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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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David Lamb
David Lamb
9 months ago

Just wondering if anyone besides me factors in an assumption that SS benefits are exposed to a potential 20% reduction in about 12 years?

Newsboy
Newsboy
9 months ago

Thanks for this timely post. I had actually saved a copy of Charley’s article from last fall and your submission had me revisit this topic. You would think there is some web-geek who had built this type of NPV calculation/projection into a web-based calculator for those of us not gifted with excel skill. Would love a link if any other readers have found such a tool out there.

Last edited 9 months ago by Newsboy
Thomas Taylor
Thomas Taylor
9 months ago

Thanks for the article. I’ve been invested in equities (at least 95% or more) in my 401(k) since my first employer that offered one in 1990 or so. It’s morphed over the years and is currently in a self-directed rollover IRA. My wife is retired and receives a small but decent pension and SS. I’m still working and plan to work about 4 more years. From a household income perspective, her pension and SS account for about 40% of the total. When I retire, I’ll have a small pension and my SS. This will increase the income stream from these sources to about 80% of our household income. Our overall income should not change much, just the type. This would more than cover our expenses, so I don’t feel uncomfortable keeping the high allocation to equities in my IRA. She also has a 401(k) which will have RMD’s in about 5 years. While not quite as high as mine, she has about a 75/25 allocation (equities/bonds). I feel “fairly” confident the other 20% can be withdrawn from my IRA and her 401(k) and still provide the growth piece needed to fund a hopefully, long retirement.

Jeremy Hockenstein
Jeremy Hockenstein
9 months ago

Hi, thanks for this. I also include the PV of my social security (discounted by about 20% just to be safe in case the govt cuts benefits) in my asset allocation calculation. Although, I include it as an allocation to inflation-linked bonds (TIPS) rather than regular bonds. I use the price of a long-term TIP (in my case the 2048 govt TIP) to track it. I do this because the value of what the govt will pay me goes up (or down) depending on inflation in the years ahead.

You mention it’s like a bond without the inflation rate risk – but I was wondering how you thought about the decision not to model it as a TIP allocation? Once I started doing this about 10 years ago, it led me to basically cut significantly the rest of my portfolio invested in TIPs.

Last edited 9 months ago by Jeremy Hockenstein
Kevin Madden
Kevin Madden
9 months ago

Thanks for the article, Howard. I really appreciate pragmatic write-ups like this. I’ve done an NPV call on SS and pensions to help complete my net worth picture but hadn’t thought to so directly have it influence my investment strategy.

steveark
steveark
9 months ago

I wonder if Social Security isn’t more in the same risk category as stocks than bonds. It would be a safe fixed income and inflation adjusted bond like asset if the politicians agreed to fund it but some of the options that have been floated includes means testing to kick wealthier people out of the system or reduce their benefits significantly. I don’t think that will happen in the next few years but it could easily happen in our lifetimes.

Brent Wilson
Brent Wilson
9 months ago

Good article and kudos to you for taking more risk after incorporating other fixed income streams. As a non-retiree, I think you made the right choice. I can imagine it’s a much more difficult decision in retirement, even after a careful analysis.

Rick Connor
Rick Connor
9 months ago

Great article Howard. I love this kind of DIY analysis because it gives a good feel for what’s important, and to do what if scenarios.
it would be interesting to benchmark your SS model against Mike Piper’s SS calculator. https://opensocialsecurity.com/

Howard Rohleder
Howard Rohleder
9 months ago
Reply to  Rick Connor

I have another article in process that looks at my use of opensocialsecurity.com to try to sort out when would be best for my wife and I to start SS. Hint: I was surprised at the results!

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