Don't sell young retirement savers short

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A recent paper from the influential Research Affiliates investment management firm (with more than $140 billion in assets managed) takes the provocative stance that young adults saving for retirement should not start out with a large portion of their money invested in stocks.

I respectfully disagree.

One key point of the paper is that young adults have a tendency to cash out their 401(k)s when they are laid off. Given that layoffs are most prevalent during a recession—precisely when stock values are falling—the last thing a young person wants is a portfolio that has sharply declined in value right when they need it.

But that just seems to concede that cashing out a 401(k) is a fact of life, and is somehow OK. It is not OK. I don't think we need to change the portfolio. We need to change the mindset of young workers so that they realize their 401(k) is not something to be raided. And that's a two-step process.

Retirement account mistakes
Retirement account mistakes   

First: We need to show every young adult who wants to take a withdrawal the cost of pulling that money out, including the loss of future returns. If we are really being honest that we care about the future of our young adults, and if employers are really serious about wanting to help employees build retirement security, that requires a bit more than lip service.

Educating young adults about the damage of early withdrawals is really low-hanging fruit.

Why can't every request for an early withdrawal immediately trigger an electronic message that shows an estimate of what the participant will pocket after paying tax and the 10 percent early withdrawal penalty and also show an estimate of what the existing balance could grow to by the time that person turns 70, assuming a conservative rate of return of, say, 4 percent? And let's require the participant to acknowledge they received this information and then ask them again if they still want to make the withdrawal. It's just a nudge. They are still in control. But it forces them to make an informed decision based on facts, not emotion.

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Second: We need to do better at encouraging young adults to build an emergency savings account. When you have money set aside for layoffs, or whatever, you will be less inclined to raid your retirement money. The Research Affiliates piece also advocates for this. Where we disagree is that Research Affiliates suggests that the retirement account first start as a safety account: that it be invested conservatively until the balance is equal to six months' income.

I think it's best to keep the two distinct goals in two distinct accounts, and invest each accordingly.

A 401(k) is a horrible rainy day fund: You must pay income tax on 100 percent of the withdrawn amount plus a 10 percent early withdrawal penalty. I don't think it's asking too much of twentysomethings to have them start building an emergency fund by making automatic deposits from their paycheck or checking account into a savings account. I know plenty of twentysomethings doing just that. And if and when they need to tap it, there's no 10-percent penalty and the only tax is on interest earned, which these days is nil.

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If we really think young adults can't save for both at once—a point I am not suggesting is true—then at the very least let's provide good advice: Always save in a 401(k) that offers you a matching contribution, but limit your contribution to what you need to max out on the match. And plan on never touching that 401(k) until retirement. With that long-term horizon, let's do a better job making a case for the long-term benefits of having a heavy allocation to stocks in your younger years.

Then all additional retirement saving should be done in a Roth IRA. All contributions one makes to a Roth IRA can be withdrawn at any time without any tax or penalty; it's just earnings that are subject to both. That's a better back-up emergency fund.

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