If I Have a Pension, Should I Put Less in Bonds?
Your allocation to bonds depends on your future withdrawal needs
When managing retirement accounts, one critical decision you must make is what portion of your investments to put into stocks, and what portion to put into bonds. Historically, over longer periods of time, stocks have had higher returns than bonds, but with a lot of volatility. Bonds are more predictable but may deliver lower returns.
When you have a pension, you have a predictable, stable source of income.
Some financial advisors would then suggest that a pension fulfills the role of bonds in your portfolio, and so if you have a larger pension, you can be more aggressive with your investments and allocate more to stocks.
I say, it depends on a lot more than that. Your allocation to bonds should depend on your need for additional income from your investments, not on whether you have a pension or not.
How to Allocate Based on Your Income Needs
Let’s take a look at two retirees, who each need about $60,000 a year to live comfortably in retirement.
Retiree 1 – High Pension
Retiree 1 has $250,000 saved in his/her 401(k) plan and expects to have the following sources of income once retired:
- $45,000 per year from a pension
- $20,000 per year from Social Security
With $65,000 of guaranteed income per year, Retiree 1 has their expected expenses in retirement covered. This retiree does not need the $250,000 in their 401(k) plan for living expenses in retirement.
Their decision on how much to allocate to bonds should be based on expectations about rates of return and comfort level with risk.
Retiree 1 could play it safe, as they have no need to shoot for higher returns. Or, if Retiree 1 understands the natural ups and down of the stock market, they could allocate 100% of their 401(k) to stocks, and only withdraw funds after years with good performance.
Simply because they have a pension, it is not an automatic decision to allocate less to bonds. It is a matter of circumstances and personal preferences. The next retiree is in a slightly different situation.
Retiree 2 - Lower Pension
Retiree 2 also has $250,000 saved in his/her 401(k) plan, and expects to have the following sources of income once retired:
- $25,000 per year from a pension
- $25,000 per year from Social Security
With $50,000 of guaranteed income, Retiree 2 will need to withdraw $10,000 per year from his/her savings to have the $60,000 a year needed in retirement. $10,000 divided into a $250,000 account size equals 4%. If the investments are structured properly, withdrawing 4% a year is possible.
To accomplish this, Retiree 2 will want to follow a disciplined set of withdrawal rate rules which means allocating no more than about 70% to stocks and no less than 50%. This leaves between 30% and 50% allocated to bonds. Retiree 2 has a pension, but the decision on how much to allocate to bonds is determined by the job the money needs to accomplish – not by whether there is, or is not a pension.
Because Retiree 2 needs to rely on income from the 401(k) they do not have as much freedom in how to allocate the investments as Retiree 1 does.
Retiree 1 could earn nothing and still be okay. Retiree 2 needs the $250,000 to work for them and earn a decent return, but at the same time, they can't take too much risk and lose money.
Both retirees have a plan, and the plan helps show them the range of allocation options that fit their circumstances. Most retirees should decide how to allocate their investments by first making a retirement income plan that shows the future job the money will need to accomplish.
Let's dig a little deeper into how Retiree 2 could allocate a portion of their $250,000 to bonds.
How the Bond Allocation Might Work
Retiree 2 could invest a portion of their retirement money in bonds by purchasing a series of bonds where a specific amount matures each year. This is called a bond ladder. As they need to withdraw $10,000 a year, it would make sense to purchase $10,000 of bonds maturing each year for the first ten years of retirement.
That would result in about $100,000 allocated to bonds, which is 40% of a $250,000 account. Each year as the $10,000 matures it would be withdrawn and spent. This process of matching investments to the point in time where they will need to be used is sometimes called time segmentation.
The remaining $150,000 would be entirely allocated to stock index funds. Short term volatility would not matter, as the bonds would be there to cover current withdrawal needs. Thus there is plenty of time to wait out any down years in the stock market. Assuming stocks average at least 7% a year over the next ten years, they would grow enough that along the way Retiree 2 would sell stocks and buy more bonds to replenish the ones that matured and were spent.
For example, let’s assume one year later, the $150,000 portion allocated to stocks has gone up 7%, and so it is worth $160,500. Retiree 1 would sell $10,000 and use it to buy a bond that matures in ten years. Meanwhile, assuming Retiree 1 is retired, he/she would be spending the $10,000 from the bond that matured in the current year. In this way, Retiree 1 would create a pseudo "ten-year pension" where withdrawal needs were continuously covered for the subsequent ten years.
Conclusion? It Depends
Having a pension definitely brings additional security to your retirement years. But it doesn’t automatically mean you should change how you allocate your other investment accounts. Your investment allocation should be driven by your financial plan and the projected use of your funds.