How pensions play into your portfolio

Have future topics for the Mole to address? E-mail him at themole@moneymail.com.

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

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NEW YORK (Money) -- Question: How do I view Social Security and my pension as a part of my overall financial picture?

The Mole's Answer: Yours is a very savvy question. Let me first describe what a pension is, and then I'll tell you how I take them into account for my clients.

A pension is a type of retirement plan where the employer guarantees a certain payment to the employee regardless of how the investments of the employer perform. For example, say the company promises you $1,000 a month for the rest of your life and will increase this amount with inflation. The technical term for this type of retirement plan is known as a defined benefit plan, as the benefits to the employee are defined up front.

While there are tens of millions of people still covered by these types of retirement plans, most employers now opt for what are called defined contributions plans. The two most common are the 401(k) plan and the similar 403(b) plans for nonprofit companies. The main difference here between these plans and the pension plan is that the employer defines what they will contribute and the employee takes on the responsibility and the risk for the investments. Not surprisingly, employers like this plan better as it lowers the company's risk.

Social security benefits are payments from the government based on the amount we paid in over the years. These payments generally increase each year, partially driven by inflation.

I tell my clients to think of pension and social security payments as a bond-like fixed income part of their portfolio. Combine them with your bonds and other "safe" investments when you decide how to allocate your portfolio.

But the question is, how do you put a value on them? Well, that depends on three things: the amount of the fixed payment, whether or not the payment increases over time, and the number of years you expect to receive the payment.

Take an ultra-simple situation of a 65 year old female that has the following:

• $1,000 a month pension, increasing with inflation.
• $431 a month in social security.
• $250,000 investments.

According to the government actuarial tables, the average 65 year old female will live another 20 years (vs. only 17 for us genetically defective males). So I take these assumptions and estimate how much they would have to pay in today's dollars. At current interest rates, I estimate the values of the two cash streams as follows:

• Pension - $175,000
• Social Security - $75,000

So now I value this fictitious client's fixed income value at roughly $250,000. I combine these with their portfolio of $250,000 for a total of $500,000.

Allocating assets between fixed income and equities is dependent upon two things - the client's need to take risk and the client's willingness to take risk. I always tell clients to pick an allocation target and stick with it. Never freak out in a bear market.

It's important to note, however, that this client already has half of her $500,000 portfolio in fixed income between her pension and her social security payment. Thus, if she put half of her remaining investments in fixed income, she now has only 25% of her portfolio in the stock market ($125,000 / $500,000).

My advice: I recommend that you think of these monthly payments as a part of the fixed income portion of your total portfolio. Like any fixed income investment, you have to take into account the risk of these payments. All pensions are generally much safer than stocks but a pension from the government is probably more secure than a pension from an airline. Finally, it's no secret that social security is in trouble and there is no guarantee that Congress may change things there. Much like the stock market tomorrow, I make it a practice not to predict what Congress might do.

One key advantage of thinking about these payments as part of your portfolio is that it gives you some mental discipline to stay in the market. Knowing that a larger portion of your nest egg is fixed and relatively safe, you're more likely to stay the course rather than panic and sell at the bottom of the bear, as I've seen people do so many times.

The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail themole@moneymail.com.