Got a defined benefit pension plan? Consider yourself lucky then consider it a big bond

You’ve probably heard that risk and reward go hand-in-hand.  Take on more investment risk and you might be rewarded with higher investment returns.  The potential for higher investment return is the carrot dangled in front of us for owning the risky investment.

Understanding some asset classes have more risk than others, investors often balance their portfolios, balancing primarily between stocks and bonds.  What’s the best mix for stocks and bonds?  There isn’t one (that I know of) but after some brief research courtesy of Vanguard’s website, I found out what someone might expect from their investment returns if they held the following mixtures of stocks and bonds for many decades based on historical data.


Vanguard Balanced Portfolios:

Vanguard Growth Portfolios:

Based on my investor profile (growth-oriented) my investment plan calls for an allocation of about 70% stocks and 30% bonds respectively.  Actually, I’m probably much more conservative than that.  This is because I contribute to a defined benefit pension plan at work which I consider a big bond in my portfolio.

I am very fortunate to have my defined benefit (DB) plan which makes the amounts paid out from the plan at the time of retirement known.  Contrast this to another type of pension plan, a defined contribution (DC) plan, which makes the amounts contributed to the plan until retirement known.  This distinction between a DB and DC plan is very important and it’s defined a few times over in a great book entitled Pensionize Your Nest Egg by Moshe Milevsky and Alexandra Macqueen.  Since a DB plan is a binding contract that provides guaranteed income in retirement, it’s very bond-like in my opinion.  Although valuable, DC plans on the other hand offer no guaranteed benefit at retirement; they are tax-sheltered investment plans that offer no promises of lifetime income.

For as long as I participate in the big bond pension plan I’m going to take on more equity risk; building my personal portfolio with equities.  There will be much more volatility focusing on equities (over bonds) in my investing future but I’m comfortable with this risk and it works for me right now.  You might not feel the same when your portfolio has the potential to drop 30% or more like it did only a few years ago.

Personal finance has “personal” attached to it for a reason so all investors are encouraged to consider identifying their own risk-and-reward comfort levels, pensions or no pensions as part of a comprehensive financial plan.  Understanding your risk profile and knowing some asset classes have more risk than others should help you design your financial plan for a successful retirement journey.

If you have a defined benefit pension plan, do you view it the same way I do?

If you have a defined contribution pension plan, are you more risk adverse because of it?

20 Responses to "Got a defined benefit pension plan? Consider yourself lucky then consider it a big bond"

  1. Ibbotson, the asset allocation master, did a ~32 year (1972-2004) back-tested analysis which showed having 7-16% of precious metals (SPMI) in your portfolio:
    i) lowered volatility and risk (by a max of 6%), and
    ii) increased the over-all return of the portfolio (to a max of +4.5%)

    Of course, knowing the prices of precious metals have gone up quite substantially since 2004, the returns have only increased.

  2. Although I agree that DB pension plans are generally a good thing to have there are, in my opinion, still a few warts on them. I am self employed but my wife works in the Ontario college system and has a DB plan that is funded 50/50 between herself and her employer. Although her payout at retirement is defined by a set formula, her level of contribution is NOT permanently set. When she began her job 5 years ago her contribution level was about 8% of her salary. That number has increased every year since to the point that in 2013 she will be contributing about 12.5% of her salary to her DB plan. This means that she will be contributing 56% MORE to her DB plan next year (compared to year 1) – for the EXACT same payout at retirement! The pension fund has underperformed and to make this up has simply increased the level of contributions. Next year my wife will contribute approximately $11500 to her pension and that amount will be matched by her employer. Looking at those contribution amounts and seeing the resulting payout leads me to wonder how efficiently that money truly is being invested.

  3. It’s funny that some people with defined benefit plans don’t realize how lucky they are or they don’t know what they are. We don’t have the defined plan so we have to plan our investments and retirement out and hope for the best although sometimes it can get disheartening. Mr.CBB

  4. @mtddc99

    Similar experience.
    I work for the the BC provincial government; year one I received a letter informing me of my pension details and how I (and others) would not have our contributions raised. Less than one year later I received another letter informing me (and others, I presume) that my contribution rate would now be increased due to lack of fund performance during the early 2000’s. My contribution rate has increased ~2%/yr. Keeping up with inflation, I guess. But why send out such an ignorant letter in the first place?

    As for my DB plan, it will work out great for me (unless drastic pension changes occur before I retire). I would have to net 14% annually doing my own investing in order to get the same pay-out my pension will provide.

  5. My wife and I are retired and get a pension from the Ontario Teachers’ Plan. I consider this the bond portion of our overall portfolio. Without going overboard with risk/reward, I can therefore invest in good blue chip dividend paying companies and sleep at night. What do you think?

    1. Personally, I feel this way for my portfolio. The DB plan is a big bond, I can take a bit more risk some blue-chip companies, although it’s not a HUGE risk for me to own a few Canadian bank stocks, pipelines, telcos and energy companies. I index everything else. Pretty simple portfolio for me actually.

      You’re going to have a great retirement with two OTPPs! You’ve earned it.

  6. I mostly agree with classifying the DB pension as a bond, however, I don’t know if I would still consider it that way if the plan is underfunded and the employer is unable to increase contributions. Thoughts?

  7. I may be in the minority but don’t view my wife’s govt. DB pension as a bond, and almost certainly won’t view our future CPP and OAS (hopefully) pensions as bonds either.

    A bond has more risk, the value of it can change and depending on the bond so can the yield, and there can be default. A DB pension isn’t an invest able asset, and can also carry some amount of default risk, but is generally viewed as even more robust, especially a govt one. I see it simply as another relatively safe income source, and it does not change our perspective on the investment risk we want, or most importantly need to take with our invest able assets.

    As early retirees, for our invest able assets we take a balanced approach where my investment policy allows a range from 35/65 to 50/50% fixed income to equity ratio, since retirement. After a good year and long into the bull phase we are now in the low end of the equity %. Formerly in our accumulation stage we were at most times 100% equity and fully invested. We are familiar with building a large nest egg, seeing it decline 50% and recover over the years, although this delayed our retirement plans. This experience along with our present stage of life forms the basis of our current investment policy and practices. We could possibly create more retirement cash flow with an equity only or higher ratio portfolio but would be less comfortable with this approach, and feel we do not need to take that amount of risk at this point. We live very comfortably without it.

    We like the diversification from a DB pension, varied fixed income products and a broad range of ETF indexes to create good cash flow and the most balanced approach we can. Whatever a persons risk tolerance is, there is no substitute for sleeping well at night, especially when retired and without the desire to create employment income.

    1. Thanks for the detailed comment. I guess I see pensions as bond-like because of the fixed income they provide; something you can rely on rather easily. I see bonds the same way although they are riskier as it relates to interest rates and coupon rate.

      As early retirees I could see how a 50/50 split is good although I’m tempted to hold more equities (or just as much equities as I do now) as I get older. The reason being I don’t see interest rates soaring ever again. Maybe decades away. The world lives on so much credit that it seems almost impossible for rates to rise any significant amount without some worldwide chaos. I could be wrong, but I just don’t see bonds as valuable as they used to be. If they help investors protect against themselves, great, but in terms of an asset class that will provide a meaningful return those days I believe are gone for another generation.

      Maybe I have not had enough pain to endure so your experience is valuable Deane when it comes to your IPS. Smart investors never take any more risk than they need to. You have seem to have mastered that.

  8. Thanks, but “mastering” is really too strong a suggestion.

    I should correct my statement on invest able assets. At its core a DB pension has invest able assets but for retirees its really a “guarantee” for a retirement income stream.

    I can understand why you and others view a DB pension as bond like. I think the amount of pension as a % of needed income, and the amounts of your assets all factor into this perspective as well. I also agree current and expected future interest rates have changed the game for many investors. This means more people now stretch for yield either with riskier bonds or a higher ratio of equities. And some may have enough capital they feel comfortable living from dividend yields, and can stomach the downturns, if they are able to maintain this income stream. I think the reality is future rates of return for both equities and bonds will be lower than historical norms.

    If rates were normalized and bonds could safely return 5-6% I would likely have an even higher % in our portfolio. If you asked me even 10 years ago about bonds or GIC’s I would have no interest in buying them and probably laughed at you. My investor profile was fairly aggressive growth and at times even traded some futures and penny stocks-with success but might have been more luck than anything. I think you’re right that unless you’ve ridden a major swing down with a lot of skin in the game, especially immediately before/into retirement, words in a blog can’t really do justice to the feeling. For some that may be okay and for others like us it’s more risk than wanted at this point in retirement, and fortunately more than we seem to need.

    As time goes on in retirement the plan in the back of my mind is likely to increase our equity exposure, with fewer living years left and a bigger base of fairly secure pension income- the opposite of a typical retiree evolution. Bond coupon/interest rates will have a bearing on this decision of course.

    There is no right or wrong approach. The key is to make sure an investor understands what they have, why they have it and that it lines up with their needs and risk tolerance.

    1. For sure…a DB pension has invest able assets but for retirees I see it as guaranteed-income, hence the big bond relationship although depending on the source of the DB pension, it has less risk (which is good).

      If future total returns are lower (than historical averages) it makes even more sense (to me) to live off dividends or distributions since the capital appreciation simply won’t be there. Planning to live off only the 4% ‘safe’ withdrawal rate has some risks.

      Based on your comment it makes me wonder if I’ll change my tune about bonds eventually (like 10 years from now) and own them again. I simply don’t see it happening though :)

      Thanks for the discussion Deane!

  9. Living off dividends makes sense if you want to leave a legacy, or want to have a super conservative retirement, or are simply trying to start off more conservatively in retirement and actually plan to spend capital later into retirement. (As you know, the five years before retiring and 5 years into retirement are extra important and protecting capital then has more priority) As you know, I focus on total return which includes dividends, growth, and all interest etc.I can re balance and “bank” good years returns and draw only FI & dividends in the bad years, or nothing at all in bad markets.

    I don’t ascribe to the simplicity of a safe withdrawal rate. To me its a very general guide and more helpful for those not carefully watching their cash flow. As you know our plan is fluid, adjusted annually based on previous years total returns, along with our own wishes. Key is our planned return is 60% of that indicated in the PWL great expectations white paper, and 43% of the Vanguard one you show above (I think this is US based). This helps confirm our “need” for risk is low, at least at this point. If our actual returns are at either of these rates our retirement lifestyle will greatly exceed our expectations. The pension covers all our base needs and we project all other discretionary expenses 2-3 times a year and then take out whatever that is periodically, and live within it. Our government pensions will be starting 3+ to 9 years and will build a bigger indexed income base. My concern with outliving our money is very low,as our return expectations before/after inflation are low and we are very flexible with lifestyle.

    It’s important to note this is uncharted territory for us- new retirees, drawing money instead of saving, and managing a vastly different investment base that includes a wide swath of FI, cash, GICs (these are all relatively new to us). So far the first year exceeded my expectations but one year doesn’t a retirement make so we’ll see how it goes in time. Maybe I’ll be the one jumping ship to a higher equity weighting with a dividend bias. Never say never.

    IMO, if we get to a point regularly where there are no capital gains, dividends will also likely be in jeopardy, since this may indicate earnings are weak. Think oil stocks recently.

    I don’t think anyone can project for sure where they’ll be 10 years from now. A lot can happen in the meantime and peoples ideas can change. Mine have and they may again.

    I hope I have not bored you or all of your readers too much, with my novels.


    1. This is likely how my attitude will change Deane, focusing more on total return (I should be focused on that now) and in good market years, “bank” good returns; draw down only fixed income and dividends in bad market years.

      We don’t intend to leave a legacy whatsoever but I feel we won’t have enough in retirement. I’ll know more in another 10 years as we approach semi-retirement since as you know, what you think might happen with your job, economy, life is very different than what actually happens.

      It’s also probably a safe assumption that when/if dividends every dry up so goes capital appreciation as well.

      It will be interesting for me to look back at this site and see how my ideas have changed. It certainly has in the 5 years of running the site.

      I wonder where oil will go in this country? I thought $50 was very low and I saw it coming back in the second half of this year. Maybe not?

      Thanks for the detailed comments Deane and you’re adding to the discussion certainly not taking anything away!

  10. I’m not sure at all total return approach is better. It just works for me, at least for now. It is very hard to argue against a dividend growth approach and a yield withdrawal plan. I’ve never heard tell of anyone going wrong with this strategy. You just have to stomach the bigger asset swings with the comfort your dividends are likely to continue and grow, and you may have greater exposure mainly to North America. (this could be a good thing) This approach is particularly great in the accumulation stage, but slightly more difficult to handle in withdrawal stage- for me – but very possibly not for you or others.

    My guess is you’ll have more than enough, with your approach of different income streams, and aggressive savings now.

    You’ll notice a huge difference in your disposable income in retirement- less taxes, no savings contributions, no mortgage, no work costs etc.

    It’s a wise person to acknowledge things in life, job, economy etc can well change and to be flexible with a plan B if they do.

    This sort of went off topic but hopefully others are interested. I know its beneficial to me to read other perspectives and make me think hard about why we’re doing what we are financially.

    On topic those with DB pensions are simply blessed. Decades from now they’ll be unheard of.

    1. I’ve also never heard of anyone going wrong with a “living off dividends or distributions” approach – they seem to have more capital than they need and can adjust spending habits (i.e., spend more) with ease. We figure $1 M in capital is the magic number for us given other future income streams.

      I’ve heard the same: “you’ll notice a huge difference in your disposable income in retirement- less taxes, no savings contributions, no mortgage, no work costs etc.”

      You didn’t go off topic. All things personal finance, saving and investing and the philosophies related to it are always welcome here :)


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