A common criticism from those who read our robo advisor-based illustrations is, “Why are you recommending small equity exposure even to early retirees?” We shall try to explain in this article.
If you have not read these illustrations, see:
- Retirement plan review: Am I on track to retire by 50?
- I am 30 and wish to retire by 50; how should I plan my investments?
- Can I retire by age 55? Retirement Planning Case Study
- Case Study: Achieving Financial Freedom for Early Retirement
- How should I plan if I want to retire in 20 years?
- Is it possible to combine a bucket strategy with income laddering after retirement?
We all appreciate the importance of equity when accumulating a corpus. The usual equity allocation recommended is 50-70%. We depend on equity to beat inflation in the accumulation phase.
Beating inflation is also essential in the withdrawal phase (post-retirement). However, equity allocation depends on the corpus at hand. One of the most difficult financial problems is determining if a given corpus is sufficient to beat retirement inflation.
Extreme cases – too little or too much corpus – are not a problem. Ten years ago, most middle-class retirees would have ended up on the too-little side due to a lack of capital market exposure. Today, they would have “some” experience with equity/debt mutual funds and have a corpus that is neither too small nor too big. Deciding the asset allocation for such retires is a challenging problem.
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Our recommendations are based on two basic principles: (1) Be conservative and err on the side of caution; (2) Appreciate the notion of the sequence of returns risk. Any stretch of poor equity returns at retirement can deplete the corpus quickly. Ideally, our reliance on equity after retirement should be as low as possible.
Our research based on 120 years of market history – explained in the goal-based portfolio management course and incorporated into the freefincal robo advisor – shows that this approach has more than a reasonable chance of success in retirement regardless of market conditions. So, regardless of the criticism, we will stick to our guns.
Thumb rule 1: An equity allocation of not more than 30% for typical retirements is recommended.
Anything higher than this is acceptable only if the corpus is quite large.
For example, a retiree with a 30X corpus should not venture too much into equity. Here, X = annual expenses in the first year of retirement. A retiree with, say, 75X corpus can afford some more quality.
The freefincal robo advisor tool is built with these ideas. The typical equity allocation recommended for different retirement ages (assuming the person is 26) is tabulated below.
| Retirement | Equity allocation |
| 60 | 20% |
| 55 | 22% |
| 50 | 30% |
| 45 | 32% |
| 40 | 34% |
| 35 | 36% |
| 30 | 37% |
| 27 | 38% |
Even if the 26-year-old retires by 27 (naturally an unlikely event), the suggested equity allocation is only 38%. This is because an entire lifetime is spent in (early) retirement. This would mean seeing crashes, recessions and political turmoil. The corpus will deplete even faster if we withdraw from equity during these periods.
Many reply to this assertion that “they will live frugally and not touch equity when it is down”. If only we could be sure of how our lives will be in the future, how much we will spend, etc.!
Thumb rule 2: Never assume a real return (after tax) during retirement!
This is related to thumb rule 1 and not independent, but it is better to spell it out. Zero real return or post-tax portfolio return = inflation rate is the highest real return one should assume. Ideally, I would prefer a minus 1% or even a minus 2% real return!
A bucket strategy and minimal equity dependence will automatically satisfy this. For examples, see:
- Retirement plan review: Am I on track to retire by 50?
- I am 30 and wish to retire by 50; how should I plan my investments?
- How much do I need to retire by 45 in India?
Thumb rule 3: Can you generate inflation-protected income from fixed-income assets for the first 15 years of retirement? If yes, you can comfortably work with a bucket strategy. If not, your expectations have to be significantly more conservative.
A 15-year time window offers time to handle poor sequences of returns in equity. During this time, the 20-30% equity (typically) can grow largely untouched in other buckets (see above examples) for future use.
Finally, as an added safety measure, retirees can consider income flooring options by including a pension plan. See: How to beat inflation after retirement along with guaranteed pension.
The ultimate “safe” retirement strategy combines multiple pension plans (annuities) and a bucket strategy. This is explained here: Use this annuity ladder calculator to plan for retirement with multiple pension streams.
In summary, we have discussed why we are against significant equity exposures, even for early retirees. Ideally, this should be considered right at the start of the retirement planning journey.