April 27, 2015

How Pensions and Annuities Change Your Asset Allocation

If you are blessed enough to have a pension or a decent sized annuity with a financially solid insurance company, your appropriate to asset allocation must be entirely different than your less fortunate neighbors.

The reason is because whether you realize it or not, you indirectly have a portfolio worth hundreds of thousands, or perhaps even millions, of dollars worth of bonds, cash, and fixed income securities.  Don’t believe it?  Let me explain and you’ll see the reality.

How Pensions and Annuities Act as Bond Replacements

The fastest way to calculate the “capitalized” equivalent value of your pension or annuity is to take your total annual pre-tax income generated and divide it by 0.04.  For instance, if you collect $1,200 each month from your pension, that works out to $14,400 each year.  Dividing this by 0.04, you get $360,000.  Your pension is paying you the same sustainable rate that you would earn if you had a portfolio of $360,000 in high grade bonds.

Pension Annuities Asset Allocation BondsThus, if you retire with a $200,000 personal portfolio of cash, stocks, and bonds, you shouldn’t use an asset allocation model based only on that $200,000.  You have to take the money you have ($200,000) and combine it with the capitalized bond value ($360,000) for a total of $560,000.  Your decisions about asset allocation and individual asset classes are now more complete because you know that $360,000, or 64.59% of your assets are invested in bonds.  If you were following a passive asset allocation or a balanced asset allocation model portfolio, you wouldn’t want to put any of your $200,000 in bonds because you are, indirectly, already exposed to them.  Instead, you would want to put that portion of your earnings into businesses, stocks, real estate, and cash reserves. 

Why 0.04?  It’s because decades of statistical research has shown that investors who withdraw no more than 4% of their money each year from a portfolio of investments are virtually guaranteed to never run out of money no matter how far the market crashes.  This is considered by many to be the maximum sustainable rate of withdrawal and we like to use it for the sake of conservatism.

The Asset Allocation Model Lets You Breath Easier

By having such a large portion of your “true” net worth invested in bond equivalents through your pension or annuity, you don’t need to worry near as much if your $200,000 portfolio crashes by 50% or more during times of market stress because you are still going to receive your check each month.  In fact, that check would allow you to purchase more stocks, businesses, and real estate, giving you even richer long-term results.

The moral of the story is that some financial advisers will make the mistake of overexposing you to fixed income and bond investments, not capitalizing the true value of your pension or annuity when determining the asset class mix for your asset allocation strategy.  Now you know better.  Speak up in the meeting and ask your adviser why they haven’t factored in the stability of your regular monthly checks.  Never forget that it’s your money.  You don’t need to apologize for asking questions or insisting on a full understanding of the whole picture.

  • Anonymous

    This investment portfolio is about guaranteed to never run out of
    money, behindhand of how the bazaar goes down. This is advised by
    abounding as the best acceptable amount of withdrawal, and like to
    use it for affidavit of conservatism.

  • debrha vollmer

    Very interesting read and also very informative . I learned so much from this article, thank you for sharing.

  • Dave

    Great article and thanks

    My financial advisor ignored my 108k/year pension when configuring my assest allocation. Fortunately with todays low interst rates I’ve delayed buying the recommended proportion of bonds. Now I don’t think I ever will buy them in the ratio he recommended.