If you've got a pension, count yourself as one of the lucky ones. A pension is more valuable than you realize. With a pension, you won't be forced to lower your safe withdrawal rate in retirement like those of use who don't have pensions. This post will help you calculate the value of a pension.
Pensions, also known as Defined Benefit plans, havebecome rarer as companies force their employees to save for themselves mainly through a 401k, 457, 403b, Roth 401(k) or IRA. These savings vehicles are also known as Defined Contribution plans.
But as we all know, the maximum amount you can contribute to a 401(k) or IRA is $23,000 or $7,000, respectively for 2024. Even if you max out your 401(k) for 33 consecutive years starting today, it's unlikely your 401(k) or IRA's value will match the value of a pension.
Take a look at my latest 401k savings potential chart. After 33 years of maximum contributions, I estimate you'll have between $568,000 – $1,800,000 in your 401k, depending on performance.
$1,800,000 sounds like a lot, but in 33 years, $1,800,000 will buyjust $678,000 worth of goods and services today using a 3% annual inflation rate. However, inflation is currently running at ~7.5%.
If you live for 20 after your last 401(k) maximum contribution, you'll only be able to spend $33,900 a year in today's dollars until the money runs out. $33,900 is not bad, but it's not like you're living it up after sacrificing your life for decades at a job you didn't love.
Given the power of inflation, to neithermax out your 401(k) norinvest an additional20%+ of your after-tax income if you don't have a pension is risky. When it comes to your money, it's always better to end up with too much than too little.
How To Calculate The Value Of A Pension
The best way to calculate the value of a pension is through a simple formula I've come up with. For background, I worked in finance from 1999 – 2012, got my MBA from UC Berkeley, and have written over 2,500 personal finance articles on Financial Samurai since 2009.
I live what I write and speak as an early retiree since 2012. Money is too important to not take seriously.
The value of a pension = Annual pension amount divided by a reasonable rate of return multiplied by a percentage probability the pension will be paid until death as promised.
For example, here is an example of how to calculate a pension with the following data:
Average income over the last four years: $90,000
Annual pension: $67,500
A reasonable rate of return divisor: 2.55%
Percentage probability of pension being paid until death: 95%
Value of pension = ($67,500 / 0.0255) X 0.95 = $2,514,706
One can argue my formula for calculating the value of a pension is overstated. After all, the pension's value is dependent on the terminal value, and we all eventually die. Therefore, if you are particularly pessimistic, you can apply a discount to the final calculation.
For example, if you are a pessimistic person in poor health, perhaps you multiply the final value of the pension by 50%. In this case, a $2,514,706 pension goes down to about $1,250,000.
If you have a pension, your goal is to live as long and healthy a life as possible! The longer you live, the greater the value of your pension. This means eating better, exercising, and having a good social network of friends.
How Do Pensions Work?
Most pensions start paying out at a certain age and continue paying out until death. The amount of pension you receive is determined by years of service, age in which you elect to start collecting, and usually the average annual income over your last several years of service.
If you don't know how to calculate the expected monthly or annual payment of your pension, just ask human resources to provide details.
To calculate the value of your pension involves figuring out your annual pension payment, a reasonable rate of return divisor, and a realistic expected chance of payment until the end. After all, your company could go bankrupt and welch on all its pension promises.
Deciding on areasonable rate of return divisor issubjective. The safest divisor to use is the 10-year government bond yield, which currently hovers around 4%. In other words, one can reasonably expect to earn 4% each year on his or her investments given the 10-year government bond yield is guaranteed.
One could use a more aggressive reasonable rate of return, such as 10%, to reflect a historical annual return of the stock market. However, the higher your divisor, the lower the value of your pension ironically, because it requires less capital to generate your pension income when things are booming.
Pensions Have Become Much More Valuable
Given interest rates collapsed in 2020, it took more capital to generate the same amount of risk-adjusted returns/income. Therefore, the value of a pension went WAY UP because the value of cash flow has gone way up.
Just take a look at this chart regarding how much more capital is needed to generate $50,000 a year in income. Therefore, the proper safe withdrawal rate should be lower the it was in the past.
Thankfully, interest rates have ticked up from their 2020 lows, making generating passive income easier. However, the higher interest rates go, the more headwind stocks and real estate generally have.
We're now in a situation where the Fed continues to hike rates aggressively to combat inflation. In fact, patient investors can now earn over 5% in risk-free Treasury bonds. The rates likely won't last, which reminds us of how fluid economics and investments are.
Let's calculatethe value of various pensions below.
Pension Value Example 1: Police Officer Retiring After 25 Years Of Service
Here is the example again of how to calculate the value of a pension with some commentary after.
Average income over the last four years: $90,000
Annual pension: $67,500
A reasonable rate of return divisor: 2.55%
Percentage probability of pension being paid until death: 95%
Value of pension = ($67,500 / 0.0255) X 0.95 = $2,514,706
Well how about that! After 30 years of service, this police officer will have a pension worth roughly $2,514,706 on top of whatever other assets he has accumulated. Not bad for someone who made a decent, but unspectacular $90,000 year for the last four years of his career.
Let's say this police officer joined the force at age 20. He's still young enough to start another career making additional money on top of his $60,000 pension. Talk about the perfect early retirement plan to pursue your passions without fear.
Pension Value Example #2: Foreign Service Officer Retiring After 30 Years Of Service
Let's say you started in the foreign service before 1986 and finally want to retire. Congrats! You will have a nice pension for life waiting for you.
Average income over the last three years: $120,000
Annual pension: $85,000
A reasonable rate of return divisor: 3%
Percentage probability of pension being paid until death: 100%
Value of pension = ($85,000 / 0.03) X 1 = $2,833,333
I use a 100% probability of the pension being paid until death because the payer is the federal government. This figure is also subjective, but I believe the federal government will honor their promises to older employees. They're just cutting pension benefits for newer employees.
Different Rates Of Returns Change Pension Values
If I used 2.55% as the reasonable rate of return divisor, the value of this retired foreign service officer's pension jumps to $3,333,333. The reason is because an investor needs to invest $3,333,333 incapital to generate$85,000 in annual income when the rate of return is only 2.55%.
Let's say the rate of return was 50%, the value of the pension/capital required is only $170,000. But who on Earth can reliably generate a 50% annual return each year forever? Nobody.
Thankfully, for retirees, interest rates have increased dramatically since the Fed began hiking rates in 1Q 2022. As a result, it's easier to generate passive income now through stocks, bonds, and real estate. But ironically, the value of your pension goes down in a higher interest rate environment.
For example, in 2024, the risk-free rate is around 4.1%. As a result, the value of the pension above declines to $2,073,170 ($85,000 / 0.041) versus $2,833,333 when the reasonable rate of return divisor was 3%.
Note for foreign service officers: For those of you who start the foreign service after 1986, you receive 1.7 percent of your salary for the first 20 years and 1 percent for each additional year. Therefore, 30 years only gets you 44 percent of your salary equal to a pension. However, at least you can still have 401(k) matching and collect Social Security.
Pension Value Example #3: Public School Teacher Retiring After 30 Years
Average income over the past four years: $72,000
Annual pension: $43,000
A reasonable rate of return divisor: 2.55%
Percentage probability of pension being paid until death: 75%
Value of pension = ($43,000 / 0.0255) X 0.8 = $1,349,019
Although this public school teacher wasn't earning a huge amount, she gets to retire with a $36,000 annual pension that is worth over $1,000,000. Using an 75% payment probabilityseems reasonable.
Most pensions also have an inflation adjuster built in order to keep up with inflation. Although sometimes, the inflation adjustments don't keep up.
Here's a chart I put together highlighting the values of a $35,000 and $50,000 pension (in the range of the most common pension amounts). As the rate of return goes higher, the value of your pension goes lower. Bond values work in a similar fashion as interest rates go higher and vice versa.
Thanks to the craziness of the pandemic, the 10-year bond yield has declined to under 1%. Therefore, the value of your pension has gone way up. You want to hold onto your cash cows for as long as possible. Your reasonable return of return divisor should be lowered to 1% – 2% in this low interest rate environment.
A Pension's Value Is Subjective
Obviously, my calculation is simplistic because we all die at some point. My calculation is based on cash flow into perpetuity. To counteract the perpetuity, I assign a Probability of Payout percent. Further, we all won't have surviving spouses to continue receiving the pension long after we're gone.
You're free to lower theProbability of Payout percentage to account for shorter lifespans or a more pessimistic life outlook. You can also call the Probability of Payout the Pension Discount Rate if you wish.
Just remember that value is subjective. Once we're dead, what does anything really matter? There's no longer a need to earn any money for ourselves. Given most pensions continue to pay out to a surviving spouse, s/he is covered until death as well.
What this article and my calculation attempts to do is provide an easy way for all pensioners to assign a real value to their pensions. I also want to give pensioners hope that their financial situation isn't as dire as expected if they are comparing themselves to private sector workers or my average net worth for the above average person chart.
Cherish Your Valuable Pension
All three individuals with pensions above are millionaires due to their long-term dedication and pensions. Even if you were only receiving a $15,000 a year pension, it's still worth more than $500,000 a year using a 2.55% divisor and 90% payout probability.
Given the mediannet worth in America is around $100,000, we can conclude that anybody with a pension is considered very well off. Less than 20% of Americans have pensions in the new decade.
Live As Long As Possible To Increase Your Pension's Value
There's one key variable that I haven't discussed, and that's a pension owner's lifespan. Unfortunately, the foreign service officer with a pension worth $2,833,333 can't sell his pension to anybody for that amount. Nor does the pension keep paying out after death.
Although, in some cases, a pension can keep paying out to a surviving spouse. The reality is one's pension value fadesas the owner inches closer towards the end.
Therefore, it behooves every pension owner to live as long and healthy of a life as possible to maintain the value of his/her pension. The same logic goes for anybody with passive income, including social security. The richer you are, the healthier you should try to be!
The value of your pension is subjective. You could even multiply your annual pension amount by the average P/E multiple of the S&P 500 to come up with its value. There are many variables and variable amounts to consider.
Just know that your pension has tremendous value, just like your Social Security, the nation's pension plan. If your pension plan has a high cost of living adjustment rate, then your pension is worth even more.
If you feel your net worth is lacking based on my charts forthe average net worth for above average people, simply calculatethe value of your pension using my formula. The results will likely surprise you.
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Invest In Real Estate For More Income
Given the value of cash flow has gone way up, it is wise to invest in assets that generate income. The best type of income-generating asset regular people can invest in is real estate.
Investing in real estate is like getting a pension because real estate tends to produce a steady income stream that gets more valuable over time. Inflation helps left the value of real estate and rents.
Take a look at Fundrise, my favorite real estate crowdfunding platform available for all investors. You can invest in a diversified real estate fund that primary investments in the heartland where valuations are cheaper and rental yields are higher. Fundrise manages over $3.5 billion from over 500,000 investors.
My other favorite real estate platform for accredited investors is CrowdStreet. CrowdStreet focuses on individual commercial real estate projects in 18-hour cities such as Charleston and Memphis. With higher cap rates and potentially higher growth rates due to demographic shifts to lower-cost areas of the country, CrowdStreet is very interesting.
I've personally invested $954,000 total in real estate crowdfunding to generate more diversified passive income. So far so good as my passive income hits roughly $300,000 a year. Real estate is the ultimate inflation.
Stay On Top Of Your Finances
The best way to grow your net worth is to track your net worth. I've been using Empower's free financial tools and app to optimize my wealth since 2012. It is the best free money management tool on the web.
Link up all your financial accounts to analyze your wealth. Start by measuring your cash flow. Then x-ray your portfolio for excessive fees. The best feature is the retirement planner.
There's no rewind button in life. Even if you have a valuable pension, it's important to continue staying on top of your finances. Do your best to optimize the wealth you have now.
Buy The Best Selling Personal Finance Book
If you want to drastically improve your chances of achieving financial freedom, purchase a hard copy of my new Wall Street Journal bestselling book,Buy This, Not That: How To Spend Your Way To Wealth And Freedom. The book is jam packed with unique strategies to help you build your fortune while living your best life.
Buy This, Not Thatis also a #1 best seller onAmazon. By the time you finish BTNT you will gain at least 100X more value than its cost. After spending 30 years working in finance, writing about finance, and studying finance, I'm certain you will loveBuy This, Not That.
Last Word On Pensions
Note: Pensions are most common in the following fields: military, government, education, gas and electric, insurance, and health services. Having a pension is likely winning the lottery. Enjoy it for the rest of your life! Most people are not so lucky.
In a low-interest rate environment, a pension's value has increased significantly. Calculate the value of your pension and make the best career decision possible. Although pension payouts are declining, they are still quite valuable. Don't underestimate public service jobs and other jobs with pensions!
For more nuanced personal finance content, join 65,000+ others and sign up for my free weekly newsletter. I've been helping people achieve financial freedom since 2009. How To Calculate The Value Of A Pension is a FS original post. Your pension is worth more than you think.
