How Pensions and Social Security Affect Asset Allocation?
A debatable topic carried on for decades is the consideration of pension and Social Security benefits in asset allocation. Retirement is a phase where one moves from the accumulation of money to finally using it. In the accumulation stage, an aggressive approach of investment that is balanced from time-to-time can help. However, at retirement, this strategy could need revision. The asset allocation (distribution of stocks and bonds) for retirement varies as per individual goals, risk appetite, etc. But, for allocating fixed-incomes such as pensions and Social Security benefits, there are varying schools of thought, each having its reasoning and applicability in the portfolio.
Read on to know how pensions and Social Security benefits affect asset allocation:
Case 1: Inclusion of pension and Social Security benefits in the portfolio assets
Many people believe that pension and Social Security earnings should be a part of portfolio assets. These are sources of fixed-income and help in substituting bonds in asset allocation. Thus, they should be viewed as bond-like instruments because of their secured cash flow. But, even as per this notion, the consideration of pension and Social Security benefits as assets should be made only when a person is close to retirement (ideally 12 months before the retirement age). In other cases, when the retirement age is relatively far, counting these incomes as assets may not be a wise strategy because at that time Social Security benefits and pensions are only a promise for the future and have no actual value.
That said, at the right age, when these streams are categorized as secured assets, retirees can take a bit more aggressive approach. This implies having more investments in equity and less in bonds. This concept is backed by a calculation, which assumes that the income received from Social Security benefits and pension is enough to support needs and maintain the standard of living. Hence, the purpose (to provide a stable income) for which bonds were included in the portfolio is already being served. So, the approach of the retiree can be to capture more equities to enhance the value of the portfolio rather than adopt a conservative approach and allocate more money towards bonds. Even though the latter is safe in terms of risk, securing more bonds directly implies a loss of opportunities from equity.
For example, A retiree at the age of 67 has $900,000 in his 401(k) retirement account. However, he also aims to draw the following from another stable source such as Social Security – $20,000 per year.
In this case, the retiree has $20,000 of fixed-income annually. Assuming he reaches his life expectancy in 20 years, his Social Security benefits would approximately be $600,000. As per this idea, the retiree should have a more aggressive approach towards investing. Hence, he chooses to invest 50/50 in stocks and bonds; $1,500,000 divided 50% in stocks and 50% bonds. Since the $750,000 for bonds already includes $600,000 worth of Social Security, the retiree-only needs to invest $150,000 more. Whereas, in equity, the investment has to be $750,000. This is an aggressive approach to maximize returns.
A major drawback of this strategy is that it assumes that the markets will gain. However, like the 2008 recession, the value of all investments could tank, leaving the retirees with little or no savings for their future. Moreover, irrespective of the income received from secure sources, it is not advisable for retirees to opt for equity in a large ratio. A balanced approach depending on the need, age, risk-taking ability, etc. can be a more suitable method.
Case 2: Exclusion of pension and Social Security benefits from portfolio assets
A varying approach from the above is that pensions and Social Security money, even though secure incomes, should not be classified as assets. Hence, by this logic, these should not be considered in the asset allocation strategy. The notion is backed by strong calculations, sensitivity to the retirement age, investing sentiment, as well as the fact that after a certain point, all retirees desire to have peace of mind.
This idea contradicts the inclusion approach by a simple rule that retirees should have a more conservative approach to investment. And even though stock allocation will provide more returns, the risk aspect certainly cannot be ignored. No matter how appealing the rewards, a retiree should not consider protected income sources as bond-like assets and invest a large share in equity. This is simply because the idea of including these assets in the portfolio is based on an assumption of the present value of government retirement payments. But by definition, a portfolio comprises assets that have a financial value and can be purchased or sold in the market. But pension and Social Security benefits cannot be sold to any other person. Hence, their market value becomes negligible. This does not imply that Social Security income or pensions are worthless. Instead, it stresses on the fact that they are extremely valuable and can provide secure incomes but are certainly not assets. The whole process of considering these as property and then allocating the portfolio can severely backfire for retirees.
For example – A retiree at the age of 65 years has investments worth $800,000. He also has the following income sources:
- Total pension value: $200,000
- Total Social Security benefits: $300,000
As per this school of thought, a retiree should adopt a strategy based on the risk appetite at this age, which ideally is conservative. Hence, if the allocation should be 60% in bonds and 40% in equity, then 60% of $800,000, which is $480,000, should be invested in bond-like instruments. This approach is beneficial for those who are not risk-takers and believe in investing what is in hand, rather than counting on future incomes as assets.
Comparison of the two cases
Let’s take the above example further, which applied by the first approach would mean that the retiree has $1,300,000 (assets + pension + Social Security income) worth of portfolio. So, $520,000 should be equity investments and $780,000 debt-like instruments. And because $500,000 bond-like sources (like pension and Social Security) exist, the retiree should only invest $280,000 more in this asset class. Contrary to allocating $480,000 as per the exclusion approach, the rest should be invested in equities. This will de-balance the equity-to-bond ratio, leaving more risks with the retiree.
Now, when comparing the two, the winner is the one which appeals to the investor’s risk preference, age, and investment goal. Generally, the second approach is considered to be more suitable than the first. Since the latter allocates assets based on the actual worth of the portfolio and not on the incomes that are yet to accrue. Moreover, these incomes have no real market value and exist only until the person is alive.
Furthermore, the total secured incomes cannot be accurately ascertained. This can cause complications which can hurt the portfolio. The first approach can be complex and also holds an element of uncertainty. But in certain situations, it might be the right way forward.
To sum it up
Each approach has its advantages and the choice depends on the investor. At a juncture, where one is advised to take the least amount of risk, investing based on fixed-income sources can be harmful. But a middle approach, where only a part of these incomes is substituted for assets, can be a good way out. Moreover, consulting professional Financial Advisors can help one get expert guidance for investments and future security.
