The defined benefit plan, more commonly known as a pension, is becoming more rare. I touch on this phenomenon in my book RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit and numerous posts on this blog, including the recent post, Pensions. Going, Going … . Although they are becoming more rare, some workers – including myself and my wife – are still on track to receive a pension from their current employer.
The Pension … a Dying Benefit
If you are on track to receive a pension, it is likely that your employer has provided some guidance as to what your projected pension will be, or if you are like me, you have done the calculation yourself based on your employer’s benefit formula. Most benefit formulas consider factors such as the number of years of employment, pay and a given percentage.
As an example, my employer uses the following formula for those who retire before age 62: 1% × High-3 Average Pay × Years Service. This is how it would look for someone who worked 30 years, 4 months (4/12 years or 30.33) when their highest three years – typically the final three – of salary averaged $80,000 … .01 × 75,000 × 30.33 = $22,747.50.
Rounding that down to a nice even $20,000, what would be the dollar value of that in retirement, say compared to a defined contribution plan such as a 401(k)? In other words, we typically track the value of our retirement plans (e.g. 401(k) and IRAs) and have a target number (e.g. $500,000) in mind for the day we retire. How would we convert that $20,000 pension to a comparable retirement plan number? Is a $20,000 annual pension equivalent to a $500,000 401(k) account balance? Is it worth more, less?
With $20,000 as the first relevant number, let’s look at the second relevant number, the number of years most planners assume people will spend in retirement, or at least should plan to spend in retirement, 30 years. With those two numbers we could just use the very simple formula, Number of years (30) x Annual Pension ($20,000) to get $600,000. That’s it, right? Not quite. The problem is that number does not account for inflation.
As I touch on in RWR, while one part of retirement planning is science – in that some things are known and quantifiable – other parts of retirement planning are art, meaning that some assumptions/projections have to be made. Accounting for inflation is an example of art since none of us know what it will be over the 30 years you might spend in retirement. Therefore, we’ll take a look at a couple different assumptions/projections to get a sense of the difference.
Using an inflation calculator – the results below are from the Inflation Calculator, a complementary tool to RWR, available as a free download – we get the following for 1% and 1.5% inflation on $600,000. Note that Required Amount is what would be required for the future amount to retain the same value as the present amount and Reduced Amount shows the reduced value of the present amount after inflation is accounted for over a given number of years:
As you can see, inflation can have a significant impact on the value of your money and it can vary depending on the level of inflation. So there you have it, once we account for inflation, we can project that a $20,000 annual pension is roughly comparable to a $445,153.75 401(k) or IRA account balance, at an annual inflation rate of 1.0%; or $383,857.46 at an inflation rate of 1.5%. Of course, if your employer’s defined benefit plan includes a Cost of Living Adjustment (COLA) that matches the previous year’s rate of inflation, the impact of inflation would be negated. Unfortunately however, not all benefit plans provide a COLA, or if they do, they may not offset the full rate of inflation.
Wait, Hold On
While it is kind of interesting to compare the value of a pension to a 401(k) account, there really isn’t any practical value in comparing the two. What matters in retirement is your annual income and understanding the roles your defined contribution plan (e.g. 401k) and defined benefit plan (e.g. pension), sources of portfolio income and passive income respectively, will play.
Let’s assume your desired retirement income is $50,000. Let’s further assume you have calculated that you will be receiving a $25,000 pension (passive income) from your current employer. That leaves you with a $25,000 shortfall which must be covered by portfolio income. Using the 4% rule as a guide, you will require a 401(k) balance that can provide $25,000 annually. The math is pretty straight forward … 25,000 / .04 = 625,000. In this example, an individual that desires retirement income of $50,000 and has accounted for $25,000 of that via a pension, will need a $625,000 401(k) balance to provide the other $25,000 annually.
If you are fortunate enough to be on track to receive a pension, the most important thing to understand is how to calculate what your pension will be and to calculate the required balance in your investment portfolio – which includes your 401(k), IRAs, brokerage accounts, etc. – to cover any shortfall.