How Should Nonportfolio Assets Affect Your Asset Allocation?

How many legs does your retirement "stool" have? If you're lucky, you might have three--the traditional retirement-funding stool that consists of Social Security, a pension, and your retirement assets. But more and more workers will have just two legs to rely on for their in-retirement cash flows: Social Security and their personal portfolios.

Setting aside the issue of whether a retirement portfolio plan can stand on two legs (I think it can, with some planning), another key question is how those nonportfolio assets, such as Social Security, should affect how you position your portfolio. If a healthy amount of your in-retirement income needs are being met by nonportfolio assets, does that mean you can reasonably maintain a more aggressive asset allocation with your investment portfolio? How should nonportfolio "assets" like whole life insurance and real estate holdings affect asset allocation, if at all?

Here's a look at some of the key "nonportfolio" assets that you might bring into retirement, along with how they might affect the asset allocation of your investment portfolio.

Social Security, Pensions, and Fixed Annuities On the one hand, these income sources have a lot in common with very safe assets in your investment portfolio: Their income is incredibly reliable, much like the income you receive from a gilt-edged bond; that income may also inflation-adjusted, as is the case with Social Security and some pensions and annuities.

But there are some significant differences, too. A big one is that they don't offer liquidity like investment assets do; you can't tell the Social Security Administration at the outset of your retirement that you'd like to take all of your money now, thank you very much. Nor do you necessarily know how valuable these assets will be to your financial plan, in contrast to a bond with a specific maturity date and fixed coupon attached to it. If you live a long life--or any survivors who are entitled to benefits do--these guaranteed lifetime income sources can be incredibly valuable assets. But their value would obviously be less over a shorter life span/payout period.

Is your head starting to hurt, thinking about what impact guaranteed lifetime income sources would have on your portfolio's asset allocation? Mine too. For that reason, I think the simplest way to incorporate lifetime income sources like Social Security, pensions, and fixed annuities into a retirement plan is to use them to reduce the amount that you'll draw from your portfolio. While they won’t directly influence your asset allocation, they will do so indirectly.

To use a simple example, let's say a retired college professor expects to spend $80,000 annually, and $60,000 of that amount will come from his pension. In that instance, he'd need to draw just $20,000 a year from his portfolio. Assuming he has a $500,000 portfolio and wants to use a Bucket strategy, he'd park two years' worth of portfolio withdrawals ($40,000) in cash and roughly eight years' worth ($160,000) in bonds. He'd begin retirement with 40% in safe assets (the $200,000 of his $500,000 portfolio he holds in cash and bonds) and the remainder in stocks. In other words, his hefty supply of fixed income allows for an aggressively positioned portfolio. That gets him to roughly the same spot as if he had considered his pension as a "bond," but does so in a more intuitive way.

Real Estate Investments At first blush, it might seem tempting to throw real estate investments (not the home in which you live) into the aforementioned "safe sources of guaranteed income" bucket. After all, real estate investments frequently kick off income that can be used to augment income from Social Security and pensions; many retirees own rental properties for just that reason.

But there are some notable differences. Income from real estate, in contrast with the aforementioned guaranteed income sources, has the potential for periodic disruptions--for example, if your tenant moves out, it could take a few months to find a new one. In addition, your real estate asset, because it's a single property in a single locale--could experience extreme price volatility. On the other hand, real estate ownership interests, in contrast to guaranteed sources of lifetime income, belong to your estate after you die; you could transfer the entire ownership stake to your heirs.

Those characteristics mean that real estate is neither fish nor fowl alongside your traditional investment assets. That can be a virtue, in that the price of your real estate may be relatively uncorrelated to your investments assets, but it also makes things complicated from the standpoint of asset allocation. I tend to think of real estate investments as a hybrid between an equity holding and a bond. Like a bond, it will tend to produce regular income that might even trend upward with inflation as you're able to push through higher rents. But that income flow can also be disrupted, much like a lower-quality bond or a dividend-paying stock. Real estate investments can also be illiquid and subject to extreme price volatility; you wouldn't want to be in the position of having to dump your property at a fire sale price. From that standpoint, it makes sense to think of your real estate ownership as a very long-term asset, similar to a stock or perhaps even more aptly a junk bond. As with equities or junk bonds in a bucket portfolio, you'd want to give yourself a nice long holding period to ensure that you would never have to sell in a downturn.

Business Ownership Interests Like real estate investments, it's wise to consider business ownership interests as higher risk than guaranteed income sources like Social Security, even if your stake in a private business is kicking off income. As with real estate, the cash flows from the business aren't guaranteed, and there's also the risk that the retiree would have to sell out of his or her position in a weak market environment, meaning he or she might have to take a big haircut on the position.

Of course, business ownership stakes can be structured differently, but I'd generally consider them as a higher risk, equitylike component of the portfolio. Because small businesses are an illiquid asset, individuals with significant business ownership interests should prioritize liquidity and safety elsewhere in their investment portfolios more than would be the case for other retirees. Their investment portfolios should also be positioned to reduce the idiosyncratic risk of those businesses. Not only should the portfolio downplay the industry in which the small business operates, but it should avoid big sector-specific and stock-specific risks in general. During the accumulation years, small-business owners should also prioritize investing in their investment portfolios as well as their businesses.

Variable Annuities Because they're invested in conventional assets like stock and bond funds, variable annuities can and should be considered part of your investment portfolio and be used to inform your total portfolio's asset allocation. (While you won't find data on VA subaccounts on Morningstar.com, you can usually find proxies without too much of a problem--mutual funds in similar categories run by the same firm managing your VA subaccounts. Those data will allow you to plug your VA holdings into Morningstar.com's Portfolio Manager and employ X-Ray functionality.) If and when the variable annuity is annuitized to create a fixed stream of income, those annuity payments can be used to reduce portfolio cash-flow needs accordingly, as discussed above in the context of fixed annuities.

Home Ownership Home ownership stakes make up a huge component of net worth for many households; in 2010, home equity accounted for 30% of the wealth in U.S. households. But just because your equity home is part of your net worth, that doesn't mean you should factor it into your asset allocation. In contrast with income-producing properties or traditional investments like stocks and bonds, your home doesn't generate any cash flow. It's a "use asset"; it's your home.

That's not to say home ownership should have no bearing on how you position your investment portfolio, though. If your home is a significant share of your net worth, it makes sense to diversify beyond real estate for the rest of your portfolio; purchasing income-producing properties and/or adding to real estate equity holdings would make your financial well-being overly reliant on the sector. (This paper takes a deeper dive into the topic of home ownership's effects on other parts of a portfolio.) And if a retiree takes out a reverse mortgage, he or she can factor it into cash-flow production right alongside Social Security and other guaranteed sources of cash flow.

Life Insurance Setting aside the questions of whether to carry life insurance into retirement and whether to purchase term life insurance or a permanent policy, how should you treat the cash value of any whole life insurance policy that you already own? In that instance, you can count the cash value on your books as a cash equivalent, since that amount can't lose in value and earns a fixed rate of interest.