The Money Mustache Community
Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: mancityfan on November 01, 2014, 03:32:26 PM

As a teacher I am due for a pension which at age 60 would be around $40k a year with the time I have in the system. So my thinking is... 40k thought of as a 4% withdrawal would give a value of 1M for my pension in my Net Worth calculations. What do you all think?

Does the pension increase with inflation?

yes,there are COLA adjustments.

The problem you're overlooking is that the $1 million is in future dollars, not current dollars. You have to discount the $1mil at the presumed investment return rate for all of the years between now and when you can collect it. That will give you its current value.
Example: If you're 40 years old today and already eligible to collect $40k/year at age 60, then if you assume a 4% withdrawal rate (probably high given how pensions are managed) you correctly forecast the future value as $1mil 20 years from now. If you then assume 7% total return between now and then, your pension is really worth about $250k today. So if you had $250,000 in hand today you could invest it at 7% and it would be worth $1mil in 20 years, from which you could start paying yourself $40k/yr.
This sort of Net Present Value calculation is very sensitive to the discount and payout rates you use, especially for long time periods. I wouldn't put too much faith in it.
A better way to think of it, IMO, is to subtract the future $40k/yr off of your future (inflated) living expenses in real dollars. Then figure out what size stash you need to support that newly reduced amount of expenses. Otherwise your'e making assumptions both forwards and backwards that might turn out to be wildly wrong, and doing so for no good reason. Subtracting the pension from your expenses reduces the number of unknowns down to just one, your future expenses, and then you can focus on things you can actually control, like your savings rate.
Of course, it does complicate your desire to "pad" your net worth calculation. Let it go.

As a teacher I am due for a pension which at age 60 would be around $40k a year with the time I have in the system. So my thinking is... 40k thought of as a 4% withdrawal would give a value of 1M for my pension in my Net Worth calculations. What do you all think?
I count the commuted value of my pension in my net worth. The commuted value is what it would cost to pay me out of the plan right now, not when I'm able to retire.
In my case, I can retire on $43k/year at age 57 (in 2025), but the commuted value of my pension currently is nowhere near $1M. It is around $333k.
So, no $1M is not an accurate number to add to your net worth unless you are actually 60 years old.

Many thanks for the responses. 51 at present but looking at age 60 to stop if the stars align.

A fault in the thinking is the fact that with the 4% SWR, you do not burn down the principle. In fact, in most scenarios, it actually grows over time. The pension on the otherhand is gone when you die (could have some survivor benefit but no lump of original balance). You could think of it as being a fund you withdraw at a much higher rate to have the equivalent effect of being depleted when you die. In your case, I would use a multiplication factor of about 15, not 25. So a 40K pension could be worth about 600k. Or at least that is what I would want someone to five me to walk away from that pension.
Another option would be to get a quote for an annuity that has your pension payment characteristics. The cost of that annuity could be a good estimate of its present value.

A fault in the thinking is the fact that with the 4% SWR, you do not burn down the principle. In fact, in most scenarios, it actually grows over time. The pension on the otherhand is gone when you die (could have some survivor benefit but no lump of original balance). You could think of it as being a fund you withdraw at a much higher rate to have the equivalent effect of being depleted when you die. In your case, I would use a multiplication factor of about 15, not 25. So a 40K pension could be worth about 600k. Or at least that is what I would want someone to five me to walk away from that pension.
Another option would be to get a quote for an annuity that has your pension payment characteristics. The cost of that annuity could be a good estimate of its present value.
Good point, Ken. One of the reasons I am considering taking commuted value is that I wouldn't have dependents who would get a pay out when I die, but maybe, just maybe there will be a reasonable estate for my son.

A fault in the thinking is the fact that with the 4% SWR, you do not burn down the principle. In fact, in most scenarios, it actually grows over time. The pension on the otherhand is gone when you die (could have some survivor benefit but no lump of original balance). You could think of it as being a fund you withdraw at a much higher rate to have the equivalent effect of being depleted when you die. In your case, I would use a multiplication factor of about 15, not 25. So a 40K pension could be worth about 600k. Or at least that is what I would want someone to five me to walk away from that pension.
This is one reason why governments and corporations do not fully fund their defined benefit obligations in the manner most would expect.
Actuarial science is morbid, but useful in this regard.

A 4% WR typically leaves lots of money left  often much more than the starting amount. A pension typically leaves $0 left. So valuing it at 25x annual payout vastly overvalues it.
Typically one would do one of these two things:
1) Take the NPV of the payment stream based on life expectancy
2) Price an annuity  what lump sum would it cost to buy you that annual payout?

Government pensions often allow you to leave it to a spouse etc for a reduction of your pension while you are alive. This can be a good choice so the remaining spouse has that guaranteed income.

Example: If you're 40 years old today and already eligible to collect $40k/year at age 60, then if you assume a 4% withdrawal rate (probably high given how pensions are managed) you correctly forecast the future value as $1mil 20 years from now. If you then assume 7% total return between now and then, your pension is really worth about $250k today. So if you had $250,000 in hand today you could invest it at 7% and it would be worth $1mil in 20 years, from which you could start paying yourself $40k/yr.
A clarification for OP: If it is the case that OP's $40k figure is in today's dollars (which it would presumably be as the pension is presumably a % of salary which will go up with inflation), the 7% discount rate Sol is using would be your expected *real* (after inflation) return. I personally estimate 4% real return for long term planning, which would give the hypothetical pension of $40k (in today's dollars) 20 years from now a net present value of $456k rather than an NPV of $258k which you get using a 7% discount rate. The distinction I'm making is only of practical importance if you are debating whether to give up (part of) a pension by retiring early.
As ARS pointed out, the pension is worth less than X where X times 4% = annual pension amount because there is no residual value. Of course, if you don't care about leaving money to heirs on charity, this distinction doesn't matter much either.

Spartana, our reduction for my hubby & I is small & because we both have chronic health issues it was cheaper this way then to get the life insurance. We checked both ways because this had been a big topic at work. After my Dad died my Mom lived another 17 years on the part of the pension he left her. Together it supported them for 30 years. There are no guaranteesyou just have to make the best choice choice you can. With our pensions if your spouse dies then they automatically upon proof of death raise your pension back to the level it would have been if you did not take the deduction but of course you don't get the $ you paid in back.

A clarification for OP: If it is the case that OP's $40k figure is in today's dollars (which it would presumably be as the pension is presumably a % of salary which will go up with inflation), the 7% discount rate Sol is using would be your expected *real* (after inflation) return.
This is variable between pensions, and from what I've seen most of them don't work the way you've describe.
Federal employee pensions, for example, are based on your salary before retirement and then NOT inflation adjusted between retiring and collecting your first pension payment. When you retire at 40 and they offer your 20% of your salary on that day, to be collected at age 62, that's a dollars offer. Not 20% of what your salary would have been at age 62. There's a huge difference, and it's accounted for by using the beforeinflation return. All of this math is much simpler if you just use real dollars, worth what they are actually worth in the year they exist.
There are some exceptions, of course. Military pensions for example are paid based on the current salary of someone holding your old job, no matter how much time has elapsed between when you retire and when you collect. Those sorts of deals are MUCH better for the early retiree crowd, but not very common.

Personally I ignore my pension, and my husband's, in terms of net worth as they are unrealized. However, I do include them in planning. As in, my estimated retirement expenses are X. Our pensions are Y. I need Z to make up the difference (XY=Z).

I was thinking a bit more about how do you turn the value of a future pension into a current net worth.
My conclusion really is "why bother?".. About the only reason to do such a calc is to play a game called "Mine is bigger than yours".
If you think about it, the real question is what will a net worth of X translate into in terms of income that one can reliably live off.. which is where 4%, 3% or whatever comes from... So if you have $1M today at 4% will reliably pay out $40k per year in todays dollars.
Seems to me if you have a guaranteed pension of say $40k in 20 years time one could figure out what the spending power will by dividing the future income by the rate of inflation raised to the power of years in the future.. i.e for 20 years at an assume 2.5% compound inflation = 40/1.025^20 = $24k.. I,e $40k in 20 years is worth the $24k today.
But trying to equate it into current net worth is kinda pointless.
What if you have both a stash AND a future pension that pays out in 20 years.
Well take your $1M multipy by 7% compound ( a reasonable market growth figure) and take 4% of the final total in 20 years to get your income.. plus add your pension income.
so thats 1,000,000*1.07^20 = $3.87M.. take 4% = $154k per year.. plus your pension of course.
This way you have an income number.. not a net worth number.. Which is what we're all striving for anyway right?
Frank