In “What Are We Doing to Our Young Investors?” Rob Arnott, chairman and CEO of Research Affiliates, and Lillian Wu, researcher at Research Affiliates and co-author of the report, suggest that since younger workers sometimes treat their retirement accounts as rainy day funds, they should be able to put some savings into an account separate from a 401(k) or other retirement plan that could be accessed to meet emergency needs without penalties.

One reason is the timing of the investor’s entry into the market can be a critical factor in how the investor comes to view savings and the market, Wu explains. People are very sensitive to experience, such as the market crash of 2008-09. If investors happen to begin their portfolios during a bull market, the portfolio will go up. “That’s very encouraging,” she tells PLANSPONSOR. “But there is a flip side, if they enter in a bear market. The balance starts shrinking, and it’s very discouraging when the account value simply plunges.”

Katrina Sherrerd, president and chief operating officer of Research Affiliates, says the problem of being demotivated to save and leave savings in a retirement account may not be limited to younger savers and workers. “Investors in general tend to flee equities markets after they go down and not come back until they’ve come back and are about to crash again,” she tells PLANSPONSOR. “Investors tend to make very poor tactical decisions on their own.”

Another reason for the idea of an account separate from a retirement plan is that target-date funds (TDFs) used by these plans start these youngest employees with a heavy allocation to equities with the expectation that they will shift into bonds later on. But, if they lose their jobs in a bear market and decide to cash out, it can be a triple whammy if the retirement plan is their only savings. They may have to cash out to meet basic living expenses, and the assets invested may actually be less than what was set aside from their paychecks. In addition, they must pay stiff penalties for the early withdrawals.

Because a young adult’s job security is highly correlated with the business cycle, the paper says, younger workers endure higher rates of unemployment, higher job turnover and longer-lasting unemployment. For this reason, it’s possible that younger savers are less suited to the higher-risk profile than older ones.

In addition, a high allocation to equities may not be suitable because younger investors have different investor behaviors and reasons for savings, Wu points out. They save for a precautionary purpose, for rainy days and short-term emergencies. “They need funds that can cover basic living expenses,” she contends. “They don’t save for retirement.”

While they are advocates of workplace-based saving for retirement, Arnott and Wu contend that a second investment vehicle is needed to meet the specific needs of younger workers, and they recommend features that would address several concerns. First, the account would provide a range of asset classes—not just stocks and bonds, Wu says, but exposure to real estate investment trusts (REITs), commodities, emerging markets in both equities and bonds and some high-yield debt. “It wouldn’t be a risky portfolio,” she says. The mix could be close to 60/40 and it should be resilient through a range of market conditions.

Having a more stable non-401(k) solution could be ideal, Sherrerd feels, but a product that resembles the target-date fund (TDF) is likely not the answer. If the idea gains traction, there would need to be some product innovation by providers, and plan sponsors might have some opportunities to consider different types of portfolios for different types of investors. “One size fits all may not be the best solution,” she says. “We believe improvements can be made in the dominant TDF solution space,” she says.

As an aside, Sherrerd feels the traditional TDF, bond-centric at the end, doesn’t seem to best serve investors at any age. “We’re starting to do some research to look at alternative solutions that plan sponsors can offer to retirees,” she says. “It’s possible that the glide path should not be as steep.” In general, Research Affiliates’ investigations have led them to think retirement plan participants would be better off in TDFs that are more balanced, include more asset classes and have more alternative ways of risk reduction. “Shifting from equities to bonds isn’t the only way to reduce risk,” Sherrerd notes.

A change in mindset of younger savers and investors might be necessary, Wu says. Although their finances can be tight, right now they have no other workplace option than auto enrollment into a 401(k) plan. A more flexible, low-risk portfolio could add a layer of comfort, she says.

Sherrerd is in favor of younger workers making contributions to both a separate rainy day fund and a 401(k) plan but knows this could be a financial stretch for many. A multi-pronged approach could be part of the answer, with a greater range of investing solutions and more financial education about the cost of taking loans. Workers should be educated to understand that only the most dire of emergencies should lead them to take money out of the retirement plan, Sherrerd says.

Of course, she adds, the ideal situation is for borrowers at any age not to tap into their retirement plans until they reach retirement age. If awareness among all savers could be heightened to make them see the importance of saving for retirement, “we’d all be much better off,” she says. Until then, it may be realistic to create some savings vehicle that speaks to the savings behaviors and financial realities of younger workers.

“What Are We Doing to Our Young Investors?” can be downloaded from the Research Affiliates website.