There’s an old adage that you’ll probably hear about investing: that your portfolio’s allocation to stocks should be 100 minus your age. For example, if you are a 70-year-old retiree, you should have a portfolio that is 30% stocks with the remaining 70% in bonds and cash.
There’s a serious problem with this age-old “advice”: it isn’t quite true. Today’s reality is simply that bonds don’t pay much in interest. Long gone are the days where you can buy 5 CDs and ladder them 5 to 10 years out, locking in a government backed stream of income at 5% or more. Today, you would be lucky to get half that income for the same CDs, so investing 70% of your assets in CDs to earn enough just to keep up with inflation makes little sense.
With this low interest rate environment in mind, it probably makes sense to think of Social Security as a bond equivalent within the context of your total portfolio. If you don’t, you might have a recipe for underinvesting disaster.
Think of Social Security as a Bond
Very few people, including financial advisors, think about Social Security income as a type of bond. That means that it is rarely included in your portfolio’s bond-to-stock ratio which means advisors invest more into bonds than they should. Clearly, that hurts your income, since bonds pay relatively little interest. If your Social Security income was thought of as interest from a large US government bond portfolio, you’d probably want to increase your stock holdings to keep the proper ratio of stocks to bonds.
Treating Social Security income as a bond is a prevalent view in the academic community, and the idea is supported by a number of prominent individuals in the investment community, including Jack Bogle, the founder of The Vanguard Group. These people argue that Social Security income must be viewed as an inflation-linked “bond,” much like Treasury Inflation Protected Securities (TIPS), which have cash flows linked to inflation. These “bonds” exist in an expanded portfolio that generates income from dividends and interest, part-time jobs, defined-benefit pensions, and, yes, Social Security benefits. The one counter argument to that Social Security is like a TIP is that the Social Security Administration is not bound to increase payments by the inflation rate.
Estimating Your Expanded Portfolio
Now that you’re thinking of your Social Security benefits as part of your portfolio’s allocation, you’re probably wondering how you can estimate your allocation and avoid being underinvested. One way is to estimate your Social Security income and apply the 4% rule.
Consider the following example of a couple making $40,000 in total Social Security. According to the 4% rule, they have a portfolio equivalent to $1 million ($40,000/.04). This couple also has another $1 million in retirement assets, for a total of $2 million when their Social Security income is factored in as part of their expanded portfolio. In the case where Social Security makes up a smaller percentage of income, then the investment portfolio should include more bonds. If Social Security makes up more than half of the retirement income, couples should probably have a higher percentage of their investments in the stock market. Of course, you should factor in your emotional response to market volatility.
If you remember that Social Security should be considered a bond (backed by the safest entity out there, the US government), then this couple already has half of their portfolio in bonds. That makes a pretty strong case for putting most (if not all) of the remaining 50% into stocks—but it’s unlikely that their financial advisor would do that. Instead, they’re much more likely to have a mix of stocks and bonds in that $1-million portfolio, which might mean that 75% or more of their total portfolio is in bonds. That is almost certainly the wrong mix—which means this couple, like so many others, is underinvested in the stock market*.
Manage Your Portfolio’s Allocation
Once you’ve looked at that example, it becomes clear that you need to be taking into account all of your assets when you’re determining how to divide up your portfolio. If you don’t, you’ll almost certainly be underinvested and may run out of money in retirement, or at least have a tight budget. It’s fairly clear how this hurts you: bonds generally pay less than stocks, and bonds that pay at the rate of inflation (as they are today) aren’t really paying you much at all, so being underinvested eats away at your investment earnings, your purchasing power, and your financial future.
If you want to avoid being underinvested, make sure that your financial advisor takes your complete, expanded portfolio—including Social Security—into account when determining the right mix of equities for you. It’s the best strategy for avoiding the all-too-common misstep of underinvestment.