How to Determine the Right Equity Allocation

We all understand the importance of having a balanced portfolio when building a nest egg. Typically, allocating 50-70% of one’s investments to equity is recommended to counter the effects of inflation during the accumulation phase.

However, beating inflation remains crucial during the withdrawal phase, even after retirement. The specific allocation to equity depends on the total corpus available. One of the most challenging financial dilemmas is determining whether a given corpus is sufficient to combat inflation during retirement effectively.

Having an extremely small or excessively large corpus is not a concern. Even a decade ago, many middle-class retirees lacked exposure to the capital market, resulting in insufficient savings. Nowadays, they have gained some experience with equity and debt mutual funds, which has allowed them to accumulate a corpus that falls within a reasonable range. Nonetheless, deciding on the appropriate asset allocation for such retirees is still difficult.

Our recommendations are based on two basic principles: (1) Be conservative and err on the side of caution; (2) Appreciate the notion of the sequence of returns risk. Any stretch of poor equity returns at the start of retirement can deplete the corpus fast.

Ideally, our reliance on equity after retirement should be as low as possible.

Thumb rule 1: An equity allocation of not more than 30% for typical retirements is recommended.

Anything higher than this is acceptable only if the corpus is quite large.

For example, a retiree with a 30X corpus should not venture too much into equity. Here X = annual expenses in the first year of retirement. A retiree with, say, 75X corpus can afford some more quality.

The freefincal robo advisory tool is built with these ideas. The typical equity allocation recommended for different retirement ages (assuming the person is 26) is tabulated below.

Even if the 26-year-old retires by 27 (naturally an unlikely event), the suggested equity allocation is only 38%. This is because an entire lifetime is spent in (early) retirement. This would mean seeing crashes, recessions and political turmoil. The corpus will deplete even faster if we withdraw from equity during these periods.

Many reply to this assertion that “they will live frugally and not touch equity when it is down”. If only we could be sure of how our life will be in future, how much we will spend etc.!

Thumb rule 2: Never assume a real return (after tax) during retirement!

This is related to thumb rule 1 and not independent, but it is better to spell it out. Zero real return or post-tax portfolio return = inflation rate is the highest real return one should assume. Ideally, I would prefer a minus 1% or even a minus 2% real return!

A bucket strategy and minimal equity dependence will automatically satisfy this. For examples, see:

Thumb rule 3: Can you generate inflation-protected income from fixed-income assets for the first 15 years of retirement? If yes, you can comfortably work with a bucket strategy. If not, your expectations have to be significantly more conservative.

A 15-year time window offers time to handle poor sequences of returns in equity. During this time, the 20-30% equity (typically) can grow largely untouched in other buckets (see above examples) for future use.

Finally, as an added safety measure, retirees can consider income flooring options by including a pension plan. See: How to beat inflation after retirement along with guaranteed pension.

The ultimate “safe” retirement strategy combines multiple pension plans (annuities) and a bucket strategy. This is explained here: Use this annuity ladder calculator to plan for retirement with multiple pension streams.