If you’ve got a pension, count yourself as one of the lucky ones. Pensions, also known as Defined Benefit plans, have become rarer as companies force their employees to save for themselves mainly through a 401k, 457, Roth 401k or IRA. These savings vehicles are also known as Defined Contribution plans.
But as we all know, the maximum amount you can contribute to a 401K or IRA is only $18,000 or $5,500, respectively for 2017. Even if you max out your 401k for 33 consecutive years starting today, it’s unlikely your 401k or IRA’s value will match the value of a pension.
Take a look at my latest 401k savings potential chart. After 33 years of maximum contributions, I estimate you’ll have between $568,000 – $1,800,000 in your 401k, depending on performance. $1,800,000 sounds like a lot, but in 33 years, $1,800,000 will buy just $678,000 worth of goods and services today using a 3% annual inflation rate.
If you live for 20 after your last 401k maximum contribution, you’ll only be able to spend $33,900 a year in today’s dollars until the money runs out. $33,900 is not bad, but it’s not like you’re living it up after sacrificing your life for decades at a job you didn’t love.
Given the power of inflation, to neither max out your 401k nor invest an additional 20%+ of your after-tax income if you don’t have a pension is risky. When it comes to your money, it’s always better to end up with too much than too little.
Calculating The Value Of A Pension
The difference between defined benefit and defined contribution has most certainly widened in 2017
Most pensions start paying out at a certain age and continue paying out until death. The amount of pension you receive is determined by years of service, age in which you elect to start collecting, and usually the average annual income over your last several years of service. If you don’t know how to calculate the expected monthly or annual payment of your pension, just ask human resources to provide details.
To calculate the value of your pension involves figuring out your annual pension payment, a reasonable rate of return divisor, and a realistic expected chance of payment until the end. After all, your company could go bankrupt and welch on all its pension promises.
Deciding on a reasonable rate of return divisor is subjective. The safest divisor to use is the 10-year government bond yield, which currently hovers at around 2.55%. In other words, one can reasonably expect to earn 2.55% each year on his or her investments given the 10-year government bond yield is guaranteed.
One could use a more aggressive reasonable rate of return, such as 7%, to reflect a historical annual return of the stock market. However, the higher your divisor, the lower the value of your pension ironically, because it requires less capital to generate your pension income when things are booming.
Let’s calculate the value of various pensions below.
Example 1: Police Officer Retiring After 25 Years Of Service
Average income over the last four years: $90,000
Annual pension: $60,000
A reasonable rate of return divisor: 2.55%
Percentage probability of pension being paid until death: 95%
Value of pension = ($60,000 / 0.0255) X 0.95 = $2,235,294
Well how about that! After 30 years of service, this police officer will have a pension worth roughly $2,117,657 on top of whatever other assets he has accumulated. Not bad for someone who made a decent, but unspectacular $90,000 year for the last four years of his career.
Let’s say this police officer joined the force at age 20. He’s still young enough to start another career making additional money on top of his $60,000 pension. Talk about the perfect early retirement plan to pursue your passions without fear.
Example #2: Foreign Service Officer Retiring After 30 Years Of Service
Average income over the last three years: $120,000
Annual pension: $85,000
A reasonable rate of return divisor: 3%
Percentage probability of pension being paid until death: 100%
Value of pension = ($85,000 / 0.03) X 1 = $2,833,333
I use a 100% probability of the pension being paid until death because the payer is the federal government. This figure is also subjective, but I believe the federal government will honor their promises to older employees. They’re just cutting pension benefits for newer employees.
If I used 2.55% as the reasonable rate of return divisor, the value of this retired foreign service officer’s pension jumps to $3,333,333. The reason is because an investor needs to invest $3,333,333 in capital to generate $85,000 in annual income when the rate of return is only 2.55%. Let’s say the rate of return was 50%, the value of the pension/capital required is only $170,000. But who on Earth can reliably generate a 50% annual return each year forever? Nobody.
Example #3: Public School Teacher Retiring After 30 Years
Average income over the past four years: $72,000
Annual pension: $36,000
A reasonable rate of return divisor: 2.55%
Percentage probability of pension being paid until death: 75%
Value of pension = ($36,000 / 0.0255) X 0.8 = $1,058,823
Although this public school teacher wasn’t earning a huge amount, she gets to retire with a $36,000 annual pension that is worth over $1,000,000. Using an 75% payment probability seems reasonable.
Most pensions also have an inflation adjuster built in order to keep up with inflation. Although sometimes, the inflation adjustments don’t keep up.
Here’s a chart I put together highlighting the values of a $35,000 and $50,000 pension (in the range of the most common pension amounts). As the rate of return goes higher, the value of your pension goes lower. Bond values work in a similar fashion as interest rates go higher and vice versa.
I’ve highlighted 2% – 4% in the chart because that’s where the 10-year bond yield is and where I think it will be for the foreseeable future. In other words, using a 2% – 4% divisor in your calculations is appropriate.
Pensions Are Extremely Valuable
All three individuals with pensions above are millionaires due to their long-term dedication. Even if you were only receiving a $15,000 a year pension, it’s still worth more than $500,000 a year using a 2.55% divisor and 90% payout probability. Given the median net worth in America is around $90,000 – $100,000, we can conclude that anybody with a pension is considered very well off.
There’s one key variable that I haven’t discussed, and that’s a pension owner’s lifespan. Unfortunately, the foreign service officer with a pension worth $2,833,333 can’t sell his pension to anybody for that amount, nor does the pension keep paying out after death. Although, in some cases, a pension can keep paying out to a surviving spouse. The reality is one’s pension value fades as the owner inches closer towards the end.
Therefore, it behooves every pension owner to live as long and healthy of a life as possible to maintain the value of his/her pension. The same logic goes for anybody with passive income, including social security. The richer you are, the healthier you should try to be!
The value of your pension is subjective. You could even multiply your annual pension amount by the average P/E multiple of the S&P 500 to come up with its value. There are many variables and variable amounts to consider.
Just know that your pension has tremendous value. If you feel your net worth is lacking based on my charts for the average net worth for above average people, simply calculate the value of your pension using my formula. I’m sure you’ll be surprised on the upside.
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Related:
How Much Should I Have In My IRA By Age?
Readers, how many of you have pensions? After how many years of service does it kick in? How does your company/organization calculate how much you will get in annual pension? How many of you are earning double or triple income by collecting a pension and working a new job?
Note: Pensions are most common in the following fields: military, government, education, gas and electric, insurance, and health services.
