Bogle On Favoring Dividends And Capitalizing Social Security

by: David Van Knapp

I continue to be surprised by things that John Bogle is saying about the importance of income planning for retirement. Bogle, of course, is the founder of The Vanguard Group, Inc., the largest mutual fund organization in the world. Vanguard comprises approximately 170 mutual funds with current assets totaling more than $2 trillion. The Vanguard 500 Index Fund, the largest fund in the group, founded by Bogle in 1975, was the first index mutual fund.

Bogle has been giving a series of interviews to Morningstar. After an interview in July, I wrote an article about his views on retirement income. In it, I expressed surprise that he was reinforcing several themes that most dividend growth investors believe in. My surprise emanates from the fact that Bogle is a staunch indexer, and I had not heard before of his emphasis on retirement income.

He's done it again. In an interview published October 25, Bogle acknowledges that his views on capitalizing Social Security (SS) for asset allocation purposes are not widely shared. In July, I visited the Bogleheads site, and I could see that many Bogleheads did not believe that he meant what he had clearly said. Apparently he has felt that sort of feedback.

I'm on this pretty much one-man, I think, crusade to have people, particularly retired people, look not at the value of their portfolio, but at the income stream they get. They're going to go out to the mailbox and they're going to open, let's say, the middle of every month when the fund or group of funds pays their dividends. They're going to get a certain dividend. Dividends are what matter to these people. The stream of income is what matters, and dividends [tend to increase] in history.

As in the earlier interview, Bogle spoke of "capitalizing" income streams. Here's what that means: If you have the right to receive an income stream, that right has a capital value. Bogle believes that you should estimate that value, and then do your asset allocation taking that value into account as if it were invested in fixed-income investments, because the income result is the same.

So, there's an asset [Social Security], and truth told, it is a fantastic asset. It's got a nice interest rate with an inflation hedge… So, taking let's say $400,000 as the central value of Social Security… you have $400,000 in equities, 100% of your investments are in equities, $400,000; $400,000 in fixed income in the form of Social Security. And you're 50/50. I mean, people ought to at least do that math…

Here is what Bogle is saying if viewed in asset allocation pie charts. We'll use his numbers: $400,000 in an investment portfolio and $400,000 representing the capitalized value of SS. If all of your investments are in stocks (ignoring SS), your pie chart looks like this.

But if you capitalize your SS rights, your asset allocation really is this: 50-50.

The SS benefits represent fixed income, same as bonds. (In actuality, SS is indexed for inflation, which just makes it a little better than fixed income.) Your legal right to receive SS is the functional equivalent of owning assets that generate the same income stream.

For many investors and investment advisors, the second pie chart looks a lot safer and more intelligent than the first. But nothing has changed. I have simply reframed, as Bogle suggested, the rights to receive SS payments to show them as capital invested in assets that generated those payments. In essence, that is what you accomplished by contributing to SS during your working years.

Thus, with SS capitalized, your asset allocation is really 50-50. The ramification of this is what many have difficulty with: You do not need any bonds at all. Your "fixed income" allocation is covered by Social Security.

Bogle stated this most clearly in his July interview.

You can do this a lot different ways, but let's suppose that the capitalized value of Social Security at age 65 for most people is, say $300,000 to $350,000. Let's use $300,000... So you've got a $300,000 fixed-income position and probably the best fixed-income position you will ever have in your life. It's got a cost-of-living adjustment; the payouts are good. The payouts are as close to certain as things can be in this world. So you're sitting there with that $300,000.

The difficulty that people have with this concept is that they are accustomed to thinking of asset allocation only in terms of their own investment portfolio. They do not consider the income rights from SS or a pension to be an "investment."

But in reality, those rights to monthly income are worth something. "Capitalizing" them simply means figuring out what they are presently worth, and then considering that your total financial situation is the same as if you had that much invested in fixed income assets.

Thus, if your investment portfolio is targeted to a traditional 50-50 stock-bond mix, you are really over-invested in fixed income when you take SS into account. Your actual allocation is 33-67 instead of 50-50.

Bogle hammers this point home in his latest interview. The interviewer (Christine Benz) brings up target-date funds.

So, I'd say, when you think about Social Security, an awful lot of people in this country using target-date funds are underinvested in equities, and maybe it'd make me look stupid when the next great crash comes. But at least consider it.

Let's talk about target-date funds. These are funds - growing in popularity - that are managed for you as you age, gradually tilting away from stocks and toward fixed income. The reallocation toward bonds theoretically reduces risk as you get older. "Risk," of course, is defined as the degree of volatility under Modern Portfolio Theory (MPT).

The funds are designed by experts. Every company does them differently, but they all have the common theme of becoming more conservative as you age. Conservatism is based on MPT notions of reducing volatility by lowering the percentage of stocks as time goes on. I have come to think of target-date funds as proxies for MPT-style asset allocation.

Here is Vanguard's depiction of how their target-date fund allocations change as one ages.

As you can see, the allocation to "nominal bonds" (i.e., fixed income assets) increases dramatically starting at about age 40 (shown on the chart as 25 years until retirement). The slider on this screenshot is set at their 2010 fund, representing an ideal asset allocation for someone who has just retired. Here is the asset mix in that fund.

As you can see, the fund is down to 40% stocks by that age.

But if we go back to Bogle's assumptions -- $400k invested and SS capitalized at $400k - here is what the person's real asset allocation is.

The actual stock allocation has dropped to just 20%.

The reason that many people have trouble with the idea of capitalizing Social Security and considering it an "investment" is that they confine their view of risk to the traditional MPT notion: As variability in the capital value of their portfolio. That becomes something to be feared and avoided, especially as one moves into their 60s and 70s.

But that ignores the dampening effect on the volatility of their total assets - including income rights - that they own. The variability of that is not nearly as high.

Bogle addresses investor psychology in dealing with higher volatility in a portfolio.

Look at the dividend and try to ignore the market. As I've often said… the stock market is a giant distraction to the business of indexing, and in particular for the business of retirement investor. It's the income flow from Social Security, pensions, whatever it might be, and dividend income, and that's what's important. It's amazing how this dividend line [tends to increase over time] and the market [goes up and down over time], but they track each other in the long run.

In saying this, Bogle has said exactly what dividend growth investors have known for years: Focus more on the income, less on the market. Emphasize the importance of generating income streams that cover your expenses in retirement. That way, you don't have to sweat out daily and weekly changes in the stock market wondering where your income will come from.

By the way, for an easy way to estimate the capital value of your Social Security, use the calculator at Immediate Annuities ( The calculator allows you to input a monthly income plus a few personal details, and it will compute how much it would cost to buy an annuity that sends you that amount of cash for the rest of your life. Input your monthly SS benefit, and it will tell you what its present capital value is, in the sense that you could spend that capital today for an annuity that gives you the same amount as your SS income every month.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.