What is Your Pension Worth?

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.

QuestionAs 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.

Retirement Planning

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:

Pension Projection I

Pension Projection II
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.

Retirement Income

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.

Blogger-in-Chief here at RetirementSavvy and author of Sin City Greed, Cream City Hustle and RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.

11 Comments

  1. Hello James, I am trying to determine what to do regarding a previous employer I worked for who provided a pension benefit until a few years ago; prior to my leaving. I have a choice to accept a lump sum or continue the same course. Employer formula is 1.5% of monthly average salary with a 5 year guarantee and life benefit which carries to spouse after my death. I worked for this company for 7 years and average pay monthly $4166. The monthly benefit for this short time period would be $437 monthly. I currently am making over double my previous salary and am participating to the max 401k benefit of my employer (25%). I wonder if the lump is a good idea I do not know what the value of this pension is.

    • A difficult question as there are a lot of factors. The first thing I would do is contact the HR department to find out the value of the lump sum if you went that route. With that information in hand, there are at least four factors to consider. If you take the lump sum, what would you do with it? The best option would likely be to roll it over to an IRA, as taxes will likely be due if you take the money now. A second thing to consider is the stability of the company. If it’s a solid company and you’re confident they will be financially sound for years to come – well into your retirement – that would make maintaining the pension benefit more attractive. Conversely, if there is some doubt as to the company’s long-term viability, taking the money now is more attractive. A third thing to consider is what are/will be your other sources of passive income? I’m a big fan of locking in a few sources of passive income where possible. As an example, the wife and I will have three sources of passive income – five if I include Social Security – so I would likely take the lump sum and put it to work myself. However, if we didn’t have another source of passive income, I would probably be more inclined to leave the money with the company and maintain the pension benefit. And finally, you really have to consider your total retirement plan. In other words you have to take a holistic look at all the factors (i.e. your current age, your desired retirement age, value of current investments, current contributions, projected savings, projected rate [average] of return, the 4% rule, and sources of passive income) that will come into play.

      I discuss developing a plan – based on all the relevant factors – in my book RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit and walk readers through how to use my planning spreadsheet.

      I also make the spreadsheet I created available as a free download. If you decide to check out the book or just download the spreadsheet, feel free to reach out to me via email and I would be glad to walk you through it to help answer your question.

  2. James, I’m at that point (63) where I wonder (as everyone else), will I have enough? I have a $1,500/mo pension from my late wife. My Social Security benefit (at FRA) is currently projected to be $2,650/mo. I have no mortgage (house is paid). I have about $600k in annuities (last year I got hesitant about leaving that amount in the stock market). I’m managing a modest income ($32k) from real estate sales after losing my 6 figure income in 2014. Health is excellent (so far). Your thoughts?
    Lifestyle questions: I would love to do a bit of international travel. I don’t smoke, or drink (1 drink/2-3 months).

    • I would love to give you my thoughts. There is a lot to consider, and therefore, I have sent you an email with some guidance as to how we can talk in some detail. I look forward to hearing from you.

  3. Hey, James. You’re a brave soul. I haven’t even attempted to wade through Piketty’s Capital in the Twenty-First Century. Perhaps when I’m done with the Bible, I’ll give it a go. But Piketty’s insights are one of the reasons I came up with the Junior IRA. I’d rather see adults give the children in their lives the gift of capital rather than more games or toys that will soon be abandoned.

    • I really enjoyed the book and absolutely recommend it. If you get a chance to tackle it, I would love to hear your thoughts.

  4. I have a defined pension from my job, but they slashed it years ago so now it is only one-third of what it used to be. I haven’t run the numbers, but I have the feeling it will basically cover my gas money each month when it comes time to collect 🙂 This is also especially true as I plan to retire early!

  5. Once again a great article Savvy James! In my line of work, I run across many military pilots who leave active duty at the 10 – 12 year mark, mostly for quality of life issues but others just to test the civilian pilot market. Granted for some, military life just doesn’t fit but for the remainder, I always try to “enlighten” them on the value/benefit of a military retirement/pension and how close they are to receiving one. It’s not so much the dollar amount, but the piece of mind it’ll give them is priceless. As a retired military officer, I know you’ve heard this line many times, “If I only stayed until 20…..”

    • “It’s not so much the dollar amount, but the piece of mind it’ll give them is priceless.” Indeed! As always, thanks for stopping by and adding to the conversation, my friend.

  6. Interesting article. I don’t think people look at it in those terms, I know I didn’t. Eye opener for sure. I will have to sit down and figure out if I am still on the right track. Thank you SavvyJames.

Leave a Reply

Your email address will not be published. Required fields are marked *