Do You Have Too Much Money In Fixed Income?

Wilson Hughes Widow's Pension

Pensions, old school style

“Always be nice to bankers. Always be nice to pension fund managers. Always be nice to the media. In that order.”
–John Gotti

As you get older, you should look at having some fixed income – bonds, annuities, etc. – in your portfolio. There are rules of thumb associated with your age, such as 110 – your age as the percent of your portfolio which should be fixed income. The idea behind this class of investment diversification is that you want to protect some of your portfolio from the swings of investing in stocks and other assets. Bonds tend not to swing as much in price, and, barring default from the bond issuer, as an investor, you know that you will at least get a guaranteed income stream for the length of the bond.

Is it possible, though, that you’re not valuing other streams of income properly and making yourself too dependent on fixed income?

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This could be a dangerous situation when you consider how inflation can decrease the value of a fixed income investment. Let’s say that you invest $10,000 in a 10 year bond paying 3% annually. This means that you’ll get $300 in payments a year, or $25 a month. Let’s also assume that the same $25 will buy you a dinner at your favorite restaurant. If inflation is 3% per year, that same dinner will cost $33.60 in 10 years, but you’ll still be getting $25 in monthly payments, leaving you with a shortfall. Thus, you need to invest in assets which will beat inflation in order to keep up your purchasing ability.

Too high of an asset allocation in equities, particularly when you get older, could be risky as well. Normally, the stock market rises and falls in greater amounts than bonds, so if you’re depending on your investments to make ends meet, you do not want to be exposed to too much risk. Therefore, it’s a balancing act – the justification for the aforementioned rules of thumb.

If you have a pension, though, you need to count that future or current cash flow in your overall set of investment assets. While you do not have the cash in hand, you have the equivalent amount in an already purchased annuity.

Let’s look at an example to see what I mean. Let’s say that you are 50 years old with $500,000 in investable assets, and you’ve qualified for a $2,000 a month pension which will start at age 65. Normally, by going by the rule of thumb, you might think about being approximately 40% in fixed income and 60% in equities (NOTE: I’m giving a rule of thumb. Your asset allocation will depend on many other factors.). You should, then, have $200,000 in fixed income and $300,000 in equities, right?

No. The present value of that pension is approximately $105,000. This means that if you wanted to purchase an annuity which paid $2,000 a month starting at age 65 and making payments for life, you’d have to pay approximately $105,000 today to buy that deferred annuity. Therefore, your actual assets should include the value of that pension, meaning you have $605,000 in assets. Using the same rule of thumb as previously mentioned, you’d want to have $242,000 in fixed income and $363,000 in equities. $105,000 is already accounted for in your pension, so of your investable assets, you’d want to buy $137,000 in other fixed income, not the $200,000 which you previously thought.

While investing too much in fixed assets will reduce the risk of ruin – the risk you face of running out of money when you get older, it increases the risk that you won’t be able to buy as much with your money as you once could. With the costs of healthcare and assisted living outpacing inflation, that could be a risky position to be in as you age.

Don’t compound the problem by forgetting to include your other income streams in your portfolio diversification strategies.

About Jason Hull, CFP®

Jason Hull, CFP®, is the Chief Technology officer of myFinancialAnswers, an online comprehensive financial planning service.