How to Compute PV of Social Security as if Bond

[headingout]

'...fixed pension, then you own, in essence, a bond issued
by your former employer. If that employer was the government, you
can capitalize (that is, discount) its payments by a low rate --
say 6%. Your Social Security payments should be capitalized in
the same way....it would not be a bad idea to increase your stock
holdings to reflect the "bonds" you effectively own via your
pension and Social Security.' [Four Pillars, Bernstein, p.278]

I agree with this, and have chosen to allocate my assets this way. So how exactly should I compute the PV of my future Social Security payments? Here is the actual Excel formula I've been using:

=PV(6%, years_to_retire, 0, -(12*monthly_payment)/6%)

But two things concern me:

(1) Would it be more realistic to use the safe withdrawal rate of 4% as that 2nd rate above?

(2) Social Security payments are inflation-adjusted, which would seem to imply a larger PV. How should I account for this inflation-adjustment: do I just add 3% to that first rate above?

If there are any good financial heads out there who can help with this, I'd appreciate it. Thanks!

P.S. I realize the future of Social Security is debatable. I'm choosing to handle that with a separate 'safety factor', not shown here, but let's debate that issue in another thread if necessary.

 

[haha]

'(2) Social Security payments are inflation-adjusted, which would seem to imply a larger PV. How should I account for this inflation-adjustment: do I just add 3% to that first rate above?

If there are any good financial heads out there who can help with this, I'd appreciate it. Thanks!

P.S. I realize the future of Social Security is debatable. I'm choosing to handle that with a separate 'safety factor', not shown here, but let's debate that issue in another thread if necessary.

By far the most realistic and helpful way to do this is to not do it. You cannot compute the PV of a variable cash stream without making a lot of assumptions that are guaranteed to be wrong.

Why do it?

Ha

 

[Rustic23]

IMO you use the SWR. The SWR is the rate that you can withdraw from retirement funds and each year it goes up with inflation. Seems to me that is just what SS does. May not be entirely correct, but close enough for me.

However, like Ha, what difference does it make?

 

[ats5g]

William Jennings and William Reichenstein did two papers on the subject:

Strategic asset allocation for individual investors: The impact of the present value of social security benefits

Estimating the value of Social Security retirement benefits

- Alec

 

[jIMOh]

Let me offer an alternative point of view (not saying I agree or disagree with this, but consider):

If you reduce bond holdings in liquid accounts (I consider SS to be an illiquid account) because SS is valued at X, then the markets tank y%, you cannot rebalance with the bond position tied up in social security.

What if you decided an 80-20 allocation was appropriate, then the calculation comes out to SS is all 20% of that allocation. You have nothing to rebalance with when one asset class outperforms the other or underperforms the other.

Thoughts?

 

[Tadpole]

I just used the amount of money from an inflation indexed fixed annuity that it took to produce the same income for the first year of retirement. This has the problem of using current rates.

 

[headingout]

Thanks for the excellent references Alec: just what I was looking for!

All retirement planning requires assumptions, and as those references say, the reason to look at PV of SS is:

"Excluding social security wealth from the asset mix decision
causes economically significant measurement errors and
sub-optimal portfolios. If individuals optimize their traditional
portfolios, which exclude Social Security, then they have
excessively conservative, suboptimal true portfolios."

jiMOh makes a good point about allocation into "illiquid" bonds. In my case (50/50 equity/bond allocation) the SS "bond" would only ever be a fraction of the bond allocation. Still, this is something to keep an eye on.

 

[OAG]

4% payout = annual amount times 25 (10,000 a year = capitalized value of 250,000). Probably not accurate but it is conservative as some may live to 87-91.

 

[ats5g]

Thanks for the excellent references Alec: just what I was looking for!

All retirement planning requires assumptions, and as those references say, the reason to look at PV of SS is:

"Excluding social security wealth from the asset mix decision
causes economically significant measurement errors and
sub-optimal portfolios. If individuals optimize their traditional
portfolios, which exclude Social Security, then they have
excessively conservative, suboptimal true portfolios."

jiMOh makes a good point about allocation into "illiquid" bonds. In my case (50/50 equity/bond allocation) the SS "bond" would only ever be a fraction of the bond allocation. Still, this is something to keep an eye on.

My problem/issue with the approach by Jennings/Reichenstein is that they assume that you first decide on your AA. Here's what I wrote in a recent conversation at the diehards forum.

...your split b/w stock and bonds should not be some arbitrarily arrived at ratio. For example, say someone with a pension and SS, has a 50/50 stock/bond split in their investment portfolio, but taking into account the PV of the pension and SS as bonds, the overall asset allocation is 20/80 stock/bonds. But so what? Does this mean they should put more of the investment portfolio in stocks, or even make it 100% stocks? Not necessarily.

The final asset allocation, i.e. ratio of stocks to bonds, is the end result of figuring out [to paraphrase Larry] your need, ability, and willingness to take risks. And how does one figure out how much risk they need to take? They take their proposed expenses in retirement, minus the pension and SS income, and then decide on an asset allocation for the investment portfolio to fund the rest. The asset allocation is the chicken, not the egg.

Another example is a comparison b/w someone like Zvi Bodie [whose 90%] TIPS, and my in-laws who've got CSRS fed pensions coming up soon, so their probably around 90% TIPS as well. Should each invest that last 10% in risky investments? Both Bodie and my-in laws probably can take those risks, but don't need too, or may not be willing too.

Recognizing that one has a large amount of "guaranteed income", or large PV, in the form of pension/SS, is fine. But that does not mean that one should increase the % of risky investments in their investment portfolio b/c someone thinks they should be at 60/40 stocks/bonds for their age or whatever. Likewise, someone with a huge amount of human capital [PV of future earnings], like a tenured prof or fed employee, certainly can increase the % of risky investments in their investment portfolio, but they don't need too. Increasing the % of risky investments may or may not lead to higher returns or a higher standard of consumption/living.

- Alec