Changing your allocation as you age

The idea that portfolios should become more conservative with age is widely accepted and rests on assumptions worth examining.

The logic

Why it makes sense.

The time available to recover from a decline shortens as a goal approaches.

Human capital — future earnings — declines with age, and human capital acts like a bond-like asset for most people, meaning a young person's total wealth is already heavily weighted towards something stable.

The consequence of a large loss is more severe when there is less time and less earning capacity to compensate.

And sequence risk becomes relevant as withdrawals begin.

All of which supports reducing risk as a goal approaches.

The standard rules

And their limitations.

Age-based rules holding a bond percentage related to age are crude and have some intuitive appeal.

They ignore other income sources, guaranteed pensions, capacity for loss, health, dependants and the intended use of the money.

Someone with a substantial guaranteed pension covering essential spending has a very different capacity for loss from someone entirely dependent on a portfolio, at the same age.

Which means the rules are starting points rather than answers.

Target date fund glide paths

Which vary enormously.

Funds with the same target date from different providers hold materially different equity allocations, both at the outset and at the target.

Some glide to the date and stop; others continue reducing through it.

The terminal allocation reflects an assumption about how the money will be used — a path designed for annuity purchase differs from one designed for continued drawdown.

Which means the glide path embeds assumptions that should be checked against your own plan.

The rising equity glide path

A counterintuitive alternative with some support.

Research has suggested that reducing equity exposure approaching retirement and then increasing it again during retirement may improve the sustainability of withdrawals.

The logic: the vulnerable window for sequence risk is around retirement, and after surviving it, a longer remaining horizon supports more growth exposure.

This is contested and is worth knowing as an alternative to the assumption that risk should decline monotonically forever.

What should actually drive the change

Rather than age alone.

Time until the money is needed.

Capacity for loss, which depends on other income and on how much flexibility exists in spending.

Whether essential spending is covered by guaranteed income.

The size of the portfolio relative to what is needed — someone with substantially more than required can afford more risk, and someone with barely enough may need more growth rather than less.

Health and expected longevity.

And whether the money is intended to be spent or to be passed on, since money intended for the next generation has a longer horizon than your own.

The practical approach

How to implement it.

Review the allocation every few years rather than adjusting continuously.

Make changes gradually rather than in large steps, which avoids making a single large decision at a single point in time.

Use new contributions to shift the allocation while accumulating, which avoids selling.

Consider building the cash buffer for the vulnerable window in the years before drawing.

And decide the terminal allocation based on how the money will be used, which requires having decided that.

Money for different purposes

A useful framing.

Rather than one allocation for everything, consider separate horizons for separate purposes.

Money for the next few years: cash.

Money for the following decade: a balanced allocation.

Money not needed for twenty years or intended for heirs: growth allocation.

Which produces a more logical result than applying a single age-based rule to the whole, and which is essentially what bucket approaches formalise.

The error in both directions

Worth stating.

Too much risk near a goal produces the possibility of a decline at the worst moment, from which there is no time to recover.

Too little risk over a long horizon produces a shortfall, which is invisible until it arrives and which affects a great many people holding too much cash for too long.

Given that retirement may last thirty years, a portfolio that de-risks entirely at retirement is holding a thirty-year horizon in short-term assets.

Which is the less discussed error and is at least as damaging.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.