FP Answers: Should I include a pension as part of my fixed-income holdings when determining my asset mix? (2024)

By Julie Cazzin with Allan Norman

Q: When calculating your asset mix, should you include a pension as part of your bond/cash holdings in a portfolio with a mix of 60 per cent in equities, 20 per cent in bonds and 20 per cent in cash? If you had a pension that was paying $450,000 a year, this would be equal to a $1-million guaranteed investment certificate (GIC) at four per cent. Am I thinking about asset allocation correctly? Or should I be taking something else into consideration? — McLeod

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FP Answers: It’s certainly fair to include things such as pensions, home equity, mortgage paydowns, business sales, inheritances, etc., as part of your asset allocation strategy. After all, asset allocation is an opinion-based approach to help investors determine how much of their money should be invested in various investment categories — traditionally stocks, bonds and cash — based on their future goals and risk tolerance.

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But keep in mind that asset allocation is not an exact science. If it was, every investor would be assigned the same portfolio allocation no matter which investment firm or questionnaire they used, and this isn’t the case. That’s because asset allocation is opinion based, meaning investors have some latitude with their portfolio asset allocation decisions.

A benefit of asset allocation is thinking through the process, which forces you to consider the characteristics of your investment and account holding choices regarding expected returns, tax characteristics, liquidity and volatility.

I can see you’re considering all the assets you’ll be using in your retirement to create an income. My guess is you’re thinking, ‘My pension is just like a giant GIC, so I should be able to substitute it in as part of my cash or bond holdings.’ Taking it a step further, you may also be thinking, ‘If I don’t include my pension, that may mean holding a lot of bonds in my portfolio and that might reduce my overall expected portfolio return.’

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Those are good thoughts and that is why it may make sense to include the other income-producing assets you own, or will own, as part of your final portfolio asset allocation.

I say “may” because we haven’t addressed investment risk. Intellectually, it is easy to be logical about asset allocation, but human behaviour is a different beast. How would you behave if your investment portfolio dropped 20, 30 or 40 per cent? Would you sell, or would you find comfort knowing your pension is sitting in the background?

I’ve seen people with pensions, or other seemingly conservative assets, shudder when markets drop. If volatility bothers you, including your pension in your portfolio allocation may not be a good idea. Volatility is often associated with risk, so the more volatile the investment, the greater the risk. However, volatility on its own is not risky. Risk shows up when volatility is combined with withdrawals, and the reason people make withdrawals is to support their lifestyle, or when they panic and cash out.

An alternative to asset allocation is asset dedication, which is about assigning a specific job to each of your investments. For example, equities are in a portfolio to protect future purchasing power by trying to grow faster than the rate of inflation. GICs may be included if you plan to make a big purchase within the next few years and capital protection is a greater concern than inflation.

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Asset dedication rests on the idea that volatility only becomes harmful when it creates risk. The risk is created when markets are down and investments have to be withdrawn or sold. The idea is to reduce the combined risk of volatility and withdrawals and maximize the growth potential of the remaining investments.

To do this, the portfolio is split into two or more sleeves. One sleeve is dedicated to providing an income through withdrawals, and the remaining sleeves are oriented towards portfolio growth. The income sleeve may hold cash, GICs, bonds or equivalents. The growth sleeves are often made up of alternatives and equities.

If retirement is many years away, an asset-dedication portfolio may suggest all growth sleeves and no money allocated to a conservative investment sleeve. Here is an example of how an asset dedication strategy might work for a retiree needing $40,000 per year from a $1-million investment portfolio. For simplicity, inflation and portfolio growth have been excluded.

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If the retiree has a view that most market recoveries take about five years then they may decide to set five years of investments in the income sleeve ($40,000 times five equals $200,000), plus any money needed for one-off purchases. If the stock market substantially declines, they know they’ve bought themselves five years’ time before they have to start drawing money from one of the growth sleeves.

This approach may appeal to investors looking to maximize returns, but the use of logic to calm investors’ natural fear of volatility is lacking. Asset dedication deals with this by suggesting that if you think it might take longer for markets to recover, then add more money to the income sleeve. If less, then add less money to the income sleeve. Again, these are opinion-based decisions.

There is no foolproof way to design an investment portfolio. My suggestion is to start with a plan. What do you want to achieve? How much money is it going to take? What are your investment options? What do you need to do to meet your objectives? Then update your plan and review the forecast every year to keep assumptions honest, build confidence in your plan and make small course corrections as needed.

Allan Norman provides fee-only certified financial planning services through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Investment Industry Regulatory Organization of Canada. Allan can be reached at alnorman@atlantisfinancial.ca.

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