Social Security: Bond, Income Source, Or...?

By Christine Benz

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Readers weigh in on how Social Security and other income-producing assets affect their asset allocations--or don't.

I kicked a hornet's nest--er, sparked a lively discussion--recently when I wrote an article exploring whether Social Security should be treated as part of one's asset allocation--specifically, as part of the portfolio's fixed-income weighting.

So many readers responded in the Comments section below the article that I made the topic the centerpiece of a recent Morningstar.com Discuss forum thread.

Some posters in the thread, in the Portfolio Design/Management section of Morningstar.com, said they shared Vanguard founder Jack Bogle's view that Social Security should be treated as a bond asset, and their investment portfolios are equity-heavy as a result. Others, meanwhile, said that they've separated income streams from Social Security and pensions from their investment assets, in the belief that their fundamental characteristics are inherently different.

Still other respondents take a nuanced view of the question. Even though they don't consider their Social Security or pensions as part of their investment portfolios, the presence of those income streams had prompted them to take on additional equity risk.

'Social Security Is the Low-Risk Asset in My Portfolio'

Some posters were unequivocal: As Bogle suggested, they consider their Social Security benefits as part of their bond holdings and run with an equity-heavy investment portfolio as a result.

Mfinvestor noted, "I simply count my two pensions plus Social Security as 'bonds,' or the fixed-income portion of my portfolio. Other than money in cash accounts, I have no individual bonds, bond funds/ETFs, or annuities."

That's the same strategy used by RAKendall, who wrote, "I consider my Social Security income and small pension as bond income. All my investments are in stocks."

Seeking returns also employs an equity-heavy mix, whipping out the financial calculator to arrive at a current value of future Social Security payments: "Social Security is the low-risk asset in my portfolio. I estimate the present value of the future Social Security revenue stream and that becomes my 'bond' allocation. It allows for a much higher allocation to risk assets, specifically low-cost, actively managed mutual funds."

But as tlcdbc's post hints, putting a value on Social Security requires making some assumptions: "I regard a pension and Social Security as cash flows that have a present value based on when they will start to be received, how long they might last, and an estimate of a reasonable interest rate. It gives me an idea of what I would have to invest in fixed-income investments if the pension or Social Security went away. Both seem like high-quality cash flows, but in the current environment where debt levels can adversely impact the government and corporate debt levels can change quickly, nothing is certain."

Among the most vocal proponents of factoring Social Security into asset allocation decision-making is Mazama, who arrives at the value of Social Security by looking at how much someone would have to plunk down in an annuity to receive a similar stream of lifetime payments: "I value my Social Security benefit by reference to the current cost of a single [premium] fixed annuity (SPIA) that promises to provide an inflation-adjusted payment equal to the Social Security benefit I would receive if I drew the benefit today. Presumably the Social Security benefit is no riskier than a contract with a private insurance company."

'It May Not Make Sense Psychologically'

The majority of posters, however, said they did not consider Social Security as an investment asset.

Odr20136 wrote, "Social Security is unlike a bond or stock in so many respects I just consider it an apple in the fruit basket along with the oranges, bananas and pears of other financial assets."

Darwinian, never one to mince words, argued that Social Security and pensions are fundamentally different from investment assets: "Let's go back to definitions. An 'asset' is your property, something you own. Social Security and pensions are not your property; they are, at best, an entitlement. You can't sell them, and they can be modified without your consent. Mixing entitlements and properties is a sure way to confuse yourself." (In an interesting exchange, Zorkl55 questioned Darwinian's use of "entitlements" suggesting "earned benefits" was a more apt descriptor for both Social Security and pensions.)

Staythecourse argued that one of the chief reasons to not count pensions or Social Security as part of an investment portfolio is that it can lead to an overly aggressive portfolio that's difficult to live with: "While it may make mathematical sense to count a pension as an asset (since, like an annuity, it will deliver an income stream), it might not make sense psychologically. I think people can only tolerate so much volatility. So even if the guaranteed income stream of a pension might be counted as an asset (and thus allow for taking on more risk in one's investments) it may be difficult to sit out the greater fluctuations that result. I think people would be better off investing a portfolio at a risk level that is comfortable for them. Question: How much of a loss of net worth could you tolerate before panicking or falling into despair?"

For many posters in the thread, their investment portfolios will pick up where Social Security, pensions, and other steady sources of income leave off.

RichNot wrote, "We consider our Social Security, pensions, and annuities to be separate from the investment portfolio. We consider the investment portfolio income to supplement the other income."

That's how Alpro1 thinks about Social Security, too: "For me it's simple. Income gap. My pension and soon to be Social Security is a type of fixed income to cover basic expenses. What is left on a monthly basis is an income gap. That is where using my portfolio will come into play."

Darwinian explained the way he would account for Social Security and pension payments in a retirement plan: "The correct way to adjust for entitlements in a retirement financial plan is to subtract them from your income needs and determine the appropriate allocation of your actual assets to fill this income gap. Your allocation should be essentially the same if have a need for $75,000 and $25,000 of Social Security, or a need for $50,000 and no Social Security."

'I Do Carry More Risk Than Some My Age'

Yet even posters who said they don't consider Social Security as part of their asset allocation frameworks noted that the income they receive from it had allowed them to employ a more equity-heavy asset allocation mix.

Goodyearguy wrote, "I have Social Security, rental [income], federal pension and a survival annuity as income. I don't count it in my asset allocation as part of any formula…. I do carry more risk than some my age in my portfolio because I have significant income."

Stockvapors also runs with an equity-heavy mix thanks to Social Security: "In managing my IRA portfolio, I do not include Social Security as an asset but it still has had a huge influence. My portfolio is currently at 65% equity/20% bond/15% cash. This is an accumulation-stage allocation rather than a retirement-stage allocation. Thus, knowing and planning for SS has allowed me to take on much more equity risk than I would have been comfortable with if IRA income was my only source of income for life."

Ditto for Jacrod, who has used anticipated in-retirement cash flow and income needs to back into an asset allocation mix with a heavy emphasis on stocks: "Fifteen years ago we built a spreadsheet to model our spending/budget, taxes, health insurance, income, Social Security, pension, required minimum distributions, [and] real estate, ... over 50 years. The 50-year model projects how much we'll need from investments each year for living expenses. We take a conservative approach to modeling inflation, unplanned expenses, and investment growth rates. In this model we've overlaid the bucket approach discussed in Morningstar. We keep 2 years of estimated investment withdrawals in cash. The next 5 years are kept in cash plus short and intermediate bond funds. The rest is in a diversified portfolio of equities. Social Security and pension income are treated as part of the cash stream that allows us to keep years 8+ of our retirement funds in equities."

Other respondents argued that the extent to which Social Security and other income streams influence asset allocation depends on the individual.

Tomas47 used himself and his mother-in-law to illustrate: "For me personally at 66 years I consider Social Security as an income stream that reduces the withdrawal I need to make from the investment portfolio. It does not influence my asset allocation."

This poster went on, "For my mother-in-law at 93 years her Social Security and pension are sufficient to cover around 80% of her cash flow needs. On a qualitative basis that allows us to be more comfortable with a large equity allocation in her portfolio to avoid capital gains taxes that would flow from rebalancing. It also protects the eventual step up in cost basis at her death."

Erryl points out that ultimately, asset allocation is a highly personal decision, dependent not just on the investors' other stable sources of income but on personal preferences as well: "Factoring in pensions and Social Security as fixed income investments might call for putting many (and often conservative) investors into a very equity heavy investment portfolio. Can a person with Social Security and pension afford to take on more risk? Sure. The person without Social Security or a pension may very well need the higher total return of equities, though. It is very hard to make generalizations about people and what their asset allocation should be. It is a very personal decision." (news.morningstar.com)