Ask the Spud: Is My Pension Like a Bond?

Q: My wife and I have been using the Couch Potato strategy for a few years now, but something has always nagged me. I am fortunate enough to have a defined benefit pension that will pay me $50,000 a year in retirement. Should I consider this the fixed income portion of my portfolio and put the rest in equities? – Brian

This a critical financial planning question for anyone with a pension, and yet it’s often framed in an unhelpful way.

A popular school of thought says you should think of a pension as a bond, presumably because both bonds and pensions pay predictable amounts of guaranteed income. The problem is, there is no way to put that idea into practice when managing a portfolio.

In this case, our reader has a pension that will pay him $50,000 a year. What would an equivalent bond holding be? Let’s assume he also has $300,000 in personal savings, and that it’s all equities. What would his overall asset allocation be? Even if he did establish a present value for the pension, how would that be helpful when it was time to rebalance the portfolio to its targets? Clearly this is the wrong way to approach the problem.

When we work with clients, establishing an appropriate asset allocation is one of the most important parts of the job. We don’t find it useful to think of pensions as a type of bond: rather, they are simply one of several factors in assessing each client’s ability, willingness and need to take risk.

The pension paradox

Your ability to take risk is largely a function of how long you expect to earn income, as well as the reliability of that income. If your job is tenuous and you except to earn nothing after you quit work, then you have limited ability to take equity risk in your portfolio. But our reader, who can look forward to a guaranteed pension of more than $4,000 a month in retirement—as well as Canada Pension Plan and Old Age Security benefits—likely has an unlimited capacity for risk with his personal savings. These guaranteed income sources should meet all of his income goals, and a market crash would have no meaningful impact on his financial situation.

The need to take risk depends primarily on the rate of return required to achieve your financial goals. Many investors need to earn 4% or 5% to meet their long-term objectives, based on their current savings rates and expected retirement date. A guaranteed pension has an enormous effect on this factor: my guess is our reader could achieve his retirement income goals even if his personal savings had a return of 0%. (With a client we’d test this assumption with Monte Carlo simulations.)  In other words, although he has the ability to take a lot of equity risk, he likely has no need to do so.

As much as you can bear

All of this means the decision comes down to weighing the third factor in the asset allocation decision: the willingness to take risk. Unlike the other two factors, this one is purely psychological.

If our reader’s pension income is sufficient to meet all his income needs, then he can take as much or as little equity risk as he wants with his personal savings. If he is entirely unconcerned with stock market turmoil (though few people fit that description), he could indeed invest 100% of his portfolio in equities. That would be the right choice if his objective was to leave a large inheritance, for example. If instead he’d prefer to merely keep pace with inflation and sleep soundly every night, he might just as well build a GIC ladder.

After going through this exercise, our clients almost always end up somewhere in the middle of those two extremes. We review the expected returns of various portfolios, as well as their historical volatility and maximum losses. Then the investors decide on the asset allocation that allows them to achieve reasonable growth at a risk level they can stomach.

 

33 Responses to Ask the Spud: Is My Pension Like a Bond?

  1. L.T. Smash April 14, 2014 at 8:28 am #

    I am in this exact situation, though my wife and I are planning for early retirement (MMM anyone?). We look at our pension as a giant, super-fantastic safety net, but we are approaching it from the angle that it is hardly there. We determined that 60-40 allocation should be more than sufficient for us, thanks very much to your information on the historical returns post for differing allocations (noting of course that past performance is not guarantee of future returns. 😉

  2. Jeremy April 14, 2014 at 9:25 am #

    How close to your retirement do you need to be before you actually “count on” your pension? My wife and I both potentially have excellent government/education pensions but that assumes that we stay in our jobs for 25-30 years more, and that those pensions don’t get reduced to nothing by subsequent governments.

  3. Canadian Couch Potato April 14, 2014 at 10:12 am #

    @L.T. Smash: Yes, one has to be very wary of projecting the returns of balanced portfolios based on the last few decades of performance. This post gives a more realistic outlook:
    http://canadiancouchpotato.com/2013/02/25/estimating-future-stock-returns/

    @Jeremy: Great question, and it’s precisely why financial plans need to be updated every few years, particularly when there are significant life changes. If you or your wife expect to work in the same jobs for your whole career you can start by making projections based on your pension estimates. But if one of you changes jobs, or if there are cuts to the promised benefits, then you would have to revise the plan accordingly.

    As general rule, trying to project retirement income 25 to 30 years in advance is futile. During this stage of life it’s better to focus on reducing debt, controlling expenses, and putting together a saving and investment plan.

  4. Al April 14, 2014 at 10:41 am #

    Interesting. Now what is the status of a whole/universal life insurance policy with an
    investment component that can conceivably be borrowed against or annuitized. How do you count that as an asset allocation?

  5. James April 14, 2014 at 11:08 am #

    A well framed discussion Dan, thank you.

  6. Alex April 14, 2014 at 11:09 am #

    Thanks for tackling this question. I’m in a similar boat with a DB pension, and while I’ll admit it can be an enviable situation to be in, but it still makes for some difficult decisions (and sometimes anxieties about whether the pension will remain as promised in the future).

    Where I’m currently a bit stuck is deciding whether to buy a home in a relatively expensive housing market or to continue to rent and invest the difference. I don’t know if I’m comfortable dipping into retirement savings for a down payment, even with the pension, and it can be difficult to differentiate between an actual desire to own a home (and the accompanying work and responsibility) and the familial and societal pressure to do so.

  7. Jon April 14, 2014 at 12:18 pm #

    Thanks for the post! Have you considered writing about the withdrawal phase of life?

    I imagine that I’d run into the same problems with income from renting houses out and shouldn’t consider this as fixed income?

  8. Dave J April 14, 2014 at 12:36 pm #

    I am also in a DB plan with a similar retirement income but my wife has no income at all. When we made our decision on asset allocation, we decided a 60/40 split in favour of bonds.

    This decision was made after reviewing my wife’s survivor benefit should something happen to me. It made more sense (for us) to manage our portfolio on the conservative side of things so if the worse case scenario happened, my wife could use our portfolio to top up her survivor benefit.

    @Jon – I too wonder about the withdrawal phase of life given my situation. Should I begin withdrawing sooner to minimize tax implications and put the money into a TFSA or should I wait until I’m 71 and eat the higher tax levels?

  9. Canadian Couch Potato April 14, 2014 at 12:59 pm #

    @Jon and Dave J: I have been planning to write a white paper describing the basic ideas behind the total-return approach to investing during the withdrawal stage. This would explain why investors don’t need to focus on income generating investments when they are drawing down their portfolio: they can use the same investment style they did during the accumulation phase. But regarding whether individuals should make early RRSP withdrawals and the like, those are strictly tax planning issues that are beyond the scope of this blog.

    RE: Jon’s question about income properties, I would not consider these to be a bond-like investment. As with the DB pension, the income should be included in your retirement projections, but I don’t think it makes sense to reduce your bond holdings because you earn rental income.

  10. Craig M April 14, 2014 at 1:04 pm #

    I struggled with this for a while, and was variously 20-100% in equity mutual funds with the remainder in cash (cash was down payment saving, not retirement) I’m now pushing all increases in income into my TFSA couch potato account with e-series funds and my boys’ RESP (which I’m in process of moving out of traditional mutual funds into e-series.

    The other implication of a good pension plan in addition to an investing plan is that it may make the TFSA a better bet than RRSP – I expect if I work to full pension with this plan, I’ll be paying a higher tax rate than I am now. I’m saving RRSP room for when I run out of TFSA and/or am making more closer to retirement. My contributions use up most of my RRSP room every year anyway.

  11. Edward April 14, 2014 at 1:18 pm #

    I’m completely ignoring my pension while doing the Couch Potato thing. I also get irked when people put it into their net worth statements. …Ask the guys who used to work at Nortel how that worked out for them. 🙁

  12. Craig M April 14, 2014 at 1:28 pm #

    Edward – It’s difficult to figure out just how secure your DB pension is – government pensions, while less worry about solvency, political action could change the value of that pension. Level of government can be a concern as well – municipalities have relatively little control over taxation (revenue). Companies – well, before Nortel started it’s shooting star period, it was a stodgy, solid telecom company. Holding up Nortel and Enron doesn’t mean to ignore it completely though. If you’re vested, planning on the amount you would recieve if you retired today is likely a reasonable amount – you should be able to count on at least return of contributions in most plans.

  13. Canadian Couch Potato April 14, 2014 at 2:23 pm #

    If you have already earned substantial service, I don’t know how you can ignore pensions in a net worth statement or a financial plan. While there is always some level of risk and uncertainty, it makes little sense to plan only for a worst-case scenario (such as assuming your company pension will be worth zero, that CPP will be cancelled, that you’ll zero on your investments, etc. all of which I have heard before). That’s just the flip side of assuming 10% annual returns with no volatility. It’s prudent to be conservative, but that’s not the same as presuming the worst.

  14. Steve April 14, 2014 at 4:17 pm #

    A DB pension? What’s that?

    With the greatest respect for some of the comments above, complaining that having a DB pension creates difficulties qualifies as a First World Problem.

    Having a limited DC or no pension at all (other than CPP) – and the corresponding “need” to earn a high rate of return on one’s savings while having a low “ability” to take the necessary risk – is a real difficulty. Squaring that circle with a DB pension, no matter how subject to political or company risk, would be investing and retirement Nirvana for most people if they could get it.

    Just keeping things in perspective.

  15. Brian April 15, 2014 at 8:17 am #

    @ Steve – In all honesty most if not all topics discussed on this site would qualify as problems of the first world. You know it is funny but I don’t remember anyone complaining about how trying to figure out how to properly calculate their ACB in a non-registered account so they can harvest a capital loss at tax time is a problem of the first world…

  16. Trevor April 15, 2014 at 9:52 am #

    Dan,

    Just retired at 55 with a private sector defined benefit plan and I am expecting to live off that alone and let the other assets I have grow. Your article is very timely as I was thinking of my pension as my fixed income portion of my asset allocation but I didn’t really understand your point on re-allocation. I know the actuarial value of the plan now as I was given it when I retired and I know the interest rate that gives me that. If rates go up sufficiently I was thinking I would shift equity investments to bonds to re-allocate to the ratio I’m looking for. Would this strategy not work?

    Another related question which I know is a bit extreme…if the equity portion is aimed to be drawn down at some distant point in the future like 15 or 20 years then should it not be allocated to small cap high value fund as a high percentage since it should see a true long term return? The ultimate in couch potato where you do nothing for decades?

  17. Canadian Couch Potato April 15, 2014 at 10:14 am #

    @Trevor: I’m not sure how the actuarial value of the pension helps the decision, especially of you have already elected to take the pension as a life income rather than taking the commuted value as a lump sum. A pension with an actuarial value of $1 million is not equivalent to a $1 million bond portfolio.

    There are all kinds of problems with this idea once you actually try to apply it to a real situation. If the pensioner were to die, for example, his or her spouse would receive a reduced payout (often 60%) immediately. Whereas the holder of a (registered) bond portfolio would simply pass that whole asset to the spouse. I just don’t feel it’s a useful way to approach the question.

    Regarding your second question, sure, it might make sense to use a very aggressive allocation if you don’t need the money for 20 years. But all the usual caveats apply: small-cap equities can be far more volatile, and too many investors overestimate their ability to tolerate volatility. And the small-cap premium may not persist: there’s no guarantee of outperformance, even over 15- to 20-year time frames.

  18. Kim April 15, 2014 at 11:03 am #

    @ Jon / Dave J: Have a look at this blog post. It has a very useful spd/sht for planning withdrawals and factors in the income tax implications.

    http://www.thebluntbeancounter.com/2014/04/retirement-planning-spreadsheet.html

  19. Trevor April 15, 2014 at 11:26 am #

    Dan,

    I think the actuarial value can be useful in discussing asset allocation. The actuarial value is only just the NPV using expected remaining life and expected return assumptions. If you assume the actuary is right for the discussion to start with and the pension company is right at the moment for expect returns you can an idea of what you would have to have in the bank to generate that income or what your company has put in the bank for you. My pension is worth 2M$ today, that’s what I would have to have invested to generate my pension income until age 80 at approx 3% return. If I walked into your office at 55 years of age with 2M$ in fixed income assets and .5M$ in equities pretty sure you wouldn’t tell me to re-allocate to more fixed income and that would suggest beyond my pension it should all be in equities at my age. But if I had 5M$ in equity and 2M$ in fixed income pretty sure you would say re-allocate to fixed income today.

    Its all a gamble at end of life. How long are you going to live, how much are you leaving behind. I don’t think the discussion of the pension value is any different than the rest of the allocations and using an actual value helps people decide how to manage the risk (including a pension option for higher surviving spouse benefits). But that’s me.

  20. Jake April 15, 2014 at 12:12 pm #

    is the new BMO BOND FUND SERIES D a replacement for the TD Canadian Bond Index Fund TDB966 for couch potatoes? Looks to have a lower management fee.

  21. Canadian Couch Potato April 15, 2014 at 5:02 pm #

    @Jake: I want to look a little more deeply into BMO’s new D-Series funds before reporting on them.

  22. Steve April 16, 2014 at 12:56 am #

    @ Brian:

    For an explanation of the ironic use of the precise expression “First World Problem” may I recommend a perusal of Urban Dictionary.

    As for the complaints upthread that having a DB plan creates difficulties, I note a 2009 Statscan paper called “Shifting Pensions” which catalogues the increasing prevalence of DC pensions, particularly for younger workers (http://www.statcan.gc.ca/pub/75-001-x/2009105/pdf/10866-eng.pdf). As noted in the paper:

    “A change in the prevalence of [DB and DC] plans would imply a modification in the distribution of risk between employers and employees, which could have an impact on the standard of living of future Canadian retirees … the investment risk with DC plans is assumed mainly by contributing members because their retirement benefits are entirely dependent on contributions and plan performance.”

    This means that future retirees will have an increased “need” (as defined by Dan in his post) to earn a higher rate of return in their DC pension savings to fund their retirement in the absence of DB guarantees, while having a lower “ability” (as defined in the post) to take the risk necessary to achieve those returns than current DB retirees, due to the lack of those same DB guarantees.

    In effect, DB beneficiaries gain on both sides of the “need” = “ability” relation (lower need, higher ability), while DC plan holders suffer on both sides (higher need, but lower ability).

    Under those circumstances, by all means beneficiaries of DB plans should optimize asset allocation decisions as discussed by Dan in his post – but to hear them in addition whinge about the difficulties of benefitting from a DB plan is more than a little rich (pun intended).

    I hope this clears it up for you.

  23. Brian April 16, 2014 at 8:32 am #

    @ Steve

    I do not need anything cleared up – I understood the intent of your original post very well and I guess it is on me for taking the bait.

    I also understand the use of ‘First World Problem’ and I still contend that the discussion of any topic on this site would qualify yet the only time (that I have seen) anyone has taken a shot like you did is when the topic of DB plans came up. I agree that having a DB plan would be a luxury most do not have but it appears that the only person that appears to be ‘whinging’ about it is you and your apparent lack of one. I went back and re-read the thread, and the comments were clearly indicating that they felt quite fortunate to be in the position they were in and just wanted some sound financial advice on how to plan accordingly – something that this site does very well (at least in my opinion).

    Which of these posts qualify as ‘whinging’?

    “We look at our pension as a giant, super-fantastic safety net”
    “My wife and I both potentially have excellent government/education pensions”
    ” I’ll admit it can be an enviable situation to be in”

  24. Canadian Couch Potato April 16, 2014 at 9:28 am #

    I’d like to shut this comment thread down before it gets out of hand. Nothing about Brian’s original question or later comments could be interpreted as complaints. He simply asked a very common financial planning question that, in my opinion, is often approached in the wrong way. It’s not for anyone else to be judgmental about it, or to turn it into something personal. I appreciate everyone’s cooperation.

  25. MAF April 17, 2014 at 8:27 pm #

    I believe that a DBP particularly if it is from a government and the plan is fully funded (as is the federal plan) is exactly like a bond. In calculating my asset allocation I include zero for bonds as I consider that they are fully covered by my pension plan. However, I still allocate a percentage for fixed income, using preferred shares which pay better and are taxed better than bonds, in my asset allocation model. But as discussed by others, the DBP allows me to take on more risk and accordingly I have allocated 80% to various categories of equities despite having recently retired. Given the historical return of 8% for equities vs about 3% for bonds today that seems to me to be a good decision.

  26. cmj April 17, 2014 at 9:04 pm #

    MAF
    I share a similar situation with having a government DBP and am glad to be able to come across this blog to learn how to diversify appropriately with equities. I am especially thankful to learn about ETFs that are invested in developed and emerging countries. CCP is core in how I make my decisions in a portfolio that is mostly equities and additional income that is derived from REITs and preferred shares. I’ve also learned how to balance this portfolio. Thanks again, Dan

  27. Daniel April 27, 2014 at 6:18 am #

    Dan,
    I too work in a company with good DB. At work I have been having that same conversation with coworkers. It does come down to a personal decision and profile but it certainly is an important factor to consider. So in my personal portfolio the small component allocated to bonds is entirely in short term bonds simply because the communed value of the DB is very sensitive to long term interest rates. On the equity side, having a DB, for example, helps rationalize having a higher component in small caps than the average investor would have.

  28. Michel Bourassa June 19, 2014 at 9:57 am #

    I understand that this thread is closed; perhaps my comment could be useful in the future.

    My experience with enjoying a DB pension plan is good – now.

    After 18 years working in the private sector, and contributing to a DB pension plan, I switched to the public sector to a job that paid the same salary. However, I received a very unpleasant and unanticipated shock when I saw that my net pay, after a huge increase in pension contribution, was markedly less. My family had to adjust our lifestyle a bit to accommodate this reduced revenue. I retired 24 years later and am now benefitting from what can best be termed as “forced savings”. In essence, I now receive deferred wages.

  29. Honixx July 10, 2014 at 10:02 am #

    It was mentioned above that Index funds no longer retain their advantage when the MER’s start to get too high. Based on that, what do you consider a high MER to be when looking at Index Funds?

    I have a DB Pension plan through work which is offered through Manulife Securities and of the 40 or so funds that I have to choose from their are only 4 which follow an index. There is a Bond index, a Canadian, US and International index. The fees associated with those range from as little as 1.225 to 1.4%

    Based on this does it still make sense to follow a CP approach or no?

    Thanks!

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