Pension Options Advice

[AJDZee]

I hate to ask for advice on this - usually run my own analysis and let the numbers do the work, but I feel like I'm missing something and looking for another opinion/advice.

Background:
I recently got a new job that has a defined benefit pension plan and need to make a selection in the next few days. (I'm used to defined contribution pension, which I like much better)

There are 2 options I can choose...
1. Join the regular pension where my employer makes all contributions up to the government pension contribution max which is $53,600 for 2015. (I don't pay anything, but it's a lower payout when I'm retired)

2. Join a second additional part of the penion where I contribute a % of my salary above that $53,600.
This works out to about $1,400 /year contribution of my own money. Once you join this group you cannot back out. You can always join #2 at a later date, but it's at a reduced payout formula when you retire.

When I use their pension projection tool the estimate is (in future dollars, not today's dollars, and does NOT increase with inflation!!)...

Retire at 50 (2033)
1. $8,250
2. $13,500

Retire at 55 (2038)
1. $14,700
2. $24,200

Retire at 65 (2048)
1. $42,000
2. $70,000

The tool doesn't allow for a projection retirement age below 50, which is about where I plan on being FI.
I built a spreadsheet and it looks as though over the next 20 years if I did Option#2 I would invest $33,000 of my own money. In return I would get an extra $4,500/year (future dollars) for the rest of my life.

My gut is telling me I can do better with my $1,400/year added to my own investments, and should stick with Option #1 only. But if that's the case, I basically have to think of it as 'I have no work pension' because $8,000/year in 2033 is pretty sad and will only be worse as inflation eats that up.

Any thoughts or advice? I don't want 'old me' to look back and think 'young/cocky me' screwed it up.

[MDM]

...looking for another opinion/advice.

Appears you are on the good side of the Dunning-Krueger effect. :)

...about $1,400 /year contribution of my own money.
Retire at 50 (2033)
1. $8,250
2. $13,500
...over the next 20 years if I did Option#2 I would invest $33,000 of my own money. In return I would get an extra $4,500/year (future dollars) for the rest of my life.

Some inconsistency in the numbers above.  For discussion I'll assume $1,500/yr for 20 years gets you the extra $4,500/yr.  That's about a 7% return.  Up to you to decide whether that is good enough.

Background: see http://forum.mrmoneymustache.com/investor-alley/%27every-25-year-old-in-america-should-see-this-chart%27/msg487448/#msg487448 and http://forum.mrmoneymustache.com/investor-alley/%27every-25-year-old-in-america-should-see-this-chart%27/msg489997/#msg489997.

Your case lands smack in the middle of the chart from the second of the above posts (also see below).  I.e., after 19.7 years investing X at 7%, the 7% annual return on your accumulated investment will be 3X.  Of course, you will also have the accumulated investment as well as the annual returns.  But the pension will be guaranteed whereas your investment return is not.  Choices....

	4%	5%	6%	7%	8%	9%	10%
1	17.2	13.7	11.4	9.8	8.5	7.6	6.8
2	27.3	21.9	18.2	15.6	13.6	12.1	10.9
3	34.6	27.7	23.0	19.7	17.3	15.3	13.8
4	40.2	32.2	26.8	23.0	20.1	17.9	16.1
5	44.9	35.9	29.9	25.7	22.5	20.0	18.0

[AJDZee]

I realize it's been far too long since I've used any form of math above simple BEDMAS  haha thanks for the info DMD!

To get a 7% annual return, did you assume I was going to live for a certain number of years? i.e $4,500 x [years of pension] is a 7% annual return on the initial $30,000 investment?

What stumps me is that all the formulas I'm used to assume inflation adjusted numbers.

How do I correctly evaluate the return on my $30,000 (contributed from 2014-2034) when it gives me $4,500/year starting in 2035, and remains at $4,500 for the rest of my life. Each year the delta option #2 provides becomes less valuable as it's eaten by inflation. And by the time I get the $4,500 in 2035, it's only worth about $2,800 in today's dollars.

I feel like with all that in mind it's not a 7% annualized ROI... but could be wrong!

Do you how I could build in a section in excel that would account for the decreasing value of the payout year over year, if I lived until a certain age? I feel like that's what's needed to be able to truly compare the two scenarios.

[MDM]

To get a 7% annual return, did you assume I was going to live for a certain number of years? i.e $4,500 x [years of pension] is a 7% annual return on the initial $30,000 investment?

In Jeopardy format, the answer was ~7% and the question was "at what interest rate must $1,500/yr be invested, such that in 20 years that same interest rate, with no further investment, will return $4,500/yr?"

How do I correctly evaluate the return on my $30,000 (contributed from 2014-2034) when it gives me $4,500/year starting in 2035, and remains at $4,500 for the rest of my life. Each year the delta option #2 provides becomes less valuable as it's eaten by inflation. And by the time I get the $4,500 in 2035, it's only worth about $2,800 in today's dollars.

Absolutely correct that inflation will have its effect.  For the choice facing you now, however, you can "merely" consider whether you will do better or worse than a 7% nominal return over the next 20 years if you invest the money rather than putting it into the pension.
Inflation will do its thing regardless of whether the money will be coming from the pension fund or your own investment.

Do you how I could build in a section in excel that would account for the decreasing value of the payout year over year, if I lived until a certain age? I feel like that's what's needed to be able to truly compare the two scenarios.

You can divide the annual amount by (1 + i)^n, where i is the assumed annual inflation rate and n is the number of years in the future.

[AJDZee]

Thanks!