Deciding Target Allocation for retirement

[Sarkar07]

Here is a thought I had about investing in something really long-term like a Pension Plan. The so-called financial advisors in India (may be in US also but I do not know) suggest the equity:debt ratio should go on changing as one gets older. Typically the debt component will become higher as one nears the retirement age. There is also a formula that calcualtes the equity-debt ratio based on age...

What I do not understand is this: Say you start your pension plan at age 30 and plan to withdraw money from age 60 onwards. That is a total time of 30 years of staying invested in the market. If equities give higher returns than any other investment class (is this always true?) over a LONG-TERM, then why should one not be 100% equities till say age 55 (i.e. 25 years) to maximize returns and then for the last 5 years get all/majority of the money in debt funds (to make it "safer")?

Is there something fundamentally wrong here? Will gurus like Desi, Bobus, RRK et al please comment on my query? Thanks!!

[Bobus]

#673:

Long term or short-term, equity is more risky than fixed income.

The reason that higher equity i.e. more risk makes sense when one is younger is that a young person has a lot more human capital (net present value of expected future salary which is what, as an aside, a friend mine said his FIL looked for in his potential SIL before agreeing to give his daughter in marriage to him :)) than an older person, so that in the event of reverses in financial investments, the human capital reserve acts as a buffer.

Regarding your proposal, if market tanks at age 55, then it is Govinda with a mere 5 years of working life left to make it up.

[submarine66]

#673:

Long term or short-term, equity is more risky than fixed income.

The reason that higher equity i.e. more risk makes sense when one is younger is that a young person has a lot more human capital (net present value of expected future salary which is what, as an aside, a friend mine said his FIL looked for in his potential SIL before agreeing to give his daughter in marriage to him :)) than an older person, so that in the event of reverses in financial investments, the human capital reserve acts as a buffer.

Regarding your proposal, if market tanks at age 55, then it is Govinda with a mere 5 years of working life left to make it up.

Bob, given today's day and age and the concept of semi-retirement/retirement at 40, should one look at these ratio's a little differently, especially if he or she has the required asset base to retire today and can draw upon 3% of their assets annually.

Shouldn't such individuals still stay invested in the market at an appropriate ratio (higher bond, lower equity; may be 60/40, and move 1% over every year to bonds) given the fact that they will be consuming over a very long period (say another 40 years).

[Bobus]

Bob, given today's day and age and the concept of semi-retirement/retirement at 40, should one look at these ratio's a little differently, especially if he or she has the required asset base to retire today and can draw upon 3% of their assets annually.

Shouldn't such individuals still stay invested in the market at an appropriate ratio (higher bond, lower equity; may be 60/40, and move 1% over every year to bonds) given the fact that they will be consuming over a very long period (say another 40 years).[/quote]

Submarine:

By ratios, if you mean the formula that equity portion ought to be 100 minus age in years, then am skeptical of formulas coz individual situations vary.

My prior post merely talked about the effect of human capital on risk tolerance. Actual risk taking (percentage of equity) is not merely a function of risk tolerance.

A person who has retired at age 40 (unless he banks on coming back into work force if investments tank) cannot reasonably bank on human capital to decrease his risk tolerance whereas a 40 year old who expects to continue to work until age 60 can.

Beyond risk tolerance, the need for growth also affects actual risk taking - percentage of equity in portfolio. Without growth, in many situations, one can be reasonably sure of poverty towards the end of one's life coz of the erosive effects of inflation and taxes which are more severe on fixed income investments. Faced with such a situation, one is forced to invest in equity. It is like eating bread coz one cannot afford cakes - I would not read a preference for bread over cakes from the choice - I read compulsion.

So a retired 40 year old who expects to live long and is thus more exposed to the erosive effects of inflation than a retired 70 year old has to invest more in equity for growth (unless corpus is very large relative to estimated living expense needs) to combat inflation and taxes.

[submarine66]

Submarine:

By ratios, if you mean the formula that equity portion ought to be 100 minus age in years, then am skeptical of formulas coz individual situations vary.

Beyond risk tolerance, the need for growth also affects actual risk taking - percentage of equity in portfolio. Without growth, in many situations, one can be reasonably sure of poverty towards the end of one's life coz of the erosive effects of inflation and taxes which are more severe on fixed income investments. Faced with such a situation, one is forced to invest in equity. It is like eating bread coz one cannot afford cakes - I would not read a preference for bread over cakes from the choice - I read compulsion.

So a retired 40 year old who expects to live long and is thus more exposed to the erosive effects of inflation than a retired 70 year old has to invest more in equity for growth (unless corpus is very large relative to estimated living expense needs) to combat inflation and taxes.

Thanks Bob for your response. When I used the term "ratio", I did not necessarily mean the formula that equity portion ought to be 100 minus age in years. I was relating to the distribution of an individual's asset base between Equity and Fixed Income/Bonds.

I do relate very well to the point that you/Desi have made in the past, that when ones spending goals are in the horizon of say the next 3-4 years, the funds needed for those goals should be invested into very low risk instruments.

You have answered my question that investing in equity is absolutely needed for a retired 40 year old to deal with the erosive effects of inflation and taxes. That was my understanding as well, but what I grapple with is the distribution between equity and bonds as one grows older.

Am I right in presuming that there is no silver bullet or magical formula here, but just to adjust it each year in a manner where if one's consumption needs for the next 3-4 years are in very low risk instruments, one can continue to invest the rest of their portfolio in a manner that is in tune with their risk tolerance. This may even enable an individual who retires when he is 40, to account for all his future needs till he dies, and still leave behind an asset base for his heirs?

regards
Submarine

[Bobus]

I do relate very well to the point that you/Desi have made in the past, that when ones spending goals are in the horizon of say the next 3-4 years, the funds needed for those goals should be invested into very low risk instruments. [/quote]

I agree with the above when it comes to short-term financial goals.

However am not sure how the above translates (see quote below) to a prescription to keep a reserve of 36-48 months of living expenses in very low risk instruments - a reserve that can easily be as high as 10% of a retirement portfolio.

While I understand the need for liquidity, and the undesirability of forced liquidation of equity in market downturns to meet consumption needs, I dont see a need for a high 10% separate reserve in low risk instruments, beyond what the equity : fixed income split of AAP would dictate.

Equity can be liquid, and undesirable equity liquidation in market downturn to meet consumption needs can be avoided by dipping more into fixed income investments for consumption in the event of market downturn - during equity market downturn the rebalancing of equity:fixed income to preset percentages would take care of this anyway.

Other than the above, am fine with the approach you have outlined.

Am I right in presuming that there is no silver bullet or magical formula here, but just to adjust it each year in a manner where if one's consumption needs for the next 3-4 years are in very low risk instruments, one can continue to invest the rest of their portfolio in a manner that is in tune with their risk tolerance. [/quote]

[submarine66]

I agree with the above when it comes to short-term financial goals.

However am not sure how the above translates (see quote below) to a prescription to keep a reserve of 36-48 months of living expenses in very low risk instruments - a reserve that can easily be as high as 10% of a retirement portfolio.

While I understand the need for liquidity, and the undesirability of forced liquidation of equity in market downturns to meet consumption needs, I dont see a need for a high 10% separate reserve in low risk instruments, beyond what the equity : fixed income split of AAP would dictate.

Equity can be liquid, and undesirable equity liquidation in market downturn to meet consumption needs can be avoided by dipping more into fixed income investments for consumption in the event of market downturn - during equity market downturn the rebalancing of equity:fixed income to preset percentages would take care of this anyway.

Other than the above, am fine with the approach you have outlined.

Bob - thanks for your crystal clear response. :emsmile: I am in sync with your point on not needing to keep a separate reserve of 36-48 months for living expenses. Your point on dipping more into fixed income investments in the event of market downturn makes perfect sense. Thanks for helping me think through this, and the reassuring effect it has on my plans for retirement/semi-retirement.

regards
Submarine

[RRK]

With equities, the risk is that it may show up any time. Longer the duration, we expect the market to recover and give a positive inflation adjusted return. This is why we choose equities for the portfolio and there is no other asset class that can do this job better.

At the same time carrying them too long in the portfolio can turn out to be hazardous.

Say some one is planning at the age of 30 for a retirement portfolio and decide 70/30 ratio to be optimal and target to draw fixed income beginning at the age 60. To provide a stable income, assuming the person will draw the money for next several years, let us we plan 50/50 ratio.

The adjustment towards to 50/50 from 70/30 has to be done slowly and gradually. One should plan to sell 20% of the stocks on the 60th birthdayday of the investor. Another rule is any money that is required in 5 years should not be in equities. So, you start adjusting the portfolio from the age of 55 to 60, every year gradually.

Say if the delta is 20%, ( like in this example) divide it by 5 and start moving 4% of the equities every year to bonds.

Start selling those with short term losses first, LT losses next, LT gains next, ST gains last in this order..