Figuring your asset allocation or stock/bond split may seem like pretty simple math. Let’s say your investment accounts total $100 k with $60 k in stocks and the other $40 k in bonds/cash. So your stock/bond split is just 60/40 right? Not so fast. To better calculate your TRUE stock/bond split I would argue for considering these 3 things:
1) Tax deferred vs. taxable (i.e. after-tax) accounts
2) Social Security
3) Your mortgage
1) Tax-deferred vs. taxable (i.e. after-tax) accounts. Let’s say the $60 k in stocks is in a taxable account whereas the $40 k in bonds is in a traditional 401k. The trouble is the $40 k in bonds are pre-tax funds whereas the $60 k in stocks was created out of after-tax funds. So if you had to liquidate everything today and your tax rate was 25% then you would net $90 k after tax, with $60 k from stocks (assuming no capital gains were realized) and $30 k from bonds (i.e. $40,000*75%). That works out to a 67/33 stock/bond split.
So the idea is to put all your accounts on the same tax basis. Personally I like to work with pre-tax figures so I gross up my taxable accounts to a pre-tax basis. Staying with the above example the $60 k taxable stock account is really $80 k (=$60k/75%) on a pre-tax equivalent basis. The adjusted total is then $120 k of which $80 k stocks and $40 k bonds, giving the same 67/33 split. I like working on a pre-tax basis for 2 reasons:
a) It’s easier to compare the amounts to your salary (which is of course pre-tax)
b) I think for most people, most of their money is in pre-tax accounts.
Now some may argue that it is your future tax rate in retirement that should be used and that this is too uncertain to estimate. It’s a valid concern. But be aware that just adding up your accounts ignoring their tax basis is equivalent to assuming you will have a 0% tax rate in retirement-that hardly seems realistic.
The Bogleheads wiki has some perspective on this as well:
http://www.bogleheads.org/wiki/Tax-adju … allocation
2) Social Security: Many (young) investors decide to simply ignore social security. It is too far off and they think the trust fund may be depleted by then anyway. But older investors often find Social Security to be a very meaningful part of their retirement picture. Let’s say you are in mid-career with retirement on the horizon and you want to start factoring social security into your asset allocation- what should you do? Well the idea is to somehow estimate the present value of your future social security benefits and count that towards your bond allocation (pre-tax).
It sounds tricky but this is one of those issues that I think just being in the ballpark is good enough-at least for mid-career asset allocation purposes. Here’s a quick and dirty way to factor in Social Security: Just add up your (and your employers) contributions over your working career to date. The basic assumption here is that the current value of your earned social security benefit is equivalent to the government having invested these contributions over time at a 0% nominal return. That may be pessimistic, but then again it may be realistic and it certainly makes the math easy!
It used to be easy to find your contribution history when SS mailed you a statement every year. If you have an older SS statement to work from you can keep the total up to date by looking at your more recent W2s. In case you can’t find the info easily or can’t be bothered, here is a table by age of what the contributions would total assuming: 1) you started work at age 22, and 2) you earned the maximum social security wage each year ($113.7 k for 2013).
As of 7/1/2013
Age…start work year….Sum of Max SS contributions through end 2013 ($k)
Most people would want to make 2 adjustments to use this table. First: interpolate based on your age or year you started work. Say you are 42.5 years old. Then you would average the figures for 40 and 45 and get $217.4 k. Or say you are 45 now but didn’t start work till age 26, i.e. in 1994. Then you would interpolate between the $199.56k and $235.31k figures to get $206.7k [=199.56 + (235.31-199.56)*(1/5)].
Second: estimate what percentage, on average, your salary has been relative to the maximum taxable social security wage. You can find the historical maximums here:
(note: in working out this average you shouldn’t take any credit for the years your salary is above the max). So again if you are now 42.5 and figure your salary over your career has been roughly 60% of the social security max salary then your estimated contributions (including those of your employer) would be 60%*217.4 or $130.4k
3) Mortgage: Opinions vary on how to figure your mortgage into your asset allocation. Some argue to ignore it all together and some to treat it like a negative bond. My position is more middle of the road- basically I think its usually safe to ignore it early in life but as you get close to retirement you should start treating a mid-to-large mortgage like a negative bond. So how do we translate that intuition into a working rule of thumb? Let’s lay out some assumptions and then work some examples:
a) goal: payoff or defease mortgage before you retire. Let’s assume the (now) standard SS retirement age of 67 & then drop that to age 64 to build in a 3 year margin of safety (note: if you are targeting early retirement for other than health reasons, you may have less of a need to build in a margin of safety).
b) house to be paid off pro-rata over a 30 year period (i.e. standard mortgage period)
c) assume you just bought your house yesterday at fair market value (check Zillow http://www.zillow.com/).
So let’s look at some examples:
d) Let’s say you bought a house 3 years ago for $400k. It’s now worth $500k and you are age 40. Your current mortgage balance is $275k. So basically your house is 45% paid off (again you calculate using the current $500 k market value, and thus the unpaid amount is $275k/$500k = 55%). Your goal is to pay off your house prorata over the 30 years before age 64. So based on that, since you have 24 years to go, you would need to have only 20% of your house paid off (= 1 -24/30). So you are ahead of the game and your mortgage can be safely ignored. Note that according to the logic here, the $400k purchase price and the fact that you bought your house 3 years ago are basically irrelevant. Only the current market value of the house, your age, and your mortgage balance matter.
e) Now let’s tweak that example and say that instead you are aged 55. So now you have only 9 years to go until the target payoff age of 64. So your house should be 70% paid off (=1-9/30) but as before your house is only 45% paid off. So you are 25% short or in dollar terms $125k (=25%*$500k). I would argue you should treat that $125k as a negative bond in your asset allocation. And moreover that $125k shortfall is an after-tax amount. Pre-tax it is $167 k (again assuming a 25% tax rate).
4) Putting it all together: Let’s stay with part 3e) above and put that together with the info from 1) and 2). To sum up:
Taxable stocks = $60 k = $80 k pre-tax
401k bonds = $40 k = $40 k pre-tax
SS (est.) = $282 k pre-tax bonds (assuming your salary was at the yearly SS max taxable salary on average)
Mortgage = negative $125 k = negative $167 k pre-tax bonds
So putting it all together, on a pre-tax basis you have:
Stocks = $80 k
Bonds = $40 k + $282 k – $167 k = $155 k
Total pre-tax = $235 k
Stock/bond split = 34/66
What Grok is saying in the example is that the investor who thought they had a stock/bond spit of 67/33 actually has a 34/66 split. So, he is advocating for a much higher equity holding to account for the bond value of SS, as well as the outstanding balance of loans such as your mortgage as a negative bond. John Bogle has also said this on http://www.morningstar.com/cover/videocenter.aspx?id=339534
My take on this is that SS has bond-like characteristics, but it has zero liquidity and can’t be rebalanced. It should be handled separately from your asset allocation, as an income source that reduces the amount of money you will have to draw out during retirement. I do not agree with placing the future value of your SS benefits into your current asset allocation. So I have to disagree with both Grok and Mr. Bogle on this one.