Where Social Security Fits in Your Retirement Portfolio

Q. Can I consider Social Security the bond portion of my portfolio and invest a higher percentage of my savings in stocks? -- Michael H., Pittsboro, Ind.

A. Social Security does function somewhat like a bond in that it provides steady income (although unlike most bond payments, Social Security's payouts increase with inflation). So, in theory at least, it makes sense to factor in your Social Security benefit when deciding how to invest your savings in retirement.

As a practical matter, however, you need to be careful about how far you take this notion, as you could end up with a portfolio that many retirees might consider too risky.

Here's an example. Let's assume you retire at age 66 and that you need real, or inflation-adjusted, income of $60,000 a year, $20,000 of which will come from Social Security. And let's also say youhave $1 million in savings and that you divvy up that nest egg equally between stocks and bonds in order to have a reasonable balance between long-term growth and short-term protection against market setbacks.

If you think of Social Security only as a stream of income and forget about the fact that it's also kind of like a bond,then the issue you face boils down to how to get the rest of the income you need from your $1 million nest egg. If you go to an online retirement calculator, plug in savings of $1 million,an allocation of50% in stocks and 50% in bonds and assume a $40,000 initial withdrawal that is annually increased by inflation, you'll see that there's a roughly 80% chance your savings will last at least 30 years.

But this approach ignores the fact that Social Security also acts somewhat like a big bond.

Indeed, many economists would say that you don't just have $1 million in assets. You have $1 million, plus a "Social Security" bond that makes inflation-adjusted payments of $20,000 a year. They'd also say that by not taking that bond into account, you may be investing too cautiously, ending up with more in bonds than you should. In so doing, you may be giving up a significant amount of investment return, and extra retirement income.

You can argue about how to set the value of that Social Security bond. But in today's interest rate environment, William Meyer of Social Security Solutions, a firm that helps people decide when to claim their benefits, estimates its value would be roughly $500,000 for someone whose full retirement age for Social Security purposes is 66 and who begins collecting payments at that age.

Considered from this vantage point, you would have the equivalent of $1.5 million -- $1 million in savings, plus a Social Security bond valued at $500,000. Which means if you want to maintain an investment mix of 50% stocks and 50% bonds, you would put $750,000 of your $1 million savings into stocks.

The remaining $250,000 would go into bonds, which, combined with your $500,000 Social Security bond, would give you $750,000 in bonds overall, resulting in an effective 50-50 stocks-bonds split for the $1.5 million.

But here's the rub: If you look only at the actual assets you have access to -- that is, your $1 million in savings -- you've got 75% in stocks ($750,000 of your $1 million) and 25% in bonds ($250,000 of your $1 million). That's a pretty aggressive portfolio for a retiree.

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Meyer agrees that such a high stock stake would "freak out" a lot of people, as it's more prone to sizable setbacks. But he also argues that the higher volatility of such a portfolio shouldn't unduly upset you because you also have those guaranteed Social Security payments coming in every month regardless of what's going on in the financial markets.

So the value of that Social Security bond holds up even when the market is falling apart. Thus, if you take a broader view, your portfolio isn't as volatile as it may seem.

In a purely logical sense, he's right. But I'm also reminded of 19th century humorist Edgar William Nye's famous quote that "Wagner's music is better than it sounds." Which is to say that you can't always go by logic alone, especially when it comes to something like your lifetime savings. You've also got to consider the emotional and psychological impact of how you invest that money.

I think most retirees are going to focus on the account balance they can see, the $1 million, not the combination of that amount plus a hypothetical asset value they can't actually see, or tap into for that matter.

So even if they own the theoretical equivalent of a $500,000 Social Security bond, I'm not sure that most investors would be prepared to handle the volatility of a $1 million nest egg invested 75% in stocks and 25% in bonds if a 50-50 split is more their speed.

Besides, if your nest egg is all you have to get you through emergencies and absorb unexpected costs, it's important you don't unduly expose it to the vicissitudes of the market. After all, if that money runs out, it's not as if you can cash in a portion of your Social Security bond to pay for larger-than-expected health care expenses.

And while a $1 million nest egg invested in a blend of 75% stocks-25% bonds has roughly the same likelihood of generating $40,000 a year throughout retirement as a 50-50 mix does -- and could generate even more -- you run a larger risk of exhausting your savings if the market takes a dive early in retirement.

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That said, I could see situations in which factoring in Social Security might lead you to invest more aggressively.

For example, if Social Security, alone or combined with some other type of guaranteed income, such as a pension, covers so much of your living expenses that a big downturn in the value of your savings wouldn't force you to scale back your lifestyle, a more stock-heavy portfolio with the potential for higher returns could be a reasonable way to go.

Even then, however, tilting more toward stocks would make sense only if you also have the emotional and psychological tolerance to handle the potentially larger setbacks.

Bottom line: I think you should consider your Social Security payments when deciding how to allocate your savings between stocks and bonds in retirement. Ultimately, though, whatever mix you come up with for the actual savings you have in retirement accounts should be one that has a realistic shot of generating the income you need in retirement --and that you'll be comfortable sticking with even if the market nose dives.