Is My Pension Like a Bond?

pensionDan Bortolotti: Q: My wife and I have been using the Couch Potato strategy for a few years now, but something has always nagged me. I am fortunate enough to have a defined benefit pension that will pay me $50,000 a year in retirement. Should I consider this the fixed income portion of my portfolio and put the rest in equities? – Brian F.

This a critical financial planning question for anyone with a pension, and yet it’s often framed in an unhelpful way.

A popular school of thought says you should think of a pension as a bond, presumably because both bonds and pensions pay predictable amounts of guaranteed income. The problem is, there is no way to put that idea into practice when managing a portfolio.

In this case, our reader has a pension that will pay him $50,000 a year. What would an equivalent bond holding be? Let’s assume he also has $300,000 in personal savings, and that it’s all equities. What would his overall asset allocation be? Even if he did establish a present value for the pension, how would that be helpful when it was time to rebalance the portfolio to its targets? Clearly this is the wrong way to approach the problem.

When we work with clients of our DIY Investor Service, establishing an appropriate asset allocation is one of the most important parts of the job. We don’t find it useful to think of pensions as a type of bond: rather, they are simply one of several factors in assessing each client’s ability, willingness and need to take risk.

The pension paradox

Your ability to take risk is largely a function of how long you expect to earn income, as well as the reliability of that income. If your job is tenuous and you except to earn nothing after you quit work, then you have limited ability to take equity risk in your portfolio. But our reader, who can look forward to a guaranteed pension of more than $4,000 a month in retirement—as well as Canada Pension Plan and Old Age Security benefits—likely has an unlimited capacity for risk with his personal savings. These guaranteed income sources should meet all of his income goals, and a market crash would have no meaningful impact on his financial situation.

The need to take risk depends primarily on the rate of return required to achieve your financial goals. Many investors need to earn 4% or 5% to meet their long-term objectives, based on their current savings rates and expected retirement date. A guaranteed pension has an enormous effect on this factor: my guess is our reader could achieve his retirement income goals even if his personal savings had a return of 0%. (With a client we’d test this assumption with Monte Carlo simulations.)  In other words, although he has the ability to take a lot of equity risk, he likely has no need to do so.

As much as you can bear

All of this means the decision comes down to weighing the third factor in the asset allocation decision: the willingness to

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