Arnott's father said every 40-year-old should have a year's income stashed in a "go-to-h--- fund."

The conventional wisdom that says “100 minus your age” indicates how much of your portfolio should be stocks, with the remainder going to bonds, forces the young to gamble away their safety net and exposes retirees to the ravages of inflation.

That is the surprising upshot of the latest investor newsletter from Research Affiliates, authored by firm founder Rob Arnott together with researcher Lillian Wu.

Arnott, whose dozens of mostly equity-based indexes attest to a generally stock-friendly disposition, confines his allocation argument to advice conventionally proffered by the rapidly growing $650 billion target-date fund (TDF) industry.

Critics have noted that target-date funds are heavily allocated toward equities, and indeed the average stock allocation for an investor 25 years out from retirement is 70% or more.

Since target-date funds serve as a government-sanctioned default choice for 401(k) investors, the portfolios of younger workers are increasingly invested according to a glide path, according to which younger employees own equity-based portfolios that only slowly shift to bonds as they age.

But Arnott and Wu lament that this approach is “allergic to arithmetic and empirical testing.”

Specifically, they cite a Fidelity study from earlier this year of 12.5 million retirement plan participants showing that a whopping 41% of investors between the ages of 20 and 39 cash out some or all of their assets when switching jobs.

Younger workers are thus exposed to a “triple-whammy” of raiding their savings to meet basic living expenses; selling when their assets may be valued at less than the amount they invested; and having to pay the IRS a stiff penalty for their withdrawal.

The authors cite additional data showing that younger workers are far more vulnerable than older workers to bouts of unemployment — with workers in their 20s suffering an unemployment rate over double that of workers 45 or older over the past quarter century, for example.

Recessions exacerbate this problem, with younger workers experiencing unemployment increases at a rate 60% higher than older co-workers.

Since stock market declines typically precede recessions, “young investors’ equity-heavy TDF investments plunge just when they’re more likely to be laid off, and/or just before they cash in their DC fund!” the authors write.

Because of this reality, Arnott and Wu reject what they consider the ill-founded assertion by finance academics that “human capital is like a bond” so that we should replenish our diminishing human capital with bonds as we age.

“Pardon me, but doesn’t employment income feel more like equities … with ever-rising uncertainty the farther we look into the future?” the authors ask.

Arnott and Wu seek to remedy the to them dubious industry and academic approach with a proposal for what they call a “starter portfolio” — essentially a rainy-day fund composed in equal thirds of stocks, bonds and “diversifying inflation hedges.”

That latter category includes Treasury inflation-protected securities (TIPS), low-volatility equity and high-yielding bonds, though could also contain moderate amounts of real estate investment trusts and emerging market stocks and bonds.

The basic principle was captured by Arnott’s father, who “strongly advocated that no 40-year-old should fail to have a liquid reserve amounting to one year’s income,” something the theologian colorfully called his “go to h—“ fund because it permitted him to use this refrain if any employer ever thought he was dependent on his biweekly paycheck.

Arnott and Wu’s starter portfolio suggest a less conservative threshold of a reserve equal to six months of income, after which investors can freely load up on riskier asset classes.

The starter portfolio model they advocate for defined contribution plans would end today’s practice of forcing “young savers to gamble aggressively with their early savings” and have the added benefit of shaping their risk tolerance — helping them to learn at an early age that “investments involve some risk” and giving them the confidence they’re covered for a rainy day.

Arnott and Wu conclude:

“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.”

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