Author Topic: How to value, and plan with, a defined benefit pension plan?  (Read 989 times)

mrteacher

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How to value, and plan with, a defined benefit pension plan?
« on: January 09, 2020, 04:00:02 PM »
Hi folks:

I've wondered for awhile how to determine the yearly worth/value, in salary, of my defined benefit pension plan. I'm also wondering about how to factor it in to my financial planning.

Here are the basics:

- Employer funds the pension entirely
- Vested after 5 years (I am a little under 3)
- Normal retirement age (full benefit factor) is 67
- Payout = years of service * average five years highest salary * .015, which means, approximately speaking, a 30ish year career nets me 50% of my salary

I've tried to ballpark how much this is "worth" to me in yearly salary, but I am not really sure how to go about valuing it. I'm curious about this because I do not know if it's worth $5,000 in yearly salary, $15,000, or something more or less. I'm also wondering about advice for how to include (or not include - something like this is not guaranteed, of course) this in my financial planning.

Thoughts?

BECABECA

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #1 on: January 09, 2020, 04:22:22 PM »
This will be a little complicated, since your estimated pension earned to date will change each year.

Once youíre eligible, you can calculate the annual pension amount that youíll get at full retirement age. Take that annual amount and calculate the present value of those dollars. For the discount rate on the present value calculation, I use 7% since I would be investing any extra money that I had now. If you would instead be spending extra money you had now, then youíd instead use just a 2% inflation rate.

Then calculate the annual pension amount at full retirement with one additional year of service than youíve earned to date. You could get fancy and drop off the lowest yearís pay and average in one more year of your current rate. Then take that annual amount and calculate the present value of that amount.

Now subtract the first calculation from the second and that tells you how much extra salary you can estimate is the annual value you get from that pension component.

For example: letís say youíve worked there for 5 years and so are vested. Letís say you made $30k, 35k, 40k, 45k, and now $50k. The average of those values is $40k. So your benefit earned to date is 5*40000*.015 = 3000. Letís say youíre currently 30 years old, so thatís 37 years in the future when youíd get this pension. And letís say you would invest any extra money you had, so we will use a discount rate of 7%. So plugging that into the present value calculator says that pension is currently worth $245.43. And now to calculate one more year, 6*44000*.015 = 3960, which has a present value of $323.96. So staying and working an extra year is like getting paid an extra $78.53 that year.

Basically, at the beginning of your career, itís worth a pretty small amount, because youíre not making much and because you have lots of years of compounding that weigh against it in the present value calculation. But as you get raises and get closer to the full retirement age, itís worth a lot more. So if you get a job offer for a decent salary bump today, you should take it, but if youíve been there 25 years then the salary bump would need to be a lot bigger to make leaving worth it.
« Last Edit: January 09, 2020, 04:37:37 PM by BECABECA »

sui generis

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #2 on: January 09, 2020, 04:33:42 PM »
Quick thoughts: I also have a pension, and basically what I've done is subtract the amount I get (I'm retired now, so unlike you, there's less ambiguity) from my expenses and then planned from there for my net unfunded expenses.  Then I planned to get to at least 25x those unfunded expenses to see when I could retire.  Actually I went further than that as I didn't feel comfortable with the 4% rule/withdrawal rate, but substitute in whatever your number that you want to use there. (I do a 3.25% WR currently.)

Regarding your ambiguity, honestly, I wouldn't count it at all until you are vested.  Once vested, I would keep calculating it in, just like you do with a growing stash in a investment account.  Let's say in 2025, you have 8 years, at $50k for 5-year avg salary, you can plan on $6k per year when you hit 67.  You can actually treat this a lot like most people include Social Security in their retirement planning. Anywhere from not counting on it, because it is far in the future and uncertain as to fund health, or do the math of subtracting it from your anticipated expenses starting at age 67 to get your FIRE number.  A lot of FIRE calculators will allow you to incorporate new cash flows like that into the calculation, iirc and if you want to go that direction.  And each year you continue working for the employer and get added service years and a higher 5 year average, you'd incorporate that new number into recalculating your FIRE number.  So your FIRE number will shrink at the same time as your stash grows, which will be really cool to see!

Villanelle

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #3 on: January 09, 2020, 04:47:33 PM »
For valuing it in your financial plan/FIRE calculations, I'd just subtract the benefit you expect/hope to earn from annual expenses.  That's what we do, although ours is somewhat more complicated because ours is inflation-adjusted. 

Since there are a lot of factors that make your pension uncertain, I think I'd run the math for two scenarios--one toward the more conservative side (lower number/earlier retirement) and one toward the more optimistic side (higher number/longer tenure).  That sets your outer boundaries and allows you to know roughly where you could end up. 

Then you just punt until you are closer to making actual retirement/new job moves.  You don't really need to know anything more than a very rough estimation until you are ready to make a move of some kind. It's similar to the fact that a 22 yo, planning to work until 40-45, doesn't need a hard annual spending number.  Knowing that he wants between $50k and $75k, even though that's a 50/33% difference is close enough.  When he's 36, then refining that to be between $55k and $605 k is likely good enough, and then a few years later getting that to a specific number would be required because that's when he'd might actually be making a decision about quitting or working a bit longer.

I'd count it as nothing until vested, however. 

px4shooter

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #4 on: January 09, 2020, 08:57:43 PM »
How many service years do you need for retirement?

Is it a public or private employer?

So, it is 1.5% for each year of service. Since they are fully funding the plan, are their contributions considered as additional income when figuring out the retirement amount?  My employer's is. So, say I make 80k, but the employer covers my contributions. My contributions have to be 15% of my income, so the plan shows I make 92k each year. That amount is used to determine my retirement.

Do you have options to purchase years of service, so you can retire from them earlier and begin a new shorter career?

mrteacher

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #5 on: January 10, 2020, 04:36:20 AM »
How many service years do you need for retirement?

Is it a public or private employer?

So, it is 1.5% for each year of service. Since they are fully funding the plan, are their contributions considered as additional income when figuring out the retirement amount?  My employer's is. So, say I make 80k, but the employer covers my contributions. My contributions have to be 15% of my income, so the plan shows I make 92k each year. That amount is used to determine my retirement.

Do you have options to purchase years of service, so you can retire from them earlier and begin a new shorter career?

I am trying to read up myself, but I will give you what I believe to be true for each of your questions.

- As far as I can tell you can retire anytime after five years, but you cannot collect your full benefit until 67; if you want to collect earlier you take a pretty significant penalty that severely reduces the .015 pension factor. Unless your years of service and age add up to 90, in which case you can retire early and apply the full .015 pension factor.
- Private
- Yes, 1.5% for each year of service...unless you retire early, as outlined above
- I do not think that my employer's contributions are extra income
- I do not know if I can purchase years of service - I have heard of folks in other workplaces/industries doing this. Something to look into, but it seems like age is the biggest factor with this particular plan.

wellactually

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #6 on: January 10, 2020, 08:48:49 AM »
I have a very similar defined benefit pension. I'm in local government. And the employer contributions absolutely do not count as income for me, that would really suck! Do you still pay into social security? I've been in the same pension system for 6 years, but the first 4 with a different employer and they chose to take advantage of the exemption from social security. So if I had stayed there, that would factor in to my calculations. I've never heard of that anywhere else, so probably not your case.

My benefit is 2% x years of service x final (3 year) average salary. I can receive full benefits at 60 and it includes a cost of living adjustment.

Here are my evolving considerations of this benefit:

-Did not consider this benefit in my planning at all until I vested.
-Greatly considered this benefit when I realized I HAD to leave first employer with 4.25 years in; thus only applied at other employers in the system
-Did not AT ALL consider previous public employee retirement system as it was underfunded IMO. Only consider my current pension because it's 94.9% pre-funded
-Mostly try not to think about it. I do consider it when I am thinking about future job changes. I'm 30 and not looking to retire super early. As I get closer to that date, I'll factor it in with more certainty. For the next 10 years, I'm okay just focusing on our total % saved annually and maximizing our available accounts.
-When I do consider it for FIRE purposes, I usually think of it as an offset. Right now it would cover property tax and home insurance in retirement, so we'd only need to cover the rest  of expenses with the stache.

Basically, I treat it similarly, but slightly more prominently and with a bit more confidence, to social security in my planning.

ETA: very simply, once you are vested, each additional year's worth can be calculated with the same benefit formula. 1.5% x 1year x average salary = additional annual value. But only after you vest. So your 5 year amount is your base and each year after is valued with that. Of course it can change with salary increases, but those are unheard of in my local government pension! FWIW, my value is each year of service gets me about $920/yr extra in retirement, starting at age 60.
« Last Edit: January 10, 2020, 08:53:34 AM by wellactually »

px4shooter

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #7 on: January 11, 2020, 01:31:21 PM »
I am trying to read up myself, but I will give you what I believe to be true for each of your questions.

- As far as I can tell you can retire anytime after five years, but you cannot collect your full benefit until 67; if you want to collect earlier you take a pretty significant penalty that severely reduces the .015 pension factor. Unless your years of service and age add up to 90, in which case you can retire early and apply the full .015 pension factor.
- Private
- Yes, 1.5% for each year of service...unless you retire early, as outlined above
- I do not think that my employer's contributions are extra income
- I do not know if I can purchase years of service - I have heard of folks in other workplaces/industries doing this. Something to look into, but it seems like age is the biggest factor with this particular plan.

Read up on the plan and another very good source is those that have been in the plan for awhile. It sounds like 5 years is the point you are actually vested in the plan. If the hard age is 67, that sure lessens the value to me.

One area not discussed is the salary compared to other employers. Are you making the same, less, or more compared to another employer doing the same job? Also, is there a 401k match/option?

To get on with my public employer, I took a 20k hit in salary. It took me 4 years to make that back up, but the retirement system was the biggest factor. The lower pay and better long term retirement plan was something I had to look at. I had considerably lower expenses at the time and the loss of salary was not that bad of a hit.

mrteacher

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Re: How to value, and plan with, a defined benefit pension plan?
« Reply #8 on: January 12, 2020, 12:09:01 PM »
I am trying to read up myself, but I will give you what I believe to be true for each of your questions.

- As far as I can tell you can retire anytime after five years, but you cannot collect your full benefit until 67; if you want to collect earlier you take a pretty significant penalty that severely reduces the .015 pension factor. Unless your years of service and age add up to 90, in which case you can retire early and apply the full .015 pension factor.
- Private
- Yes, 1.5% for each year of service...unless you retire early, as outlined above
- I do not think that my employer's contributions are extra income
- I do not know if I can purchase years of service - I have heard of folks in other workplaces/industries doing this. Something to look into, but it seems like age is the biggest factor with this particular plan.

Read up on the plan and another very good source is those that have been in the plan for awhile. It sounds like 5 years is the point you are actually vested in the plan. If the hard age is 67, that sure lessens the value to me.

One area not discussed is the salary compared to other employers. Are you making the same, less, or more compared to another employer doing the same job? Also, is there a 401k match/option?

To get on with my public employer, I took a 20k hit in salary. It took me 4 years to make that back up, but the retirement system was the biggest factor. The lower pay and better long term retirement plan was something I had to look at. I had considerably lower expenses at the time and the loss of salary was not that bad of a hit.

Well, with the Rule of 90 I mentioned above, I could retire at 59 or 60 and take my full benefit. Obviously each additional year gets me another 1.5%, though.

I am making about the same as those who do a similar job. There is no 401k match, but we do have the option to invest in a 401k. The funds offered are not so great, so we use my wife's instead.