Retirement Asset Allocation – By Age or Goal or Risk Tolerance?

How should the retirement asset allocation be done – by age or by goal or by risk tolerance? Before jumping to the answer of this question, let’s first understand what asset allocation is all about.

What Is Asset Allocation?

Asset allocation basically means how much of your investments should be divided into equity and debt instruments. Equity instruments like stocks, equity mutual funds and debt instruments like FDs, Bonds, Debt mutual funds etc.

Can Asset Allocation Be Done Only On The Basis Of Age?

No, asset allocation can`t be done only on the basis of age. Let me give you an example – Suppose you’re aged 35 and you’ve heard that the equity allocation of your portfolio should be 100 minus your current age. (i.e. in this case 65% should be your equity allocation.) But can it be held true if you want to retire at age 40? No, equity allocation can never be 65% if your goal is just 5 years away.

So, asset allocation cannot be done on the basis of age. In fact, it’s done taking into consideration the time frame needed to achieve the goal.

Taking the above example, asset allocation can`t be done solely on the basis of risk tolerance too. You cannot invest 65% in equity instruments even if you’re a very aggressive investor.

Ultimately, it comes down to the time frame needed to achieve the goal. And that’s indeed the most important factor for asset allocation. Whereas age and risk tolerance are secondary factors.

Now, let’s see how to do retirement asset allocation by taking different cases one by one.

Case 1 – Retirement Asset Allocation For Young Investor

Suppose Ajay is 30 years old and he’s planning to retire at age 60. He wants to provide retirement expenses of 30,000 per month in today`s cost. Assuming inflation rate as 6% during the accumulation phase and a life expectancy of 85 years.

The corpus required would be 4.50 Crores assuming 1% return over inflation during the withdrawal phase.

Also Read: How to calculate your retirement corpus without using excel or calculator?

How to accumulate this 4.50 Crores within a time frame of 30 years? First, calculate the PF amount at the time of retirement. This is normally a default debt option for everyone.

With a basic salary of 30,000 per month, the PF amount per month would be 3,600+2,350 = 5,950 (employer+employee contribution). Let’s assume a 5% hike in basic salary every year and 6% returns throughout the period. The PF amount at the time of retirement would be around 107 Lakhs.

Check your PF amount at the time of retirement

Now the remaining amount required is = 450 Lakhs – 107 Lakhs = 343 Lakhs

Here comes the actual importance of the risk profile. Further asset allocation is determined by analyzing the risk profile of the investor. Hence, the asset allocation is done based on whether the investor is a conservative, balanced or aggressive investor.

Also Read: How to assess your risk profile?

Can an aggressive investor be suggested 100% equity to achieve the remaining corpus of 343 Lakhs? The answer is a big NO. You need to check the previous investment of the investor. A person who’s never invested in equity before may not be able to handle the sudden downfall in the market. So, it’s better to increase the debt portion a bit.

Let’s say, I ask the investor to open a PPF account and invest 50,000 annually in the PPF account. At the end of 30 years, the PPF amount would be around 40 Lakhs.

Also Read: How to use financial formulas in excel?

Now, the remaining amount required is 303 Lakhs. It can be invested in equity mutual funds and the monthly investment amount required would be 15,000. (Assuming returns of 10%.)

How much would be the asset allocation in this case?

  • Equity – 15,000 per month
  • Debt Instruments – PF+PPF – 5,950+ 4,166 = 10,116 per month
  • Total Investment – 25,116 per month

This is an equity/debt ratio of 60%/40%.

You can ask me why it’s not preferable to invest 100%. Let’s say the person invests 100% in equity instruments to achieve the remaining 343 Lakhs (no investment in PPF). The monthly investment required would be 17,000 per month.

  • Equity – 17,000 per month
  • Debt Instruments – PF – 5,950 per month
  • Total Investment – 22,950 per month

This is an equity/debt ratio of 74%/26%.

The total difference in investment per month is just 2,116 while the 1st option is much more secured.

(PPF is just an example, the person can invest in other debt instruments like debt MFs as well.)

What if the investor is cautious? Simple, increase the investment in PPF to 1 Lakh per month.

  • PPF – 80 Lakhs – 8,333 per month
  • PF – 107 Lakhs – 5,950 per month
  • Equity Mutual Funds – 263 Lakhs – 13,000 per month
  • Total Investments – 27,283

This is an equity/debt ratio of 48%/52%.

Here, you can see that there’s an additional investment of 2,167 from the 1st type of investor.

Sometimes, you must put in efforts to make a cautious investor understand that equity investment is required for long-term goals.

If you’ve an existing investment, the retirement asset allocation can be done in the same way with the existing investments. I’ve assumed that Ajay has no existing investments while planning for retirement.

Case 2 – Retirement Asset Allocation For Middle Aged Investor

Fast forward 10 years, Ajay is now 40 years old. What should be the retirement asset allocation?

  1. If you’ve followed the asset allocation mentioned in the 1st and 3rd case in the above example, there’s no need to change it. You can continue the asset allocation as it is.
  2. Even if you’ve started investing just 3-4 years back, the same asset allocation (as in point 1) can be used.
  3. Suppose you’ve equity/debt asset allocation of 74%/26% as mentioned in the 2nd point in the above example (case 1). You can reduce your equity exposure by 10%. Thereby making it 65%/35% or 60%/40% as mentioned in the 1st case of the above example.

Case 3 – Retirement Asset Allocation For People Nearing Retirement

Another 10 years and this is a crucial time for rebalancing. Once Ajay reaches the age of 50, the asset allocation should be reversed.

  1. For an aggressive investor – equity/debt ratio should be 50:50
  2. For a moderate investor – equity/debt ratio can be 40:60
  3. And for a cautious investor, it should be 30:70

Take note that you need to be careful while rebalancing. You can`t do it in a single go. You cannot say that exactly at age 50, I’ll move 20% of my equity into debt after 10 years. There’s a possibility that markets may be down at that point in time.

So, what you need to do is analyze the returns every year for the purpose of rebalancing. There may be a year when markets are giving exceptional returns in the range of 14%-15%. In such a situation, you can move a larger part of equity investments into debt funds. There may be continuous years of good returns when you can move small parts of equity investments into debt.

Case 4 – Retirement Asset Allocation At The Time Of Retirement

At the time of retirement, asset allocation should be as follows:

  1. For an aggressive investor – equity/debt ratio should be 30:70
  2. For a moderate investor – equity/debt ratio can be 20:80
  3. And for a cautious investor, it should be 10:90

Even an aggressive investor can reduce the equity portion to 20%.

Is equity investment required even after retirement?

Though it’s not necessary to remain invested in equity after retirement. But retirement is a kind of goal where you don’t require the entire money immediately. The retirement corpus would be used in the next 25 years. Hence, you’ll still have around 10-15 years to remain invested in equity. This is the main reason why equity investment is suggested even after retirement.

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