One question I get from time to time is how Social Security or pension income should affect your asset allocation. Specifically, should it be counted as a large bond holding?
My answer: Not exactly.
Yes, Social Security and pension income are predictable in much the same way that income from a bond is. And yes, all else being equal, an investor with a pension can probably take more risk in his portfolio than an investor without a pension.
That said, there are some meaningful differences between Social Security and a giant bond holding. For example, you can’t sell your “Social Security bond.” Among other things, this means that you can’t rebalance back and forth between a “Social Security bond” and a stock fund in the same way that you could with real bond holdings.
How to Account for Social Security Income
Rather than counting Social Security income and pension income as part of your bond allocation, I’d suggest using this method for fitting them into your overall retirement plan:
- Determine how much money you’re going to be spending each year during retirement.
- From that, subtract any part-time job or business income you expect to earn.
- From that, subtract your Social Security and pension income to determine how much income you will need from your investments.
- Divide that number by the size of your portfolio to calculate your required withdrawal rate.
- Choose an asset allocation that you believe will best satisfy that withdrawal rate.
This way, rather than counting Social Security and your pension as liquid, tangible investments (which they aren’t), you’re counting them as income sources (which is what they are).
Social Security Bond Problems
In case you aren’t convinced, let’s take a look at how counting Social Security income as a bond could cause some problems.
Let’s imagine that you get $20,000 per year in Social Security income and $20,000 in pension income. If we were to count those income streams as bonds and we assume the bond has a 4.07% interest rate (that of a 30-year T-Bond at the moment), they’d be worth a total of $982,800.
And let’s assume that you need another $20,000 each year in addition to your social security and pension income. If you have a $450,000 portfolio, that’s a 4.44% withdrawal rate. If you retire at age 65 and use the “age in bonds” rule, you’d have the following allocation:
- $0 in bonds; $450,000 in stocks (because social security and pension income would more than satisfy the entire bond allocation).
In other words, in such a scenario, if you count Social Security and pension income as if they were bonds, you’d be going into retirement with all of your investable assets in stocks, and you’d be using a 100% stock portfolio to satisfy a 4.44% withdrawal rate.
Yes, if things go your way and the stock market performs well when you need it to, your plan would work out OK. But it’s far from a sure bet.
Instead, count the income streams as an offset to your expenses, then ask yourself what allocation you should use to satisfy the necessary 4.44% withdrawal rate.
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