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Traditional pension and bonds (and stocks)

Chris Farrell Nov 3, 2008

Question: I am hoping to retire in 5 years at age 62. I’ve got a three-part retirement plan: a government pension, social security and a 457k. Rather than following John Bogle’s advice to invest in bonds at a percentage = to your age, I invest my 457k mostly in stock funds, reasoning that the pension is kind of the equivalent of the more secure bond funds. Also, I expect to be drawing from the 457k for maybe 30 years, which seems like another good idea to keep it in stocks for awhile. What do you think? I’ve never seen this question addressed before. (I wish I had asked this question before the current financial crisis – I don’t mean to gloat over having an actual pension.) Connie, Portland, OR

Answer: Your question illuminates the value of a traditional defined benefit pension plan, the kind that pays out a monthly income to a retiree based on a salary and years of service formula. But fewer and fewer workers are covered by that kind of pension plan. Take this paragraph from a recent research paper by David F. Babbel, finance and insurance professor at the Wharton School and Craig B. Merrill, professor of finance and insurance at the Marriott School of Management.

The economic implications for the average individual are significant. Under a traditional pension program, the retiree receives a set monthly income for as long as he or she lives. Under a defined contribution program, such as a 401(k) or 403(b) program, the amount of income you collect after retirement and how long you continue to receive it is anyone’s guess. There are no guarantees. In effect, the risk of retirement has been shifted away from the employer and the PBGC that insures the pension benefits, and placed upon the shoulders of the employee. Put another way, the financial risk of retirement has been transferred from those best able to bear it to those less knowledgeable and least able to bear it.

I think it’s a good idea to treat the pension plan as the equivalent of fixed income. Those regular payments make it a bond-like portion of your portfolio. “Too many investors forget that Social Security and pension benefits are fixed-income assets,” says Jack Bogle, the legendary founder of the Vanguard mutual fund.

In other words, your overall insight is sound and you can hike the equity portion of your 457 defined contribution pension plan. As an aside, I agree with you that you have time on your side with your equity investments. Brad DeLong, economist at the University of California, Berkeley and former assistant U.S. Treasury secretary during the Clinton Administration, recently made a compelling case for equities. He notes that stocks have been a terrible investment over the past decade, and that the recent 40% or so decline may not be the end of the bad news.

Still, with a time horizon of one to two decades, he argues the math favors stocks. “At the moment, the yield-to-maturity of the 10-year US Treasury bond is 3.76 percent. Subtract 2.5 percent for inflation, and you get a benchmark expected real return of 1.26 percent. Meanwhile, the earnings yield on the stocks that make up the S&P composite is fluctuating around 6 percent: that is how much money the corporations that underpin the stocks are making for their shareholders…. Thus, the expected fundamental real return on diversified US stock portfolios right now is in the range of 6 percent to 7 percent.

The whole article is well worth reading.

As for your traditional pension, a few risks to keep in mind. The insight that it’s a bond like part of your portfolio doesn’t tell you how much to have in stocks and bonds. For another, inflation can erode the value of that pension. While many government defined benefit plans do increase the payout along with increases in inflation, not all do. Almost all private sector traditional pensions don’t take inflation into account. Check out how your pension deals with inflation. I would consider adding Treasury Inflation Protected securities or TIPs to an overall portfolio.

In addition, I wonder if the pension plan should be treated as the equivalent of a corporate bond. After all, many public and private sector pensions are under financial strain and there is always the risk that benefits could be cut into the future.

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