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How Should I Count [Something] In My Asset Allocation?

I often receive questions about how (or whether) to count various things (e.g., Social Security, a pension, or an annuity) in your asset allocation. For example, a reader recently wrote in with the following question:

“I want an asset allocation of 50/50. $200,000 of my total portfolio is in a Vanguard variable annuity that is actually a Wellington managed mutual fund with the guaranteed withdrawal benefit rider in place. The Wellington fund has 65% in stocks and 35% in bonds.

When I figure the allocation, do I include the $130,000 in the stock allocation and the $70,000 in bonds in the allocation, or because I am taking the guaranteed benefit rider should I look at the $200,000 as fixed income? Or should I ignore it completely?”

I think it makes more sense to approach the question from the other direction. That is, rather than setting a desired overall allocation, then trying to figure out what the annuity should be counted as in order to reach that allocation, I would instead ask how you want the rest of the portfolio to behave.

Remember, the goal isn’t a specific allocation. The goal is a specific level of risk. So, given how the annuity works, how much volatility are you comfortable having in the rest of your portfolio? The answer to that question (rather than a desire to meet an allocation goal) should inform the decision of how you allocate the remainder of your portfolio.

For example, using the reader’s example from above, if we assume a $1,000,000 total portfolio, $200,000 of which is in the Vanguard variable annuity), if you:

  • Decided that the largest portfolio decline you could tolerate from the non-annuitized portion is, say, $200,000, and
  • You’re comfortable assuming stocks won’t fall by more than 50%,

…then you would want to limit your stock allocation (in the non-annuitized portion) to $400,000 (that is, twice the $200,000 maximum tolerable loss).

But that decision could be stated in any of a few ways:

  • You could choose not to count the annuity as part of your allocation, and say that you want a 50/50 allocation (that is, half of the $800,000 portfolio being in stocks).
  • You could choose to count the annuity as fixed income, and say that you want a 40% stock, 60% bond allocation (that is, 40% of the $1,000,000 portfolio being in stocks when you count the annuity as a bond).
  • Or you could choose to count the annuity based on its underlying (65% stock) allocation, and say that you want a 53% stock, 47% bond allocation (that is, 53% of the $1,000,000 portfolio being in stocks when you count $130,000 of the $200,000 annuity as stocks).

Those are all the same portfolio, just expressed in different ways.

Personally, I think the easiest approach is to count things like annuities, pensions, and Social Security (i.e., everything other than plain-old investments like stocks, bonds, and mutual funds) as factors affecting your ideal allocation rather than as a part of your allocation. But what matters is not whether you count these things or how you count them. What matters is what is actually in the portfolio, and whether or not that results in a level of risk that is suitable for your needs.

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