Pension In Asset Allocation Decisions

Reader Question

I'm one of those increasingly rare folks who may qualify for a pension (I'm a teacher). Although my state has underfunded the system, it becomes a "sure thing" for me in 4 1/2 years when I'll be 55. How should I think about this? (I could quit teaching at 55 and collect this pension - nearly 60% of my pay - but I might not chose to retire for some years after this, in which case the benefit grows.) My personal asset allocation (apart from my state pension plan) has always been 60% equities/40% bonds (not counting a generous cash reserve). Should I consider this increasingly certain pension to be a part of my bond allocation? I've been considering slowly increasing my equity ratio (say, 1%/year?) as this income becomes more and more certain. Does this make sense? Does a similar logic apply to my (and others) social security? I'd appreciate your perspective. Thank you.

My Reply

Very good question. And yes, you are correct, Social Security considerations would be very similar. I don't think you could go terribly wrong with your approach simply because the 60% salary replacement pension is such a great retirement plan all on its own, but my inclination would be to do something different. I would view future pension not as part of your portfolio assets, but instead as an offset to your future expenses. E.g. if your total retirement living expenses will be $3500 per month and your future pension will deliver $2000 per month (you didn't mention it, but I'm assuming your pension payouts will grow with inflation) then your future cashflow requirements become $1500 per month to keep up with your expenses. This does not mean that your pension is not asset, of course. It is an asset and a very valuable one (try pricing an annuity that delivers the same cashflows to get an idea of your pension's value), but I would still not include it in portfolio asset allocation decisions.

The distinction between viewing pension as part of a fixed-income portfolio versus as a sort of negative expense may seem academic, but it has at least two good reasons. First, unlike other assets in your portfolio, you can't sell your pension should for some reason you need a large amount of cash or wish to invest the capital into a different asset class. Second, viewing pension as an offset to future expenses makes it easier in my view to arrive at the correct conclusion that the pension should lead you to lower, not raise, your equity allocation.

As you age and continue to work your future expenses shrink relative to the size of your portfolio for a number of reasons: because you, unfortunately, have fewer years left in retirement, because your portfolio grows on its own, because there is more certainty about your pension eligibility, and because that pension itself may start growing larger if you work past 55. All of these point in the direction of your having less and less requirement for future cashflows as you keep working and aging. That means you have less and less need to take risks with your portfolio because you probably don't need it to grow much or even at all to cover the gap between your pension and future expenses. And if you have less and less need to take risk, then you should be looking to decrease, not increase, your equity allocation!

To drive home this point consider what would happen to your portfolio's equities should something terrible happen to your pension. If your state ever becomes unable to fund your pension, it wouldn't be during rosy economic times. It would be in the times of great economic distress, almost certainly nationwide and worldwide.  At those same times equities would be getting pummeled like it's March 2009. In other words, both your biggest assets  -- the pension and the 60+% equity allocation of your portfolio -- would suffer dramatic losses. Definitely not what you want. On the other hand, if you were invested in, say, 70% high quality bonds your portfolio would be weathering the crisis much better, even though pension would still in trouble. I am not saying this situation is likely, but it's hardly impossible. We could have easily found ourselves in this sort of predicament in 2008-2009 had the government and the central bank failed to act.

To me it's very clear that as your future expenses shrink (whether in absolute terms or in relative terms, compared to the size of your portfolio and pension -- both are the case with you) the rational thing to do is to lower your risk. As tempting as it is to wish for a bigger retirement portfolio due to equity growth -- and, to be clear, I do believe equities will deliver higher returns than bonds over the next decade or two -- the upside benefit is relatively small as far as improvement to your lifestyle, but the downside risk can be huge in the worst-case scenario.

Now there may be some other consideration in play here. Your pension may not be inflation-indexed. This scenario, should we have a 1970s-like outbreak of inflation, could be tough on a bond-heavy portfolio. By no means do I think we are due for hyperinflation any time soon, but it's not impossible. To protect against this scenario you could limit the average bond maturity of your portfolio to under, say, 3 years. Again, this is just another variation on taking less risk with your portfolio -- just as we did with reducing equities. Shorter-maturity bonds are much less risky than longer-maturity ones though in exchange for this reduced risk you give up significant amount of return.

But just as before, the key is to meet your needs before reaching for your wants. Depending on the exact numbers there is a very good chance of short-term bond portfolio's being adequate in "normal" scenario while providing good protection in a high-inflation scenario. Equities, after all, will not weather the hyperinflation scenario particularly well either. If you want more extreme inflation hedges consider real-estate ownership (at least your own home) -- with 30-year mortgage locked into low interest rate for maximum inflation protection -- and maybe even gold, though the latter has run up so much that I personally wouldn't use it.

You may know that your retirement is likely secured one way or another and wish to leave a larger inheritance to your children. This is very reasonable and rational. But there is still little reason to increase equity exposure in your portfolio since your children will not benefit from your pension. Thus you'd be simply increasing the risk (though also the expected return) of their inheritance. If your portfolio is primarily intended as an inheritance then I would simply maintain constant allocation of stocks and bonds in it, such as the 60/40.

Finally, you may simply be seeing the near-absolute certainty of low returns from today's bonds and choosing to invest more into equities which are, though by no means cheap, are priced more favorably than bonds. This would make sense if the returns from equities were as certain as returns from bonds. Unfortunately they are not. Equity returns become less, not more, certain even when looking over very long horizons because even small differences from expected compound over the years. This would again be a case of reaching for something that may or may not materialize. I would not reduce allocation to bonds simply because equities appear to be priced more favorably.

Hopefully the above helps you make your allocation decisions. For myself, if the pension covers most of my future expenses and is inflation-adjusted and if the primary purpose of my portfolio is to fund my own retirement (as opposed to become an inheritance) then I would be looking to cut equity exposure to as low as 20-30% (but probably not lower) of the portfolio and I would certainly not raise it. Another thing I would strongly consider is invest in I Savings Bonds, higher-yielding FDIC-insured CDs, and maybe EE Savings Bonds using taxable funds over conventional bond choices. I Savings Bonds in particular are a no-brainer at today's valuations. You can find a number of posts about these choices on this blog, including http://www.longtermreturns.com/2012/09/best-bond-investments-today.html .