Monday, October 7, 2013

Retirement - Your Second First Job (3)


More on asset allocation.  When considering their portfolio's division between equity and debt, many retirees look at their retirement savings as the only assets which must be considered in arriving at their debt and equity percentages.  Many individuals do not look upon their monthly Social Security check as a retirement asset, but it most certainly is.  I believe your Social Security benefit should play a part in formulating your portfolio allocation.

AARP, formerly American Association of Retired Persons, recently reported that the average 401 (k) balance for individuals in the 55+ age category had reached $255,000.  Let's assume, for the sake of discussion, that by the age of 65, the 401 (k) balance of a person who is retiring today has reached $400,000.  This sum constitutes his or her entire retirement savings.  The individual retires and transfers that money into an Individual Retirement Account (IRA).  Now, how to invest that money?  Following the traditional age based allocation rule, 65% of the portfolio ($260,000) would be invested in debt securities, such as US Treasuries, state or municipal obligations and corporate bonds.  The balance, $140,000, goes into publicly traded stocks or mutual funds, i.e., equity securities.  

However, if you consider your Social Security check as a monthly interest payment you receive on a government debt obligation that you own, those dollar allocations change.  The first step is to find the interest rate on a one year US Treasury obligation.  This information is available every day in the Wall Street Journal.  Assume you receive a monthly benefit of $1,000 from Social Security - $12,000 per year.  Assume further that the current interest rate on a one year Treasury is 3% per annum.  Your hypothetical treasury obligation generating a 3% return of $12,000 would have a notional principal of $400,000 ($400,000 x 3% = $12,000).  In effect, you may now consider that you have an $800,000 retirement portfolio consisting of $400,000 in a hypothetical one year 3% treasury obligation and your actual $400,000 cash IRA.  Under your age based allocation, your total portfolio of $800,000 (hypothetical plus cash) should then contain $520,000 of debt securities and $280,000 of equity securities.  Given the $400,000 notional value of your Social Security "investment", your cash IRA could then be divided into $120,000 of interest bearing securities and $280,000 of stocks or mutual funds.  Under this scenario, your IRA, on a cash basis, could contain twice the equity securities that it would if you did not include the Social Security payment in your allocation decision.  Equities have proven in the past to be a much better defense against inflation than debt securities.

Once a year, maybe each January, you should recheck the going interest rate for one year Treasuries, redetermine the present value of your Social Security "investment" based on your monthly checks (which are increased for inflation) and reallocate between debt and equity.  As stated in an earlier post, asset allocation is not a one time decision.  It should be revisited at least annually.  The allocation also changes as you age, resulting in more debt and less equity.  The age based reallocation need not be precise, year by year.  During your 60s, you might allocate 65% and when you are in your 70s, the debt percentage of the portfolio goes up accordingly. 

The age based allocation has been touted for many years by financial advisers; however, with the extended longevity expected for today's retirees, it may be necessary to consider an allocation which reflects a larger portion of equity in your portfolio than called for under the age formula.  This decision depends, however, on your capacity for risk tolerance.  Like Mr. Morgan's troubled friend, do your stocks or mutual funds keep you up at night?

Comments are always welcome.

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