How much is a Pension Worth?

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mtb286
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How much is a Pension Worth?

Post by mtb286 »

Say you're 50 and just retired. You have a defined benefit pension with your employer (large State government) that will give you $10,000 each year in cash and a $5,000 each year subsidy for State health insurance. Your employer wants to negotiate a lump sum offer instead of monthly lifetime payments...what is the lowest lump sum payment that you would accept?

One could factor in a 4% SWR and figure $15,000*25 = $375,000. However, I think more factors come into play with inflation, medicare, and if you want to leave an inheritance for someone. So, based on this theoretical example, what would be your lump sum amount and why?
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market timer
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Post by market timer »

These values are highly sensitive to current interest rates. I'd get a few quotes for annuities paying $15K/year (maybe less if you won't use the full $5K/year health insurance subsidy).
Last edited by market timer on Thu Jul 14, 2011 7:26 am, edited 2 times in total.
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bobcat2
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Post by bobcat2 »

Why don't you price a life annuity at age 50 that pays $15,000 per year to arrive at the lump sum your benefits are currently worth?

BobK
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ofcmetz
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Post by ofcmetz »

bobcat2 wrote:Why don't you price a life annuity at age 50 that pays $15,000 per year to arrive at the lump sum your benefits are currently worth?

BobK

I think the price of an annuity is the closest thing. Also take into account whether you get cost of living raises with your pension as well as any survivor benefits that it has. Mine pays me 100% and then pays my wife 75% if I croak before her.
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Carl53
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Post by Carl53 »

You can do a present worth analysis via a spreadsheet. You need to discount the value of future receipts back to the current year so that you can make a fair comparison. This might not be necessary if your state government makes inflation adjustments to the pension as many of them do. I know of no private pension funds that do this. One plus of taking the pension lump sum would be that if you were otherwise eligible for SS as a spouse or if you had 40 quarters of non governmental work. I believe that eliminating the government pension via a lump sum payment would help you in avoiding offsets or WEP that might otherwise impact your SS.

To be complete, you need to layout projected SS receipts, pension options, IRAs and the like to determine what the best overall plan is. Personaly I did not have a lump sum option, but the analysis did reveal that there may come a point at which the company no longer has to put any more money away for your pension assuming the date of your expiration is fixed. Basically, that means the PW of pension yet to be earned no longer is going up and may decrease, at least for those in the private pension world.
staythecourse
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Post by staythecourse »

ofcmetz wrote:I think the price of an annuity is the closest thing. Also take into account whether you get cost of living raises with your pension as well as any survivor benefits that it has. Mine pays me 100% and then pays my wife 75% if I croak before her.
I agree. Just make sure you are comparing apples to apples. Take into account any COLA and survivor benefits.

Good luck.
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Dandy
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Post by Dandy »

State pensions used to be a sure thing - now probably. Whatever the numbers say remember two things:

1. The state wants to shift risk to you very badly- if you have a large retirement portfolio then you are already managing a large risk pool. If you do not have a large retirement portfolio then you probably need some "secure" income. Either way it seems to me a pension is usually the better choice.
2. There is great peace of mind when a pension and social security etc meets
all or most of your ongoing expenses. When a good portion of your ongoing expenses depends on your portfolio management skills (or later on - on your spouse's skill) it can become worrisome. I try to remember that my sharpness may fade faster than my knowledge of it.

Make sure the lump sum is enough to at least buy an annuity that approximates the pension offer.
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mtb286
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Post by mtb286 »

Thanks, that's pretty insightful. I'm years away from retirement so I don't know that much about annuities, pensions and other retirement things. I was trying to gauge how much the current retirement system that I'm in is worth. For example, how much of a salary increase would it take for me to be willing to drop the pension. There are a lot of variables, but a real rough estimate for me at this stage (5 years in) might be ~15%.
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runthetrails
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Post by runthetrails »

Take a look at https://www.networthiq.com/people/Finan ... on-benefit

I like to include my pension in our net worth, so here's the calculation that I do in LibreOffice. It should be the same in Excel.

Code: Select all

CELL     CONTENTS 
C3        $2100.00
C4        09/01/2024
C5        6.5%
C6        25
C7        =PV(C5/12,C6*12,-C3,0)
C8        =PV(C5/12,MONTHS(TODAY(),C4,0),0,-C7)
Where
C3= the monthly benefit
C4= the commencement date
C5= the discount rate
C6= how many years of retirement
C7= the lump sum value at retirement
C8= the discounted present value of the future lump sum
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mtb286
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Post by mtb286 »

runthetrails wrote:Take a look at https://www.networthiq.com/people/Finan ... on-benefit

I like to include my pension in our net worth, so here's the calculation that I do in LibreOffice. It should be the same in Excel.

Code: Select all

CELL     CONTENTS 
C3        $2100.00
C4        09/01/2024
C5        6.5%
C6        25
C7        =PV(C5/12,C6*12,-C3,0)
C8        =PV(C5/12,MONTHS(TODAY(),C4,0),0,-C7)
Where
C3= the monthly benefit
C4= the commencement date
C5= the discount rate
C6= how many years of retirement
C7= the lump sum value at retirement
C8= the discounted present value of the future lump sum
Wow, that's really cool! Exactly what I was looking for. What is the discount rate and how can I determine what I should enter for it?
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artthomp
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Pension evaluation

Post by artthomp »

I went to the following Berkshire Hathaway Pension Estimator web site:

http://www.brkdirect.com/spia/EZQUOTE.ASP

I entered a birth date of 7/14/1961 (50 years old) and a desired monthly payout of $1,250 ($15,000 / 12).

The answer for life contingent was:

"Your investment of $266,686 will yield 3.97% based upon our mortality assumptions and the U.S. Treasury yield curve as of July 11, 2011. This investment will provide you with $1,250 every month for as long as you live, beginning on September 1, 2011."

The answer for Joint & Survivor was:

"Your investment of $293,650 will yield 4.19% based upon our mortality assumptions and the U.S. Treasury yield curve as of July 11, 2011. This investment will provide you with $1,250 every month for as long as you or the joint annuitant are alive, beginning on September 1, 2011."

Anything below $267K would probably make the pension more desirable and anything above $293K would probably make the lump sum more desirable. I think you will find that any lump sum offered is generally less than it would take to purchase an annuity for the pension amount.
Art
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runthetrails
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Post by runthetrails »

mtb286 wrote:What is the discount rate and how can I determine what I should enter for it?
Well, I chose 6.5% as the more conservative estimator from the range suggested in the article I linked. A higher discount rate means a lower present value. However, I'm not a finance guy, so can't give you a reasoned explanation for that number.
gsmith
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Post by gsmith »

runthetrails wrote:
mtb286 wrote:What is the discount rate and how can I determine what I should enter for it?
Well, I chose 6.5% as the more conservative estimator from the range suggested in the article I linked. A higher discount rate means a lower present value. However, I'm not a finance guy, so can't give you a reasoned explanation for that number.
A discount rate is the return that a pension fund can deliver on an annual basis. If they don't meet that number, the government has to pay to make up the remainder.

6% is reasonable ROI over a long period of time, but you will see states like Illinois push the number up so they can push payments out.
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mtb286
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Post by mtb286 »

Well I ran some numbers based on the "runthetrail formula" and the lump sum for my pension is coming out to ~$240,000. Now, if I take my mandatory contributions and grow that at 4% until I retire, I get $170,000.

I was actually pretty excited that the difference isn't as much as I originally figured. I'd like to stay with my current employer until I retire but that's a ways away so this makes me feel less tied down.

Does anyone know if state pensions affect SS benefits and medicare? If so, by how much?
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Post by Prudent Saver »

gsmith wrote:
runthetrails wrote:
mtb286 wrote:What is the discount rate and how can I determine what I should enter for it?
Well, I chose 6.5% as the more conservative estimator from the range suggested in the article I linked. A higher discount rate means a lower present value. However, I'm not a finance guy, so can't give you a reasoned explanation for that number.
A discount rate is the return that a pension fund can deliver on an annual basis. If they don't meet that number, the government has to pay to make up the remainder.

6% is reasonable ROI over a long period of time, but you will see states like Illinois push the number up so they can push payments out.
That's incorrect. What you describe is the expected long term return on plan assets. The discount rate is the settlement rate. In other words, what rate of discount would current and future pensioners accept to get paid a lump sum today instead of the annuity at a future point in time. This rate depends on the perceived riskiness of the party that owes the money. And when benefits are constitutionally protected, there's no way a rational investor would accept such long term return expectations.
Be greedy when others are fearful, and fearful when others are greedy.
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Post by joe8d »

State pensions used to be a sure thing - now probably. Whatever the numbers say remember two things:

1. The state wants to shift risk to you very badly- if you have a large retirement portfolio then you are already managing a large risk pool. If you do not have a large retirement portfolio then you probably need some "secure" income. Either way it seems to me a pension is usually the better choice.
2. There is great peace of mind when a pension and social security etc meets
all or most of your ongoing expenses. When a good portion of your ongoing expenses depends on your portfolio management skills (or later on - on your spouse's skill) it can become worrisome. I try to remember that my sharpness may fade faster than my knowledge of it.

Dandy makes some excellent points here.I would stay with the DB pension.
Last edited by joe8d on Thu Jul 14, 2011 8:20 pm, edited 1 time in total.
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Post by dandan14 »

runthetrails wrote:Take a look at https://www.networthiq.com/people/Finan ... on-benefit

I like to include my pension in our net worth, so here's the calculation that I do in LibreOffice. It should be the same in Excel.

Code: Select all

CELL     CONTENTS 
C3        $2100.00
C4        09/01/2024
C5        6.5%
C6        25
C7        =PV(C5/12,C6*12,-C3,0)
C8        =PV(C5/12,MONTHS(TODAY(),C4,0),0,-C7)
Where
C3= the monthly benefit
C4= the commencement date
C5= the discount rate
C6= how many years of retirement
C7= the lump sum value at retirement
C8= the discounted present value of the future lump sum
While that's close, that's not exactly accurate because no one knows "how many years of retirement" we'll have. Only in large numbers can that be estimated.

So I agree with others. The easiest way is going to be to price a similar annuity.

This one will give you prices, but doesn't have a cola option:

http://www.immediateannuities.com/
Harold
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Post by Harold »

In one way or another, this question comes up all the time in this forum. And it usually generates a whole array of approaches for approximating the value -- and usually none of them are the way actuaries and other finance professionals in the arena would do it.

It's really a fundamental concept worth understanding, since a pension can be valued the same as a bond, mortgage, stock, or anything else that's the present value of a stream of payments.

You can take a spreadsheet and fill one column with the expected payments (known in the case of pension/bond/mortgage, estimated in the case of stock).

For the next column, fill in with 1/(1+i)^n where n is the time until payment and i is an interest rate commensurate with the risk of the payment being made (such current market rates are readily available, Treasury, Bloomberg, etc.).

For the next column, fill in with a probability expressing whether the stipulated payment is to be made (for bonds 1, for pensions there are mortality tables available at ssa.gov among other places).

Multiply those columns together in a 4th column, and add all the entries to get the value.

(I simplified just a little bit, because stocks for example might have more payments/earnings than there are rows in the spreadsheet, so you'd want to use formulas for infinite series or the like.)

Edited: to clarify the probability column, since there was apparent confusion
Last edited by Harold on Fri Jul 15, 2011 9:06 am, edited 1 time in total.
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Post by Prudent Saver »

Harold wrote:In one way or another, this question comes up all the time in this forum. And it usually generates a whole array of approaches for approximating the value -- and usually none of them are the way actuaries and other finance professionals in the arena would do it.

It's really a fundamental concept worth understanding, since a pension can be valued the same as a bond, mortgage, stock, or anything else that's the present value of a stream of payments.

You can take a spreadsheet and fill one column with the expected payments (known in the case of pension/bond/mortgage, estimated in the case of stock).

For the next column, fill in with 1/(1+i)^n where n is the time until payment and i is an interest rate commensurate with the risk of the payment being made (such current market rates are readily available, Treasury, Bloomberg, etc.).

For the next column, fill in with a probability expressing whether the payment will be made (for bonds 1, for pensions there are mortality tables available at ssa.gov among other places).

Multiply those columns together in a 4th column, and add all the entries to get the value.

(I simplified just a little bit, because stocks for example might have more payments/earnings than there are rows in the spreadsheet, so you'd want to use formulas for infinite series or the like.)
The discount rate already accounts for probability of payment. If you have a column that calculates expected value for a probability of payment, you've double counted this factor if the discount rate isn't risk free. If you insist on having this column, you the must use the risk free rate as the discount rate.

The simplest way to value the pension in a lump sump sum would be as follows:

1. Follow your excel formula you outlined and model the stream of payments up until expected mortality (using well known mortality tables, not your own estimate)

2. Discount the payment based upon risk. For governments, these are constitutionally protected in most cases. It's appropriate to use the risk free rate for those. For corporations, use that entities borrowing rate. If there is no bond issue with a comparable term, use the average corporate bond with a similar risk rating and similar duration.

3. The resulting value is the lump sum the obligated entity would pay. At this point, it would be wise to consider family history, to get an idea if your genes indicate you will live longer or shorter than average. If longer, then I don't think it makes sense to take the tax effected lump sum as the present value of your payments would be higher than average, and the rate of return you'll get from an annuity will almost always be less than the pension discount rate as those fees can be vicious. If shorter, then it may need to be considered, but you still MAY NOT WANT TO, depending on your investing skill, risk tolerance, makeup of your entire portfolio and balance sheet, etc.

I hope this post was helpful.
Be greedy when others are fearful, and fearful when others are greedy.
Dandy
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Post by Dandy »

Some things to consider when evaluating an annuity vs the state pension are:
1. Will the annuity exceed the state "guarantee" of private annuities? States have a annuity guarantee program that is not often known and I believe insruance companies can't mention it in their sales pitch. I think most states use $100,000.
2. If the amount you have to commit to a private
annuity is greater than you state's guarantee you need to buy annuities from several companies to make sure you don't "put too many eggs in one basket".

3. Pensions are insured by the Federal government for about $40k per year. Of course that agency of the government is very underfunded and a lot of company and state pensions are underfunded. Not absolutely sure if the Federal Government provides pension guarantees for state pensions.

4. If the monthly payout of the pension and private annuity are close -- you may want to consider which "provider/insurer" has the lower risk of default - the state or the private insurance compay(s).

It used to be that pensions especially state pensions and private annuities from highly rated insurance companies were very secure. That is probably the case now but since the 2008 crash and in the current government debt, the recession affecting private companies, and the political climate about the role of government, regulations and taxes -- makes long term financial arrangements a bit more dicey.

Sorry if the above muddies the decision waters but there are a lot of things going on and today is different than yesterday and tomorrow is likely to be different than today.
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Post by Harold »

Prudent Saver wrote:The discount rate already accounts for probability of payment. If you have a column that calculates expected value for a probability of payment, you've double counted this factor if the discount rate isn't risk free. If you insist on having this column, you the must use the risk free rate as the discount rate.
You're mistaken.

The discount rate reflects the risk of the payment being offered (e.g. whether a bond issuer will honor its agreement). The probability (e.g. in a pension where a participant needs to be alive) reflects the likelihood of a stipulated payment being needed.

Look, this is how it's done. It's not being put out there to argue about from first principles.
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Post by Harold »

Prudent Saver wrote:model the stream of payments up until expected mortality
I'll offer another clarifying observation.

The reason for not using the simplifying assumption of an expected lifetime and certainty of payment (or stipulation of payment) is that it's not mathematically equivalent to using the individual probabilities of survival (an application of Jensen's inequality).
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runthetrails
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Post by runthetrails »

dandan14 wrote:
runthetrails wrote:Take a look at https://www.networthiq.com/people/Finan ... on-benefit

I like to include my pension in our net worth, so here's the calculation that I do in LibreOffice. It should be the same in Excel.

Code: Select all

CELL     CONTENTS 
C3        $2100.00
C4        09/01/2024
C5        6.5%
C6        25
C7        =PV(C5/12,C6*12,-C3,0)
C8        =PV(C5/12,MONTHS(TODAY(),C4,0),0,-C7)
Where
C3= the monthly benefit
C4= the commencement date
C5= the discount rate
C6= how many years of retirement
C7= the lump sum value at retirement
C8= the discounted present value of the future lump sum
While that's close, that's not exactly accurate because no one knows "how many years of retirement" we'll have. Only in large numbers can that be estimated.

So I agree with others. The easiest way is going to be to price a similar annuity.

This one will give you prices, but doesn't have a cola option:

http://www.immediateannuities.com/
I agree -- 25 years is what I used as a conservative estimate, which may not be suitable for the OP's calculation.

I like the idea of pricing an immediate annuity to get the value of one's pension, as it should have mortality information built in, but don't we then need to discount that value (which is a future lump sum) to get the present value? Time value of money and all that? Or can one get a quote on an immediate annuity to begin 20 years from now?
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