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Are Target-Date Retirement Funds Doing Things Backward?

Stan Luxenberg

NEW YORK ( TheStreet) -- Financial advisers have long preached a cardinal rule: As you get older, shift your portfolio to more conservative assets.

The approach has influenced target-date mutual funds, which are used by millions of retirement investors. Using a typical target-date portfolio, a person in his 20s starts with an aggressive portfolio that has 80% of assets in risky stocks and 20% in safe bonds.

Over the years, the stock allocation declines gradually, following what is called a glide path. By the time the retiree reaches his 80s, the portfolio might have 20% in stocks and 80% in bonds.

The approach has satisfied many savers. But now some advisers are challenging the old dogma. The critics say that instead of reducing stock holdings, you should keep a static allocation, perhaps holding 50% of your assets in stocks for decades.

Some studies suggest that you would do better by starting with a low equity allocation and gradually raising it. So far, the critics have gained few followers. But their provocative studies present a challenge to traditional thinking.

Among the most compelling critics is Michael Kitces, research director of Pinnacle Advisory Group, a wealth-management firm. Kitces says that the greatest threat to a nest egg can occur when the market tanks just as a saver is beginning to take retirement withdrawals. If that happens, assets can be quickly exhausted.

Downturns that happen near the end of the retirement would not necessarily cause the saver to go broke. Kitces says that standard glide paths don't provide the best protection against crucial losses in the early years.

To understand his point, consider a hypothetical saver who retired in 2008 when many portfolios lost 40%. The saver started with 60% of assets in stocks and gradually lowered the allocation to 30% in the next 30 years.

If we assume that the market would deliver historic returns, the saver would likely have done better to move in the reverse direction, starting with 30% in stocks and gradually shifting to 60%.

The big allocation to bonds in the early years would have protected the portfolio during the downturn of 2008. Odds are good that subsequent rallies would benefit the portfolio as it gradually increased equity holdings.

Kitces says his approach would outperform conventional glide paths in most scenarios. If the saver retired during a market boom, the nontraditional strategy could underperform because of the heavy bond allocation -- but there would still be enough assets to cover living expenses. Kitces says that a saver may have to tolerate some periods of underperformance in order to avoid a disaster in an early downturn.

Robert Arnott -- chairman of Research Affiliates, a firm that advises investment companies -- tested how a variety of different portfolio allocations would have performed during the 141 years ended in 2011.

Arnott looked at how a worker would have done if he saved $1,000 annually, starting with 80% of assets in equities in 1871 and gradually lowering the allocation to 20% when he retired after four decades. Then Arnott considered people who started in 1872 and in subsequent years.

Next the researcher considered what would have happened if the theoretical workers held a constant allocation of 50% in equities and 50% in bonds.

The study showed that workers with the static allocation would have ended with average assets of about $137,000, topping the conventional glide path by $13,000. Arnott says that the outperformance of the static portfolio is no fluke.

With the conventional glide path, the worker had a big allocation to stocks in the early years when the portfolio was small. So if the market surged, the portfolio would increase only by a few dollars. In the later years, the conventional portfolio might be large, but a stock rally would not help much because the assets were mainly in bonds. In contrast, the static portfolio had enough stocks to achieve big dollar gains in the later years when the portfolio was large.

Should you dump your target-date fund and shift to balanced funds with 50-50 allocations? Perhaps.

Some top balanced funds have long records of delivering solid results. But many aging investors may still favor the conventional glide paths. As retirees spend down their nest eggs, they may prefer the comfort of knowing that most of the remaining assets are in bonds.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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