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Retirement Planning > Spending in Retirement > Income Planning

Guaranteed Income Belongs on the Retiree Balance Sheet

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What You Need to Know

  • The balance sheet is an important way to communicate an investor’s net worth, but income streams like Social Security are often left out.
  • Guaranteed income can affect portfolio risk levels and guide withdrawal rates.
  • Here's a look at how advisors can estimate the value of guaranteed income streams.

Retirement is the largest purchase most people will ever make. Fortunately, a good chunk of that expense is covered from a variety of guaranteed income sources, such as Social Security retirement benefits.

Despite the importance of guaranteed income, though, in my experience most advisors view guaranteed income only as an income source and do not attempt to estimate its value to share with clients.

That’s a mistake.

While guaranteed income may not be an asset in a more traditional sense, like a 401(k) or IRA, it definitely has an economic value that should affect decisions around things like the appropriate portfolio risk levels and safe withdrawal rates.

While you may think the idea of estimating the value of guaranteed income is nuts, 67% of respondents in an incredibly unscientific poll I ran on LinkedIn thought that guaranteed income should be included as an asset on the balance sheet for retirees.

Therefore, if you’re already providing information about the estimated value of guaranteed income to clients, bravo! If not, hopefully this article can help change your mind!

Building a Better Balance Sheet

The balance sheet is an important way to communicate an investor’s net worth. A traditional balance sheet typically focuses on assets and liabilities that are relatively easy to value, such financial accounts, like a 401(k)s or IRAs, the home, etc.

Many assets that are included on the balance sheet typically are assumed to be income sources during retirement, especially financial accounts. For example, it is common to assume a retiree will draw down an IRA to fund spending in retirement. From this perspective financial assets are implicitly assumed to be both an asset on the balance sheet and income source during retirement.

While it is common to include guaranteed income as an income source during retirement (in a financial plan), the estimated value of guaranteed income is not typically included on a balance sheet, or even communicated to clients, based on my experience communicating this concept to advisors.

While I acknowledge that guaranteed income is not a traditional asset, it is possible to estimate the value of the benefits and how this value can affect a variety of retiree decisions. I’ll discuss three.

1. It can help clients better understand their true net worth.

Sure, guaranteed income isn’t as liquid as an IRA, but a retiree household with $50,000 in guaranteed income is a lot wealthier than one with $10,000 in guaranteed income, ceteris paribus.

2.  It should affect portfolio risk levels.

Guaranteed income is a relatively safe, bond-like asset. For example, Social Security retirement benefits are effectively an inflation-linked government bond. This means retirees may need a lower allocation to government bonds than traditional asset allocation models would suggest.

Additionally, overall risk levels for retirees can be higher among retirees with more guaranteed income given the bond-like nature of the asset, especially with respect to funding retiree consumption.

3. It should affect portfolio withdrawal rates.

Relatively speaking, the more of a retiree’s wealth that is in guaranteed income, the higher the potential portfolio withdrawal. This is because the potential impact of “failure” is lower.

For example, a retiree who gets 90% of her income from guaranteed income can have a higher portfolio withdrawal rate than one who only gets 10% from guaranteed income because the implications associated with portfolio shortfalls are very different.

Unfortunately, this is something that is not generally captured in financial planning tools that use metrics like the probability of success to define an outcome.

A balance sheet can be extended to include other assets and liabilities as well.  For example, a retiree could include other liabilities, such as the total estimated cost of retirement (i.e., retiree consumption).

It also would be possible to include the total expected value of human capital for individuals who still are working (along with pre-retirement consumption). While there are number of potential ways to do this, I’m most interested in advisors conveying an estimated value of guaranteed income, which is why I only focus on that for this piece.

Estimating the Value

There are two potential approaches that can be used to estimate the value of a given stream of guaranteed income.

First, determine the value of a comparable private annuity. For example, according to immediateannuities.com, the payout rate for a nominal, life-only immediate annuity for a 65-year-old man is approximately 6% as of May 24. This means it would cost around $330,000 to replicate a $20,000 nominal pension benefit, with no cost of living adjustment (COLA) for a 65-year old man.

Because there are no private annuities that offer benefits directly linked to inflation, assuming a 2% fixed COLA (for example) would be one way to approximate the value of Social Security retirement benefits.

Second, estimate its value using a present value calculation. To do this, estimate the term and a discount rate. The term can be either the individual’s (or couple’s) life expectancy or the actual individual mortality weights by age (if you want to get fancy.)

The discount rate should reflect the risk of the underlying payments. For example, Social Security benefits probably should be discounted using government bond yields or some other incredibly safe fixed income instrument.

I put together an Excel file on my website that approximates all this, but it definitely isn’t as complex as it could be.

It’s important to note these estimates don’t necessarily have to be overly precise (something’s better than nothing), and approximations can work just fine. For example, for the average 65-year-old, multiplying a Social Security retirement benefit by 20 is a decent estimate. Therefore, if total benefits for a household are $50,000, the approximate value of those benefits is around $1 million.

Guaranteed income may not be something many advisors commonly define as an asset; however, it clearly has an economic value. Therefore, estimating the value of guaranteed income, and sharing the information with clients (especially retirees), can result in better decisions and is something all advisors should be doing!


David Blanchett is head of retirement research for Morningstar Investment Management LLC. Views expressed are his own and do not necessarily reflect the views of Morningstar Investment Management LLC. This blog is provided for informational purposes only and should not be construed by any person as a solicitation to effect, or attempt to effect transactions in securities or the rendering of investment advice.