No one would consider a defined-benefit pension to be a retirement problem. But when a significant slice of an investor’s retirement income will come from a DB plan, it can be a challenge to decide on the right asset allocation for the client’s personal portfolio.
Some people with a pension consider it to be a kind of fixed-income investment, and they argue they can afford to be much more aggressive with their RRSP and non-registered investments. Others take a completely different view and suggest the reliable income from a DB pension allows them the luxury of being more conservative. Who’s right?
Actually, both arguments have merit. An investor’s asset allocation must consider both the ability and the need to take risk. The first factor is largely a function of time horizon, but income security is also a factor: a senior public servant or tenured professor has more capacity for investment risk than a self-employed entrepreneur. Meanwhile, a client’s need to take risk depends primarily on the rate of return required to achieve his or her financial goal.
A reliable DB pension affects these two factors in opposite ways. On one hand, if the pension will provide enough income to meet day-to-day spending needs, an investor has an almost unlimited ability to assume risk with personal savings. Since a sharp decline in her investments would cause little hardship, an aggressive, equity-heavy portfolio might be appropriate. But on the other hand, that same client has less need to assume risk, since the pension makes it virtually certain she’ll reach her income goals whether her portfolio returns 2% or 8%.
Looking at the bigger picture
When clients are confused by this apparent paradox, it helps to frame the question for them: simply model the pension payouts as you would any other kind of income expected in retirement, including wages from part-time employment and government benefits such as CPP and Old Age Security. The pension income will obviously lower the amount of cash flow needed from other sources, which will reduce the client’s required rate of return on the personal portfolio.
At that point, you can begin the discussion about the ability and need to take risk and help the client decide which asset mix makes sense. This chat will touch on the third factor in the asset allocation decision: the willingness to take risk. If the investor can meet her goals with only a 30% or 40% allocation to stocks, she may be perfectly content with a low-volatility portfolio. But others in the same situation may decide they’re prepared to deal with the volatility of a portfolio with 60% or 70% equities with the goal of leaving a larger estate.
The final decision is up to the client, but when it’s presented in this way it becomes a relatively painless choice between two favourable outcomes.