The Place of Social Security in Your Retirement Portfolio

The portfolio

Let’s assume that Sue also has a portfolio of stocks and bonds worth another $415,000. Her total retirement portfolio is $830,000, comprising:

How should Sue invest her portfolio? If we consider both Social Security and the pension as a bond, then she could have her entire retirement portfolio in stocks and still have a relatively balanced portfolio of 50 percent stocks and 50 percent bonds. I would consider that taking on far too much risk.

My recommendation is to treat the pension and Social Security very differently. I consider the pension part of the portfolio but Social Security income as the amount we know it’s ok to spend. That’s because Social Security is inflation-protected while the pension is taking on a lifetime of inflation risk. The pension is like a super long-term bond, whereas Social Security is an inflation-adjusted paycheck for life.

Though it may seem inconsistent, I value Sue’s portfolio at $480,000 ($415,000 stocks and bonds plus $65,000 pension) and exclude Social Security. I do that because the goal of the portfolio is to allow Sue to safely spend what she has worked so hard to accumulate.

Morningstar has done some outstanding work on safe withdrawal rates. In its most recent study, Morningstar concludes that withdrawing 3.8 percent of the portfolio (increasing that with inflation) is safe, but only with a moderate portfolio. Put too much in stocks and you risk enduring a long bear market with no additional income to make up for losses. Put too much in bonds, and you risk losing money to inflation. I agree with Morningstar’s conclusion that a moderate portfolio of 40 to 50 percent stocks maximizes the safe spend rate.

To maximize what Sue can spend in retirement, we take the risky assets (the pension, stocks and bonds) of $480,000 and design a portfolio with half in low-cost stock funds that track an index, such as the Standard & Poor’s 500, and half in bonds and the pension. The portfolio would be composed as follows:

The 3.8 percent safe withdrawal rate means that Sue can spend $18,240 a year and increase that for inflation each year. With the riskless inflation-adjusted $21,384 Social Security payment, this gives her a total of $39,624 that she can live on.

Conclusion

Although there is always some risk that Social Security payments could be reduced, I consider it the closest thing to a riskless asset, with no market or inflation risk. Thus, I carve out the inflation-adjusted cash it generates and look at how much cash flow can be generated by the rest of the portfolio. Because a pension has a large amount of inflation risk, it has a bond-like risk, even though it pays for a lifetime. It just might not buy very much later in life, so I include it as part of the portfolio of stocks and bonds.

This is a conceptual way of viewing both Social Security and pensions rather than looking at claiming strategies. For example, in reality, Sue would likely be better off spending down her portfolio and letting her Social Security grow until she reaches age 70. But claiming strategies are a whole other article.