Q: My advisor told me to think of my Social Security income as a big bond. What did she mean?
A: Most of us have some fixed income investments in our portfolios – perhaps individual bonds, or bond funds / ETFs, or even bank CDs. Even cash is considered fixed income, despite its typically low yield.
We rely on fixed income equity investments to provide an “income stream” ie. somewhat fixed income, such as interest. So conversely, any income stream can be considered the equivalent of a fixed income investment. Your advisor talked about it. She made a lot of sense in discussing how a relatively safe long-term income stream isn’t all that different from owning a “safe” bond that pays that amount.
This fact can make a difference when considering how your total wealth is distributed. As an example, let’s take a retired government employee who has a pension of $50,000 per year. The retiree and their spouse also receive a combined Social Security benefit of another $50,000 per year. Let’s say the couple has another $1 million in retirement savings (both before and after taxes). How should the liquid million dollars be distributed?
When we look at total wealth, we can think of pensions and Social Security as a big bond. As a rough approximation, $1 million should allow a safe withdrawal rate (4%) of about $40,000 per year for many retirees in their sixties. So to get to a “safe” $100,000 a year would require $2.5 million.
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Now suppose the couple would like an asset allocation of sixty percent in stocks and forty percent in fixed income. Many families (and advisors) would only make this distribution in a liquid portfolio ($1 million in this case). If that were the case, they would buy $600,000 of stock funds and $400,000 of fixed income funds (to make a 60/40 split). They will allocate liquid funds in this manner, ignoring the $100,000 per year income stream.
Given the couple’s combined wealth, they have an income stream/fixed income “to the tune of” $2.5 million and another $1 million that is liquid. In the above example, they would have invested $600,000 of their $3.5 million “worth” portfolio in stocks, which is only about 17% of the total.
There are also several other caveats when estimating the amount of a portfolio that is considered fixed income. As noted earlier, the income stream should be considered very secure and very long-term (Social Security and many other government pensions qualify here).
If the pension is not adjusted for inflation, you have to accept that the income stream has less purchasing power with each passing year. Finally, however, the calculation changes with age. As noted earlier, the “safe cancellation rate” at age 60 increases to more than 5% in the eighth decade. So a $100,000 per year income stream would only require $2 million at that age.
I’m not making any judgments about the proper distribution, but I do note that income streams are “considered” part of the family’s asset distribution. In many cases, the more guaranteed the income stream, the more liquid funds can be allocated to stocks. Think about that with Social Security, large pensions, and other guaranteed income, such as from an immediate annuity.
Stephen Podnos is a fee-based financial planner in Central Florida. He can be reached at Steven@wealthcarellc.com and www.WealthCareLLC.com.