What is the best investment vehicle for retirement

Are pension entitlements a bond?

Investors should not only summarize the assets they own, but also group them according to their function. Anyone who has taken out capital-forming life insurance, for example, can afford to have a higher share quota in their custody account than an investor who has no life insurance. Because life insurance policies in their classic version have a bond-like profile - they bring annual coupons (which are reinvested) and a minimum amount is paid out at the end of the term. From a functional point of view, life insurance policies are therefore bonds.

Conversely, supposedly conservative investment vehicles such as diversified bond funds or defensive mixed funds can turn out to be the proverbial wolves in sheepskin. In view of the low level of returns on the bond markets, fund managers have often added increasingly risky securities to what are actually defensive investments. Often, high-yield bonds or structured bonds such as ABS can be found among the holdings of these funds. That doesn't have to be a bad thing, but it does lead to changed risk-return profiles that investors need to know about.

But the realization that no portfolio is an island leads to even more far-reaching consequences. Not only do you need to include property ownership and occupational retirement provision in the equation, but also statutory pension and human capital. For many people who are about to retire or who have already retired, the statutory pension is the most important item on their balance sheet. The gross pension level in Germany is currently 46 percent of the most recent income. This is significantly less than what was last seen in working life, but it is “safe” - in the sense of a steady stream of income. (Although this supply quota will gradually decrease over the next few years, it is likely to remain the largest source of income for German pensioners in the medium term at around 40 percent.)

Conversely, most young people have only acquired low pension rights. Most of them are also unlikely to have saved any significant wealth. The most important asset they own is their human capital. But how is that to be assessed? That depends very much on the individual situation, but two rules of thumb can be formulated: Anyone who works in a cyclical industry should rather allocate their human capital to the stock market. This means that the rest of the portfolio should be conservative. On the other hand, anyone who works in an industry that is little dependent on the ups and downs of the economy is moving in the direction of bonds. Those who work in the civil service as civil servants have fully reached the bond segment. He cannot be terminated and his income stream is secure. This means that the securities portfolio can be more stock-heavy. In a nutshell, bankers should buy bonds, teachers should buy stocks.

Bogle: Pension offers coupons and also inflation protection 

This holistic portfolio structuring is not without controversy, but financial planners will typically proceed in this way. Jack Bogle, the founder of US fund house Vanguard who died in January 2019, has also argued that investors should consider annuities as part of the bond component of their portfolios. Pension payments are similar to income distributions. He specifies that they are comparable to an inflation-linked bond because they are adjusted for inflation. (In Germany, this connection is indirect, since pension development is linked to wage development.) As a result, pensioners could weight stocks a little higher than their personal asset allocation actually allows, according to Bogle.

David Blanchett, Head of Retirement Research at Morningstar, tends to be in favor of such an approach. “The social benefits are a government bond and part of a person's total assets.” Therefore, they should be viewed in the portfolio as a bond-like asset. A paper co-authored by Blanchett and Paul Kaplan shows that an individual's total asset allocation, fixed assets, and pensions, benefits, and human capital is one of the strategies consultants can use to increase their clients' income streams in retirement . 

Or is it not a bond? 

But not all experts agree that the pension should be treated as a bond. Some experts admit that social benefits were similar to a bond in that they promise regular (partially inflation-adjusted) cash flows. However, the statutory pension has no due date; payments will continue as long as the beneficiary is alive. That makes the matter extremely unsafe. Social benefits in the event of premature death are far less valuable than for a 95-year-old who has been drawing a pension for 30 years.

Depending on the start of retirement and length of life, the value of the benefits that a person receives varies by several hundred thousand euros. This makes social benefits a difficult asset to value, which in turn complicates the percentage of pension that is included in the portfolio allocation.

Determining the actual value of pension benefits is made even more complicated by the risk of benefit cuts for younger generations, as can be expected in Germany by 2030. If the service level is reduced, the value of the services could turn out to be a lot lower than calculated in advance.

Even from a more fundamental point of view, critics say that benefits should not be viewed as part of an investor's retirement portfolio because those receiving benefits would not have the same degree of control as holders of other assets: you can't choose the due date or the interest rate, you can you cannot decide how risky this income stream will be and thus receive a higher risk premium, you cannot replace your income stream with another (as with an exchange of securities), you cannot sell the income stream, you cannot request a lump sum payment and if you have died no capital flows into the estate (as is the case with insurance companies).

There are many implementation issues 

Other financial planners argue that one of the top reasons not to think of the statutory pension as a bond has something to do with behavioral finance. One of the main advantages of bonds is that they act as a counterbalance for the riskier segments of the portfolio - bonds usually go up, or at least don't drop as much, when stocks go down. This in turn helps ensure that investors do not panic if their equity investments collapse, because their portfolio as a whole is relatively stable through the crisis.

Using an asset allocation model and considering annuity as a bond, the portfolio can handle a much larger stock allocation. But many investors should not calm themselves down in a crisis by offsetting their future pension claims against current loss positions on the equity side; future pension flows are simply not physically visible in the portfolio.

This is why our pension expert Blanchett warns that considering the bond-like characteristics of pension payments does not automatically result in a higher equity weighting. The fact that annuity payments are similar to a bond does not necessarily mean that one should be more aggressive in their portfolio.

Presumably, many financial planners are likely to adopt a hybrid approach. Even though the annuity is not viewed as part of the bond quota, higher equity weights would still be possible. Financial planners can look at the present value of benefits and pensions and consider what the retired person might need to cover their living expenses. If a sufficiently high income requirement were determined to cover the costs, an increase in the equity quota would be an option.

But in the end these sober considerations lead to questions such as the personal circumstances of the investors, risk-bearing capacity and risk preferences. All-inclusive solutions are therefore out of place - but the realization that a portfolio is not an island and that other assets, both tangible and intangible, must be included in the calculation. Anyone who has reached this intellectual starting point has at least taken the first right step towards a holistic view of their financial situation.

This post is part of the topic week on bonds and bond funds 2019. Here you can find the overview article, which also links to all articles.

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