Pensions, even though they seem dated now, are a relatively recent invention when considered in respect to non public employees. Public employees, primarily military, have received pensions for centuries. But the first corporation to offer a pension in the US was American Express, as recent as 1875. The pension came about as a way to reward long term employees and quickly became the standard amongst large employers.
Pensions have begun to Disappear
More recently these vehicles have begun to disappear. Part of this is because corporations over promised on pensions, leading to some fairly visible corporation collapses due to liability issues. It has become no longer tenable for large corporations to have significant pension liabilities hanging over their shareholder investments. As such pensions for most new corporate employees is a thing of the past.
In fact my current employer no longer offers pensions to new employees and has stopped contributing to existing pensions. That means what is in my pension now will be what I receive. So the first question everyone asks is how to determine what your pension is worth?
Calculating Pension Value
Well when I was accruing new contributions my plan used the most common method of determining plan value. This is basically the average of a certain number of recent years of your pay multiplied by a factor and then multiplied by the number of years of employment.
Sample Calculation of Value
So imagine if you worked 10 years for the company while the plan was active. Now let’s take a hypothetical salary that averaged 75K over those 10 years. Most companies take and average of ten years for calculations. Now imagine they used a factor of .02. That would mean your annual pension would be 75K*.02*10 or a pension of 15K/Year in retirement. Divide this number by 12 to determine the monthly benefit. The numbers here are fictional, but you get the idea. In fact my plan changed funding factors a few times over my own 10 years of employment. As such my own calculations are much more complicated.
Evaluating Pension Value in Retirement
In terms of evaluating my pension value for my retirement there are two options.
- The first option, depending on your employer, is fairly simple. My employer’s benefits administrator has a running real time quote for lump sum payout if you cash out your pension. This is what I value my retirement at. If I can cash out today at that rate than the value in cash today is at least equal to that cash out amount.
- The second option is to use discounted cash flows to estimate the net present value of that future monthly pension payment. Essentially the net present value of the pension should be a factor of all payouts of the pension and any discount rate. To determine the net present value open excel. Create a row for every year between now and your life expectancy. Enter your pension amount in all years the pension pays out. Then enter 0 in the rest of the years. Use the function NPV. The arguments are simply the discount rate and then all of your rows.
What to use for a discount rate? Well a good place to start is your expectations of yearly inflation. Say 2%. From there you can make your way up to your expected return on other investments, for example 7% for stocks. In some respect it might be a good idea to do this even if there is a lump sum option. In that way you know whether the current lump sum is a better option than awaiting the pension. When used in conjunction with an employer provided lump sum this can tell you if you would be better taking the lump and reinvesting it in another instrument.
Discounted Cash Flow with No Lump Sum
In general if I were doing a discounted cash flow analysis without a lump sum payment I would use the current risk free rate of the 10 year treasury as a stand in to determine the actual present day value of the pension. Why? Because essentially my pension is risk free. As such it’s true investing equivalent is a risk free treasury bond.
Is My Pension Risk Free?
Risk Free you say? I’m sure some of you are asking what about all those corporations and governments with pension liability issues. Well if you work for the government in theory your pension is backed by the taxation ability of the issuing body. To avoid politics I’ll skip any more on how that might turn out. But for a corporation your plan is most likely backed by the Pension Benefit Guaranty Corporation (PBGC). This corporation is a government entity funded by fees charged to pension plans, investments, and recovered assets of pensions and pension sponsors. This government agency will essentially bail your pension out should your company no longer be able to run your pension.
Pension Solvency is Company Specific
This is important since a company largely determines how much it contributes to your defined benefit plan in investments each year for future payouts to participants. PBGC gives certain guidelines based on assumptions of investment returns of your pension, but many plans use too rosy an estimate. This is why everyone is concerned about the future of pensions. Because many of these plan administrators have estimated overly ambitious returns on the investments of pension plan assets, this has left their plans significantly underfunded in cases where these investments do not deliver. If that underfunding coincided with a bankruptcy of the parent company, PBGC would then have to step in.
Risks Still Exist with PBGC
It’s not all 0 risk for a participant if PBGC steps in either. In order to avoid overly rosy promises of massive pensions and to maintain the integrity of the PBGC funding the corporation limits how much it will guarantee based on your age or years of service (depending on single or multiple employer plans). This means if your company goes bust with an underfunded pension then you are only guaranteed up to a certain amount. Anything your employer promised you over that amount is out the window. You can find those guaranteed amounts here.
There is one more thing to consider, does the PBGC have enough funding coming in to continue to pay out on failed pension plans. As noted they are not backed by general tax revenues, but instead fees. That means there is a possibility they could need to payout more then they have in funds.
Under current law should this occur the agency is charged with decreasing guarantees until they can cover all needs. At present insolvency in the pension plan backing for multiple employers is imminent. Single employer PBGC is currently funded separately and based on projections in ok financial shape. It is also important to consider whether the government may step in with additional funds to secure these plans. There is nothing in government law to require it to do so, but there is precedent. The government stepped in to bail out the federal branches backing mortgages during the 2008 crisis despite a similar setup. Your mileage may vary.
Normal Single Employer Pension are Relatively Safe
So at least for those of us with smaller corporate pensions that are single employer and decently funded the odds seem high we will receive our annuity. If you have a gold plated multi employer pension with severe underfunding I wouldn’t count on receiving the whole thing.
In my case my pension is well below the backing limits, is well funded, and is a single employer plan. As such I have no concerns at this time. Should I see that begin to erode I would be sure to execute my lump sum withdrawal long before it gets to a position of concern. This is perhaps the only benefit of having a plan that no longer receives contributions. Under our new policies there is also no hurdle for me to pull funds if issues occur. Again your mileage may vary, do your due diligence.
Cashed Out Pensions are Not Insured
One final note on PBGC. PBGC only insures your pension until you cash out the lump sum or take the pension in the form of an annuity. The annuity is essentially an insurance contract that pays you based on the pensions promises. As noted previously an annuity is only as good as the issuing body. So as you do evaluate whether you should take the lump sum or the pension, investigate the health of the issuing insurance agency as well.
You Should Understand Your Pension
So where does this leave us? Well I noted before I evaluate my pension using the risk free rate for discount rate considerations. Under the same logic I consider the lump sum value or net present value of my pension as the equivalent of a risk free investment. I have no fears that my current pension value will disappear due to lack of funding. As such my pensions value is just another add to my risk fee allocation number for purposes of asset allocation. In our case my wife has a pension too but both lump sums are fairly small compared to our other investments. Honestly given the size the whole thing is more of an oddity for me then a significant contribution. Still I find it important to understand all of my investments.