Question: There are rules of thumb in personal finance that I need clarification on. One of them is the 100 minus age rule. Is this applicable in the Philippines?—From “Ask a friend, ask Efren” free service at www.personalfinance.ph.
Answer: The 100 minus age rule is about asset allocation. The rule maintains that an individual should hold a percentage of his investment portfolio in stocks equal to 100 minus his age. For example, if an individual is 40 years old, he should have 60 percent (i.e., 100 minus 40 then divide the answer by 100 and express in percent form) of his investments in stocks.
Why use 100 when people normally do not live up to that age? That is because the people who invented this rule wanted to provide a buffer so that those who apply the rule face a lower chance of running out of funds especially in retirement.
The rule has its appeal in its simplicity. But it is in this simplicity that the rule encounters difficulties.
First, the rule implies that you would constantly be reducing your equity allocation by one percentage point each year you age. Equity investing is by nature long-term. You cannot expect to earn returns on your investment after just one year.
Secondly, volatility in the stock market is the new norm. Coupled with a regime of low interest rates, you may end up not having a buffer for your future needs and wants, like that dream vacation or carefree retirement. The solution posed by some is to change the formula to 110 or even 120 minus age.
Thirdly, the average Filipino is more risk-averse. He will probably not welcome a 40 percent exposure to stocks when he is 60 years old, much less a 30 percent exposure when he is 70 years old.
Fourthly, the simplicity of the rule can lead people to the danger of just applying it blindly, which is another case of focusing on the tool and not personal finance goals.
Take three standard rulers (e.g. 12 inches or 30.48 centimeters in length) and tape them end to end. Now try balancing the taped rulers on your palm by just looking at the end of the rulers touching your palm. You will no doubt find the task difficult. But the challenging act becomes a lot easier if you balance the rulers by focusing on the end farthest from you. The same is true with focusing on personal finance goals.
Now let us see how much the 100 minus age rule falls short. Consider an individual with the following personal circumstances: 21 years of age; a gross monthly pay of P12,000 with a 3 percent annual merit increase; and, content to enjoy a P30,000 per month retirement lifestyle in today’s money for 20 years starting at age 60.
Let us assume further that: This individual’s retirement pay will be one month’s pay for every year of service; a long-term average return of 15 percent per annum for equities and 4 percent per annum for fixed income; and an inflation rate of 4 percent a year.
Given the above assumptions, our individual would need to save 31 percent of his annual income up to the time he retires, a number too high for funding just his retirement goals.
As he gets older and settles down, he will have other needs and wants to fund like children’s education, buying a house, buying a car and many others. An alternative and more affordable financial plan is definitely in order.
My calculations show that if the individual were to invest all of his portfolio in stocks up to the age of 49 (thus allowing more time for his equity investments to grow in value), he can just rest easy and invest in money market instruments from age 50 up to the end of his retirement. More importantly, he will need to save only 15 percent of his gross income from now up to the time he retires.
I have done computations for older individuals. The results are the same: a person does not need to be invested in stocks all the time, and especially when he is nearing or is in retirement.
Investing does not just focus on the age of the investor, like what the 100 minus age rule does. When properly tweaked, a plan can serve as a solid foundation for a brighter future.
But, as they say, the only certain thing in life is death and taxes. That is why financial plans must be reviewed every two to three years to ensure that they are still on track with goals.
To know more about investing for retirement, visit www.personalfinance.ph. There is a range of free tools and articles to allow you to hit the ground running with financial planning.
You may also want to attend our Financial Planner’s training in the cities of Mandaluyong, Baguio, Davao, Cebu, Cagayan de Oro and Iloilo, the details for which can be found on our website.
(Efren Ll. Cruz is a registered financial planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-505-0709 or emailed to efren@personalfinance.ph. To learn more about the RFP program, attend a FREE orientation on March 5,, 7 p.m. at the PSE Center. Email info@rfp.ph or text <name><e-mail><RFP> at 0917-3464126 to register.)