How Do I Calculate The Value Of A Pension?

How Do I Calculate The Value Of A Pension?

If you’ve got a pension, count yourself as one of the lucky ones. You won’t be forced to lower your safe withdrawal rate in retirement like those of use who don’t have pensions. This post will help you calculate the value of a pension. The value of a pension has skyrocketed since interest rates collapsed during the global pandemic.

Pensions, also known as Defined Benefit plans, have become rarer as companies force their employees to save for themselves mainly through a 401k, 457, 403b, 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 $19,500 or $6,000, respectively for 2021. 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. 

How To Calculate The Value Of A Pension

The best way to calculate the value of a pension is through a simple formula. The value of a pension = Annual pension amount divided by a reasonable rate of return multiplied by a percentage probability the pension will be paid until death as promised.

For example, here is an example of how to calculate a pension with the following data:

Average income over the last four years: $90,000

Annual pension: $67,500

A reasonable rate of return divisor: 2.55%

Percentage probability of pension being paid until death: 95%

Value of pension = ($67,500 / 0.0255) X 0.95 = $2,514,706

How Do Pensions Work?

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.

Less than 15% of the American workforce have a pension (defined benefit) in  2021 - how to calculate the value of a pension
The difference between defined benefit and defined contribution has most certainly widened in 2021

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 under 1%. In other words, one can reasonably expect to earn 1% 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.

Pensions Have Become Much More Valuable

Given interest rates collapsed in 2021, it takes more capital to generate the same amount of risk-adjusted returns/income. Therefore, the value of a pension has gone WAY UP because the value of cash flow has gone way up.

Just take a look at this chart regarding how much more capital is needed to generate $50,000 a year in income.

Let’s calculate the value of various pensions below.

Example 1: Police Officer Retiring After 25 Years Of Service

Here is the example again of how to calculate the value of a pension with some commentary after.

Average income over the last four years: $90,000

Annual pension: $67,500

A reasonable rate of return divisor: 2.55%

Percentage probability of pension being paid until death: 95%

Value of pension = ($67,500 / 0.0255) X 0.95 = $2,514,706

Well how about that! After 30 years of service, this police officer will have a pension worth roughly $2,514,706 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: $43,000

A reasonable rate of return divisor: 2.55%

Percentage probability of pension being paid until death: 75%

Value of pension = ($43,000 / 0.0255) X 0.8 = $1,349,019

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.

How to calculate the value of your pension chart

Thanks to the craziness in 2021+, the 10-year bond yield has declined to under 1%. Therefore, the value of your pension has gone way up. You want to hold onto your cash cows for as long as possible. Your reasonable return of return divisor should be lowered to 1% – 2% in this low interest rate environment.

A Pension’s Value Is Subjective

Obviously, my calculation is simplistic because we all die at some point. My calculation is based on cash flow into perpetuity. To counteract the perpetuity, I assign a Probability of Payout percent. Further, we all won’t have surviving spouses to continue receiving the pension long after we’re gone.

You’re free to lower the Probability of Payout percentage to account for shorter lifespans or a more pessimistic life outlook. You can also call the Probability of Payout the Pension Discount Rate if you wish.

Just remember that value is subjective. Once we’re dead, what does anything really matter? There’s no longer a need to earn any money for ourselves. Given most pensions continue to pay out to a surviving spouse, s/he is covered until death as well.  

What this article and my calculation attempts to do is provide an easy way for all pensioners to assign a real value to their pensions and to give pensioners hope that their financial situation isn’t as dire as expected if they are comparing themselves to private sector workers or my average net worth for the above average person chart.

Cherish Your Valuable Pension

Percentage of households by annual pension income

All three individuals with pensions above are millionaires due to their long-term dedication and pensions. 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 $100,000, we can conclude that anybody with a pension is considered very well off. Less than 20% of Americans have pensions in the new decade.

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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Fundrise historical returns

Stay On Top Of Your Finances: The best way to grow your net worth is to track your net worth. I’ve been using Personal Capital’s free financial tools and app to optimize my wealth since 2012. It is the best free money management tool on the web.

Just link up all your financial accounts (I have 35), and start measuring your cash flow, x-raying your portfolio for excessive fees, calculating your retirement income, and more. There’s no rewind button in life. Therefore, you need to do your best to optimize the wealth you have now.

Planning for retirement when paying for private grade school
Personal Capital sample retirement planner calculator. Are you on track? Click to find out.

Note: Pensions are most common in the following fields: military, government, education, gas and electric, insurance, and health services.

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