Your Pension and Your Portfolio
So you have a pension, now what?
Retirement income is difficult to imagine. For many folks out there, retirement savings, investing, and future income combines into a blur. Sure, you have a 401k, but what about Social Security? Also, you might have deferred comp to consider or some sort of pension (if you’re lucky). It’s a difficult package to understand. In order to best understand how they fit together, you can either think of them individually, or step back and stack them together as one cohesive unit. I’m sure you can guess what I prefer.
For now, let’s consider only your pension and retirement savings. Recently, I’ve talked to many folks about viewing these two separate pieces of retirement a little differently. They’re easy to view individually because, well, they are separate. However, there is another way; considering your pension as part of your asset allocation.
First, let’s talk about a few ideas that will get us there.
Asset Allocation
If the term “asset allocation” seems complicated or vague to you, don’t worry; you’re not alone. “Asset allocation” is a perfect example of taking a rather simple idea and saying it in a more confusing or intentionally sophisticated way. Admittedly, the financial advisory field is filled with such things. After all, what are you paying us for?
Simply put, asset allocation refers to the assets (stocks, bonds, etc) you own in your portfolio. They are hopefully organized with some thought or purpose behind them; hence the term “allocation”. Together, “asset allocation” indicates a thoughtful selection, curation, and organization of investment assets put together for a certain reason. Whether it be stocks, bonds, real estate, precious metals, crypto, and so on, the hope is these investments ultimately work together to help you achieve a specific goal. For this article, we’re talking about asset allocation in your retirement accounts (401k, IRA, etc), how they are best suited for retirement, and ultimately how your pension fits in.
The most common allocation
If you are familiar with the term asset allocation, you’re probably familiar with the most common form of it. The most common asset allocation is a mix of stocks and bonds. These assets move in dissimilar ways, making them an easy and widely used way to diversify and create a solid allocation for a portfolio.
If someone says “I have a 60/40 portfolio” it means they have 60 percent in stocks and 40 percent in bonds. If they say 50/50, you guessed it, even split.
Breaking down the most common allocation
Before bringing your pension into the fold, one more detour. It’s important to understand how these parts of your allocation operate. Sticking with our common use example, we’ll look at stocks and bonds.
Stocks (Equities): These represent actual ownership in companies. The returns you receive are in the form of dividends and the growth of the stock price itself. Stocks can be more volatile, which means the price of the stocks can increase or decrease unpredictably. Further, dividends of stocks may be infrequent or unpredictable.
Bonds (Income): These represent money lent to a company or government agency. The returns are in the form of interest payments made on the borrowed money as well as potential increase of the bond price itself.
Bonds are nicknamed “Income” because of the steady nature of how returns are realized. If you owned individual bonds and held them to maturity, you would experience a steady flow of interest payments from the borrower. Hence, “income”. Since you can count on these payments, they behave much different than equities. While bonds usually have a lower rate of return, their predictability counteracts the volatility of the stocks and helps smooth out overall returns.
Pension: The Greatest Income Allocation
Alright, back to our main idea: your pension.
Comparing your pension with the idea of stocks and bonds, do you notice any similarity? Stocks are unpredictable and may or may not pay dividends. Bonds are more steady and (should) pay a steady income of interest payments. Any thoughts?
If your pension is related to either of these ideas, it would certainly be bonds. Since bonds pay a steady income of interest, your pension has some nice symmetry with them. When holding a bond, you expect regular payments. Similarly, with a pension, you expect regular payments. The regular nature of these payments counteracts the volatile nature of stocks (yes, for bonds and pension payments alike). It’s the behavior of these assets that we’re interested in. The nature of them matter very little. Income is income.
Part of the asset allocation
So, if we view your pension properly, it would be included in the “income” part of your portfolio. That’s easier said than done.
If you own stocks and bonds, their value is easy to compute. You can check stock prices and bond prices daily, making you well aware of how they’re doing. You can then take these prices and determine the balance of your assets.
For instance, if you started the year at a 60/40 allocation and your stocks outperformed your bonds, you might end the year at 65/35. If that happened, you could simply sell stocks and buy bonds until you get back to your 60/40 allocation. Congrats, you now understand rebalancing! More on that here.
Valuing your Pension
Pensions are more difficult to value in this way. This typically isn’t a problem because, for many individuals with pensions, they usually don’t include pensions as part of their retirement investment portfolio. Likely, these folks read somewhere that they should have a 70/30 portfolio or similar based on their age or some other variable. These people then allocated their retirement accounts to 70/30 and completely ignored their expected pension benefits.
Viewed separately, their pension and retirement portfolio seem in great balance. However, viewed together, suddenly things are wildly askew.
Warning: math ahead
For those of you not interested in doing any math today, this is where I leave you. Reach out today and let me do the heavy lifting for you. Bring your pension details and I will gladly help you find the value of your benefit and help you understand it as part of your portfolio.
For you math nerds, get your calculators ready.
The present value of a pension
The good news: there is a way to include the value of your pension in your portfolio.
The bad news: it’s math
First, we need to determine the present value of your pension benefit. The present value of your pension is the present value of all future payments if you were paid today. Sadly, this isn’t simply the value of all payments added together. You also need to consider the idea of investment return and growth of these payments (if applicable). Basically, we need to determine the value of a lump sum received today if you invested in the stock market and withdrew payments each month. In other words, what lump sum today has the same value of all future payments?
The formula (remember, I warned you)
PV = present value of the pension
PMT = initial annual pension benefit (monthly payment x 12)
g = growth of pension payment (if the payment is adjusted for inflation, use 3% or whatever estimate you're comfortable with. Lower is more conservative)
r = rate of return if you invested the lump sum in the stock market. Traditionally, 8% is a good estimate.
n = number of years you expect to receive the benefit. Most common estimate is until age 90.
For example
Let’s say you just retired at age 60 and begin receiving a pension benefit. The benefit will pay you $800 per month ($9,600 a year) and will continue until your death. The payment will adjust annually and you estimate inflation to be around 3% a year. Finally, you expect to live another 30 years and the return you normally get from invested accounts is around 8% a year.
If you wanted to know the present value (PV) of your pension, your calculation would look like this:
Once calculated, you would find the present value of your pension equals $145,686.75. That’s a nice chunk!
Now make it part of your portfolio
You now have the present value of your pension payment. Now what?
To continue the example, let’s now imagine you have $400,000 in your IRA and have decided that a 50/50 portfolio will fit your risk tolerance. 50 percent stocks and 50 percent income. You therefore allocate $200,000 to stocks and $200,000 in bonds.
Oops, you forgot to include your pension! Adding your pension benefit to your portfolio, you now have $200,000 in stocks and $345,686.75 in bonds/income. That’s a 37/63 split, not a 50/50! Looks like we need to rebalance your portfolio but how do we do that? It’s pretty straightforward.
First we add the present value of your pension to the total value of your IRA. We come to a total of $545,686.75. Since we want a 50/50 portfolio, we need to split this total evenly to discover our stock/bond mix. Divided in half, the totals for each should be $272,843.37.
Since our pension value can only be considered part of our bond/income allocation, we begin with that. We subtract the pension value ($145,686.75) from the bond allocation target ($272,843.37) and arrive at our actual bond allocation number for the IRA: $127,156.62.
After investing the $127,156.62 in bonds, we’re left with $272,843.38 to invest in stocks.
The totals:
Pension: $145,686.75
IRA Bond allocation: $127,156.62
IRA stock allocation: $272,843.38
To double check our math, we can add our pension and bond allocation together and compare it to our stock allocation. $145,686.75 + $127,156.62 = $272,843.37. 50/50 allocation achieved!
Why this matters
Why should we go through all this?
There is (or should be) a great deal of thought put into your investment allocation. You should consider your risk tolerance, risk capacity, age, time horizon, expected return, and so on. There are lots of things to consider when finding the right balance of assets.
Once you find the right allocation, it’s important to view it as it fits into your real, total retirement situation. Just as with our example, finding the right asset allocation only to ignore a pension benefit will leave your portfolio wildly out of balance. Doing so will make your allocation much more conservative than you intend to be.
What’s wrong with being more conservative? There actually are a few problems with being too conservative. Underperforming overall returns can cause your portfolio to lag inflation and erode over time. This small pull can be unfelt in the short run, but implode your plan over the long term.
More importantly, you’ve already decided on how conservative you want to be. That is, once you decide on an asset allocation, you have already determined the amount of risk you’re willing to take. And remember, risk is tied to return. The risk you have decided to take reflects the return you need to complete your plan. Ignoring your pension benefit means you actually have less risk (and less return) than you originally decided on.
