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investor clinic

A friend of mine has a defined-benefit pension plan and says he can therefore take more risk in his investment portfolio, which is heavily tilted toward equities. I'm not so sure that's a good idea. Can you settle this debate?

Determining an appropriate asset allocation between stocks and fixed-income is complex and depends on factors such as your age, savings, expected income needs and risk tolerance. Generally speaking, a DB plan – which provides a guaranteed source of income in retirement – does allow you to dial up the equity component of your portfolio, says retirement and pension expert Malcolm Hamilton, a senior fellow at the C.D. Howe Institute.

"If it's a public sector government defined-benefit plan, where to the best of my knowledge nobody in the history of Canada has failed to get the promised benefit, then you can basically view that like a government bond portfolio," he says.

For those who can live with the added portfolio risk, he suggests treating the present value of the DB pension as fixed income, and then adjusting the asset mix so that the overall allocations are aligned with your targets.

For example, say you have a $500,000 investment portfolio and a DB plan with a present value of $300,000, and you're aiming for an overall asset mix of 50-per-cent stocks and 50-per-cent fixed income. To achieve that, you would put $400,000 – or 80 per cent – of your investment portfolio into stocks, and the remaining $100,000 – or 20 per cent – into fixed income. (The DB plan's $300,000 present value, plus $100,000 in fixed income, equals $400,000 – or half of your total assets).

People who are not yet retired can often find the "commuted value" of their DB pension in their annual statement. Those who are already retired can use an annuity calculator to estimate the present value of their pension, or have a financial planner crunch the numbers. For those nearing retirement, a rough approximation of a DB plan's present value can be calculated by multiplying the annual benefit by 15, Mr. Hamilton says.

"The bottom line is that it's not like anybody knows to three decimal places what their asset mix should be anyway," he says. "It's a matter of taking a thoughtful look at how much money you have, how much money you need and how much risk you can realistically afford to take and then backing into the asset mix."

You also have to take into account the health of the DB plan, he says. If the plan is underfunded and the company is on shaky ground, you shouldn't count on receiving the full retirement benefits. What's more, even if a DB plan is rock solid, not all investors will be able to stomach the additional risk that comes with increasing their equity exposure.

"If you are very uncomfortable with equities, it doesn't matter what the present value of your pension is. Arguably you shouldn't be that exposed to equities," says Jason Heath, a fee-only financial planner with Objective Financial Partners in Toronto.

He recalls a client whose previous adviser, citing the person's large DB pension, urged him to put his entire portfolio into equities. Unfortunately, this was before the stock market collapse of 2008.

"He and his wife felt very disappointed because when they looked back at the portfolio over the previous 10 years, they had invested and added to it, but it was in the same place 10 years later," he says.

The moral of the story? The size of one's DB pension "should definitely play into the discussion about asset allocation, just maybe not as much as some people think it should," Mr. Heath says.