Is my pension like a bond?

If your pension is sufficient to meet your income needs, you can take as much or as little equity risk as you want.

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Q: My wife and I have been using the Couch Potato strategy for a few years now, but something has always nagged me. I am fortunate enough to have a defined benefit pension that will pay me $50,000 a year in retirement. Should I consider this the fixed income portion of my portfolio and put the rest in equities? –Brian F.

A: This a critical financial planning question for anyone with a pension, and yet it’s often framed in an unhelpful way.

A popular school of thought says you should think of a pension as a bond, presumably because both bonds and pensions pay predictable amounts of guaranteed income. The problem is, there is no way to put that idea into practice when managing a portfolio.

In this case, our reader has a pension that will pay him $50,000 a year. What would an equivalent bond holding be? Let’s assume he also has $300,000 in personal savings, and that it’s all equities. What would his overall asset allocation be? Even if he did establish a present value for the pension, how would that be helpful when it was time to rebalance the portfolio to its targets? Clearly this is the wrong way to approach the problem.

At PWL Capital for instance, establishing an appropriate asset allocation is key. The firm doesn’t find it useful to think of pensions as a type of bond: rather, they are simply one of several factors in assessing each client’s ability, willingness and need to take risk.

The pension paradox

Your ability to take risk is largely a function of how long you expect to earn income, as well as the reliability of that income. If your job is tenuous and you except to earn nothing after you quit work, then you have limited ability to take equity risk in your portfolio. But our reader, who can look forward to a guaranteed pension of more than $4,000 a month in retirement—as well as Canada Pension Plan and Old Age Security benefits—likely has an unlimited capacity for risk with his personal savings. These guaranteed income sources should meet all of his income goals, and a market crash would have no meaningful impact on his financial situation.

The need to take risk depends primarily on the rate of return required to achieve your financial goals. Many investors need to earn 4% or 5% to meet their long-term objectives, based on their current savings rates and expected retirement date. A guaranteed pension has an enormous effect on this factor: my guess is our reader could achieve his retirement income goals even if his personal savings had a return of 0%. (PWL tests this assumption with Monte Carlo simulations.)  In other words, although he has the ability to take a lot of equity risk, he likely has no need to do so.

As much as you can bear

All of this means the decision comes down to weighing the third factor in the asset allocation decision: the willingness to take risk. Unlike the other two factors, this one is purely psychological.

If our reader’s pension income is sufficient to meet all his income needs, then he can take as much or as little equity risk as he wants with his personal savings. If he is entirely unconcerned with stock market turmoil (though few people fit that description), he could indeed invest 100% of his portfolio in equities. That would be the right choice if his objective was to leave a large inheritance, for example. If instead he’d prefer to merely keep pace with inflation and sleep soundly every night, he might just as well build a GIC ladder.

Most investors end up somewhere in the middle of those two extremes. Then the investors decide on the asset allocation that allows them to achieve reasonable growth at a risk level they can stomach.

4 comments on “Is my pension like a bond?

  1. This article is perfect. It is the EXACT question that I was wondering about right down to the amount I will draw from my db pension in just a couple of years. Thank you for the excellent explanation. Now I can continue building my ‘most basic’ couch potato portfolio.

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  2. This article is excellent and long overdue. I don’t agree with the PWL Capital philosophy. My wife and I enjoy the luxury of a single DB pension. The integration of a DB pension in any asset allocation plan is essential. The same basic considerations exist when allocation and rebalancing is done. It is not what risk could be taken, but what risk is necessary when the DB pension is taken into account, and what risk can be tolerated by the owners of the DB pension and direct market linked assets. Many advisors still can not integrate a DB pension into a financial plan proposal to clients. Our advisor can and does. And that is one major reason why we work with him and recommend him to others who have the luxury of a DB pension…..and those who don’t.

    Reply

    • What firm is your advisor with?

      Reply

  3. Asset allocation is a tool to help force you to sell high and buy low. The article states you can’t do that when your pension is essentially 90% of your portfolia in bonds that you can not buy or sell. So what can we do to trigger us when we should be selling high fliers? Then what do we do with that cash when we do not want to buy bonds?

    Reply

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