Pension - how to figure role in asset allocation

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ConfuseACat
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Pension - how to figure role in asset allocation

Post by ConfuseACat » Wed Jan 18, 2012 9:18 pm

Hi Folks,

I just joined after reading the tip near the end of Common Sense on Mutual Funds 10th addtion. Many books, including the one sited, speak to the idea of having a pension as part of the asset allocation formula. Pension to be used as part of your bond segment. But regarding the calulation, all I've read so far lack specifics.

For the following scenario, what tips do you have on rationalizing the pension component into a $ value for asset allocation calculation?
Retire in 15 years.
Pension fixed at $xxK (choose a number, say $30K).
Pension payment not to change (no inflation protection).

Thanks!
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john94549
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Re: Pension - how to figure role in asset allocation

Post by john94549 » Wed Jan 18, 2012 10:04 pm

Personally, I don't use pensions as part of my AA.

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ofcmetz
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Re: Pension - how to figure role in asset allocation

Post by ofcmetz » Wed Jan 18, 2012 10:10 pm

Welcome to the forum ConfuseACat. I read the original Common Sense on Mutual Funds a few years ago. I'm now reading the 10th anniversary edition on my Kindle that I got for Christmas. I enjoyed all the 10 year later remarks that Mr. Bogle has included. I highly recommend you read The Bogleheads Guide to Investing next.

As far as a pension there are many ways you can use it in regards to your asset allocation.

1. You could count it as a portion of your bonds and decide to invest way more aggresive than normal.

2. You could decide that you don't need to achieve as high a return because you have a pension and invest more conservatively than you would normally invest because of the pension. This makes more sense to me than number 1.

3. You could invest as if you did not have a pension and only use the pension in calculations in regards to how much retirement income your portfolio will need to generate. Therefore you would consider it in this equation. Retirement income needed - pension income = portfolio income needed. I've chosen to go this route and invest in a stock/ bond mix based on my age minus 10.

If I counted my pension as a bond I would never ever use bonds and would always be 100% stocks. A portfolio this aggressive would cause me to lose sleep at night.
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Re: Pension - how to figure role in asset allocation

Post by pkcrafter » Wed Jan 18, 2012 10:17 pm

Welcome to the forum
For the following scenario, what tips do you have on rationalizing the pension component into a $ value for asset allocation calculation?
Opinions on whether to use a pension as a bond will very. Not everyone will agree that it's a good idea. My position is do not take risk you don't need to take. When you do it you end up with a higher allocation to stocks, which means you've added unnecessary risk and you subject your portfolio to greater losses. If anything, a pension may allow you to reduce your risk by lowering stock allocation.

I'm sure you will get other opinions. In the end, the choice is up to you.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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GregLee
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Re: Pension - how to figure role in asset allocation

Post by GregLee » Wed Jan 18, 2012 10:47 pm

ConfuseACat wrote: For the following scenario, what tips do you have on rationalizing the pension component into a $ value for asset allocation calculation?
Retire in 15 years.
Pension fixed at $xxK (choose a number, say $30K).
Pick an interest you think is reasonable for bonds to yield -- say 3%. Suppose you buy x worth of bonds today, and with reinvestment of interest, their value increases 3% each year for 15 years until you retire, at which time the bonds you have then will yield at 3% the amount of your expected annual pension (your $xxK). Now, solve for x, and that is the present value of the bonds that would give you the same amount as you expect your pension will give. For the example figures, 3%(x * 1.03^15) = $30K and (if I did it right) x = $641,890.
Greg, retired 8/10.

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Re: Pension - how to figure role in asset allocation

Post by sport » Wed Jan 18, 2012 10:53 pm

pkcrafter wrote: ...do not take risk you don't need to take.
IMO, this says it all.

Jeff

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Dick Purcell
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Re: Pension - how to figure role in asset allocation

Post by Dick Purcell » Wed Jan 18, 2012 11:17 pm

Your purpose is dollar value for future needs and goals, right? I'd want to compare allocations in result probabilities for the purpose. You can certainly include the pension in doing so.

Apply Monte Carlo simulation of your plan with the pension built in, look at the goal-result probability distributions of various allocations, and choose the one you like best.

Dick Purcell

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Re: Pension - how to figure role in asset allocation

Post by Harold » Wed Jan 18, 2012 11:21 pm

First of all, whether you consider a pension part of your bond allocation or not should make absolutely no difference in the overall risk you're taking. Put another way, if treating your pension as a bond "forces" you to take on more risk, you have a problem with how you're viewing the risk of your financial profile in the first place.

Secondly, there is no need to calculate the pension's value as an equivalent bond. Generally, people invest for income at some future date. Part of that amount is already determined for you by the pension. You can merely invest to achieve the remainder of the desired income stream.

Having said that, if you still want to calculate the value of the pension, the method is to realize that the pension is a stream of payments payable at future dates assuming survival. At any given time, there's an active bond market making a consensus guess at what an appropriate discount rate is for each of those payments, and there's a mortality table providing a guess at the likelihood of the payment needing to be made. For each possible payment, multiply the payment amount by the probability of survival, then divide by a discount factor (i.e. (1+i)^n, where i is the discount rate and n is the time until payment). The sum of those amounts (a spreadsheet helps here) is the estimated present value of the pension.

You should recognize that the present value is merely an estimate (because nobody knows the true discount rates and mortality). So you lose accuracy by "converting to a bond". And there's no need since you already have a perfectly accurate defined benefit income stream.

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Re: Pension - how to figure role in asset allocation

Post by sscritic » Thu Jan 19, 2012 12:11 am

I agree with Harold. Here is a little analogy that might help, but then again it might not.

I drive 70 on the freeway, but 35 on city streets (15 in a school zone when children are present). I have a pension worth $1 million and a portfolio of investable assets of another $1 million. If I am on the freeway (exclude the pension), I drive 70 and have $700,000 in stocks. If I am on a city street (include the pension), I have $700,000 in stocks (35% of $2 million). Both are equally risky. If I want to be safe, I drive by a school and only put $300,000 into stocks.

Conclusion: driving the freeway at 70 is risker than driving at 15 past a school with children present, and investing $700,000 in stocks out of $1 million (pension excluded) is risker than investing $300,000 in stocks out of $2 million (pension included).

An investor who invests with his eyes closed is like a driver that drives with his eyes closed. If you invest the same percentage in stocks with your pension included as you do with your pension excluded, you might as well drive the same speed past a school as you do on the freeway. Hint: that's not a good idea. It is better to keep your eyes open and know where you are.



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Re: Pension - Do not figure its role in asset allocation

Post by bobcat2 » Thu Jan 19, 2012 12:34 am

I also agree with Harold.

What you want to know is, how can I safely turn the equity and bond holdings I own today into retirement income? Not, how can I turn my retirement income into a stock of wealth as of today? In other words your retirement problem is how to turn your portfolio of equities and bonds into retirement income. There is little point in trying to do the reverse and turn a stream of retirement income into a current stock of wealth.

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Re: Pension - how to figure role in asset allocation

Post by GregLee » Thu Jan 19, 2012 12:38 am

sscritic wrote:I agree with Harold. ...
An investor who invests with his eyes closed is like a driver that drives with his eyes closed. If you invest the same percentage in stocks with your pension included as you do with your pension excluded, you might as well drive the same speed past a school as you do on the freeway.
I get that. But in saying that, how are you agreeing with Harold, who said the opposite? (He said: "First of all, whether you consider a pension part of your bond allocation or not should make absolutely no difference in the overall risk you're taking.")
Greg, retired 8/10.

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Re: Pension - how to figure role in asset allocation

Post by RRP » Thu Jan 19, 2012 1:12 am

Harold, thanks for your post. I'm not a finance expert and some Boglehead exchanges are a tad above my head, but your explanation, in plain English, made perfect sense to me.
Wiki

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Re: Pension - how to figure role in asset allocation

Post by sscritic » Thu Jan 19, 2012 1:19 am

GregLee wrote:
sscritic wrote:I agree with Harold. ...
An investor who invests with his eyes closed is like a driver that drives with his eyes closed. If you invest the same percentage in stocks with your pension included as you do with your pension excluded, you might as well drive the same speed past a school as you do on the freeway.
I get that. But in saying that, how are you agreeing with Harold, who said the opposite? (He said: "First of all, whether you consider a pension part of your bond allocation or not should make absolutely no difference in the overall risk you're taking.")
Because $700,000 in stocks has the same risk as $700,000 in stocks, whether you call it 70% of $1 million (exclude the pension) or call it 35% of $2 million (include the pension). I believe that Harold would agree that the risk of $700,000 is the same whether you include the pension or not. The risk is in the $700,000 in stocks, not in the percentage. I might be putting words in Harold's mouth, so let's put them back in mine. The risk from $700,000 in stocks is the same no matter how you count it; whether you consider a pension part of your bond allocation or not makes absolutely no difference in the overall risk you're taking putting $700,000 into stocks. Treating your pension as a bond doesn't force you to buy more stocks. If you think treating your pension as a bond forces you to increase your risk, you might not understand something (I won't say what).



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Re: Pension - how to figure role in asset allocation

Post by Harold » Thu Jan 19, 2012 9:43 am

RRP wrote:Harold, thanks for your post. I'm not a finance expert and some Boglehead exchanges are a tad above my head, but your explanation, in plain English, made perfect sense to me.
Thanks, I appreciate this -- expressing the idea in clear language is the often elusive goal.
sscritic wrote:I believe that Harold would agree that the risk of $700,000 is the same whether you include the pension or not.
Yes, that's right.

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Re: Pension - how to figure role in asset allocation

Post by Rodc » Thu Jan 19, 2012 9:57 am

While Harold gives a correct calculation, there is an easier way.

Find the price of an annuity that starts the same year as your pension, and provides the same income (or close). Make sure to match inflation provisions if applicable. (if pension is adjusted to say half of CPI just find the price of one not adjusted and the other adjusted to CPI and average).

That is a good approximation to the value of your pension as cash. In the general scheme of things you could use that as the value as "bonds" or "fixed income" as well.

Personally, I think it is better to just use future known income to offset future desired income, and adjust portfolio to hopefully best provide the difference.

You can't buy and sell, rebalance, tap early for an emergency, etc. a pension, so in the end it really is not like cash, bonds, etc. So I don't want to pretend it is.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: Pension - how to figure role in asset allocation

Post by Rick Ferri » Thu Jan 19, 2012 10:06 am

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Re: Pension - how to figure role in asset allocation

Post by bertilak » Thu Jan 19, 2012 10:17 am

Harold wrote:Secondly, there is no need to calculate the pension's value as an equivalent bond. Generally, people invest for income at some future date. Part of that amount is already determined for you by the pension. You can merely invest to achieve the remainder of the desired income stream.
As a recent retiree with a good pension and social security income that's exactly how I ended up treated things after some considerable head scratching. I read somewhere the following comparison:
  • Ask an American how much someone is worth and you will get an answer like $XXX dollars.
    Ask an Englishman how much someone is worth and you will get an answer something like $YYY Pounds a year.
The Englishman has the more relevant answer because one's worth really is a matter of cash flow. What you need to do is think of your needs/wants in terms of cash flow and add up all the pieces of that. It makes more sense to look at your investments as a source of positive cash flow than it does to look at your cash flow (pension, etc.) as the face value of a pretend bond. You eventually need to convert everything back to cash flow anyway. Doing an extra conversion into and out of a pseudo bond adds two steps that increase uncertainty.
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Re: Pension - how to figure role in asset allocation

Post by GregLee » Thu Jan 19, 2012 10:36 am

sscritic wrote: Because $700,000 in stocks has the same risk as $700,000 in stocks, whether you call it 70% of $1 million (exclude the pension) or call it 35% of $2 million (include the pension).
A danger of holding a portfolio heavy in stocks is that you may be forced to sell stocks to meet living expenses at a time when stocks are low in value. A pension mitigates that risk, since the pension income will continue even when the stock market is down, and the pension income can be used for some of your living expenses. While it is of course true that having a pension does not prevent stocks from diminishing in value sometimes, this does not harm you so long as you don't have to sell the stocks during temporary dips in the market. So I don't think there is a dispute that having a pension justifies holding a higher proportion of stocks in your portfolio, since there is less danger of having to sell when stock prices are low. The question asked was about just how much the appropriate proportion of stocks is affected by a pension of a given amount. (The question was not about the present value of the pension.)
Greg, retired 8/10.

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Re: Pension - how to figure role in asset allocation

Post by Sbashore » Thu Jan 19, 2012 10:49 am

bertilak wrote:
Harold wrote:Secondly, there is no need to calculate the pension's value as an equivalent bond. Generally, people invest for income at some future date. Part of that amount is already determined for you by the pension. You can merely invest to achieve the remainder of the desired income stream.
As a recent retiree with a good pension and social security income that's exactly how I ended up treated things after some considerable head scratching. I read somewhere the following comparison:
  • Ask an American how much someone is worth and you will get an answer like $XXX dollars.
    Ask an Englishman how much someone is worth and you will get an answer something like $YYY Pounds a year.
The Englishman has the more relevant answer because one's worth really is a matter of cash flow. What you need to do is think of your needs/wants in terms of cash flow and add up all the pieces of that. It makes more sense to look at your investments as a source of positive cash flow than it does to look at your cash flow (pension, etc.) as the face value of a pretend bond. You eventually need to convert everything back to cash flow anyway. Doing an extra conversion into and out of a pseudo bond adds two steps that increase uncertainty.
Good explanation and example. I've done my share of 'head scratching' since retiring 6 years ago and you're right, it all comes down to cash flow. I also have a good pension and SS and I manage my portfolio with risk and cash flow in mind.
Steve | Semper Fi

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Re: Pension - how to figure role in asset allocation

Post by maxfax » Thu Jan 19, 2012 10:53 am

I would not make any allowances for a pension 15 years ahead of retirement. You may change jobs. The provider may go bellyup. The plan may be converted to Defined Contribution, etc.

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Re: Pension - how to figure role in asset allocation

Post by bobcat2 » Thu Jan 19, 2012 10:54 am

bertilak wrote:
Harold wrote:Secondly, there is no need to calculate the pension's value as an equivalent bond. Generally, people invest for income at some future date. Part of that amount is already determined for you by the pension. You can merely invest to achieve the remainder of the desired income stream.
As a recent retiree with a good pension and social security income that's exactly how I ended up treated things after some considerable head scratching. I read somewhere the following comparison:
  • Ask an American how much someone is worth and you will get an answer like $XXX dollars.
    Ask an Englishman how much someone is worth and you will get an answer something like $YYY Pounds a year.
The Englishman has the more relevant answer because one's worth really is a matter of cash flow. What you need to do is think of your needs/wants in terms of cash flow and add up all the pieces of that. It makes more sense to look at your investments as a source of positive cash flow than it does to look at your cash flow (pension, etc.) as the face value of a pretend bond. You eventually need to convert everything back to cash flow anyway. Doing an extra conversion into and out of a pseudo bond adds two steps that increase uncertainty.
Here's how Nobel laureate Robert Merton makes the same point.
"In Pride and Prejudice (written 200 years ago), Jane Austen didn't describe Mr. Darcy by saying he was worth 100,000 pounds. She'd say that he was worth 4,000 pounds a year. That's how we usually think of our standard of living."
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Re: Pension - how to figure role in asset allocation

Post by sscritic » Thu Jan 19, 2012 11:06 am

GregLee wrote:
sscritic wrote: Because $700,000 in stocks has the same risk as $700,000 in stocks, whether you call it 70% of $1 million (exclude the pension) or call it 35% of $2 million (include the pension).
A danger of holding a portfolio heavy in stocks is that you may be forced to sell stocks to meet living expenses at a time when stocks are low in value. A pension mitigates that risk, since the pension income will continue even when the stock market is down, and the pension income can be used for some of your living expenses. While it is of course true that having a pension does not prevent stocks from diminishing in value sometimes, this does not harm you so long as you don't have to sell the stocks during temporary dips in the market. So I don't think there is a dispute that having a pension justifies holding a higher proportion of stocks in your portfolio, since there is less danger of having to sell when stock prices are low. The question asked was about just how much the appropriate proportion of stocks is affected by a pension of a given amount. (The question was not about the present value of the pension.)
Maybe we are reading different questions. There is a pension. Do you count it? The question is not whether your circumstances are different when you have a pension than when you don't. The answer to that question is yes, having a pension changes your circumstances, but that wasn't the question asked. And I agree, if you count your pension, your $700,000 of stock is now a different percentage of a different denominator. How could it not be? If you divide the same number by two different denominators, you get two different answers.
The question asked was about just how much the appropriate proportion of stocks is affected by a pension of a given amount.
Where do you read that in the OP? Actually, the OP didn't even ask if the pension should be included in the calculation, so I am just as much off topic as you are. :)
what tips do you have on rationalizing the pension component into a $ value for asset allocation calculation?
Not if, but how.



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Re: Pension - how to figure role in asset allocation

Post by GregLee » Thu Jan 19, 2012 11:43 am

sscritic wrote: Not if, but how.
You and Harold were arguing the if question, not me. I took that as obvious, and I gave my answer about how to figure it earlier. The income from a pension and the income from bonds would both serve the purpose of mitigating the risk that stocks must be sold during a market low, so during retirement, the pension will have a similar effect to having bonds with the same income, and that tells you how to count the pension in asset allocation. I believe that the answer I gave was exactly relevant to the question. (Whether it was exactly correct is arguable.)
Greg, retired 8/10.

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Re: Pension - how to figure role in asset allocation

Post by Rodc » Thu Jan 19, 2012 12:41 pm

maxfax wrote:I would not make any allowances for a pension 15 years ahead of retirement. You may change jobs. The provider may go bellyup. The plan may be converted to Defined Contribution, etc.
Good point
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: Pension - how to figure role in asset allocation

Post by ConfuseACat » Thu Jan 19, 2012 8:13 pm

Folks,

Now I'm really glad I bought Bernstein's 4 Pillars of Investing book, which recommended Common Sense o Mutual Funds along with a dozen or more (I've read 5 of them so far). Due to Mr. Bogle's 10th edition, I found this investment message board. Thanks so much for the detailed answers and reasoning behind your thoughts. I found my first post very fruitful.

My initial conclusion, for general interest, is to not count the pension as part of asset allocation. I'll give it more thought, but that's my initial reaction.

Thanks!

-ConfuseACat

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Re: Pension - how to figure role in asset allocation

Post by Dandy » Thu Jan 19, 2012 10:21 pm

A pension allows you to take more risk than if you didn't have one. It is income not an investment. I don't include pension, social security or my residence as part of my investment portfolio. So, keep it simple and just determine your risk tolerance, your allocation between equity and fixed income and rebalance on some basis.

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Re: Pension - how to figure role in asset allocation

Post by jack1719 » Thu Jan 19, 2012 10:32 pm

GregLee wrote:
sscritic wrote: Because $700,000 in stocks has the same risk as $700,000 in stocks, whether you call it 70% of $1 million (exclude the pension) or call it 35% of $2 million (include the pension).
A danger of holding a portfolio heavy in stocks is that you may be forced to sell stocks to meet living expenses at a time when stocks are low in value. A pension mitigates that risk, since the pension income will continue even when the stock market is down, and the pension income can be used for some of your living expenses. While it is of course true that having a pension does not prevent stocks from diminishing in value sometimes, this does not harm you so long as you don't have to sell the stocks during temporary dips in the market. So I don't think there is a dispute that having a pension justifies holding a higher proportion of stocks in your portfolio, since there is less danger of having to sell when stock prices are low. The question asked was about just how much the appropriate proportion of stocks is affected by a pension of a given amount. (The question was not about the present value of the pension.)
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I think if a pension allows you to pay all or almost all of your must be paid bills in retirement,then it changes the game during a big stock market downturn,the worst thing during a downturn in the market in retirement is to dip into an already beat down portfolio of stocks..it gives you flexibilty to ride out things much better..ThaT MAKES a big difference in helping to stabilize things.

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