Most investment allocation rules of thumb ignore the existence of non-financial household assets such as Social Security, pension benefits and life annuities in the calculation of a portfolio’s target investment allocation. As a result, such allocations frequently fail to properly measure the amount of risk being assumed by the retired household in its overall retirement asset allocation.
This post was inspired by a recent Motley Fool article entitled, “S&P 500 Bear Market: Is It Really Safe to Retire Right Now?” The Motley Fool article discusses several factors that may affect your readiness to retire, including Factor #1—"Is your asset allocation appropriate for your age?”
With respect to portfolio asset allocations, the Motley Fool article says,
“There's no set rule as to what your asset allocation should look like. A general rule of thumb, though, is to subtract your age from 110, and the result is the percentage of your portfolio that should be allocated to stocks. If you're 65 years old, for example, you may aim to allocate 45% of your portfolio toward stocks and 55% toward bonds.”
We have seen modifications of this 110 – age rule, including using 120 - age or 100 - age. Under each of these variations, the portion of the household portfolio to be held in stocks at age 65 should be 20 percentage points higher than at age 85 (and the portion of bonds 20 percentage points lower), but there are no adjustments for household assets that may be owned outside the portfolio. For retirement planning purposes, we believe this is a mistake, as the riskiness of the total household asset portfolio may not be properly measured.
In this post, we will develop portfolio allocations for three hypothetical households using the Steiner Allocation formula discussed in our post of September 2, 2022 and shown below. Each of the households has accumulated savings of $1,000,000 and present value of essential expenses of $1,500,000, but the three have different present values of non-financial floor portfolio assets.
Household #1—Social Security only
Household #1 is assumed to have Social Security benefits with a present value of $600,000. Applying the above formula produces a 90% target portfolio allocation to non-risky investments [($1,500,000 - $600,000)/$1,000,000] and a 10% target allocation to risky investments.
Household #2—Social Security and Defined Benefit Pensions
Household #2 has the same present value of Social Security benefits as Household #1, but they also have pension benefits with a total present value of $400,000. Applying these facts to the above formula produces a 50% target portfolio allocation to non-risky assets [($1,500,000 - $1,000,000)/$1,000,000] and a 50% target allocation to risky investments.
Household #3—Social Security, Pension and Life Annuities
In addition to the same Social Security and pension benefits as Household #2, Household #3 has life annuity contracts with a present value of $300,000. Applying these facts to the above formula produces a 20% target portfolio allocation to non-risky assets [($1,500,000 - $1,300,000)/$1,000,000] and an 80% target allocation to risky investments.
The examples show that considering the value of non-financial non-risky assets in the calculation of the portfolio allocation between risky and non-risky assets can make a significant difference in the household target portfolio asset allocation. If you are like we are, you may reach the conclusion that it is pretty darned important to reflect your non-financial assets when developing your target portfolio asset allocation.
Other differences between the Steiner allocation approach and age-based allocation rules of thumb
- The Steiner Allocation approach is not aged-based. It is simply based on the Liability Driven Investment (LDI) strategy to fund expected essential expenses with non-risky assets. Of course, if older households wanted to invest less of their portfolio in riskier assets than indicated by application of the formula, they could certainly do so.
- Age-based rules of thumb allocate between stocks and bonds. Our approach allocates between risky and non-risky investments. In some economic environments, there may be risks involved with investing in certain types of bonds.
- Unlike the age-based rules of thumb, the Steiner allocation approach does not necessarily require rebalancing in the event risky assets fall below the target allocation. It does, however, require full funding of essential expenses (which may involve periodically either increasing investment in non-risky assets or decreasing estimates of essential expenses).
Summary
Several of our prior posts have covered this issue, and we apologize if you believe that we have been somewhat repetitive on this subject. However, since we continue to see potentially misleading advice in the retirement trade press (like the Motley Fool article above), we feel an obligation to point out the potential problems associated with ignoring significant non-financial assets in the development of a reasonable investment strategies for retired households. As discussed in prior posts, retired households need to grow assets, to protect assets and to prudently spend assets. In order to do this, we believe retired households need to rely more on reasonable approaches and less on questionable rules of thumb.
