Valuing My Income

Howard Rohleder

READER COMMENTS on one of my blog posts prompted me to dig deeper into my thinking about asset allocation. A trip to the HumbleDollar archive led me to a Charley Ellis article where he emphasized that readers should incorporate Social Security, pensions and annuity payments into any analysis of their asset allocation and portfolio risk.

A guaranteed stream of income is clearly valuable. I knew this, but I had missed the obvious conclusion—that the net present value (NPV) of these income streams should be considered part of a portfolio. Specifically, they’re bond substitutes but without the interest rate risk of true bonds.

I used the NPV function in Excel to value the three income streams I’m due, so I could then evaluate each as part of my portfolio’s asset allocation. This required some assumptions:

  • When will I begin Social Security? I decided to use my full Social Security retirement age, with benefit values based on my current statement, which I downloaded from the Social Security website. I factored in my wife’s spousal benefit at 50% of my benefit. Since my start date for Social Security is in the future, the NPV calculation had to account for a few years with no payments.
  • For future cost-of-living adjustments for Social Security, I used the average for the past 10 years, which was 1.88% per year. Given current inflation, that may prove conservative.
  • The other two income streams I’m due are a pension and an income annuity. One has started and the other will start later this year. Both are fixed amounts, so there was no need to estimate annual inflation increases.
  • For all three income streams, I had to assume how long my wife and I would collect. For this I went to the IRS joint life expectancy tables and, based on our ages, arrived at 28 years.
  • The final input was the discount rate. Ultimately, I decided to use 3%, recognizing that anywhere from 2% to 5% might be justified in today’s environment. I did want to acknowledge some credit risk implicit in pensions and income annuities, which justifies a small premium above the risk-free Treasury rate.

By building this model in Excel, it was easy to see the impact of changes in assumptions. What if we both live to 100? What is the impact of a 5% discount rate versus 3%? What if Social Security cost-of-living adjustments average 3% instead of 1.88%? I was also able to model the difference if I opt to defer Social Security until age 70.

Incorporating the three present value calculations into my portfolio added 25% to its worth. Treating them as bond substitutes led to a key conclusion: I could move considerable bond and cash investments into stocks, and still sleep at night.

This is a reversal of the quandary I discussed in my earlier blog post. One revelation: Because my three income streams aren’t subject to interest rate risk in the same way an investment in bonds would be, I already enjoy downside portfolio protection, and don’t need to shift money into bonds at a time when interest rates may rise. At the same time, this exercise highlighted how the cushion provided by regular income payments can help my wife and me weather a big stock market decline.

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