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Social Security: A Bond in Your Asset Allocation?

One question I get from time to time is how Social Security or pension income should affect your asset allocation. Specifically, should it be counted as a large bond holding?

My answer: Not exactly.

Yes, Social Security and pension income are predictable in much the same way that income from a bond is. And yes, all else being equal, an investor with a pension can probably take more risk in his portfolio than an investor without a pension.

That said, there are some meaningful differences between Social Security and a giant bond holding. For example, you can’t sell your “Social Security bond.” Among other things, this means that you can’t rebalance back and forth between a “Social Security bond” and a stock fund in the same way that you could with real bond holdings.

How to Account for Social Security Income

Rather than counting Social Security income and pension income as part of your bond allocation, I’d suggest using this method for fitting them into your overall retirement plan:

  1. Determine how much money you’re going to be spending each year during retirement.
  2. From that, subtract any part-time job or business income you expect to earn.
  3. From that, subtract your Social Security and pension income to determine how much income you will need from your investments.
  4. Divide that number by the size of your portfolio to calculate your required withdrawal rate.
  5. Choose an asset allocation that you believe will best satisfy that withdrawal rate.

This way, rather than counting Social Security and your pension as liquid, tangible investments (which they aren’t), you’re counting them as income sources (which is what they are).

Social Security Bond Problems

In case you aren’t convinced, let’s take a look at how counting Social Security income as a bond could cause some problems.

Let’s imagine that you get $20,000 per year in Social Security income and $20,000 in pension income. If we were to count those income streams as bonds and we assume the bond has a 4.07% interest rate (that of a 30-year T-Bond at the moment), they’d be worth a total of $982,800.

And let’s assume that you need another $20,000 each year in addition to your social security and pension income. If you have a $450,000 portfolio, that’s a 4.44% withdrawal rate. If you retire at age 65 and use the “age in bonds” rule, you’d have the following allocation:

  • $0 in bonds; $450,000 in stocks (because social security and pension income would more than satisfy the entire bond allocation).

In other words, in such a scenario, if you count Social Security and pension income as if they were bonds, you’d be going into retirement with all of your investable assets in stocks, and you’d be using a 100% stock portfolio to satisfy a 4.44% withdrawal rate.

Yes, if things go your way and the stock market performs well when you need it to, your plan would work out OK. But it’s far from a sure bet.

Instead, count the income streams as an offset to your expenses, then ask yourself what allocation you should use to satisfy the necessary 4.44% withdrawal rate.

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  1. I agree.
    Think back to 2008. If the person in your example had been 100% in stocks he would have been selling at lower and lower prices to get his 4.44% from his “nest egg”. This is the exact opposite of the benefits of dollar cost averaging when building up the “nest egg”.
    The studies that have found a 4% withdrawal rate works over the long term generally assume a portfolio that is 60% stocks/40% bonds.

  2. Great point, Mike, and very well explained. I think the only time you should look at your Soc Sec or pension as a “bond holding” is when you don’t need any income beyond that and you’re looking to build a legacy. In that case (where you don’t need any income from your investment portfolio), you don’t have to be as worried about volatility.

    However, I still wouldn’t go 100% stocks at that point. There is a very reasonable chance that your benefits could be reduced for some reason. Plus, the bonds can increase the risk-adjusted return of your portfolio.

  3. I’d go farther than this and say everyone under 40 should plan their investments as though they will not receive any Social Security when they retire. Social Security is the ultimate Ponzi scheme where early “investors” are paid off by late “investors.” Worked great when there were 7 – 10 working people for every retiree. Demographic changes with the aging of the baby boomers will eventually bankrupt this program, and benefits will have to be cut, or means tests put in place, or the government will just have to crank up the printing press… none of which is a good thing. Don’t fool yourself into thinking there is a trust fund; Congress has already spent the money and that trust fund is nothing but a bunch of IOUs from Uncle Sam sitting in a binder in Parkersburg, WVa. In my book, you’re over analyzing if you consider Social Security a bond in your investment allocation. At best it is an annuity from the government whose terms can be changed at a moments notice, most likely in a negative way in the future especially for those who save and plan for their future. I do my investment allocation planning assuming I will get $0 from Social Security. It helps me sleep better at night. And if I get an unexpected surprise when I go to collect, so much the better.

  4. Social Security and Pensions are like lottery. Just like you don’t count on winning a lottery, don’t count on SS and Pensions. If I get lucky, I will have extra income when I retire!!

  5. Aaron @ Clarifinancial says

    I like how you really broke this down to get to the answer. Something I often say is that “solving cash flow usually solves your other problems.” Looking at it from that perspective would tend to put retirement assets in the right allocation because you would adjust your savings with your *income risk tolerance* and expected return. Retirement isn’t about assets, after all.

  6. “Solving cash flow usually solves your other problems.”

    I like that. A lot.

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