Question on PV of pension- financial asset?

[Duke of Sands]

Hi all

Wifey and I ER'd 6 years ago at age 53 and I just discovered this great forum! Got a decent annuity-type, non-COLA pension (40k+/yr ) and just signed up for Flagship account at Vanguard where we have IRA's and a small taxable account. Allocation of around 50% stock funds, 40% bond funds, 10% cash. Have been running FIRECalc and like the results.

My question might be more philosophical than practical but here goes: AAII articles suggest using your "expanded portfolio" (add PVs of pension and SS as equivalent bonds to total financial assets) in order to decide on asset allocation. If I do that then our IRAs should be entirely in stock funds since the PVs add up to over 40% and am shooting for 60:40 stock:bond ratio.

I note that FIRECalc simply reduces withdrawals by the pension and SS amounts and asks about standard investment allocation.

So what should we be doing, heading toward 100% stock funds in our IRAs or staying put?

Thanks!
Duke

 

[donheff]

I have a substantial COLAd pension. The way I deal with this question is to calculate my needs above and beyond what is covered by the pension -- those are the expenses I will be reying on the nest egg for. The issue of allocation becomes one of risk profile with respect to that remaining amount. To avoid very high volatility in the nest egg, you need to diversify your holdings. If the pension covers most or all of your subsistence expenses that will allow you to sleep better with a higher volatility than might be possible if the nest egg is the whole enchillada.

 

[AltaRed]

I am in a similar situation (just retired earlier this year at 57). I too want to be about 60:40 in asset allocation, but I do include the PV of my non-COLA'd pension in my asset allocation split. That would suggest almost 100% equity in my non-pension investments.

But I know that I do not have a risk tolerance for 100% equity (and FIRECALC does show volatility of 100% equity portfolio), so regardless of the pension , I will always have a FI component to my asset allocation. I am currently at 40% FI looking for great buying opportunities and when they come, I will draw down to 15-20% FI. I could be comfortable at that level at least for the next 10-15 years.

You need to find your comfort level by asking yourself could you stand a 25-30% drop in your investment portfolio, or worse....as in 1987.

 

[kcowan]

I include the PV for both my non-COLA pension and my COLA'd one in calculating allocations. Yes it makes the investment portfolio high in equities but we are counting on the higher returns.

 

[OAG]

Maybe (the method I use) calculate the pension based on the multiple of a 5, 10, 30 T-BILL. I the current rate is 4% just divide 1 by 4% which would give you a multiple of 25. So a pension that gives you $10,000 per year would be valued at $250,000. Guess you could do that each year to keep it current. Provides a lot of freedom (maybe too much) with the rest of the nest egg.

 

[AltaRed]

Maybe (the method I use) calculate the pension based on the multiple of a 5, 10, 30 T-BILL. I the current rate is 4% just divide 1 by 4% which would give you a multiple of 25. So a pension that gives you $10,000 per year would be valued at $250,000. Guess you could do that each year to keep it current. Provides a lot of freedom (maybe too much) with the rest of the nest egg.

Think that conversion works good for COLA'd pensions, but IIRC, it is better to use 18 or 20 for a multiple for non-COLA'd pensions.

 

[Duke of Sands]

Thanks for the comments, folks. I found and read some of the older threads on this topic and I got the feeling that, at least 4 years ago, most folks weren't hot the idea of treating a pension as a bond equivalent. I think I might nudge my ratio toward more stocks but not go overboard. I also plan to build up our cash reserve to around the 2-yr needs level.

Thanks again, and I do welcome any more comments on the pro's and con's.

DoS

 

[FIRE'd@51]

Maybe (the method I use) calculate the pension based on the multiple of a 5, 10, 30 T-BILL. I the current rate is 4% just divide 1 by 4% which would give you a multiple of 25. So a pension that gives you $10,000 per year would be valued at $250,000. Guess you could do that each year to keep it current. Provides a lot of freedom (maybe too much) with the rest of the nest egg.

The problem with your method is it ignores the fact that with a pension, the principal goes away at death - i.e., at 4%, 250K would produce 10k in perpetuity without ever touching the principal. You need to use a method that amortizes the principal over your expected lifetime (like the way a fixed-rate mortgage works). To PV a non-COLA'd pension, I would do it the following way. Into a financial calculator, you enter

FV = 0

I = long-term Treasury rate (4% in your example)

N = your life expectancy (from actuarial tables)

then calculate PV

For a COLA's pension or SS, I would do the same calculation but use the YTM of the TIPS that most closely matches your life-expectancy for the interest rate.

 

[donheff]

The problem with your method is it ignores the fact that with a pension, the principal goes away at death - i.e., at 4%, 250K would produce 10k in perpetuity without ever touching the principal. You need to use a method that amortizes the principal over your expected lifetime (like the way a fixed-rate mortgage works).

Why not do it the way the market does? Go to immediateannuities.com and see what it costs. For a COLAd pension the Vanguard inflation protected SPIA at least comes close. Isn't the *real* present value what it would cost to buy it? Thats retail. If you want wholesale, see what you could sell the income stream for - per other posts, there are vampires organizations out there that will buy it from you.

 

[MJ]

Pardon my ignorance, what is PV? "_____" value?

 

[FIRE'd@51]

Pardon my ignorance, what is PV? "_____" value?

PV is present value of a future payment(s)

 

[FIRE'd@51]

Why not do it the way the market does?

Actually the "market" prices it just the way I suggested. I was only trying to suggest to OAG that his method ignored the amortization of the principal. The PV of an annuity is, as you know, the discounted value of the payment stream (or assumed payment stream). The only question is what rate to use to discount the future payments. For SS or a gov't pension I would use Treasury rates. For other than the gov't, one should use a somewhat higher discount rate to reflect the issuer's credit. The mathematical calculation in either case is the same, only the discount rate is different.

 

[brewer12345]

Duke:

How secure is this payout? Is it from a corporate employer, government, or is it a payout annuity sold by an insurer?

I see things a little differently here. I take it that the annuity covers most/all of your present living expenses? If so, the big risk for you is inflation. Over time, the real spending power of that fixed $40 k will drop significantly. If inflation picks up, it could drop far and fast. I think this sort of thing is why "on a fixed income" came to mean "poor" in the 1970s. So your big risk is inflation, and I would try to structure your portfolio so that you offset the inflation risk.

How might you do that? Well, ideally your portfolio would be heavily invested in stuff that tends to do well in inflationary times. I would put all of your fixed income allocation into TIPS. I would also add some commodities exposure (commodities went on a rocket ride to the moon in the awful 1966-1982 period). I would seriously consider tossing in a smidge of precious metals and some of the biggest and most stable commodities producer equities (Archer Daniels Midland, Exxon Mobil, maybe a gold stock, a coal miner, etc.).

 

[Duke of Sands]

Brew and FIRE,

Thanks for the advice, especially relative to inflation risk so will chew it over carefully. FYI the pension is corporate with Lucent so it's got some risk, true. Will recalc that PV discounted with something like 8%, seem reasonable? It does cover most of our basic expenses, not counting trips , etc.

No comments on the philosophy of considering the "extended portfolio" for asset allocation? Maybe not something worth worrying about??

DoS

 

[OAG]

Adjusting it for life expectancy is what I meant when I said "Guess you could do that each year to keep it current." For example if one is 65 and the life expectancy you were using was 90 then the multiplier is 25 for remaining lifespan; next year it becomes 24, etc.,). This does not consider any residual value (such as a sposal benefit) that remains after the subjects death which adds to the value; but I would not consider this in setting the rate unless the other surviviving party was a child or a much younger spouse. Additionally, a Government Pension with COLA has a much greater value (especially if the life expectancy/multiplier is large (such as 15-25, or more)). Of course if the current pension payout covers all or most of ones current living expenses and if it is expected (due to the COLA) that it will contiune to do so, for the forseeable future, it does free up almost all other available cash resources for more aggressive investing; if one wants to see it that way. However, if it is not COLA'd then one could conceviably just allocate enough funds in a cash or cash like account yearly to cover the then current inflation rate and, in effect, establish thier own COLA'd pension.

By the way I did try some of the Annuity Calculators I could find and the value they calculated when considering COLA, residual value to a survivor, and the principals age, were pretty close to this method. Only quibble seems to be in the rate used which goes to how strong the vendor is or remains. Govenment is gold or my 4% suggestion and others I wound suggest are some higher rate such as the 8% already suggested (which seems to be pretty high to me).