Retirement planning literature has several commonly referenced rules of thumb. In my experience in helping clients plan for retirement and successfully manage their financial lives throughout their retirement years, I have found most rules of thumb apply only by chance. Even if the rules were right on average, that would imply they are right about half the time and wrong the other half. Would you like a 50% chance that you will get your retirement spending right?
The rule is known by a few names. Simplistically it states that whatever you current age, this is the percentage of bonds you have in your investment portfolio. Then the balance of your portfolio is held in stocks. Said another way, stocks equal 100 minus your age.
For example, assuming you are age 60, you would invest 60% of your portfolio in bonds and 40% into stocks (100 – 60 = 40%). The reasoning is that as you age, you have less time to recover from downturns in the stock market.
Problems with the Investing Rule
I am all for simple and effective. However, this rule is overly simplistic and generally not effective. There are a whole host of things wrong with this rule. Let me highlight a few.
The most egregious is that the investments have no direct link to whatever goal it is you are investing for. Rather, you are throwing a dart at the dart board and hoping you hit bullseye.
Also, what type of stocks or bonds should you own? You can own very risky bonds that are more stock-like than bond or bonds that behave more like cash in the bank. And how do you own the bonds – directly, through a mutual fund, or closed-end fund?
Recent studies have shown that doing the exact opposite of this long-standing rule actually yield better results in making your retirement money last throughout your lifetime. From a 2013 paper published in the Journal of Financial Planning, “Results show that where the portfolio starts out conservative and becomes more aggressive through the retirement both the probability of failure and the magnitude of failure is reduced for client portfolios.”
A Better Approach For Retirement Investing
First, whenever you are investing, you should clearly understand what goal you are investing for and tie your investments to the goal. I call this goal-based investing. In the context of retirement, this would be your spending throughout retirement. Yet, retirement spending should be broken down into various goals – essential expenses, healthcare, car purchases, travel, etc. – and appropriately modeled over time.
Your goals should also be ranked in importance. The ranking terms we use are needs, wants, and wishes. Needs have to be met first and so forth. After all, you should not buy the big RV and continually pump it full of gas unless you can rest assured that your needs are first fully covered for your lifetime.
To invest to meet your various retirement goals, shorter term goals need to be met with shorter term assets like cash and high quality bonds. Yet, longer term goals or those that are in the wants and wishes category may be met with stocks. Over longer time horizons stocks are more likely to outpace inflation and actually become less risky.
Second, this rule completely ignores retirement income streams you may have. While you should follow a goal-based investing approach, you should first model and optimize your retirement income streams like Social Security, pensions, and deferred compensation payments. Then any goals not met by these income streams need to be met by the investments.
I have several clients who are in their retirement years whose spending goals are met solely their retirement income sources. If they so choose, they can still have a stock-dominant portfolio to grow their wealth and leave more to their kids and charity.
Conversely, many clients have no pension and may still be able to retire relatively early. Plus I may advise that they defer their Social Security to as late as age 70. If you retire at age 60 but do not start Social Security until age 70, your portfolio needs to do all the work to meet your goals over the coming decade. In this case, you are likely to find that you should be invested much more conservatively.
The bottom line? The rule falls woefully short and is no substitute for having a well thought out plan to make your money last your lifetime.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent registered investment advisory and wealth management firm specializing in retirement, tax, and investment planning.