Common thinking on the street is that, as you get closer to your retirement date, you should de-risk your portfolio by reducing your allocation to equities, and have more of it in safer stuff like cash and bonds.
And that thinking is pretty solid – imagine working for all of 40 years and then, just as you are about to retire, the market pulls a Covid-19 on you, wiping out a third of your capital because you had everything in equities.
This would translate into 33% less income for the rest of your days – nasty.
For this reason, some retirement products have built in airbags which will reallocate more and more of your portfolio into safer assets as you get closer and closer to retirement. It’s usually called a life-stage model and I reckon it has been (and will likely continue to be) a life retirement saver for many.
These life-stage models have defined asset allocations at particular points on your retirement investing journey. For example, with ten years to go till retirement, they will put you into 40% equity, 60% bonds/cash, and then with five years to retirement you get 25% equity and 75% bonds/cash.
And this got me thinking….
Could we maybe achieve something similar, but without a fund:
- Needing to take any active decisions (e.g. when to sell and buy and in what allocations)
- Needing to incur the costs of selling something and then buying something else
Now the below is far from perfect, but it is kinda interesting (well to me at least…)
Imagine someone starts their retirement investing journey right at the beginning of their career. Now, in my view, there is no reason why this person, with around 40 years of runway ahead of them, should not be fully in equity.
So let’s assume they allocate everything to equities. Let’s also assume that equities deliver a 12% annual return, with the caveat that 2.5% of that return comes from dividends.
And now the engine behind my idea. Go against everything you have learnt about long-term investing and don’t reinvest those dividends.
That’s right – we leave the dividends in the account as cash, where it earns interest of 6%.
My calculations* around this strategy leave you with the following asset allocation percentages:
|% Equities allocation||% Cash allocation|
|Start (40 years to retirement)||100%||0%|
|After 5 years (35 years to Retirement)||92.93%||7.07%|
|After 10 years (30 years to retirement)||87.66%||12.34%|
|After 20 years (20 years to retirement)||78.89%||21.11%|
|After 30 years (10 years to retirement)||72.35%||27.65%|
* I calculated the results using an annual investment (instead of monthly) and as if the dividend is paid on the investment balance at the end of each year.
And the full ‘Cash Glide©’ (that’s what I’m calling it, patent pending) over time is shown below (click for larger image)
After starting with 100% in equities, this person’s asset allocation would have slowly self-adjusted to around a third cash by the time they are ready to retire. Now that is still probably a little high in terms of equity exposure, but it does lead me to an interesting thought around Regulation 28 and pension funds…..
A different approach to Regulation 28
Just a quick recap, Regulation 28 (or Reg 28 as the cool kids call it) are rules which govern how you can allocate your investments inside retirement funds (pension, provident, preservation funds and retirement annuities or RAs).
In a nutshell, the regulation says that at least 70% of your funds need to be invested locally, and no more than 75% in equity (which is one of the nine reasons I do not like RAs).
Now I am not going to get into the politics around forcing investments locally (there will be enough of that once corona blows over and we are back to headlines around prescribed assets), but I do want to maybe offer an alternative to the maximum 75% in equities restriction, just as a bit of a thought experiment.
In my view, there is no reason not to allow someone at the start of their working careers to invest 100% into equities if they wanted to.
With such a long-term view, this will surely give them the best shot at the best risk-adjusted returns, and we are not doing them any favours by capping them at 75% if they are happy to take on more equity exposure.
So how about scrapping the rule that says maximum 75% in equities, and instead make a new rule – no re-investment of dividends allowed.
That way you could force an investor’s exposure more and more into cash as they get closer and closer to retirement. This automatically reduces their risk as their retirement date approaches while at the same time not penalising young savers too much.
Just an interesting thought….
And of course this approach is super easy in theory, not so much in practice – how do you handle total return funds, and what if someone only starts their pension product at a later age?
Anyways, would love to hear your thoughts? (It could just be that I am smoking my socks because looking at these same four walls for over 50 days has made me a little batty….
This article was first published on Stealthy Wealth here, and republished with permission