Ditch the Age-Old Retirement Equation

AbacusIt sounds like an old parlor trick:

Subtract your age from 100—and the resulting number is the percentage of your retirement savings to put into stocks. The remainder (voila!) goes into bonds!

By that logic, a 40-year-old would put 40% of her retirement savings into a bond fund and 60% into equities. But if you follow that old formula now and “invest your age,” you’re likely to run out of money when you retire.

The trouble with older formulas is that they emerged at time when expectations were different. A generation or two ago, people didn’t enjoy such long retirements, and many workers were still covered by guaranteed pensions. Naturally, people didn’t need to save as much, and it made sense to be more conservative.

A better rule-of-thumb today: Forget your age, and invest according to your goals.

Bonds do offer a safe, or fixed return. The long-term average return is only 1% or 2% after inflation, and that’s not enough to meet the retirement needs for most investors. By comparison, stocks typically produce returns of 6% to 8% a year after inflation, historically.

Maybe a 5% difference doesn’t sound like much, but consider this: A 35-year-old earning 2% on investments today needs to save more than $24,500 a year to reach $1 million by age 65. Earn 7% and it takes about $10,600 a year to reach the same goal.

In theory, investing more of your money in equities could deliver that higher return. But there’s no guarantee—and there’s risk involved.

But losing money is just one kind of risk. Other risks are just as serious: i.e. running out of money early in retirement—or never having enough money to retire at all.

Figure out how much you have saved, how much you can save in the future, and what sort of return you need to meet your ultimate goals. While you’ll be nervous about seeing your stocks lose value in a bad year, the risk of not having enough money for a good retirement could be even scarier.

Tip your hand. How did you pick the percentage of stocks versus bonds in your portfolio?

Stephen Simpson, CFA, is a financial writer and consultant. More of his writings can be found on Investopedia and his blog, Kratisto Investing.

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