For many people approaching and entering their retirement years, Social Security benefits are the most valuable "asset" they have. According to statistics compiled by the Urban Institute, a two-earner couple earning average wages over their lifetimes and starting Social Security at 65 in 2010 would receive nearly $1 million in Social Security benefits over their lifetimes.
The specific dollar value of benefits received will depend on each individual's earnings history, marital status, and longevity, among other factors. But that amount still looms large over the investment assets that many retirees bring into retirement. At the end of the third quarter of 2013, the average Fidelity 401(k) investor age 55 or over who had been contributing to a 401(k) for 10 years or more had about $270,000 in his or her account. Meanwhile, the average IRA balance for Fidelity investors between the ages of 50 and 59 was about $76,000 as of the end of 2012. The stock market has certainly helped boost many account values in recent years, but for many pre-retirees, those accounts are no match for the lifetime value of their Social Security benefits.
The question is, should you actually factor in those Social Security benefits when it comes to determining your portfolio's asset allocation? Or are Social Security benefits different enough from investment assets like stocks and bonds that you should separate them from your asset allocation decisions?
A survey of investment experts revealed a range perspectives on this issue. And in the end, the right answer depends a lot on personal circumstances--the retiree's risk capacity as well as risk preferences.
Count 'Em In?
In the camp of factoring Social Security benefits into one's asset allocation plan is Vanguard founder Jack Bogle. When I interviewed him at the Bogleheads conference this past October, he made the point that investors ought to consider Social Security as part of their portfolios' fixed-income weightings. Not only does Social Security deliver income payments in a way that a bond does, but those payments are also adjusted for inflation.
For those reasons, Bogle believes that Social Security is akin to an inflation-protected bond that pays income for the rest of your life. By extension, he thinks that retirees who are eligible for Social Security can reasonably hold a higher equity weighting than traditional asset allocations would dictate. Indeed, although Bogle is normally a huge believer in investing simplicity, he believes that target-date funds fall short as all-in-one vehicles because their asset allocation frameworks don't factor in an individual's other sources of income during retirement.
Morningstar head of retirement research David Blanchett is also in favor of taking a holistic approach to retirement portfolio management and asset allocation. "Social Security is a government bond and part of someone's total wealth and therefore should be considered in the portfolio as a bond-like asset," he said. In a paper Blanchett co-authored with Morningstar's Paul Kaplan, total wealth allocation--encompassing investment assets as well as non-portfolio assets such as pensions, Social Security, and an individual's human capital--is one of the strategies that advisors can employ to enhance their clients' income streams during retirement.
But not all financial experts agree that Social Security is entirely bond-like and should be treated as such in a portfolio. Rick Ferri, founder of investment management firm Portfolio Solutions, concedes that because Social Security promises regular, inflation-adjusted cash flows, it's similar to a bond.
But it's different in a few key respects, too. (Ferri and Craig Israelsen discussed why pensions should not be counted as bonds in a recent FinancialCounsel.com article, but their conclusions can be applied to Social Security as well.) For one thing, Ferri and Israelsen point out, Social Security has no maturity date; your payments will continue as long as you live. If you die young, Social Security will be a much less valuable asset than if you live to age 95. Depending on the start of benefits and overall life spans, the value of benefits that an individual receives could differ by hundreds of thousands of dollars. That makes Social Security a squishy item to value, and in turn, to count as a percentage of your portfolio's asset allocation.
Determining the true value of Social Security and its value as a percentage of your portfolio's asset allocation is further complicated by the possibility of benefit cutbacks for younger generations; if benefits are scaled back or if means-testing is applied for younger beneficiaries, then the value of benefits for those individuals will be that much lower.
Even more fundamentally, Ferri believes that Social Security benefits shouldn't be counted as a portion of an investor's fixed-income portfolio because Social Security recipients lack the same level of control that owners of other assets have. "You can't pick the maturity date or the interest rate, you can't decide how risky this income stream will be, thus collecting a higher risk premium, you can't swap your income stream for a different one (unlike bond swaps), you can't sell the income stream, you can't ask for a lump sum payout, and when you're dead, your estate doesn't get any principal (unlike insurance)," he said.
Implementation Issues Abound
Other financial-planning practitioners argue that one of the biggest reasons not to count Social Security as fixed income is behavioral. One of the key benefits of owning bonds is that they serve as ballast to the riskier parts of the investment portfolio--bonds typically go up, or at least don't lose as much, when stocks go down. That, in turn, helps investors stick with their plans when their equity investments inevitably slump.
By contrast, investors who are using Social Security as part of their fixed-income allocations don't have that same ballast. Financial planning guru Harold Evensky made that point vividly in an interview I did with him: "If you're doing an asset-allocation model and you factor in Social Security as a bond, then you can have a much larger equity allocation in the financial assets. Intellectually, that makes all the sense in the world," he said. "The problem is when the market is down to tell someone, 'Oh don't worry about it. Your bond is doing fine.' And they say, 'What? I don't own any bonds.' If your response is, 'Oh, Social Security,' it just doesn't resonate."
In a similar vein, Morningstar's Blanchett is careful to note that paying attention to Social Security's bond-like characteristics shouldn't automatically lead to a higher equity weighting. "The fact that Social Security is bond-like doesn't mean someone should be more aggressive in their portfolio, depending on their risk tolerance/capacity," he said. "But at a minimum it should at least inform the decision."
Financial planner Sue Stevens, CEO and chief investment officer of Stevens Wealth Management in Deerfield, Ill., employs a hybrid approach. While she doesn't consider Social Security as part of a client's fixed-income weighting, some of her clients may in fact end up with higher equity weightings as a result. "I like the concept of liability matching," she said. "When formulating a plan I look at the present value of Social Security and pensions--what the person would need in retirement to cover expenses for the rest of their lives. If you've carved out enough income needs for expenses, you could potentially hold more stocks."
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