The Essentials of Retirement Asset Allocation

By Markets Fool.com

There are a lot of rules of thumb for retirement income planning. One common recommendation (and the strategy of almost every target-date fund) is to reduce your equity exposure and go conservative over time.

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It makes sense intuitively that you'd want to reduce risk when you're relying on your 401(k) for income. But does it actually work to help guarantee a lifetime of income?

It turns out, it doesn't. Here's what you need to know and what to do about it.

The importance of the market
A comprehensive study of the evidence took into account 140 years of trading information.

The authors found that the valuation of the market really matters when it comes to retirement. In other words, whether the market is overvalued or undervalued makes a big difference to how successful your allocation strategy will be (the authors defined a "neutral" market as having a value between 2/3 and 4/3 of the long-term average).

What do you do in these situations?

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Using the value of the market
Given the influence of market valuations, reducing your equity exposure isn't always the best course.

When the market is overvalued, for example, the authors found that it makes more sense to start with a lower equity exposure and build it up gradually over time, instead of doing the opposite.

That's the situation we're in today, and the study authors argue that for optimal portfolio performance (meaning a lower chance of outliving your money), you're better off increasing your equity exposure over the coming years rather than decreasing it.

On the other hand, when the market is undervalued, it makes sense to do the opposite: Invest heavily in equities today, and reduce exposure over time.

Unfortunately, the trouble with using a valuation rule like this to make investing decisions is that you can over- or under-shoot the market by quite a long way. Even the authors note that using their rule would have you reducing equity exposure several years before the market actually falls.

After all, timing the market is, at best, a deeply inexact science -- and at worst a totally catastrophic one.

What real world investors can do
There are two other strategies you can use that work quite well.

The first is to allocate however you want and simply adjust your withdrawal rate to whatever is happening around you. This is a decent strategy because it allows you to set the allocation that works best for you on an emotional level while still acknowledging the reality that markets go up and down, sometimes in inconvenient ways.

Another "remarkably effective" methodology is to just stick with a 60% equity allocation. It sounds high, perhaps, but it is really good at helping to ensure long-term growth -- which is just what you'll need if you're facing 20 to 30 years of income requirements.

For most people, that's going to represent the best way forward. It's more risk than you may have thought you needed or wanted to take at 65, but considering our collective projected lifespans, it could very well be the best way to secure the longest period of financial security.

The article The Essentials of Retirement Asset Allocation originally appeared on Fool.com.

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