Before-Tax or After-Tax AA calculation?

[mickeyd]

I stole this paper from a thread on Vanguard diehards. I can appreciate how it distinguishes between allocations valued pre-tax or post-tax. Also, I agree with his assertion (I have underlined it below) that income streams (in this case military retirement) should be reflected in your portfolio.

This article challenges two aspects of the traditional approach to calculating a family’s asset allocation. First, it emphasizes the need to distinguish between before-tax and after-tax funds when calculating the asset allocation. Second, it argues that a family’s portfolio should be broadened to include, at a minimum, (1) the value of retirement income streams, such as Social Security and company pensions and (2) the mortgage as a short position in bonds. As we shall see, a family’s asset allocation varies dramatically depending upon whether we adjust account values for taxes and what we include in the family portfolio.

So, you think you know how to calculate an individual’s or family’s asset allocation? This article challenges the traditional approach to doing this. It extends and refines ideas first expressed in Reichenstein [1998]. Although it may shake readers’ confidence in their current financial planning procedures, it also provides important insights that should help them better serve their clients.

~~~~~~

Studies that examine families’ preparedness for retirement consider Social Security and other retirement income streams.3 Yet, the traditional approach to calculating a family’s asset allocation excludes retirement income streams. This is inconsistent! In my opinion, the value of retirement income streams belongs in the portfolio. I know a retired couple in their upper forties. Both partners are retired from the military. Without their inflation-adjusted military pensions, they would not be retired today. They clearly understand that retirement income streams "count" in their family portfolio. It is time for the financial professions to recognize what others already understand.

http://www.fpanet.org/journal/articles/2001_Issues/jfp0501-art13.cfm

 

[grumpy]

I believe this has been discussed before here. I maintain a spreadsheet of all my investments. One section shows the allocations to various asset classes. A portion to this shows percentages of investable assets only, the other shows the percentages with my defined benefit pension figured in as if it were the income stream from a large slug of Treasury bonds. In the first case my allocation to equities looks awfully high at 76% compared to the conventional wisdom for a retiree. However, with the pension included, my allocation to equities is only 39%.

I'm not sure I see the point of trying to adjust asset allocation based on the before-tax after-tax distinction. By the time I withdraw the last dollar from my before-tax accounts the tax laws will have been changed so many times I will have lost count. Should I assume that the capital gains and dividends on my after-tax accounts will stay at 15% forever? I wouldn't bet on that.

Grumpy

 

[jazz4cash]

Good interesting topic.  I also agree with inclusion of pension income streams in one's asset allocation.  I have heard this technique referred to as a "shadow portfolio" that would enable a family to justify a higher dollar allocation to stocks, as grumpy indicated

The other ideas represented will take ALOT more effort on my part before I could comment.  At first glance, it does not appear to make the case for distinguishing Before Tax vs After Tax from an allocation standpoint. It seems to me that the After Tax portion being in a Roth vs. other After Tax is significant........I think I'll just let the gurus around here pound on it awhile.  

 

[d]

among other things, the paper notes: "I believe Social Security should be considered a $178,500 bond in Hank’s portfolio."  HOOEY. Hank can't "cash" it or bequeth it or transfer it.  indeed, this logic would suggest that every 20-something should include in their assets the discounted present value of their future life earnings -- don't think that will pass muster with most banks.

that said, clearly any income stream would/should influence the asset allocation one decides upon, but that doesn't "create" a non-existing asset.

and double hooey to the before/after-tax asset allocation crap.  if one has $100 in after tax equities, and $100 in before tax bonds, it's 50%/50% ... not $100/$80 (assuming 20% tax on the tax sheltered), or 56%/44% as the paper suggests.  consider that one might divide both sheltered and non-shelted investments 50%/50% ... the end result is clearly 50%/50% both before and after tax ...

 

[Nords]

When valuing Social Security and military retirement, we use today’s yield on the Treasury Inflation Protection Security (TIPS) with maturity nearest the life expectancy. Like Social Security and military retirement, payments from TIPS are government guaranteed and increase each year with the consumer price index (CPI) inflation.

That's a lot easier than pricing inflation-adjusted annuities. And of course the govt would be unlikely to manipulate the value of TIPS!

 

[d]

how about social security payments being guaranteed! to comment on the CPI inflation part, we really need CFB here.