## How do you value a pension?

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
Topic Author
AndroAsc
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### How do you value a pension?

How do you valuate the "net worth" of a pension?

If the formula is 1% of the average of the last 5 years of salary, for every year of service, how do I evaluate the current "net worth" of the pension?

If for example the last 5 years salary is \$100k, and I have 10 years at the company. Do I just use the 4% rule and back calculate?

The pension at my 10th year with the company is worth = \$100k x 1% x 10 = \$10k/yr
Using 4% rule (at 3%) = \$10k / 3 x 100 = \$333k

So is the pension currently worth \$333k? I realized that this number is not entirely correct because the pension would be worth \$333k at retirement (in the future, not today). So how do I back-calculate the current "net worth" of the pension, assuming I am vested?
nisiprius
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### Re: How do you valuate a pension?

You don't need to.

Since a pension can't be marketed, bought, sold, or rebalanced, it's not clear why you would want to calculate the present value.

For planning purposes, you take your retirement income requirements and subtract the guaranteed income provided by Social Security, pensions, and income annuities. It is only the remaining amount that needs to be supplied by the investment portfolio.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
papiper
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### Re: How do you valuate a pension?

You can look at a site like immediateannuities.com and see what it would cost to buy an equivalent pension but as the previous poster mentioned, net worth doesn't translate to much that's useful. It's all about funding the left over cash flow needs.
toto238
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### Re: How do you valuate a pension?

OP, you should realize that one of the most eternal struggles on this forum is to go the OTHER way around. Meaning I have a lump of money invested in a bunch of things, how can I turn that into income?

You already have your answer. If it provides \$10,000 per year, then you have \$10,000 per year in income. The real question you should be asking is how much income is your savings worth.
curiouskitty
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### Re: How do you valuate a pension?

While I agree with all the previous responses, I think the original poster probably (like many people) tracks net worth as the number that indicates whether he/she is moving in the right direction. From this perspective, its a bit inconvenient to think "well i have 1.4% less money in my accounts because the stock market went down but my pension covers 0.63% more of my necessary retirement income because I contributed for more time. am I better or worse off now?"
aaaaaaabbbbbbbbbb
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### Re: How do you valuate a pension?

Let X be the year in which you start receiving the pension. Let's assume a constant rate of inflation. If the pension is inflation-adjusted, its expected value E in year X is the first-year payout times the number of years you expect to live beyond retirement. Then its present value is E/((1 + inflation rate)^(number of years until year X)). The reality of the matter is a bit rosier, because the longer you live, the more you risk running out of savings, but the pension pays out more if you live longer and so counteracts this. The pension is the most valuable in the case where you need it most.

If the pension is not inflation-adjusted, then its expected value E in year X is approximately the first year payout divided by (1 - the rate of inflation). Then its present value is E/((1 + inflation rate)^(number of years until year X)).

However I agree with the other posters that the significance of these calculations is limited. The reason being that the present value of a pension varies depending on your lifespan, unlike most other investments. Your stock portfolio is worth \$Y when you retire, regardless of whether you will live to age 80 or age 100. But your pension is more or less valuable if you live longer or shorter. So the best way to incorporate the pension into your planning is to look at how much per year you think you will spend during retirement, subtract from that your pension amount, and then think about what sort of investment portfolio you need to provide you the remaining required income.

Also, if your pension is not adjusted for inflation (or if the solvency of your pension fund is uncertain), then the safe route is to discount the value of the pension heavily in your retirement planning.
IlliniDave
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### Re: How do you valuate a pension?

AndroAsc wrote:How do you valuate the "net worth" of a pension?

If the formula is 1% of the average of the last 5 years of salary, for every year of service, how do I evaluate the current "net worth" of the pension?

If for example the last 5 years salary is \$100k, and I have 10 years at the company. Do I just use the 4% rule and back calculate?

The pension at my 10th year with the company is worth = \$100k x 1% x 10 = \$10k/yr
Using 4% rule (at 3%) = \$10k / 3 x 100 = \$333k

So is the pension currently worth \$333k? I realized that this number is not entirely correct because the pension would be worth \$333k at retirement (in the future, not today). So how do I back-calculate the current "net worth" of the pension, assuming I am vested?
I'd just figure the \$/month I'd get and look up the price to buy an annuity that provides the same amount.

It can be useful to know when looking at changing jobs and trading off lost pension accrual and comparing it to extra 401k matching in lieu of a pension, or to starting over in a different pension plan. Also useful if you like to track your "total compensation" from your employer, or if you are considering a pension buyout from you employer (sometimes you actually can "sell" a pension) or looking to do business with JG Wentworth.

Of course regarding the utility of it, that's just my opinion, and I'm much less averse to examining my situation from different perspectives than the playbook apparently calls for.
Don't do something. Just stand there!
CFM300
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### Re: How do you valuate a pension?

OP,

As a rough calculation, I think what you've done is okay. You could add another simple step, which would be to figure how much money you'd have to have now, in order to have \$333k at the time you begin receiving your pension. That number will depend on what assumption you're willing to make regarding investment returns. If you're 5 years from receiving the pension, and you think a 4% return is a reasonable assumption given how you'd invest a lump sum today in order to have it grow to \$333k in five years, then the present value of your future pension would be about \$274k, since 274*(1.04)^5 = \$333,363.
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### Re: How do you valuate a pension?

This thread is now in the Personal Finance (Not Investing) forum (pension).
To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.
Professor Emeritus
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### Re: How do you valuate a pension?

A pension is an asset , but not a portfolio asset.

There are many types of assets that are difficult to value.
Human capital, Remainder interests in real property,
contingent claims, small businesses and intellectual property are just a few examples.

net worth is a poor scorecard if your assets fall in this category.
seeshells
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### Re: How do you valuate a pension?

State&Local Pensions: What Now: by Alicia H. Munnell, and this link http://www.pensions-insight.co.uk/pensi ... 20.subject might be of interest to the OP.
Last edited by seeshells on Tue Apr 14, 2015 11:32 pm, edited 1 time in total.
ourbrooks
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### Re: How do you valuate a pension?

Actually, there are well known actuarial techniques for computing the present value of a life annuity, which is what a pension is. You don't have to make any assumption about how long the pension will be paid for; instead, the calculation uses mortality tables. Here's a link to a calculator which does all of this for you: http://www.webfinancialtools.com/life_annuity.html
Note that the calculator requires that you make an interest rate assumption; the present value declines as the interest rate increases, because you need less "up front" the more interest you earn over the life of the annuity. Note also that the calculator requires a gender entry; women live longer than men so the same monthly pension payment has a higher present value for a woman than for a man.

Sound like there are a lot of assumptions and factors that go into the present value of a pension? There are. That's another reason just to consider the pension from the stream of income viewpoint. If the pension pays \$10,000 a year, then you've got \$10,000 a year in income, no assumptions/calculations needed.
Topic Author
AndroAsc
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Joined: Sat Nov 21, 2009 7:39 am

### Re: How do you valuate a pension?

Should clarify something. The reason why I need to valuate a pension is for job comparison.

A sample comparison might include: if I have a job paying \$80k but with pension (using the formula outlined) vs a job paying \$100k, assuming COL are the same, which job should I take, if the main consideration is the ability to grow my net worth? By converting a pension to an equivalent "net worth", I can calculate how much "extra" the pension adds to my net worth.

There's been a lot of good suggestions, but I don't know if I want to go full actuary and mortality tables on this. CFM300's suggestion on estimating "present value" based on expected future returns and time to pensions looks like a reasonable and quick estimate. Thanks!

Of course, if there are better ideas on how to do the comparison, that would be much welcomed as well!
Dandy
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### Re: How do you valuate a pension?

I think the original poster probably (like many people) tracks net worth as the number that indicates whether he/she is moving in the right direction.

I guess we all play some mental games when it comes to money. You want to convert a pension to an asset so you feel better about your net worth. Ok if it really makes you feel better. It doesn't change reality only soothes your mind. If that results in good investment practices and better sleep go ahead.

A pension is an income stream and having it is a great thing. So is a master's degree, a good marriage and having wealthy parents that are sure to leave you money. I try to remember the good things but try not to have them complicate my true financial net worth calc. I see net worth as a big picture calc - not to include, for example, what is the value of my 6 year old Chevy.
Bill M
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### Re: How do you valuate a pension?

The value certainly depends on the reason you are determining the value.

For job comparison, I'd ignore the pension until it becomes a "golden handcuff" (I'd place this somewhere around 25 years of service to a company). Recognize that the pension formula is inherently non-linear; negligible for the first 10 years and significant for the last 10 years.

If the purpose is for tracking net worth, and seeing nice graphs of net worth over time, then the "equivalent annuity" (or doing the actuarial calculations yourself) is a reasonable valuation; the main consideration is to avoid discontinuities in the graph. The same "problem" comes up if you buy an immediate annuity (e.g., SPIA), and you don't want to see a sharp drop in net worth because of the purchase.
The Wizard
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### Re: How do you valuate a pension?

OP is trying to compare two job offers, one with a pension, one without.
That makes sense.

Not quite sure how I would go about it, since you could be changing jobs in 5 or 10 years.
If you worked at that job from age 25 to 35, you would get 10% of your age 30-35 average pay when you turn 65.
With 30 years of inflation, that would be a very modest amount.

I personally would probably ignore the pension's possible future value if taking a new job in my 20's...
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#Cruncher
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### Re: How do you [e]valuate a pension?

AndroAsc in [url=https://www.bogleheads.org/forum/viewtopic.php?p=2457301#p2457301]this post[/url] wrote:... I don't know if I want to go full actuary and mortality tables on this. CFM300's suggestion on estimating "present value" based on expected future returns and time to pensions looks like a reasonable and quick estimate.
To evaluate a pension is a two step process. First you need to estimate the "present" value of the pension at the time the pension begins. Then, if the pension begins in the future, you need to estimate its present value today. In both cases you need to pick a discount rate which can represent what you think you could earn from investing the money yourself.

To estimate the first figure you could use the mortality table method referenced in ourbrooks' post. But you could also approximate it by computing the present value of a pension running for your life expectancy. For example, here are the present values at age 65 of a \$10,000 / year pension running 20 years until age 85 discounted at 3% and at 4%:

Code: Select all

``````148800 =10000 * (1 - 1 / 1.03 ^ 20) / 0.03
135900 =10000 * (1 - 1 / 1.04 ^ 20) / 0.04``````
Your procedure in the original post of just dividing the income stream by a discount rate (333K = 10K / 0.03) overstates the present value since it represents the value of a perpetual annuity, not one that stops after a fixed number of years.

You then compute the present value today using the method explained in CFM300's post. Here it is assuming the pension would begin in 5 years again discounted at 3% and at 4%:

Code: Select all

``````128400 =148800 / 1.03 ^ 5
111700 =135900 / 1.04 ^ 5``````
DJB
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### Re: How do you valuate a pension?

I have found some practical value in a similar exercise, however instead of calculating the net value of my pension, I looked at the incremental present value of each year going forward. The purpose for doing so is to get a rough sense of the value of my total compensation to help me evaluate my current position in relation to others. It also taught me just how back-loaded these DB pensions plans are in terms of their value.
Professor Emeritus
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### Re: How do you valuate a pension?

AndroAsc wrote:Should clarify something. The reason why I need to valuate a pension is for job comparison.

A sample comparison might include: if I have a job paying \$80k but with pension (using the formula outlined) vs a job paying \$100k, assuming COL are the same, which job should I take, if the main consideration is the ability to grow my net worth? By converting a pension to an equivalent "net worth", I can calculate how much "extra" the pension adds to my net worth.
Its actually easier to do it on an "income " basis. We had a choice of pensions.

As a faculty member I knew the state contribution to the optional retirement was 7.2 % The state actuary calculated the required state contribution to fund the DB pension I was in as 14 %. (I was paying 7%) The multiplier on the state DB pension was 1.82 % It was also COLA'd

When you run all the numbers a 1% pension was worth about 7% of salary. of course there were a lot of assumptions in that number.

With DB pensions the actuarial value of the pension skyrockets in the last few years of work to the eligibility point then it levels out.

Now that I am retired I put the income stream into an annuity calculator and add 20% for the inflation protection.