"Human Capital" - Pensions as replacements for Bonds in a Portfolio?

[Patrick]

Bernstein in The Four Pillars of Investing states on p. 278 that those of us that get a regular fixed pension own, in essence a bond issued by our former employers. He says that we can capitalize that at rates between 6% and 12% (i.e. $30K/year would convert to a long bond of $30K/0.06 = $500,000) and then increase our stock holdings to reflect the "bonds" we effectively own via the pension or SS. Do any of you agree or disagree with this idea?

Thanks.

 

[crazy connie]

I tend to agree with the caveat that the PBG is not nearly so well funded. I took a lump sum when I bailed as the trust factor in big business and their promises... Well, I now get a 100% of all future health care costs... In theory it works though!

 

[FIRE'd@51]

The formula you are using which gives $500K is only correct if the 30K payment continues in perpetuity. Since the pension will stop when you die you should assume that the principal amount gets amortized over your life expectancy like a mortgage. So if you have a life-expectancy of 20 years you would calculate as if it were a 20-year fixed rate mortgage. This gives 344K if the discount rate is 6%. In general, for the rate I would use the going rate on your company's bonds that most closely match your life-expectancy.

 

[Cut-Throat]

Since I had the revelation this week to delay S.S. to age 70, I am also leaning towards upping my stock allocation to a much higher percentage after age 70 than I would have planned on before. - For the very reasons you stated!

 

[Patrick]

The formula you are using which gives $500K is only correct if the 30K payment continues in perpetuity. Since the pension will stop when you die you should assume that the principal amount gets amortized over your life expectancy like a mortgage. So if you have a life-expectancy of 20 years you would calculate as if it were a 20-year fixed rate mortgage. This gives 344K if the discount rate is 6%. In general, for the rate I would use the going rate on your company's bonds that most closely match your life-expectancy.

Wow - Bernstein made a mistake? OK, I'll take your word for it. He says 6% for a government pension and 12% for something like a Trump Casinos pension. But his formula is the same - no accounting for life expectancy.

But you do agree on reducing the bond portion of the portfolio by the capitalized amount of the pension? Cool. 8)

 

[rmark]

I expect to hold relatively little in bonds when I retire, since my wifes pension + both our Social Security checks would be adequate cash flow.

 

[jazz4cash]

Yeah, I agree except for the 12% part. Bob Brinker (boo, hiss!) calls it a shadow portfolio. I never thought about the life expectancy effect and I am not sure it really matters for purposes of asset allocation, but I agree the mortgage analogy is probably more "accurate".

 

[2B]

Not wishing to start another "who cares about heirs" thread but I'll wade in anyway. I wouldn't discount the pension for "mortality" but I would consider the spousal "share." It is worth calculating the effect of pension loss to see if a pension that goes away totally destroys the surviving spouses situation.

In my MIL/FIL case, my MIL would be cut to less than 50% if FIL passes first. If MIL goes first, FIL loses more than half of his expenses (her nursing care).

Scott Burns had a recommendation a couple of years ago at amortizing SS at 4% (SWR -- inflation adjusted) and private non-COLA pensions at 7%. That seems to mesh pretty well when I play with FIRECalc.

Enhancing your bond share with "equivalent via pension" returns seems reasonable. The one caveat to remember is that they are annuities and can not be "cashed in" like a real bond for short term, high expense periods like nursing home costs. You still need to keep a stash back in a safe place.

 

[Texas Proud]

What I did for my sister is go to immediateannuity.com and plug in the numbers.... it then gives a value for today... and includes mortality... VERY EASY and is based on market conditions...

 

[Gone4Good]

The formula you are using which gives $500K is only correct if the 30K payment continues in perpetuity. Since the pension will stop when you die you should assume that the principal amount gets amortized over your life expectancy like a mortgage. So if you have a life-expectancy of 20 years you would calculate as if it were a 20-year fixed rate mortgage. This gives 344K if the discount rate is 6%. In general, for the rate I would use the going rate on your company's bonds that most closely match your life-expectancy.

I would only discount to life expectancy if planning for heirs or spouses. As far as I'm concerned, my lifetime is equal to a "perpetutity".

 

[Gone4Good]

Yeah, I agree except for the 12% part. Bob Brinker (boo, hiss!) calls it a shadow portfolio. I never thought about the life expectancy effect and I am not sure it really matters for purposes of asset allocation, but I agree the mortgage analogy is probably more "accurate".

Why do you not agree with the 12% discount for a financially weak company? 12% is probably high given where the high-yield market is right now. But your pension is exposed to the undiversified credit risk of your former employer. The PBGC may make you whole in the event your former company goes tits up, but then again, maybe they won't.

 

[burch64]

I have noticed on this board that most people say a pension can be considered the “bond” part of your portfolio.

I feel just the opposite, my government pension is heavily dependent on the economy, my whole 30 year career as a firefighter the city that I worked for put 20% of my salary into our pension plan, and I put 10% of my salary in to the fund. After I retired the city I worked for has no further obligation to me

The retirement fund that pays my pension is invested in stocks, real estate (shopping centers, etc. They actually have professional mangers to manage the pension fund money.

The pension fund balance is dependent on the stock market and the economy, when the market is up the fund’s balance is up.

If the economy would really tank I am not sure that our pension fund would be able to meet its obligations and would probably have to cut our pensions, and I sure would feel good if I had my portfolio heavily invested in government bonds.

 

[2B]

After I retired the city I worked for has no further obligation to me

The retirement fund that pays my pension is invested in stocks, real estate (shopping centers, etc. They actually have professional mangers to manage the pension fund money.

The question is whether your pension is guaranteed by the PBGC like most private pensions, a commercial annuity company or the "full faith and credit" of the city you worked for. The PBGC limits the upper amount of a pension but mine are so far below the limit as to be laughable. Pensions are probably pretty safe with them but some additional limits and restrictions may come into the mix soon when more companies exit the defined benefit arena. Cities can tax to pay the "bills" but they can also collapse and go bankrupt as has very occasionally happened in the past. I don't know what happened to the pensions. Commercial annuity companies do invest in stocks, bonds, etc. and have failed more than the annuity proponents like to admit.

In evaluating your pension you get to decide if you have a T-bill or junk bond quality and discount it accordingly. The nice part about a non-COLA pension is that in about 10 years after getting it, it's worth far less than half its original value so losing it won't hurt as bad. In 20 years you can just forget about it anyway.

 

[Delawaredave]

The formula you are using which gives $500K is only correct if the 30K payment continues in perpetuity. Since the pension will stop when you die you should assume that the principal amount gets amortized over your life expectancy like a mortgage. So if you have a life-expectancy of 20 years you would calculate as if it were a 20-year fixed rate mortgage. This gives 344K if the discount rate is 6%. In general, for the rate I would use the going rate on your company's bonds that most closely match your life-expectancy.

I agree you should consider a pension a "bond" paying a fixed amount for your expected lifetime.

I think you should adjust the discount rate of this "bond" proportional to the risk of losing the pension if the company goes bankrupt (ask personers of bankrupt steel companies and airlines...). Even for government jobs, I suspect there'll be a "day of reckoning" where past obligations simply cannot be met.

Either adjust the rate (closer to 12%) or reduce the payment to the "backstop" amount guaranteed by the PGB. You want to adjust downward the value of this "psuedo bond" to reflect risk - and then include it in the portfolio mix calculations.