Stock Weighting in Retirement

The traditional rule of thumb is that the percentage of a portfolio in equities should be determined by subtracting your age from 100, the resulting number is what should be in stocks and other equities. The annual sequence of gains or losses has no impact on the portfolio’s total value—unless there are monthly, periodic, or annual withdrawals.

When determining the equity/fixed-income weighting, the present value (PV) of a retiree’s Social Security or pension payments is often overlooked. For example, a 65-year old male who receives $20,000 annually in Social Security has an asset worth the equivalent of $285,000 (what it would cost to buy a lifetime immediate fixed-rate annuity paying $20,000 a year for life); for a female age 65, the cost of a similar annuity would $300,000. In reality, a lifetime income from Social Security is worth even more—since few immediate annuities include an annual CPI adjustment.

The cost of an immediate fixed-rate annuity that includes a 3% annual increase is ~ 40% > a similar annuity without any kind of increase. Thus, the $285,000 annuity is really like a lifetime annuity with a 3% annual increase costing ~ $400,000 (1.4 x $285,000). Whether a $20,000 equivalent of annual Social Security benefits includes or excludes a CPI adjustment, the impact of including Social Security as a lump-sum asset can be significant on a portfolio’s equity weighting.

For example, Tom is 65 and single; he has a $1 million nest egg. Tom has no pension but is about to start receiving $20,000 a year in Social Security benefits (that include a CPI adjustment). Based on his risk profile, Tom feels comfortable with a 50/50 portfolio mix. Normally, this would mean a $500,000 commitment to equities and a similar amount going to fixed income. However, once Social Security benefits are factored in, Tom’s “real net worth” is $1 million plus $400,000 (present value of Social Security benefits with 3% annual increase).

Adding PV of Social Security to Nest Egg

The present value (PV) of cumulative Social Security benefits declines over time. For a male age 65, $20,000 a year in benefits is initially worth ~ $400,000 (partially due to annual CPI increases). However, for a male age 75, $20,000 of lifetime benefits is worth $200,000 ($280,000 with 3% annual increase, not $400,000).

Less Equities Then More Equities

Two researchers, Wade Pfau (American College) and Michael Kitces (Pinnacle Advisory Group), have come up with a new twist on the stock/bond mix for retirees: start off with a smaller weighting in equities and then increase the weighting as you become older. Results from the study indicate that many investors should reduce their initial retirement equity exposure to 20-50% and then add 1% more to equities each year thereafter, ending up with 40-80% in equities until death.

For example, suppose a 65-year-old’s risk profile suggests a 50/50 (stock/bond) mix. Based on the study by Pfau and Kitces, client might start with 40% in stocks. At age 66, he would have 41% in equities, 42% at age 67, etc. By the time the client is age 80, his stock weighting might be 65% in equities. An objective of this strategy is to minimize damage from a stock market decline during the first several years of retirement. As the client ages, the need to recover from a crash is less important because remaining life expectancy is low-to-modest.