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Post #14 – Equity Allocation – Some Final Comments

In my previous post, post #13, I suggested a couple ways to decide on your appropriate asset allocation. But, what should a person do if the average annual return, indicated by the suitable equity allocation, will not provide the long term results necessary to retire?  This is a situation that, undoubtedly, applies to many people in the 50 to 70 age range.

I can understand this dilemma. For example, a 55 year old couple is behind schedule on their retirement savings nest egg. They only have $200,000 total assets in their retirement accounts, but they know (from reading Blog Post #7) they need about $500,000 total assets in order to retire at their target age of 65. Their current annual savings rate plus any market gains is not likely to get them there.

There seems to be two different views by professionals about how to approach this problem. The first view takes the position that since the 55 year old couple is running out of time, they need to invest more “aggressively” (meaning adopt a higher equity allocation) to make up the difference. The second view is, if you do not have enough assets, you cannot afford to take on more investment risk. I agree with the latter view. One of the most important investment principles I have learned over time is that controlling investment risk is as important as maximizing gains. If you have a savings shortfall and you increase your equity allocation to make up for this deficit, you run the risk of shrinking your asset base even more at a time when you may not have enough time to catch up. I think it is best to stick to your chosen equity allocation rather than take on more risk trying to maximize your investment returns.

So what is one supposed to do if they have a retirement savings shortfall? In addressing this problem there are three parameters in play:

1.      Your annual savings rate

2.      Your target retirement date

3.      Your required annual retirement living expenses.

To deal with a savings shortfall, you have to make a change to one or more of the three parameters above. You can increase your annual savings rate, move back your target retirement date (i.e., work longer), you can reduce your annual living expenses in retirement, or an employ a combination of the three. When we were 10 years away from our target retirement date, my wife and I still had a significant savings deficiency based on an earlier version of the table shown in post #9. Only 10 years away from our target retirement date, we needed to have about 8 times our annual income in retirement assets and we had, I think, only about 5 times. We had to make a change to one or more of the three parameters listed above. We decided that our mid-50s retirement target was non-negotiable. So we elected to both increase our annual savings rate even more and lower our required annual living expenses.  Of course everyone’s priorities will be different.

I will not normally make comments on market conditions as they are constantly changing. But I will make one comment on my equity allocation in today’s market environment. I normally determine our equity allocation using the “100 minus your age” formula as discussed in blog post #13. This means, since I am in my mid-50s, that we should have an equity allocation of 45% and 55% in fixed income. However, I have dialed back my equity allocation to 40% and I may reduce it even more in the near future. Why would I do this? It is because of the state of the current financial markets which I believe are overvalued (determining how the markets are overvalued is the subject of a future post). Managing your investment risk is especially important today because the root causes of the recent financial crisis, too much debt at all levels of society, have not been fully addressed. The US debt load (and for that matter the debt of every nation in the western world) has not really been reduced since the 2008-2009 crisis. It has only been transferred from private balance sheets to sovereign government balance sheets (through bailouts, loan guarantees, etc.). The strategy for handling this environment seems to be for governments to issue even more debt. I believe the global debt situation is unsustainable. I don’t know how this state of affairs will be resolved, but I don’t think it will end well for most Americans. If you are within 10 years of retirement, I think capital preservation is more important now than ever. This is why I have reduced my normal equity allocation. I can afford to lower my equity allocation because I have already reached my minimum retirement savings goal.

A logical question might be, “If I am concerned about the financial markets right now, why don’t I just move to 100% cash.” You should never be 100% in fixed income just as you should never have a 100% equity allocation. The reason is you never know what the markets are going to do. I may think the stock market is currently overvalued, but I would feel pretty foolish if I changed my allocation to 100% cash and the stock market went up another 40% over the next 2 years.

In any event, if you are not close to your minimum retirement savings goal, you should stick to your chosen equity allocation. If there is another financial crisis and the markets do tank, this does not have to be fatal. It is possible to navigate any future market down drafts without changing your asset allocation. If you are disciplined, it is even possible to come out ahead using one important investment concept. I will discuss this investment concept in my next blog post.

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