How to calculate the worth of a fixed income product?

[Deleted User]

Linton said:

Deleted_User said:

I think it should be included in asset allocation.  Lets take an extreme case of someone with 100k per year DB income and 100k DC pension.  How should the latter be invested?  In my mind there is no doubt that it should all go into equities because the individual’s finances can withstand equity fluctuations without blinking an eye.  

This isn’t a hypothetical example; families with large DB pension provision tend to be way too conservative with investable portion which ends up costing them in the long run.  Same as young people who ignore salaries, which is effectively a fixed income source.  So, the real question isn’t “can I sell my annuity for GBP in the pocket?”  Its “How does it impact my ability to withstand market fluctuations?” 

Another example: X is selling some of his bonds to buy an annuity. Does it mean he now needs to sell equities and buy bonds to get back to 60/40?  No way. 

Could this approach end up costing the individual because of behavioural problems? Of course. But having unreasonable amount of FI because of ignoring DB/state pension is a behavioural problem too.  Saying “lets make a mistake to avoid future mistakes” does not make sense to me. 

The other way to look at it, is by focusing on the total size of your cash flow stream.  If your needs are mostly covered through DB/state pension income, then your free funds should be in equity. If your income is 90% dependent on your DC pot and you only just have enough then you need lots of FI as you can’t withstand fluctuations. But ignoring DB income is always the wrong answer.

Personally I don’t count DB pensions as part of my net worth but I do consider them as fixed income.  For purposes of asset allocation I do x25, but the actual number doesn’t matter. Its not a precise science.  And I am not getting any DB income yet, but once I do the asset allocation will be changed to reflect that. 

If you need your investible assets to produce a small income to supplement your guaranteed income why not just focus on that?  You should not need to invent extra "bonds" so you can tick the 60:40 box.  60:40 may be appropriate for a particular set of circumstances, it's not a rule that must be obeyed with the facts adjusted to make it so. With a DB pension modelled as a very expensive Index Linked Gilt you may only be able to meet the 60:40 value if you leveraged your equity!   No, just devise an appropriate allocation for the requirement,

It seems to me that if you have more assets than required to support your lifestyle that is an opportunity for derisking rather than one for accumulating even more money that you dont really need.

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

Linton

Deleted_User said:

Linton said:

Deleted_User said:

I think it should be included in asset allocation.  Lets take an extreme case of someone with 100k per year DB income and 100k DC pension.  How should the latter be invested?  In my mind there is no doubt that it should all go into equities because the individual’s finances can withstand equity fluctuations without blinking an eye.  

This isn’t a hypothetical example; families with large DB pension provision tend to be way too conservative with investable portion which ends up costing them in the long run.  Same as young people who ignore salaries, which is effectively a fixed income source.  So, the real question isn’t “can I sell my annuity for GBP in the pocket?”  Its “How does it impact my ability to withstand market fluctuations?” 

Another example: X is selling some of his bonds to buy an annuity. Does it mean he now needs to sell equities and buy bonds to get back to 60/40?  No way. 

Could this approach end up costing the individual because of behavioural problems? Of course. But having unreasonable amount of FI because of ignoring DB/state pension is a behavioural problem too.  Saying “lets make a mistake to avoid future mistakes” does not make sense to me. 

The other way to look at it, is by focusing on the total size of your cash flow stream.  If your needs are mostly covered through DB/state pension income, then your free funds should be in equity. If your income is 90% dependent on your DC pot and you only just have enough then you need lots of FI as you can’t withstand fluctuations. But ignoring DB income is always the wrong answer.

Personally I don’t count DB pensions as part of my net worth but I do consider them as fixed income.  For purposes of asset allocation I do x25, but the actual number doesn’t matter. Its not a precise science.  And I am not getting any DB income yet, but once I do the asset allocation will be changed to reflect that. 

If you need your investible assets to produce a small income to supplement your guaranteed income why not just focus on that?  You should not need to invent extra "bonds" so you can tick the 60:40 box.  60:40 may be appropriate for a particular set of circumstances, it's not a rule that must be obeyed with the facts adjusted to make it so. With a DB pension modelled as a very expensive Index Linked Gilt you may only be able to meet the 60:40 value if you leveraged your equity!   No, just devise an appropriate allocation for the requirement,

It seems to me that if you have more assets than required to support your lifestyle that is an opportunity for derisking rather than one for accumulating even more money that you dont really need.

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  Treating  income as a bond also will add its own distortions.  You model a DB pension with an index linked gilt. and fixed income as a standard gilt.  What happens when bond interest rates change so you need more or less wqealth in your "bonds". Do you change your equity %?

JohnWinder

What a great discussion. It suggests to me to look at your assured income both as bonds and not as bonds, giving you different views of the same environment to enrich your understanding. A couple of observations...

Only the purists think a 60/40 mix means 40% are in the lowest risk government bonds which is the equivalent of your pensions. So if you're a believer in high risk bonds as part of your '40', factor that in.

If you're a believer in asset allocation rebalancing, and you count your pensions as part of your '40', your pensions are not available for rebalancing when equities crash.

Two broad schools of retirement investing are the liability matching portfolio (LMP) approach and the probablistic approach. With the latter you set an AA to suit your risk tolerance and spending needs, accumulate enough for a SWR, and that's it. In which case I think you'd be viewing your pensions as bonds - safest possible.

With the LMP approach you match your consumption liabilities with safe assets that will meet your needs, and then the rest of your assets either: go into a very risky portfolio which can fail with no consequences or flourish and you travel first class despite having budgeted for economy class; or go into a very low risk portfolio and you express the attitude 'I've won the game now, no point continuing to play'; or go into something in between.

mark55man

Malthusian said:

<.. snip ..> People only take a holistic view while everything is going up, when markets start falling they compartmentalise.

Great conversation, but - especially after an unexpectedly good day on my hi risk portfolio (on top of a DB provision and a more sedate corporate DC) - this was just what I needed to read and probably the most profound thing I've seen this year. steady as she goes

Secret2ndAccount

Deleted_User said:

I think it should be included in asset allocation.  Lets take an extreme case of someone with 100k per year DB income and 100k DC pension.  How should the latter be invested?  In my mind there is no doubt that it should all go into equities because the individual’s finances can withstand equity fluctuations without blinking an eye. 

This isn’t a hypothetical example; families with large DB pension provision tend to be way too conservative with investable portion which ends up costing them in the long run.  Same as young people who ignore salaries, which is effectively a fixed income source.  So, the real question isn’t “can I sell my annuity for GBP in the pocket?”  Its “How does it impact my ability to withstand market fluctuations?”

Another example: X is selling some of his bonds to buy an annuity. Does it mean he now needs to sell equities and buy bonds to get back to 60/40?  No way.

Could this approach end up costing the individual because of behavioural problems? Of course. But having unreasonable amount of FI because of ignoring DB/state pension is a behavioural problem too.  Saying “lets make a mistake to avoid future mistakes” does not make sense to me.

The other way to look at it, is by focusing on the total size of your cash flow stream.  If your needs are mostly covered through DB/state pension income, then your free funds should be in equity. If your income is 90% dependent on your DC pot and you only just have enough then you need lots of FI as you can’t withstand fluctuations. But ignoring DB income is always the wrong answer.

Personally I don’t count DB pensions as part of my net worth but I do consider them as fixed income.  For purposes of asset allocation I do x25, but the actual number doesn’t matter. Its not a precise science.  And I am not getting any DB income yet, but once I do the asset allocation will be changed to reflect that. 

Completely agree 100% with this post.

Your fixed income is a fixed income asset and should be treated as a fixed income asset.

[Deleted User]

Linton said:

Deleted_User said:

Linton said:

Deleted_User said:

I think it should be included in asset allocation.  Lets take an extreme case of someone with 100k per year DB income and 100k DC pension.  How should the latter be invested?  In my mind there is no doubt that it should all go into equities because the individual’s finances can withstand equity fluctuations without blinking an eye.  

This isn’t a hypothetical example; families with large DB pension provision tend to be way too conservative with investable portion which ends up costing them in the long run.  Same as young people who ignore salaries, which is effectively a fixed income source.  So, the real question isn’t “can I sell my annuity for GBP in the pocket?”  Its “How does it impact my ability to withstand market fluctuations?” 

Another example: X is selling some of his bonds to buy an annuity. Does it mean he now needs to sell equities and buy bonds to get back to 60/40?  No way. 

Could this approach end up costing the individual because of behavioural problems? Of course. But having unreasonable amount of FI because of ignoring DB/state pension is a behavioural problem too.  Saying “lets make a mistake to avoid future mistakes” does not make sense to me. 

The other way to look at it, is by focusing on the total size of your cash flow stream.  If your needs are mostly covered through DB/state pension income, then your free funds should be in equity. If your income is 90% dependent on your DC pot and you only just have enough then you need lots of FI as you can’t withstand fluctuations. But ignoring DB income is always the wrong answer.

Personally I don’t count DB pensions as part of my net worth but I do consider them as fixed income.  For purposes of asset allocation I do x25, but the actual number doesn’t matter. Its not a precise science.  And I am not getting any DB income yet, but once I do the asset allocation will be changed to reflect that. 

If you need your investible assets to produce a small income to supplement your guaranteed income why not just focus on that?  You should not need to invent extra "bonds" so you can tick the 60:40 box.  60:40 may be appropriate for a particular set of circumstances, it's not a rule that must be obeyed with the facts adjusted to make it so. With a DB pension modelled as a very expensive Index Linked Gilt you may only be able to meet the 60:40 value if you leveraged your equity!   No, just devise an appropriate allocation for the requirement,

It seems to me that if you have more assets than required to support your lifestyle that is an opportunity for derisking rather than one for accumulating even more money that you dont really need.

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  Treating  income as a bond also will add its own distortions.  You model a DB pension with an index linked gilt. and fixed income as a standard gilt.  What happens when bond interest rates change so you need more or less wqealth in your "bonds". Do you change your equity %?

Look, I don’t care about precision. Just make up a factor and apply it consistently.  I just want to know ballpark asset allocation to be within a certain band. Say, during retirement I am comfortable with a 60/40 portfolio.  And I need 50k to get by but prefer 100k, of which 50k comes from state pension and other DB.  It would be dumb for me to split the liquid portion of my portfolio (lets say its 2M)  60/40.  I mean I could, but its just leaving money on the table unnecessarily. 

And your point on DB assets being illiquid... So? I have some other fixed income instruments which are illiquid (eg GICs and Israel bonds).  I can’t sell them either when the interest rates change. Are you telling me they shouldn’t be counted as FI?  I have enough for rebalancing but its a different issue.

Heck, I have solar panels which give me a guaranteed income. I count that as part of my FI. If I didn’t, the psychological incentive would have been not to invest. Which would have been dumb; its a better source of FI than any bond.  

Secret2ndAccount

Malthusian said:

A State Pension has no value. ... It's like trying to value the air in your house.

Legally correct, but the income you receive from it has a real value after you receive it and a highly predictable value before you receive it.   The air in my house, btw, I find to be quite valuable.

You can't sell part of your State Pension and reinvest it in equities when the markets fall.

Using the 20x multiplier for a defined benefit pension already in payment is potentially misleading. The 20x figure is an arbitrary multiplier which HMRC uses for a defined benefit pension that is about to be drawn. But if yours is already in payment, yours is less valuable than 20x because you've got fewer payments to look forward to than somebody just about to draw one.

I can take out a loan and a life insurance policy, knowing that my pension will make the payments.

The value, to an individual, of a DC pension or some money in a SIPP is also incalculable because they don't know if they will live long enough to spend it. The cash-in value if they wanted to spend it all tomorrow is much easier to calculate, but as a lifetime asset, it's just as hard to estimate (perhaps harder is it's more prone to fluctuation). If I came here and said "all I have is a 500k pot for the rest of my life. How much can I take out monthly?", we would all agree that nobody knows exactly, and we would have different ways of coming up with a number.

Malthusian said:

Another reason it's not a great idea to try to include defined benefit pensions in an asset allocation exercise is that people will say things like "I have £500,000 in my private pension fund, and I'm middle-of-the-road when it comes to risk so I guess I should have 40% in bonds. But I have a State Pension and a defined benefit pension that total £18,500pa, and those are fixed income which is basically the same thing, so with £370k of bonds I've already got my 40% and should whack 100% of my private fund into equities." Then their equity fund falls by £200,000 and they panic and cash it in because they didn't actually have the stomach for 100% equities. People only take a holistic view while everything is going up, when markets start falling they compartmentalise.

Your point that equities can crash and we shouldn't panic and sell is valid, and has clearly resonated with some readers of this thread. However, it could be dropped in to at least half the threads on here and be equally relevant. Having £18500 in guaranteed income would make the average person much less likely to panic if their £130k in equities crashed, once again showing that the pension should be assigned a notional asset value.

DT2001

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

Linton - How would you treat it?

The idea of allocating a value is presumably to see where you are in relation to a perceived end goal, which is measured in terms of a multiple of your number. Using Mordko’s 25 x is, I think quite reasonable but
I wouldn’t value a DB/SP in allocating assets directly but it would influence the strategy for the rest of the portfolio and therefore the balance. (I agree with Mordko it is part of your FI).
As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

Linton

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

Linton - How would you treat it?

The idea of allocating a value is presumably to see where you are in relation to a perceived end goal, which is measured in terms of a multiple of your number. Using Mordko’s 25 x is, I think quite reasonable but
I wouldn’t value a DB/SP in allocating assets directly but it would influence the strategy for the rest of the portfolio and therefore the balance. (I agree with Mordko it is part of your FI).
As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

If for example someone has a £200K pot and needs to drawdown £5K/year to supplement guaranteed income to meet their desired standard of living it is irrelevent whether that guaranteed income is £10K/year or £50K/year. 

My approach is to start from what one wants to achieve....

Put aside £25K as cash to ensure any short term disruption to payment would be covered.  Put £25K in Wealth Preservation funds to cover the medium term.  The rest can now be invested according to one's long term objectives.  That could be high risk equity if one wanted to die rich.  On the other hand it could be lower risk investments with the sole aim of matching inflation and topping up the cash buffer as required.  If one has no real use for all one's current excess wealth, why try to get more?

In neither case would I consider whether I "should" be in x% equity because a US investment guru says so.  There is no x that is right for all people at all times.  All that matters is investing appropriately to meet your objectives whilst avoiding sleepless nights..

MK62

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!