Retirees often ask us if they should consider their Social Security as part of their portfolios. It’s income, and it seems to many people as if Social Security should be in the fixed-income part of their asset allocation.  Though a lot of people take that view, we think this is a bad idea. For several reasons we discourage our clients from doing this.

Your Social Security (the same is true for a pension once you begin taking it) represents important, reliable income. But it’s not an asset. This may seem like an arcane distinction, but it’s not.

As I will show, if you think of your Social Security as an asset instead of income, you are making a mistake in the way you think about your money. And errors like this can lead to mistakes in the way you manage your money.

You can sell most financial assets and turn them into cash. You can’t do that with Social Security, which is a stream of income subject to end at any time upon your death.

You can put a reasonably accurate value on a piece of real estate or a mutual fund. But because your Social Security can’t be sold, you can’t put a value on it for asset allocation purposes.

If you’re 68 years old and receiving $2,000 a month, the value of those payments depends on how long you’ll be around to keep collecting them. If you live another 32 years, to age 100, $2,000 monthly payments could total $768,000. If you die at age 69, you might collect only $24,000. So what’s the asset value of your Social Security? Unless you’re on your deathbed, you have no way to know.

That’s the theoretical reason why this is a bad idea. There’s a practical reason that’s just as important.

Assume you have an investment portfolio worth $600,000 and somehow, against my advice, you decide that your Social Security is worth $400,000. You conclude that your “total” portfolio is worth $1 million, and (wanting to be conservative) you decide that half your money will be ($500,000) invested in stock funds and the other half ($500,000) in fixed-income.

If you count $400,000 in Social Security toward the fixed-income part of that portfolio, you’ll own $100,000 in bond funds and $500,000 in equity funds. That means your investment portfolio will be more than 80 percent in equities instead of the 50 percent target you set. That puts you at greatly increased risk.

In a serious bear market, that heavy equity allocation could wipe out your portfolio’s ability to keep generating the income you need for retirement. You’d still have your Social Security, but you might not have much else. You could be forced to drastically cut back your lifestyle – an unfortunate result that started when you didn’t think clearly about this.  

Social Security is a great thing to have coming in every month. Fortunately, it’s not hard to put that income in its proper perspective in your retirement planning.

The right approach is to treat Social Security as income, entirely separate from your investment portfolio. That income reduces the amount you need to take out of your portfolio in retirement.

The basic formula is this: Compute your cost of living in retirement. Subtract the income you already have from Social Security, pensions, fixed annuities and other sources. The difference is what you need from your investment portfolio, either monthly or annually depending on how you do the calculations.

As I have pointed out in other articles and in my book, knowing how much income you need from your portfolio is an essential building block in getting your finances to do the most for you in retirement.

Paul Merriman is the founder of Merriman.