Did you see my recent article on putting a value on a traditional pension? I then followed it up with a case study from my fellow blogger Fiery Millennial. Did you try out for yourself my special actuary methods for valuing a pension? Did you feel like an actuary with a cool spreadsheet? Feels good huh? I bet after that you were like, “I’m now a big-ass actuary and am gonna take a limmo everywhere”. You’re welcome, coz that’s how we actuaries roll!
Imagine then how pleased I was when another fellow blogger – Mr Jumpstart – contacted me with details of his pension. He is a teacher and teacher pensions can be pretty fascinating animals so that’s like catnip to an actuary!
C’mon folks let’s dive into this!
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Have you heard defined benefit (DB) pensions called the “Gold Standard” of retirement benefits? That certainly used to be the case, but then benefits got watered down and plans were increasingly frozen so that new workers can no longer join, and have to settle for a 401k. But Mr Jumpstart’s pension is very nice indeed. Is it the Gold Standard? Yep I would say so. Teaching is a really tough job (my wife is a teacher) so I’m so pleased to see a solid benefit going to this hard-working guy. Great job, we thank you for your contribution to society!
Mr Jupmstart’s pension is called a “final average pay” plan. This means that at retirement he gets an annual pension calculated with the service and the average of his last three year’s of compensation. The greater his service, and the larger his salary the bigger his pension.
In fact, his plan gives 1.7% of his final compensation for each year of service. So if he works 30 years then he will get 51% of his final compensation for life. Let’s be clear that is not a single lump sum, that is an annual pension each year, every year. Not bad!
If he works less than 30 years he will get 1.7% of each year he has worked.
When Can He Retire?
Pensions always have restrictions on when you can start, and Mr Jumpstart’s plan is no different. The Plan rule says you can retire:
- Age 65 if you have more than 5 years of service,
- Age 50 if you have more than 30 years of service
The rules actually say you can go a bit earlier with a reduced pension, but we won’t worry about that here.
Mr Jumpstart will have completed 30 years of service when he is age 52.2 which is in 8.2 years time. So he can retire at that point and get the full pension.
He is also “vested” and this means he has worked a qualifying period so that he is now entitled to a pension. This means that if he leaves teaching now he will still get a pension. He won’t earn any more service (obviously) but if he decides to pursue a long-cherished dream to become a trapeze artist, or fulltime poker player, he will still be entitled to the pension, but may not be able to take it until age 65.
From here I will assume that he grits it out for the next 8 years and retires at age 52 with 30 years of service.
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Valuing the Pension
Let’s put a value on this puppy!
Mr Jumpstart has logged onto his pension plan’s website and run an illustration that says he can retire at age 52 with an annual pension of $28,579. Not bad! This is a single life pension, and when he retires he can opt for a joint life pension. This would reduce the amount, but when he dies it would pay a pension to his wife (if surviving). However given his wife is also in line for a similar teacher’s pension this might not be needed since she will have a pension in her own right.
I then ran Mr Jumpstart’s details through the Society of Actuaries Longevity Calculator and he has a 50% chance of living another 34 years in retirement. In other words to age 86. I’ll take a 50% chance to be quite conservative on the value I put on the pension.
One really nice feature of most teacher’s pensions is that they receive cost of living increases. Every year they increase with inflation. I pulled off the participant handbook from the website and the increases are:
- CPI Urban Consumers index upto 3% a year and
- Half of any additional increase upto
- A total of 5%
Here is a chart showing CPI for the last 10 years.
The increase over the last 10 years is 1.6% per year. But look at that dip in 2008 where CPI decreased. You might expect Mr Jumpstart’s pension to decrease under a similar period, but here is a cool thing – Mr Jumpstart’s pension is also capped below at 0% increases. So given future expectations of future inflation I’m going to assume annual increases of 2% a year. In the spreadsheet below I have given the pension year-on-year 2% increases.
Here is the calculation methodology I explained in my other post.
So we get a total value of $535k. That’s a tidy value. Note that the plan does not offer this as a lump sum, we are simply putting a broad value on the pension promise.
Let’s Talk Salary Bumps
The way Mr Jumpstart’s pension works is that his annual pension is calculated off his final 36 months’ salary. This means that his salary today is irrelevant in terms of impact on his eventual pension. What counts is his salary from ages 50, 51, and 52 (assuming he retires age 52).
So my advice is that anything he can do to juice up his pay before retirement is really valuable, because it’s not just a pay rise for now, it gets crystalized as a raise for the rest of his life.
The good news is that he is taking 12 hours of graduate classes for a $600 raise. Let’s calculate what impact that will have on his pension. Remember that he will get 1.7% for every year, and if he works 30 years that is 30 x 1.7% x $600 = $306 a year, with CPI increases. Let’s put a value on that.
So I would value this salary bump as around $5,700, just taking into account the pension benefit and ignoring the value of the pay rise benefit before retirement. This is like earning $500 an hour for the 12 hour course!
In summary, Mr Jumpstart has a pretty nice benefit here; he has an inflation linked pension of about $30k a year for life and it’s worth about half a million in current money.
Are you a teacher, do you understand your pension? Even if you’re not a teacher comment below on whether your pension is mumbo-jumbo to you, or whether you dig it.
Apparently I got listed as #3 in the top 40 actuary blogs and websites for actuarial professionals. Whoever knew such a thing existed? But I guess if the internet is big enough for Japanese game shows of greased up contestants fighting to climb a slippery slope, then a list of actuary blogs is not all that surprising.