David Blanchett has a nice article at ThinkAdvisor on whether guaranteed income sources belong on a retiree’s balance sheet.
I agree with Blanchett that it’s a mistake for financial advisors (or retirees) to view guaranteed income as only an income source and not attempt to estimate its value. That said, in most cases, I would still leave it off of a balance sheet.
I think Blanchett is correct when he notes:
2. It [guaranteed income sources] should affect portfolio risk levels.
Guaranteed income is a relatively safe, bond-like asset. For example, Social Security retirement benefits are effectively an inflation-linked government bond. This means retirees may need a lower allocation to government bonds than traditional asset allocation models would suggest.
Additionally, overall risk levels for retirees can be higher among retirees with more guaranteed income given the bond-like nature of the asset, especially with respect to funding retiree consumption.
https://www.thinkadvisor.com/2021/06/01/guaranteed-income-belongs-on-the-retiree-balance-sheet/
For this reason, it is often wise to consider some estimation of guaranteed income source’s value when setting an asset allocation. The case is arguably made most clear when considering whether or not to use part of a portfolio to purchase an income annuity in retirement.
Suppose John has a $1 million IRA allocated to 60% stocks and 40% bonds. Further, suppose he is interested in purchasing a Qualified Longevity Annuity Contract (QLAC) at his maximum level of $135,000.
Because annuities have a risk profile very similar to bonds (with potential for even higher returns due to mortality credits), it would be a mistake, in this case, to then allocate the remaining portfolio ($865,000) based on the same 60% stock and 40% bond allocation. Rather, John should keep a $600,000 allocation to stocks and purchase the QLAC from his stock allocation, reducing his portfolio allocation to bonds to $265,000.
Without incorporating some value of the income annuity when determining John’s asset allocation, purchasing the bond-like QLAC from John’s IRA will result in his new portfolio looking like it is allocated roughly to 69% stocks and 31% bonds. However, by accounting for the value of the income annuity in his bond allocation, a truer picture (60/40) of his portfolio will be achieved.
Since I agree with Blanchett that there are cases where the value of a guaranteed income source should definitely be considered, why not include it on a balance sheet?
The answer is simply that, in most cases, including the guaranteed income source on a balance sheet can actually create greater confusion.
Consider, for instance, estate taxes. If Michael is single and has a $7 million portfolio with a pension that is estimated to be worth $5 million, putting that pension on his balance sheet may now give the impression that he has federal estate tax concerns given his $12 million estate (versus the $11.7 million exemption in 2021).
The reality, of course, is that Michael does not have any federal estate concerns – at least given his current portfolio size and estate tax exemption.
Similar complicating examples could be made for purposes of determining how much liability insurance to carry, ability to self-fund against long-term care risk, bankruptcy, and all sorts of other scenarios.
Therefore, adding the value of guaranteed income sources to a balance sheet can be helpful in some cases, but it is not helpful—and possibly even counterproductive—in other cases. I find that the asset allocation decision is really one of the primary contexts where including guaranteed income sources is most insightful, so I would account for guaranteed income sources when making asset allocation decisions, but in most other cases, I would leave the value of guaranteed income sources off of a balance sheet.
