Phantom Bonds Redux

[MasterBlaster]

I just saw (another) discussion over on the Bogleheads forum regarding social security and pensions as "phantom" bond allocations. Some take the point of view that your social security and pension income streams have a net present value determined by (perhaps) what an immediate annuity with the same benefits would cost. They then use that value in the bond portion of their asset allocation. None other than John Bogle (of Vanguard fame) supports this approach.

The age-based Bogle asset allocation approach suggests you allocate assets to bonds based linearly with your age. So if you are 50 years old you should allocate 50 percent to bonds. 60 years old - 60 percent bonds and so on. That's the so called 100-age bond allocation model. However those asset allocations (per Bogle) should include the value of secure income streams.

So lets compare traditional allocation versus the Phantom allocation. If you have a $1MM stock-bond portfolio and want a 60 percent bond allocation then in a traditional allocation you'd have $600k in bonds and $400k in equities.

If the net present value of your SS and pension income stream(s) is $400k, then your total Phantom and real portfolio is $1.4M ($1M + $400k). In this case you would still want to allocate your 60 percent bond portion of your real and phantom total portolio (in this case $840k = 60% of $1.4M). But the SS and pension phantom allocation is already $400k so in that case you would want to reduce your bond allocation in the physical portfolio to $440k (that's $840k less the $400k phantom allocation). So in that case the $1M physical portfolio would be then be held as $560k stocks and $440k bonds. Note that the asset allocation is now quite different than the original $400k stocks and $600k bonds.

Bogle (and others) suggest that to not include these secure income streams is to over-allocate assets to bonds to your detriment.

Any comments ?

 

[haha]

I just saw (another) discussion over on the Bogleheads forum regarding social security and pensions as "phantom" bond allocations. Some take the point of view that your social security and pension income streams have a net present value determined by (perhaps) what an immediate annuity with the same benefits would cost. They then use that value in the bond portion of their asset allocation. None other than John Bogle (of Vanguard fame) supports this approach.

The age-based Bogle asset allocation approach suggests you allocate assets to bonds based linearly with your age. So if you are 50 years old you should allocate 50 percent to bonds. 60 years old - 60 percent bonds and so on. That's the so called 100-age bond allocation model. However those asset allocations (per Bogle) should include the value of secure income streams.
So lets compare traditional allocation versus the Phantom allocation. If you have a $1MM stock-bond portfolio and want a 60 percent bond allocation then you'd have $600k in bonds and $400k in equities.

If the net present value of your SS and pension income stream(s) is $400k, then your total Phantom and actual portfolio is $1.4M ($1M + $400k). In this case you would still want to allocate your 60 percent bond portion of your real and phantom total portolio (in this case $840k = 60% of $1.4M). But the SS and pension phantom allocation is already $400k so in that case you would want to reduce your bond allocation in the physical portfolio to $440k (that's $840k less the $400k phantom allocation). So in that case the $1M physical portfolio would be held as $560k stocks and $440k bonds. Note that the asset allocation is now quite different than the original $400k stocks and $400k bonds.

Bogle (and others) suggest that to not include these secure income streams is to over-allocate assets to bonds to your detriment.

Any comments ?

If the pension and SS are deemed as secure as the bonds that they are replacing, the logic of this position is unassailable. This assumes that no dynamic asset allocation is being atempted.

Ha

 

[akck]

That's kind of the way I'm doing it. I'm planning on making a 5 year bond/CD ladder to cover the planned withdrawals from my retirement investments to meet income needs. The remainder of investments will be in equities. I've not figured the present value of pensions and SS, so the actual fixed income portion of asset allocation may be less than 50% at times. It could be greater too, but I can't change the pension portion allocation.

 

[W2R]

Since the equities:bonds balance of my AA is based on what I feel comfortable with, the decision of whether or not I should add my pension to the bond fraction seems pretty academic.

So, I don't.

If I did, I would not sell any bonds to buy equities due to "having more bonds", so I don't see the point. Maybe I just don't get it.

 

[freebird5825]

Since the equities:bonds balance of my AA is based on what I feel comfortable with, the decision of whether or not I should add my pension to the bond fraction seems pretty academic.

So, I don't.

If I did, I would not sell any bonds to buy equities due to "having more bonds", so I don't see the point. Maybe I just don't get it.

Got room on the bench next to you?
I also do not understand the concept of equating cash income (pension or annuity) with bonds. The only link I could possibly see is the "default" risk of bonds being comparable to the "default" risk of a private sector pension.
Otherwise, I remain

 

[grumpy]

We have discussed this here before. For purposes of calculating my asset allocation I treat my COLA'd pension as if it were the income stream generated by Treasury bonds. Adding that amount of T-Bonds to rest of my portfolio results in an equity allocation equal to 38%. In other words, my equity allocation without considering the pension income is 78% equities. This might seem very high for someone my age and retired but with such a secure income stream I can afford to take the risk of a high equity allocation and still sleep well at night.

 

[Retire Soon]

I agree with Phantom bond allocation theory and have made it a practice in my portfolio.

 

[Delawaredave5]

If the pension and SS are deemed as secure as the bonds that they are replacing, the logic of this position is unassailable.
Ha

I agree with this. One needs to discount the PV of the pension by some amount to account for the risk. After seeing the airline, steel, and auto industries destroy their DB pensions - there is certainly risk.

The question is how much to discount ?

Unfortunately pension failure is somewhat "binary" - either your company stays solvent or it doesn't - and either the pension pays in full or it doesn't at all. Actually, that's not totally true as the PBGC backstops a portion DB pensions (but the maximum payout at age 58 is $2,500/month.

Any ways to "hedge a DB pension" ? I wonder if there's companies that pool or insure against pension failure. Maybe do a large short option contract on your company ?

 

[ERD50]

If the pension and SS are deemed as secure as the bonds that they are replacing, the logic of this position is unassailable. This assumes that no dynamic asset allocation is being attempted.

Ha

I agree with this.

I read the OP and was going to respond, but haha's use of the word "unassailable" trumped any phrasing I could apply!

One might feel uncomfortable with the idea that the Earth revolves around the Sun, but that doesn't change a fact. It is unassailable.

Now, you might want to discount the future payout of SS or a pension. But then again, maybe I should discount the future returns of my equities? Do I really have any faith in them? They don't even have a PBGC backstop. So that's about a wash, and kinda gets me back to square one. I'm just not able to get too excited about some of these finer points of asset allocation. One balance might be better that another, but then again, maybe not. I'm equally comfortable (or uncomfortable, depending on your view) with a range of numbers.

Maybe I should just move a big chunk to ' Pssst.... Wellesley ' and call it a day?


-ERD50

 

[Maurice]

I think most people do this indirectly at least. Most of us would choose a different AA model if we had a cushy COLA'd pension then we would if we had none whatsoever.

For me, however, SS seems so remote it doesn't factor into my planning at all. If I were 61 instead of 41 I'd probably factor it in, though.

 

[Gone4Good]

The age-based Bogle asset allocation approach suggests you allocate assets to bonds based linearly with your age. So if you are 50 years old you should allocate 50 percent to bonds. 60 years old - 60 percent bonds and so on. That's the so called 100-age bond allocation model. However those asset allocations (per Bogle) should include the value of secure income streams.

I think Ha says it right. That as long as the cash flow stream is as at least as high in quality as the bonds you are replacing, then using the PV is the correct approach.

But I'd raise a red flag about the certainty (or "quality") of future social security payments for someone as young as 50. You might want to add some risk premium to your discount rate.

 

[MasterBlaster]

This assumes that no dynamic asset allocation is being atempted.

Ha

Well I suspect that periodically (yearly ??) one could re-assess the real and phantom values and re-allocate at that time. There is no reason that dynamic asset allocation could not be done. One could also up the (real and phantom) bond allocation with the age based model.

So no I don't see an issue with dynamic asset allocation.

 

[DJRR]

If you hold individual bonds to maturity for income only, then I agree with the approach.

If you hold bonds as a non correlated asset to provide capital gains when stocks are down that are then sold to replenish capital to increase portfolio survivability then I disagree.

SS/pensions are income, but not an asset class for building a diversified portfolio.

 

[MasterBlaster]

If you hold bonds as a non correlated asset to provide capital gains when stocks are down that are then sold to replenish capital to increase portfolio survivability then I disagree.

SS/pensions are income, but not an asset class for building a diversified portfolio.

Per the non-correlated asset thing. The concept is that during recessions equity values and interest rates fall causing bond values to rise. Portfolio theory suggests that by holding some mix of non-correlated assets (eg. equities and bonds) and periodically re-balancing, that better overall portfolio performance can be achieved.

It should be noted that when interest rates fall (during a recession) the net present value of your SS and pension income streams also rise. One could re-allocate using the new phantom and real values in your portfolio.

Therefore I don't see an issue with portfolio management and this phantom bond concept.

 

[DJRR]

It should be noted that when interest rates fall (during a recession) the net present value of your SS and pension income streams also rise. One could re-allocate using the new phantom and real values in your portfolio.

Therefore I don't see an issue with portfolio management and this phantom bond concept.

Except you can't reallocate a "phantom" capital gain. You need a real one to have the money.

Another way to look at it is that you have $1M in assets and need $60k per year to live on. My pea brain looks at it this way:

$0 pension 6% SWR - Gamble. Tilt towards equities so I have a chance of making it long term. Hate to deprive myself and die 4 years in Hope the Govt. or kids will support me - I did not save enough.

$20k pension 4% SWR - Take a balanced approach. Should make it 95% of the time

$40k pension 2% SWR - Be conservative. Tilt toward fixed income. Why screw up a good thing?

$60k pension 0% SWR - Gamble. 100% equities to maximize my inheritance or get a big score and change my lifestyle. Don't need the money anyway.

I don't see the pension effecting my portfolio as an asset. Only effecting my behavior of how I would invest the rest of my assets.

I am sure some smarta** can show that we are mathmatically doing the same thing, but that is how I see it

 

[Nords]

I also do not understand the concept of equating cash income (pension or annuity) with bonds. The only link I could possibly see is the "default" risk of bonds being comparable to the "default" risk of a private sector pension.
Otherwise, I remain

It places asset allocation in perspective, including the effect of survivor benefits.

When the market dives off a cliff again, you'll take great solace in being able to consider your equity asset allocation a much smaller part of the equivalent cash value of your total portfolio.

We have discussed this here before. For purposes of calculating my asset allocation I treat my COLA'd pension as if it were the income stream generated by Treasury bonds. Adding that amount of T-Bonds to rest of my portfolio results in an equity allocation equal to 38%. In other words, my equity allocation without considering the pension income is 78% equities. This might seem very high for someone my age and retired but with such a secure income stream I can afford to take the risk of a high equity allocation and still sleep well at night.

http://www.early-retirement.org/forums/f28/estimating-present-value-net-worth-44560.html

Spouse and I keep our ER portfolio invested >90% equities, but overall it's only about 10-15% of our equivalent asset allocation.

 

[DJRR]

Therefore I don't see an issue with portfolio management and this phantom bond concept.

The issue is that based on your OP, you now have $160,000 more in stocks than before. If stocks go down 10% and bonds go up 10% your portfolio has decreased in CASH by $32,000 vs. your original allocation. The present value of your pension has gone up to compensate, but your pension payment remains the same. You are worse off because of your changed allocation.

You are just changing the risk profile of your cash portfolio. It is independent of the pension. If you had some way to easily monetize your pension then it would work, but I think you have to take a large discount to cash your pension income stream.

 

[W2R]

The issue is that based on your OP, you now have $160,000 more in stocks than before. If stocks go down 10% and bonds go up 10% your portfolio has decreased in CASH by $32,000 vs. your original allocation. The present value of your pension has gone up to compensate, but your pension payment remains the same. You are worse off because of your changed allocation.

You are just changing the risk profile of your cash portfolio. It is independent of the pension. If you had some way to easily monetize your pension then it would work, but I think you have to take a large discount to cash your pension income stream.

Wouldn't it be easier to just subtract the monthly pension income from your required expenses?

For example, if your minimum expenses are $3K/month, and your pension is $1K/month, then your remaining expenses are $24K/year. If all of your income is pension and portfolio earnings, then you need $24K from your portfolio to meet your minimum expenses.

As you point out, a pension doesn't behave like a bond.

 

[DJRR]

Wouldn't it be easier to just subtract the monthly pension income from your required expenses?

For example, if your minimum expenses are $3K/month, and your pension is $1K/month, then your remaining expenses are $24K/year. If all of your income is pension and portfolio earnings, then you need $24K from your portfolio to meet your minimum expenses.

As you point out, a pension doesn't behave like a bond.

That is exactly how I look at it. The goal is to provide the required income. The pension reduces the amount of income required from the portfolio. Based on that I would be more or less aggressive with my portfolio as detailed in my earlier post.

 

[MasterBlaster]

Wouldn't it be easier to just subtract the monthly pension income from your required expenses?

Easier - Yes

But perhaps not the optimum portfolio for your particular circumstances.

 

[Gone4Good]

It should be noted that when interest rates fall (during a recession) the net present value of your SS and pension income streams also rise.

Except you can't reallocate a "phantom" capital gain. You need a real one to have the money.

As long as you don't replace 100% of your fixed income allocation this way, rebalancing shouldn't be much of a problem. You simply sell the actual bonds you have to buy stock.

 

[Bikerdude]

Wouldn't it be easier to just subtract the monthly pension income from your required expenses?

For example, if your minimum expenses are $3K/month, and your pension is $1K/month, then your remaining expenses are $24K/year. If all of your income is pension and portfolio earnings, then you need $24K from your portfolio to meet your minimum expenses.

As you point out, a pension doesn't behave like a bond.

Well I sorta agree with W2R on this. In my case my "phantom bond" allocation is more than my total current bond allocation but not enough to live on. So I think I will just subtract from expenses and produce an allocation to deal with the remainder.

 

[WilliamG]

I have to agree with those who don't appreciate the utility of "phantom" bonds. To me asset allocation is all about the allocation of assets which you actually have some control over; i.e., that are at least somewhat liquid so that you can re-allocate as necessary as well as liquidate. Income streams like SS certainly affect your projected cash flows as to what your needs from portfolio are, and that is how it makes sense (at least to me) to use them.

 

[freebird5825]

It places asset allocation in perspective, including the effect of survivor benefits.
When the market dives off a cliff again, you'll take great solace in being able to consider your equity asset allocation a much smaller part of the equivalent cash value of your total portfolio.

http://www.early-retirement.org/forums/f28/estimating-present-value-net-worth-44560.html

Spouse and I keep our ER portfolio invested >90% equities, but overall it's only about 10-15% of our equivalent asset allocation.

Ah, NOW I understand. HUGE Light Bulb!
I do not need as large of a principal in a retirement portfolio (stocks/bonds/cash investment assets) as a non-pensioned retiree would because of the guaranteed-for-life income of my survivor pension.
Being naturally thick-headed, I still see the pension as a cash asset, not a bond asset.
Go ahead and correct me on this post if necessary.
Sometimes I need a brick thrown in my direction. No pain will be incurred.

 

[Nords]

Being naturally thick-headed, I still see the pension as a cash asset, not a bond asset.
Go ahead and correct me on this post if necessary.
Sometimes I need a brick thrown in my direction. No pain will be incurred.

Some kinds of "cash" are better than others.

I think you'd have more faith in a pension coming from the U.S. govt ("more" faith, not necessarily "absolute" faith) than you would for a pension coming from the City of San Diego or from General Motors... or in an annuity purchased from AIG.

If I was a retired airlines pilot then I'd have no more faith in my pension than the amount that's "guaranteed" by the PBGC. Or at least whatever PBGC guarantees are good for.

No matter how quantitatively one figures out their asset allocation, using all available Vulcan logic, there's still an emotional component. People have to be able to sleep at night with their asset allocations-- or else it just doesn't matter whether a portfolio is evaluated as real assets or as phantom bonds.

When our ER portfolio started dropping in 2008, I could say reassuring things like "We keep two years' expenses in cash for just this sort of volatility" and "Hey, we can cut back our spending to live on my pension" or "We still have rental income from the tenants". But when the drop kept dropping (it eventually bottomed out at -58% off the peak) I felt pretty silly saying "Did you know that the present value of our future Social Security benefits is more valuable than our current ER portfolio?" I was rationally correct in my logical assessment of the situation, but it didn't exactly go over like a bedtime lullaby.

So now that we've climbed back out of the recession's hole, whenever our ER portfolio has an exceptional month we're likely to take a little off the table to help satisfy the emotional side of asset allocation.