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