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Elders and equities: How much stock should retirees own?

How old are you, and how much stock do you have in your investment portfolio?

Conventional wisdom has it that investors should reduce their equity holdings as they get near and into retirement and shift toward safer, fixed-income investments. That strategy is the basis for target-date funds, which follow a "glide path" of decreasing allocations to stocks and increasing allocations to bonds as a target retirement date approaches.

The idea is that younger investors with longer earning and investing horizons can take on more risk than older investors — particularly retirees — who may be depending on their investment portfolio for income and can't recover from large losses.

"The allocation to risky assets starts to decrease at age 40 — about the time when human capital begins to diminish," said Matt Brancato, head of defined contribution advisory services at Vanguard Group, the largest provider of target-date funds.

Senior couple retirement
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The Vanguard funds move from a 90/10 mix of stocks and bonds at age 40 to a 50/50 mix by age 65. They end up at 30/70 allocation at age 72. "We're balancing three key risks — market risk, longevity risk and inflation risk — and we want a portfolio that works across different markets," said Brancato.

The idea of ratcheting down risk as an investor ages is a sound one. Target-date funds have become the favorite default option for corporate 401(k) plan sponsors and now account for about 25 percent of the market. Brancato expects that share of assets to increase to between 40 percent and 50 percent in the next five years.

Most financial advisors buy into the idea of the decreasing-risk glide path that target-date funds follow. Many also believe, however, that the economic and retirement landscape has changed dramatically and that traditional models of stock/bond allocations for retirees need to change, as well.

"The investing experience most people have is of their parents and grandparents, but they lived in a different economic environment," said Ric Edelman, chairman and CEO of Edelman Financial Services. "If someone manages their portfolio the way their grandparents did, they will fail where their grandparents succeeded."

They will fail because of two main factors: Americans are living much longer than their grandparents, and risk-free bonds are returning almost nothing. "The target-date fund concept is valid, but the application of the strategy is often flawed," said Edelman.

"It's hard to predict the markets, and they can change quickly. It's the strategic mix of asset classes that drives long-term performance." -Matt Brancato, head of defined contribution advisory services at Vanguard Group

"People don't realize how long they're going to live, and they don't understand the impact of inflation on their portfolio," he added. "Today's low interest rates make the problem more acute."

One solution, said Edelman, is for retirees to keep thinking like long-term investors and continue holding stocks later in life. He suggests that retirees in their 60s and even 70s should have the same equity allocations they had when they were 40 or 50.

"People are too quick to reduce their equity exposure, and they can't generate the income they need to maintain their lifestyle," he said.

Ron Carson, CFP and founder and CEO of Carson Wealth Management Group, thinks that risk in the financial markets is so elevated that allocation glide paths will fail to protect retirees. "The target-date glide path is too simple," said Carson. "Stocks are priced for perfection, and interest rates are near zero. We're in uncharted territory."

Carson is not telling older clients to buy more stock. In fact, he is hedging, to varying degrees, all the investing strategies he now uses with clients, giving up potential market upside for protection on the downside.

"The question to ask today — especially for retirees — is whether you're comfortable with the risk you're taking," he said. "This is not the time to make desperation bets. I think people should take less risk and accept lower returns."

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So should retirees hold more stock or less? Fidelity, the second-largest manager of target-date funds, increased its allocation to equities across its funds in 2013. It also recently gave its portfolio managers some latitude to increase or decrease allocations to asset classes based on their views of the market.

Vanguard, which now manages $380 billion in target-date funds, has chosen not to incorporate tactical allocation into its offerings.

"We stick to the models and focus on the outcomes that are likely to occur," said Brancato, who noted that bond allocations have helped offset the volatility in stocks during the last year.

He suggested investors should focus not on the markets but on the things they can control, like the cost of funds and their rate of saving. "It's hard to predict the markets, and they can change quickly," Brancato said. "It's the strategic mix of asset classes that drives long-term performance."

— By Andrew Osterland, special to CNBC.com