There is a widely held view among financial advisors that seems sub-optimal. This is the idea that retirees’ asset allocations should become increasingly conservative as they age.
My firm recently conducted a survey of financial advisors who derive at least 20% of their income from retired people and we included this question: “Generally, do you believe that clients who are retired should reduce their exposure to equities as they get into their late 70s and 80s?” Three out of five (59%) said yes.
These advisors are not alone. Frequently, people suggest that one way to determine how much to invest in equities is to subtract one’s age from 100, or more recently from 120. This mathematical approach leads to continually reducing equity exposure with age. Additionally, many target-date funds and other asset allocation models reduce equity exposures as the investor ages.
There are a number of reasons why increasingly conservative investing is not effective and will be increasingly problematic in the future.
The main reason is the pressure on many retirees’ finances. Most people have under-funded their retirement, and in these days of rising health insurance and pharmaceutical costs for retirees, longer lives and less defined benefit coverage, this pressure will intensify.
Monte Carlo analysis suggests that it is most prudent for a retiree who is invested half in equities and half in fixed investments to withdraw 4% of assets in the first year of retirement and then increase that amount only to keep up with inflation. That means a person with $1 million should take out $40,000 in year one. Most accumulations are in defined contribution plans and IRAs, so the distributions are taxed as ordinary income. Thus, the person with $1 million will only be able to supplement Social Security by less than $3,000 a month.
Reducing the equity investment can be an anchor on performance. Portfolios that reduce allocations to equities as people age are likely to under-perform.
A better strategy, I submit, is to increase investments in equities prudently. There are two ways to do that; both should be used.