Last month’s column “18 Social Security Surprises Facing Advisors, Clients” generated some interesting e-mails. A few advisors asked similar questions about how to treat Social Security and pensions when constructing a portfolio. Their premise is basically this:

Social Security is an income stream that has value, so shouldn’t that value be accounted for when constructing a portfolio?

The answer is much more often “No” than “Yes.”

Why “No”?

Some readers were struggling with how to calculate the present value of the Social Security income stream. They would then use that figure as part of the client’s fixed-income allocations. I was asked what discount rate I use and how long I assume the income to last. Some suggested various rates based on Treasury yields or bond indexes. Some suggested various actuarial tables and online tools to assess life expectancy.

I don’t subscribe to this approach and I believe few advisors do. Accounting for Social Security as a bond can be problematic in many ways. First, Social Security bears little resemblance to a bond. 

An income stream from a bond continues until maturity. Social Security stops at the recipient’s death. 

A bond owner can sell or gift the bond. By law, no one can sell their Social Security payments or gift payments not yet received.

A bond owner’s heirs can continue to receive the income until maturity or leave the bond to their heirs or sell the bond on the open market. Not so with Social Security.

Second, a few readers were concerned that allocating the present value of Social Security would push the actual investment portfolio toward equities. They are right to be concerned. Few people, and fewer retirees, are comfortable with a portfolio laden with stocks. 

From a behavioral standpoint, the more volatile a portfolio, the more likely the client is to suffer severe losses and the more likely they will panic. Even in the absence of a dire market environment, the “normal” volatility can cause clients to lose a lot of sleep. 

The PV number derived from Social Security is simply not likely to counteract their concern. Many people can’t conceptualize present value in the first place. Moreover most people will only relate to Social Security as a monthly check. 

You tell your client “Yes, the account is down X percent, but your Social Security is worth $200,000 by our estimates so you are not really down by that much.” 

My guess is the response will be a combination of, “What are you smoking?” and “Fine, give me my $200,000.”

Their attorney might not like your response, either.

From a portfolio management standpoint, an all-equity portfolio eliminates rebalancing. With little or no cash and fixed income, instead of buying when prices have dropped, the client has to just sit and take it. This can make the client feel helpless and increases the chance they will panic out of the markets. 

Mathematically, the added volatility is often not worth the additional risk. It is not uncommon to run Monte Carlo simulations and find that while very aggressive portfolios have higher expected returns over long periods of time, the client's success rate does not improve markedly or at all. 

Higher volatility means more frequent and more severe declines. A deeper look at the simulations often reveals that the volatility causes failures to appear earlier. More frequent and severe losses from an aggressive portfolio increase the odds that, to avoid failure, clients will need to make spending cuts, sooner and deeper than they would have had to otherwise. 

No. Social Security should not be treated as a bond. The payments are received for life, not a specific term. Payments are increased to offset the higher cost of living over time.

For a married couple, payments are reduced but continue for the life of the widow or widower and cease upon the widow/er’s death.

There is no accessible value to put on a client’s balance sheet and there never will be.

Social Security is definitely not a bond. It is an inflation-adjusted immediate annuity with a survivor benefit.

However, Social Security has some quirks that make it different than a commercially available annuity.

Taxation of a commercial annuity is based upon an “exclusion ratio” that can make a portion of the payment non-taxable until the basis has been fully paid out. Social Security is taxed based upon a “combined income” which is recalculated each year. Combined income is Adjusted Gross Income + ½ Social Security benefits + non-taxable interest. 

If combined income is below $25,000 for an Individual filer or $32,000 for joint filers, Social Security is not taxed. If it exceeds $34,000 and $44,000 respectively, up to 85% of the benefits are taxable.

You can get a commercial annuity covering two lives with just about anyone. The payment amount is based on the respective ages of the income recipients.

The Social Security survivor benefit is payable only to certain people. Generally this is a surviving spouse, some surviving ex-spouses, minor children or children disabled before they turned 22. The payment amount is based upon the wages history of the deceased and is adjusted based upon the recipients age. Payments can be zero for a time (under age 60 not disabled or caring for deceased’s minor or disabled children).

For married couples, the survivor gets the larger of their own retirement benefit or the retirement benefit of the deceased, whichever is larger, not both. The survivor benefit to a surviving spouse will be between ½ and 2/3rds of what the household was receiving before the death. 

If A’s retirement benefit is $2,000/month and B’s is also $2,000, the household total is $4,000.  When either dies, the survivor’s benefit will be $2,000 – a 50% cut.  If either A or B was receiving anything less than the other, the survivor benefit becomes the larger of the two, netting a reduction of less than 50%.

However, if one of the spouse’s retirement is low enough, that spouse could have been receiving a spousal benefit of up to one-half the higher-earning spouse’s retirement benefit. So, say A’s retirement benefit is $100/month and B’s is $2,000. Depending on the ages involved, A could get a spousal benefit of up to $1,000 for a household total of $3,000.  At the first death, only the $2,000 continues  – a one-third reduction.  

Nonetheless, the proper way to account for Social Security is not as an asset for a portfolio or a balance sheet, but as an income stream from an inflation-adjusted immediate annuity. The portfolio should be constructed to generate whatever cash flow is necessary to supplement Social Security to meet a client’s spending needs and accommodate their risk tolerance and preferences.

There are hundreds of studies and countless articles written about how long portfolios will last given various spending rates. Heck, I’ve written dozens myself.  All of them start with what cash flow needs to be generated.

If a client needs $X a month from a portfolio in addition to Social Security, pensions, and whatever other income sources a client has, then the portfolio should be designed to generate that cash flow and adapt as cash flow changes over time.

As I alluded to at the beginning of this piece, yes, Social Security has value but planners may put their clients in a weaker financial position if they calculate its present value and use that figure ineffectively. Rather, planners are more likely to help clients by maximizing the value of Social Security’s annuity characteristics through good claiming decisions and supplementing the client’s benefits with smart portfolio construction, tax planning, prudent portfolio design and behavior management. 

Dan Moisand, CFP, has been featured as one of the America’s top independent financial advisors by numerous national publications.  He practices in Melbourne, Fla. You can reach him at [email protected]