- The expected number of years the payments will last—for instance, if the payments are to last for your life, use your current life expectancy, and
- An expected interest rate equal to the current rate paid by a Treasury bond with a maturity equal to the number of years the payments will last.
- If you don't count your payment stream in your asset allocation calculation, you would invest $600,000 in stocks and $400,000 in fixed income. While this represents a 60% commitment to stocks if you exclude the payment stream, it represents only a 47% commitment to stocks ($600,000 divided by $1.28 million) if you include the payment stream.
- If you do count your payment stream when determining your asset allocation, a 60/40 stock/fixed-income allocation would mean you would invest roughly $768,000 in stocks (60% of $1.28 million), and $232,000 in fixed income (40% of $1.28 million, less the $280,000 present value of the Social Security and pension plan payments).
- Use the estimate for "big picture" asset allocation decisions only—your first asset allocation decision among the major asset categories. Don't use it for your annual rebalancing decisions, where the imprecise nature of the valuation could cause you to make big and unnecessary changes to your portfolio.
- Don't use the estimate for distant and uncertain pension and Social Security benefits—for example, if you are young and not yet vested in a pension plan, or are uncertain about future Social Security payments. The uncertainty of full vesting (and Social Security's future) makes the valuation process too murky, and therefore meaningless.
- If your annual payment amounts change for any reason, you should recalculate the present value of the stream of payments and reevaluate where you stand.
- Remember that interest rate changes can affect the valuation. For that reason, you should treat the figure as an estimate rather than a pinpoint accurate number; don't worry if your target allocation is off by a few percentage points due to interest rate changes.
- Remember that as you age, the valuation of the payment stream will decrease as your life expectancy decreases. That means that to stay on target, you may need to increase your other fixed-income holdings. This is appropriate, but once again, do it only for the big picture rebalancing—a revaluation every five years is sufficient.
- You should also use your judgment when contemplating changes. For example, if you are in the latter stages of your retirement and your life expectancy is very short, you may not want to decrease your stock holdings—at this stage, you may be investing more for the benefit of your heirs than for yourself.
How to Value a Stream of Payments
Your portfolio may have a much larger pot of assets than your valuation figure reflects.
How can a large pool of assets possibly be overlooked in a portfolio valuation? It occurs when those assets are hard to put a number on. And among the most difficult assets for retirees to assign a number to are any guaranteed steady payment streams—the most common being defined-benefit pension plan and Social Security payments. Other examples include immediate annuity payments, income payments from trusts, and even (should you be so lucky) annual payments from winning the lottery.
Why should you include these assets in a portfolio valuation?
The reason is more important than simply being able to mentally run your fingers through all of your pennies. And it has to do with the all-important issue of determining an appropriate asset allocation—in particular, your allocation among the three major asset categories: equities, fixed income, and cash.
When you make an asset allocation decision, you should match the investment characteristics of the various asset categories to your own personal return goals and risk preferences in a manner that will maximize return and minimize risk. If you miscount your investment portfolio, you may wind up with an asset allocation that does not really meet your needs.
A steady stream of income payments that is guaranteed to last over many years would represent a fairly substantial chunk of your portfolio if you included its present value when totaling up your investment portfolio—and it all would "count" as a fixed-income asset.
Retirees who don't include these payments in their calculations when determining an appropriate asset allocation will end up with portfolios that are much more heavily tilted toward fixed income than they most likely need. The resulting portfolio would probably be underinvested in stocks, with lower growth prospects and more exposure to inflation.
How can you put a value on a stream of income payments you are currently receiving?
The calculation is actually relatively simple.
To estimate the present value of any stream of future periodic payments, you simply multiply the current annual payment by the present value annuity factor in Table 1.
Table 1. Estimating the Present Value of a Stream of Payments | |||||||
Years | 4% | 5% | 6% | 7% | 8% | 9% | 10% |
5 | 4.4 | 4.3 | 4.2 | 4.1 | 3.9 | 3.8 | 3.7 |
10 | 8.1 | 7.7 | 7.3 | 7.0 | 6.7 | 6.4 | 6.1 |
15 | 11.1 | 10.3 | 9.7 | 9.1 | 8.5 | 8.0 | 7.6 |
20 | 13.5 | 12.4 | 11.4 | 10.5 | 9.8 | 9.1 | 8.5 |
25 | 15.6 | 14.0 | 12.7 | 11.6 | 10.6 | 9.8 | 9.0 |
30 | 17.2 | 15.3 | 13.7 | 12.4 | 11.2 | 10.2 | 9.4 |
35 | 18.6 | 16.3 | 14.5 | 12.9 | 11.6 | 10.5 | 9.6 |
40 | 19.7 | 17.1 | 15.0 | 13.3 | 11.9 | 10.7 | 9.7 |
The annuity factor chosen should be the one that corresponds with:
As an example, let's assume that you are currently receiving pension and Social Security payments that total about $20,000 annually. If your life expectancy is 25 years and the rate paid on a 25-year Treasury bond is roughly 5%, the corresponding annuity factor is 14.0.
Multiplying your $20,000 in annual payments by the 14.0 annuity factor produces an estimated present value of $280,000.
This $280,000 should be included in your investment portfolio and treated as if it were a fixed-income asset when making asset allocation decisions.
[For very long horizons—40 years or more—the stream of payments will come close to being a perpetual stream. In these instances, you can use a quick-and-dirty calculation that doesn't require a table: Simply divide your annual payment by the long-term Treasury bond rate. For example, if your annual payments were $20,000 and you used a 5% long-term rate, the estimated present value of your payment stream would be $400,000 ($20,000 ÷ 0.05).]
You can see from the example that the payment stream can add up to a fairly substantial asset.
Here's a quick look at how "counting" that asset can impact your asset allocation.
Let's assume you have settled on an asset allocation that consists of 60% stocks and 40% fixed income; that your investment portfolio excluding the current value of the annual payments is $1 million; and that your total portfolio value including the payment stream is $1.28 million.
You can see from the example that the calculation will generate a precise number. But even though the number is precise, the approach merely produces an estimate. First, one of the "inputs" includes an estimate of how long you will receive these payments—obviously a best guess, and a number that changes as you age. Second, the other "input" is based on current interest rates; as interest rates change, the value of your stream of payments will change—when interest rates rise, the value will fall, and when interest rates drop, the value will rise. For that reason, it is important to understand when it is useful—and when it is not appropriate.