Millennial Money: How To Overcome Fear And Structure Your First 401(k)

They'll search Tinder for soul mates and dare to put their personal details all over social media, but as investors, young people are far too cautious. According to a recent UBS Wealth Management survey, millennials who are saving for retirement allocate an average of 52 percent of their portfolio to cash instead of stocks and bonds. That compares with just 23 percent for investors of other generations.

They may have the longest time horizons of any other adult generation in the U.S., but millennials are also doing themselves a disservice with conservative investment approaches.

“A record amount of cash is situated in 401(k)s right now and much of it belongs to millennials,” says Jerry Linebaugh, founder of JLine Financial in Denham Springs, Louisiana.

He attributes this risk-averse stance to a fear of losing money in the fluctuating stock market. Linebaugh says every time he visits a company to help its employees set up 401(k) plans, he sees the anxiety on the faces of young workers who don’t want to go through the pain older generations endured during the most recent financial crisis.

“Their money is precious and they don’t want to lose it,” says Linebaugh. “Millennials saw what their parents went through and they know they can’t screw this up.”

While a cautious approach may make sense for some investors, such as older people who will retire soon, Linebaugh says millennials must factor inflation, taxes and their expected life spans into the equation when structuring 401(k)s.

One problem is that the typical millennial learned little or nothing about financial management in high school or college. “Most have had no financial literacy and have zero experience handling their own financial planning,” adds Brad Sherman, founder of Gaithersburg, Maryland-based Sherman Wealth Management. “Because of this, setting up a 401(k) can be pretty overwhelming for the millennial who is just getting started in the workforce, operating in an unfamiliar environment, and focused on a million other things.”

Breaking Through 'Fear Zone'

Linebaugh explains that a 20-year-old can get away with putting as little as 6 percent of his or her salary into the 401(k), while a 30-year-old should be allocating 10 percent to the effort. “Do this,” he says, “and you won’t be playing catch-up when you’re 50.”

For 2015, the federal limit on annual 401(k) contributions is $18,000. The investment option is popular because contributions are made tax-free (i.e., the money comes out of your paycheck before taxes are withheld), employers typically provide matching contributions, and you don’t pay taxes on the capital gains or dividends generated by the investments. On the flip side, withdrawing the money before you are 59 ½ will typically trigger an early-withdrawal penalty of 10 percent.

As for specific investment options, 401(k) portfolios are usually made up of a combination of standard mutual funds, bonds and cash. A newer option is the qualified default investment alternative (QDIA). Introduced in 2006 with the Pension Protection Act (PPA), QDIAs provide automatic portfolio rebalancing as the investor ages.

“Where you might be in riskier equities when you’re younger, with a QDIA those equities will ‘trade out’ as you age,” Linebaugh explains, noting there are now “tactically managed” QDIAs that command higher fees because they are actively managed. “It’s basically a ‘set it and forget’ approach to creating a 401(k).”

Beating Inflation With A Good Mix

Sherman cautions millennials not to get hung up on the individual investment options within the 401(k) itself, but to instead look closely at your personal risk tolerance and time horizon. “Given their young ages, millennials would generally have more stocks in their portfolios,” says Sherman. “However, we’ve just gotten out of a credit crisis and people are still nervous. The key is to be comfortable with the risk that you’re taking on.”

Generally, each 401(k) plan is different and within each plan is a mix of mutual funds and bond options that you can use to structure your plan. Realizing that stock market investments compound and grow over time, and that bonds post better returns than cash over time, Sherman says millennials can come up with a mix that helps them beat inflation while leveraging tax-deferred investments and their employers’ matching contributions.

To maintain a good balance between stocks and bonds -- known as asset allocation -- Sherman says millennials should consider both international and domestic options, as well as small, mid- and large-capitalization stock funds. “You have both compound interest and time on your side, so factor both into your decision,” says Sherman. “The younger you are, and the longer you continue contributing to the plan, the more opportunity for growth.”

For more information about asset allocation, see the Securities and Exchange Commission's "Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing."