examining the relative behavior of young adults, mid-career employees, mature employees, near-retirement employees, and post-retirement investors? Are young employees likely to become risk-allergic—let alone risk-averse—if their first major foray into the capital markets ends with the triple-whammy of a lost job, necessary liquidation of their 401(k) at a loss, and a tax penalty to boot?
Now, a huge industry 3 has been formed on the basis of conventional wisdom, backed by finance theory which is itself based on a doubtful core assumption and supported by anecdotal behavioral evidence!
What could be a possible remedy? Perhaps young workers should not invest in TDFs with high equity allocations at all until their starter portfolio reaches a certain minimum balance of, perhaps, six months’ income.4
What could this starter portfolio look like? The starter portfolio is the rainy day fund.5 It would be unwise to use the rainy day fund to go gambling in the casino in the hopes of doubling it at the roulette table. Similarly, compared with traditional TDFs, the starter portfolio should be less risky and less correlated with the young saver’s primary income. A portfolio invested one-third each in mainstream stocks, mainstream bonds, and diversifying inflation hedges would be a much safer option, compared to the conventional longer-dated6 TDFs where the average stock allocation is 70% or more.
What comprises that third sleeve of the portfolio, the diversifying inflation hedges? These would typically be lower volatility asset classes, lightly correlated to mainstream stocks and bonds, ideally with higher yield or higher growth or both, and with a positive link to inflation (to diversify against the negative link of mainstream stocks and bonds).7 This component might augment the classic balanced portfolio with investments such as TIPs, low volatility equity, and high yielding bonds. Even REITs and emerging market stocks and bonds might, in moderate doses, serve to lower the volatility of the overall portfolio.
By the time the balance meets the minimum amount, the savers would be familiar with the fact that the best investments involve some risk and will fall from time to time, and they will also be confident that they are reasonably well covered for a rainy day. The investors can start loading up allocations to more risky asset classes on the amount exceeding the starter portfolio minimum balance.
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. Existing saving options force young savers to gamble aggressively with their early savings in the hope that they have enough time to recover from any unlucky market performance with more savings later in their lives. 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, one which would not force them to gamble with savings that they necessarily rely upon as a rainy day fund.
If young workers have to deal with their volatile young human capital over a long horizon—with a heightened need to cash out when the portfolio values are depressed—then it makes even more sense for younger workers to begin with a less risky portfolio. This also helps shape their risk tolerance so that their attitudes about investing and risk-bearing are not poisoned by a bad early experience. A prudent implementation would be to invest into a safer “starter portfolio” within their DC plan. Only when the relatively safe funds reach a comfortable level should investors consider taking more risk in the hope of generating excess return. And they should take that higher level of risk only on the portion of their portfolio that exceeds the starter portfolio’s minimum balance.
Prompted by this article, Noah Beck wrote about TDFs in the context of younger and older people's total assets, including their human capital. Please see "Retirement Planning: Millennials vs. Boomers."