Pension Cash Flow? Get Bonds Anyway

LOS ALTOS, Calif. ( TheStreet) -- In recent years financial planners and investment advisors have written that the cash flow from a defined-benefit pension such as Social Security is mathematically the same as a bond, so a client's investment allocation must be adjusted for this hypothetical bond ownership.

This is wrong, because when you own a bond you can make a profit when rates go down -- because bond prices go up then. When a recession occurs, interest rates drop, making bond prices go up and stock prices go down. During that time the strategy is that you sell your bonds at a high price and use the cash to buy stocks at a low price. This is called rebalancing. You can't do that with a pension income stream.
The risk of a pension is that inflation can destroy value. Cash flow from a pension simply is not enough.

Thus a bondlike cash flow from a pension is not a substitute or proxy for owning a bond. (Try to ask Social Security if they will give you a lump sum payout instead of a monthly income stream!)

So if investors decided their pension income was the mathematical equivalent of a portfolio with a 40% bond allocation, they might be tempted to have portfolios with 100% stock allocation. During a stock crash, they would suffer from deeper losses and not have spare cash to buy more stock at low prices.

If a personal crisis developed where they needed to sell assets to pay for a major expense, they would have to sell stocks during a time the price was depressed, incurring more problems. When investors own a significant allocation of bonds, they can provide stability in portfolios -- allowing the investors a more reliable asset that can be sold to pay for major personal expenses.

The risk of a pension is that inflation can destroy its value; by contrast, owning bonds means investors can sell and invest in such things as a blend of inflation hedges, short-term bonds, TIPs and foreign currency denominated bonds.

The emotional aspect of retired people feeling financially secure because they are getting a significant pension income may cause clients to be more confident and flexible about risk tolerance, making the clients better able to withstand the emotional rigors of stock investing -- leading to a greater portfolio return (by taking on more risk), but that is something that can be measured only by personalized assessment of the client's psychology.

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