Did you read my recent post on how to value a traditional pension? Apparently there are still some of you out there with these old-style pensions, and I was particularly surprised that even some millennials have ‘em!
So I was delighted to be contacted by my friend Gwen at Fiery Millennials who has a traditional defined benefit pension. In addition to writing a hugely popular blog, hosting a podcast (Fire Drill), and receiving two Plutus nominations she somehow finds time to hold down a fulltime job and earn a pension from the employer. High five!
She sent me the details with the invitation to actuary the shit out of it.
And I needed no further encouragement…
Gwen has been smart and obtained a pension statement showing the benefits she has earned. With my pension plan I can do this online, or you might have to contact HR to get this information. Her key details are:
- Assumed date of leaving 3/30/2018 (sssshh!)
- Company Service at leaving 5.71 years
- Pension Earnings $8,015.58 (monthly and includes bonus).
- Expected monthly pension at age 67 is $686
Note that she got a projection with an assumed date of leaving the firm next year. It’s not always possible to get a projection with an early leaving date so you might have to finagle the calculations, but I step through the pension calculation below.
She also got hold of the pension booklet so that provided me with some exciting bedtime reading.
Calculating the pension
There are three main types of DB pension plans.
- Final average pay
- Career average
- Cash balance
I won’t go into all the details of these different plans now, but Gwen has a Career Average pension which uses the following formula:
Service x 1.5% x Earning = Pension
So, for every year she works she gets 1.5% of her earnings as a pension in retirement. And she pays no contributions for this, her employer foots the bill and takes all the investment risk – sweet!
The first thing I do is a quick check of the company’s pension calculation. Having worked in the industry I don’t trust what I’m given so it is worth seeing if it makes sense. We have all the details above, so it’s simple to calculate:
5.71 x 1.5% x 8,015.58 = 686
So that seems to match up.
Valuing the Pension
We now want to put a value on this pension and we use the method I described in my last post. Her pension starts at age 67 so we take annual amounts starting at age 67.5, but we need to find out how long she might live.
I plugged her details into the Society of Actuaries Longevity Calculator, and given that she is in excellent health, she has a 20% chance of living to more than 100! So I am going to take my payments out to age 100. I perhaps should take the payments out to age 105, but the discounting reduces the impact so I’m not going to bother.
As before, we use our favorite function XNPV to calculate the present value, and for the reasons I set out in the original post I’m going to use a discount rate of 4%.
This gives us a value of almost $33,000. That’s not bad!
This should also give Gwen some flexibility because there is a rule in her plan that if the value is less than $5,000 she would be forced to take a cash lump sum.
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Future Lump Sum?
Many plans are offering “lump sum windows” where they write to terminated vested participants and offer them a lump sum in lieu of a future pension. It’s quite possible that after Gwen leaves she might be offered a lump sum in the future and this figure would give a useful benchmark of a rough value. She can then assess whether to take the lump sum or retain the pension.
But it seems that she might have to accept a lump sum now. The benefits hotline are telling her that since the benefit is worth less than $25,000 on their calculation method she will have to take a lump sum. I don’t see anything in the benefits booklet that refers to this, but pensions have all sorts of weird rules (after all actuaries are involved).
Include in Net Worth?
I’m usually a fan of including a pension in your net worth calculation, but in this case I am not so sure.
The main reason is inflation risk. Gwen is so young and has 40 years before this comes into payment. Over 40 years there is considerable inflation risk and her pension has no protection against that. So the spending power will erode between now and retirement. For example if inflation is a steady 2% per year then the spending power will be halved.
That has to be a major consideration in whether to accept a lump sum if offered. By investing the lump sum she has a good chance of outperforming the discount rate and her investments will likely have a better real return than zero. But it is a personal choice, and your attitude to risk can play a part here.
The question you need to ask is – Do I want a guaranteed income (nominal terms) versus investing a lump sum in risky assets?
So there you have it, Gwen is sitting on a modest egg that she might have to cash out at some point. She may be able to leave it to pay her a small pension from age 67. It’s nice to have financial options and if you can diversify your income streams then that has some value in itself.
Do you have a defined benefit pension? Have you obtained a statement of benefits and do you understand the benefits you have been given? Are you able to follow this method to put a value on it? Have you been offered a lump sum in lieu of a pension? Comment below!