How do you value your retired client's defined-benefit pension and Social Security income? Do you treat them as bonds in a client's asset allocation? If so, how do you price them?

Or, perhaps you leave these assets out of the portfolio asset allocation decision altogether. Defined-benefit pensions and Social Security benefits do not have par values and they do not have maturities. They only have an income stream that itself may be questionable.

The appropriate positioning of pension income and Social Security lies between these two extremes. Advisors can take into account anticipated cash flows from these illiquid and uncontrollable assets without attempting to calculate a precise present value. For planning purposes, they can consider the anticipated pension or Social Security cash flows in retired clients' monthly income as an offset to some portion of monthly expenses. The remaining monthly liabilities, together with risk preferences and desire for asset growth, will then determine the asset allocation model in the clients' retirement portfolios.

LIKE OR UNLIKE?

Defined-benefit pensions and Social Security income are like fixed income in several ways. They promise regular cash flows that are based on a fixed amount or an equation that is indexed to inflation. Both an employer pension and Social Security have a present value that can be computed, based on these future cash flows. This amount would be discounted at a rate based on default risk (that is, the risk that these cash flows would fail to occur). But that is where the similarity between the two ends.

Unlike bonds, pension payments and Social Security benefits have no maturity date. They do, however, have a termination date. The cash flows end when your client (or your client's spouse) terminates-literally-and there is no way to know when that will be. In addition, the par value paid at the termination date is $0. The value is gone.

Also, the risks in pension and Social Security benefits are unknown. An employer may file for bankruptcy and cut pension distributions. Government pensions may be reduced due to high budget deficits. We can all agree that Social Security for baby boomers and younger generations alike cannot remain at current levels, and even the Social Security Administration concedes this point. The unknown income cuts coming at an unknown date in the future make accurate valuations of these assets difficult, if not impossible.

LOOKING AT THE VARIABLES

Perhaps a bond analyst would use a high discount rate to adjust for the risk of employer bankruptcy and Social Security shortfalls. But what rate would that be? Even a small change will cause the present value of a pension and Social Security to fall dramatically. For example, "Discounting the Present" (top left) demonstrates the differences in present value at various discount rates for a 65-year-old who is collecting $30,000 from a pension or Social Security and has a life expectancy of 85. The table assumes beginning-of-the-month income distributions.

With a 3% discount rate, the present value of the cash flow would be $451,904. If the discount rate rose to 9%, the present value would fall to $279,946.

Also, we have assumed that the person will live to age 85. But what if that is too long or too short? How does life expectancy affect present value? The results in "Ripe Old Age" (left) assume a 7% discount rate and adjustments for longevity. If the retiree dies at 70, the present value of cash flow is $126,991. If the retiree lives another 25 years, the present value is $377,960.

According to IRS Publication 590, the life expectancy of a single 65-year-old is 21 years. Joint life expectancy for a couple is 26 years. Interpreting the results from both tables suggests a $30,000 income benefit at a 7% discount rate would have a present value of about $327,000 for an individual at age 65 and $360,000 for a couple. That would be about 11 times the annual income benefit for a single person and about 12 times the annual income benefit for a couple. These figures assume that the benefit is not cut when one member of a couple dies.

To add more complexity to the equation, present values may change annually. Many pensions feature a cost of living increase (COLA) based on the rate of inflation. For example, Social Security benefits adjust each year by the inflation rate-and if there is deflation, the benefits cannot go down. Consequently, any calculation used to figure out the present value of pensions and Social Security benefits is likely to be way off.

NO CONTROL

There is another issue that makes pensions and Social Security unlike a bond: You have no control. You have no power to change the rules of the game, and you cannot opt out of the programs if you do not like them.