The Math of Pensions and Contributions in lieu of

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The Math of Pensions and Contributions in lieu of

Postby investingdad » Thu Mar 21, 2013 8:31 am

The other thread about variable company matches to 401k accounts got me to think about this.

My employer is a Fortune 500. If you came on board after a certain date, you're not eligible for pension. In lieu of pension, you get a percent of your salary into your 401k account. This percent is based on years of service, and is from 4% of salary up to 6% of salary. All employees also get a matching contribution regardless of pension eligibility, this is up to 4% of your salary.

If you are eligible for pension, you had the choice to take the 4% contribution at the time of the cutoff and would no longer recieve credit for additional years service when your pension was eventually calculated.

Ok, so my situation is that I was never eligible for the pension. I put together a horribly rough spreadsheet to figure out what kind of returns you needed to get on the company contribution in lieu of pension based on how the pension value is calculated. This is what I came up with:

- assume I retire at 65
- assume I live to 92
- average annual return prior to retirement, 8.5%
- average annual return post retirement, 2%

Those rough annual returns are what is needed to take a yearly draw down equal the pension yearly payment w/o the balance going to zero before age 92. I'm sure the finance people spent countless hours running numbers and scenarios using acturial tables to figure out what benefits the company when they made the decision. And I'm sure I'm missing something, but very roughly...those are the types of returns I need to get on the money I'm getting now to make up for the pension I won't be getting from my employer down the road.
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Re: The Math of Pensions and Contributions in lieu of

Postby Grt2bOutdoors » Thu Mar 21, 2013 8:36 am

The finance folks are dependant on actuarial services to tell them the costs. That sounds about right, my Fortune 500 company did something similar for folks of a certain age. However, I'd say the returns you need will be far greater as you get older because most companies waited until about age 50 before making significant contributions on behalf to cover the pension expense.
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Re: The Math of Pensions and Contributions in lieu of

Postby RadAudit » Thu Mar 21, 2013 8:40 am

investingdad wrote:average annual return prior to retirement, 8.5%


If that's what you need, you may want to make plans to save more. 8.5% average annual return may be difficult to achieve because you'll want to make your portfolio more conservative as you get closer to retirement.
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Re: The Math of Pensions and Contributions in lieu of

Postby investingdad » Thu Mar 21, 2013 8:46 am

RadAudit wrote:
investingdad wrote:average annual return prior to retirement, 8.5%


If that's what you need, you may want to make plans to save more. 8.5% average annual return may be difficult to achieve because you'll want to make your portfolio more conservative as you get closer to retirement.


Oh, trust me, this post wasn't a reflection about what I'm saving and investing. I posted about my situation in another thread so I won't dovetail into that here. Rather, I was simply posting about the very high level calculation I did to see what one had to pull off in the marketplace to try to turn my employer's contributions in lieu of pension into a bucket of money large enough to make up for the pension I won't be getting.

I agree that 8.5% may be difficult to achieve, which is why my employer made the switch. It's absolutely saving them money to do this.
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Re: The Math of Pensions and Contributions in lieu of

Postby sscritic » Thu Mar 21, 2013 9:02 am

investingdad wrote:- average annual return prior to retirement, 8.5%
- average annual return post retirement, 2%

Those rough annual returns are what is needed to take a yearly draw down equal the pension yearly payment w/o the balance going to zero before age 92.

Doesn't 6.5% and 125% work as well?
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Re: The Math of Pensions and Contributions in lieu of

Postby investingdad » Thu Mar 21, 2013 9:09 am

There are many combinations that provide a solution, but limited combinations that provide a solution that also attempt to mirror historical returns consistent with an age appropriate portfolio.
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Re: The Math of Pensions and Contributions in lieu of

Postby sscritic » Thu Mar 21, 2013 9:54 am

You asked for what you were missing. I think you have chosen the wrong variables. If you make 8.5% at age 64 and 2% at age 66, how do you define an age appropriate portfolio, 90% stocks before age 65 and 10% after? If you have a portfolio that changes with age, the returns before and after retirement will not be fixed.

Perhaps you actually found a 60 year series of returns (running from 32 to 92) and your average returns are really averages, but that's not what you wrote. So let's turn it around, what am I missing?
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Re: The Math of Pensions and Contributions in lieu of

Postby g$$ » Thu Mar 21, 2013 10:25 am

your time of death assumption is over-simplified. the actuaries that helped them arrive at this would not have used a single age. more likely, they assumed x% die at 65, y% die at 66, z% die at 67... etcetera. They may have taken a similar approach to retirement age.

maybe i missed it, but did you provide a hire age? the length of the accumulation period is going to have a decent impact on the calculations.
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Re: The Math of Pensions and Contributions in lieu of

Postby Nathan Drake » Sun Mar 24, 2013 12:17 am

Be thankful that you're getting an extra 4% in lieu of a pension.

I started at my job a year after they stopped offering pensions. My extra contribution compared to my peers?

1%

....

Yeah, I'm actually so mad about it that I'm seriously considering finding another job. I feel I'm at a huge disadvantage compared to coworkers that started just a year earlier.
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Re: The Math of Pensions and Contributions in lieu of

Postby Valuethinker » Sun Mar 24, 2013 4:18 am

Just as a rule of thumb, to get, over a 35 year career, a pension equal to 2/3rds final salary, an employee must:

- make (him and employer) a gross contribution of 15% of salary for the whole career

(the actual number now, with current interest rates and prospective return, is somewhere in the 20s, perhaps 22-25%)

So you can see that to the extent the employer can abolish this:

- they save money directly if they can drop below 15%

- since in a DB scheme they pick up the tab if there is a shortfall, any prudent CFO would want to cap the liability

Helpfully, behavioural finance at work, it turns out employees don't value pension benefit dollars 1 for 1 with salary. So cutting your pension contribution by say 5% doesn't feel like a 5% cut to staff. Probably because retirement is a long way away and the calculation is complex.
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Re: The Math of Pensions and Contributions in lieu of

Postby nedsaid » Mon Mar 25, 2013 12:08 am

This is a great thread.

I will have a small defined benefit pension from my first employer right out of college.

My current employer froze its Cash Balance Pension three years ago. We get interest payments but they aren't adding new contributions to it.

So this is a topic that caught my eye.

Valuethinkers last post does a great job summarizing the math behind the defined benefit pensions that fewer and fewer companies are offering. You can see from the math why companies are making the switch.

I am glad that my retirement is mostly in accounts that I control now that so many defined benefit pensions are underfunded. It makes me squirm when I see the state of some of the public employee pensions. I won't have to worry about getting a letter from the pension plan telling me that my pension has been cut. I do have to worry about market risk.

Great thread. Great posts.
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