Net Worth Calculations: How to Value a Pension Plan

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Net Worth Calculations: How to Value a Pension Plan

Post by SkaSka »

Without consulting an actuary or other financial professional, is there a rough rule of thumb to use to value a defined benefit pension plan for net worth purposes?

Should a defined benefit pension plan even be calculated into a net worth calculation?

And if so, what is the most accurate value to enter?
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by zinfit »

Use annuities as a guide? If it is an indexed pension find out how much it would cost to buy an equivalent indexed annuity.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by parvus »

Given that a DB pension dies when you die, why would you figure it into your net worth? Would you also figure in your CPP and OAS? An annuity?

There's a basic economic concept (which I'm probably not explaining very well) that differentiates between stocks and flows.

Stocks are what you own, flows are the income they through off. Lifetime (or life-up-to-death) cash flows are good -- imperative -- to know. But they are not exactly the same as net worth, because income-producing assets are not all alike -- some are not transferable, nor, indeed, tradeable, however useful they may be to have to provide dependable income.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by SkaSka »

parvus wrote:Given that a DB pension dies when you die, why would you figure it into your net worth? Would you also figure in your CPP and OAS? An annuity?

There's a basic economic concept (which I'm probably not explaining very well) that differentiates between stocks and flows.

Stocks are what you own, flows are the income they through off. Lifetime (or life-up-to-death) cash flows are good -- imperative -- to know. But they are not exactly the same as net worth, because income-producing assets are not all alike -- some are not transferable, nor, indeed, tradeable, however useful they may be to have to provide dependable income.
I can't seem to decide whether it should or shouldn't be included because I figure if I were in a DC plan rather than a DB plan, I would calculate my investment holdings into my net worth.

And my line of thinking went that if one were to leave a DB plan before they vested, they would get their contributions plus interest back. And if one were to leave a DB plan before retirement, they could have the option of transferring to a LIRA which would hold whatever combination of assets. Therefore, unlike CPP or OAS, one can technically get their contributions back in some form or another.

I understand where you are coming from Parvus, but I still feel like I have my feet in both sides of the argument for or against in net worth. :?
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by parvus »

Okay, then you're really talking about the commuted value of a DB plan at a certain age (above my pay scale, I'm afraid).
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by AltaRed »

I don't think there is any useful purpose to calculate a present value of those future benefits until one gets closer to retirement. I've seen rules of thumb being in the range of 15 to 20...at age 65 (think of it as circa 20 years of discounted cash flow starting at age 65). At age 40, the present value is kind of meaningless since there are no payments until, say 65, and no access to it until a certain age. A highly variable number as a minimum, depending on the assumptions, and a small number in any event for a younger person.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by brucecohen »

zinfit wrote:Use annuities as a guide? If it is an indexed pension find out how much it would cost to buy an equivalent indexed annuity.
Here are current annuity rates.

BUT first think about why you'd want to include this in your net worth calculation. It's money that's beyond your reach and also beyond your control and you can't borrow against it. (BTW, if you leave your DB plan early you don't get your contributions + interest. You get the approximate commuted value of the pension you've earned.) As Parvus noted, if you're going to include your pension, you should also include the present value of your CPP and OAS. I wouldn't bother.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by ghariton »

Suppose you're a financial planner. (I'm not one, so this is a hypothetical.) Two clients come to you, each with an investible portfolio worth a million. In addition to that, the first client had a DB, deferred for ten years, which will pay $50,000. The second client does not. Will you treat the two clients the same? If not, presumably the existence of the DB pension should not be neglected.

Should you try to estimate the net present value (or money's worth) of the pension? If you take asset allocation seriously, it seems to me that you must. (If you don't care about asset allocation, like me, then perhaps not.)

Of course, there may be certain decisions facing you where you really need to know the net present value. One is whether you're contemplating taking a lump sum in lieu of a deferred pension. Another is if you're going through a divorce and must divide the spousal assets.

So I think that the OP's question is an important one. How do you value a DB pension? (A pretty good answer can be found in Moshe Milevsky's book, The Calculus of Retirement Income. Send me a PM if you want to borrow my copy.)

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Re: Net Worth Calculations: How to Value a Pension Plan

Post by peter »

A DB pension has value even when younger.

- The commuted value to me seems an obvious number to compare to a defined contribution pension as both come with similar restrictions (with the added restriction you have to leave a DB to get the commuted value).
- For planning purposes the pension also has value even if you mix cash flow and capital because for practical purposes a DB pension replaces the need for a certain amount of capital to live off after retirement. Ignoring that seems silly to me.
- A DB pension could affect your asset allocation/risk tolerance. There are examples on this board of people who should be 80% bonds if you would ignore their DB pension and take into account conventional wisdom and age, but are 100% equities. I might not be happy if my non-DB assets drop by 50% but the consequences would be much worse if I didn't have a DB as well. On the downside, a DB doesn't quite allow for rebalancing the way bonds do.
- Most people save in RRSP and TFSA. My RRSP room is $600/year but I contribute $22k/year to a DB pension plan. It makes no sense to me not to count the savings in that plan as assets in some way. Psychologically it could be frustrating for a lot of people to ignore DB contributions/value as it looks like you're going nowhere for years in most cases while that patently is not true.
- The argument that if you die a DB has no value is often made, but there are counter-arguments to that. At the very least, there are options for a surviving spouse and guaranteed periods. It's not the same as a taxable amount, but to a first approximation the pension mostly affects me/my spouse, and the effect of dying on internet boards seems over-rated :) Having a pension also might make you more flexible in giving non-pension assets to charities or children. The value of a DB on early death clearly is a difference with DC pensions and non-pension assets but it's a somewhat complicated story.

I have the commuted value of my pension in a spreadsheet line as an estimate of value as asset. I also have a longer term estimate of retirement cash flow at different ages based on the cash flow guaranteed by the pension and an estimate of the cash flow possible based on the projected value of non-pension and non-house assets. The cash flow from the pension goes up predictably and smoothly with years of service, the commuted value is all over the map over years because it depends on long bond rates and other factors. Both numbers have their use, and given my age both are projections with significant uncertainties, although I have more confidence in the projected pension pay out than in almost any other number.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by Shakespeare »

Given the uncertainties - discount rate, life expectancy - I would not bother valuing a DB pension in most circumstances (I include neither DB/CPP/OAS or house in my asset allocation, figuring they offset). If so valuing, however, a simple valuation by a factor of 15 or so is reasonable for an indexed pension. (Take pension at 65, live till 80, and figure the discount rate is roughly equal to the inflation rate which means they cancel out.)
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by AltaRed »

Agreed due to the uncertainties, but George has a point, especially: 1) as a result of splitting assets on marital breakdown, and 2) asset allocation near retirement time. In the case of 1), it takes actuarial expertise to determine value. I really don't think there is any usefulness in trying to calculate an NPV with huge uncertainties for say, a 40 year old, but there is for someone who is nearing retirement time...especially for asset allocation purposes.

I used a factor of 15 when I was about 60 years old and collecting my DB pension. I used that simply to assign it to my fixed income allocation for investment asset allocation purposes. I otherwise have no interest in the absolute number. Today, about 5 years later, I assign a multiple of about 12 for the same purpose. It helps me to be more comfortable with a 70/30 to 65/35 equity/FI allocation in my investment portfolios.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by SQRT »

I am collecting a large DB pension which if valued (using cost of a joint life annuity as my spouse has full survivor benefits) would be about 70% of my investment portfolio. As others have mentioned this is important in setting my AA. The pension is akin to a FI portfolio for AA purposes. My actual portfolio is 100% equities but when you include the value of the pension my AA is about 58/42 equities to FI. I agree that most people would ignore CPP or OAS (I do) as it is pretty universal and not large.
The other reason is that it makes you feel better. Nothing wrong with that. Also, if you are so inclined gives a better basis for comparison to others.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by denver »

To the OPs original question... I recall that the company I used to work for would be fairly good in providing 'near retirement age' employees with approximations of the commuted value of their DB plans. I presume they just relayed the query to the DB plan administrator.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by kcowan »

In 1992, I considered the present value of my immediate DB pension and that led me to retire with an immediate pension. I continued to work as a consultant for 10 years, and also got divorced. and lived through the 2000 meltdown before retiring in 2002. During that whole period, the equivalent value of that pension counted large in my financial planning.

Now 12 years on, its value does not count heavily in our ongoing financial plans. In fact, I think the company made a mistake offering an immediate pension to a 49 year-old. It certainly seemed to have been the best option. Subsequently they stopped offering that option in future early retirement packages.

I suppose statistically I have less than 10 years to go, but my first wife will then get 100% of the pension until her death. Because she lives well, I expect she will see nearly 20 more years of payments. So 40 years of payments in total.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by FinEcon »

Lots of long winded gibberish in several attempts to answer your first question in this thread so I'll give the answer via inversion in a KISS fashion.
SkaSka wrote: Should a defined benefit pension plan even be calculated into a net worth calculation?
And if so, what is the most accurate value to enter?
1) What is an asset? From Investopedia: 'A resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit.'
2) If a DB pension is not an asset, then what is it?
3) Do you believe assets should be included in your net worth calculation?
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by zinfit »

Couldn't one sell his pension plan
?
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by kcowan »

zinfit wrote:Couldn't one sell his pension plan?
Yes. It would be heavily factored. But it is possible to sell any future stream of payments.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by OhGreatGuru »

As Peter and Ghariton have discussed at some length, computing an "equivalent asset value" of a DB pension has a number of uses in determining adequacy of overall savings for retirement and making asset allocation decisions.

If you are told "you need to have $XM saved by age Y to retire", how do you count the value of your DB pension unless you calculate an equivalent this way?
If you are told that you should have X% of your retirement savings in fixed income for your age and risk profile, how do you count the value of your DB pension unless you calculate an equivalent this way?

But you have to be cautious about thinking about it as a part of "net worth" as it has no cash value.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by kcowan »

The safest way to think of it is as a reduction in the amount of SWR needed. IOW calculate your SWR on the net needed.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by Rooster »

I consider the commuted value of my DB as part of my bond allocation in my overall portfolio. The goal of my long term portfolio is funding retirement and I don't see why I should ignore DB in the assessment.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by AltaRed »

Rooster wrote:I consider the commuted value of my DB as part of my bond allocation in my overall portfolio. The goal of my long term portfolio is funding retirement and I don't see why I should ignore DB in the assessment.
For asset allocation purposes perhaps, but for net worth? They are distinct and different, and pensions have highly variable net worth values, e.g. age, mortality, etc. My pension has a net worth of approximately 0 if I fall dead at the PC in the next 2 minutes, and not a lot more if I fall dead next year.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by Rooster »

AltaRed wrote:
Rooster wrote:I consider the commuted value of my DB as part of my bond allocation in my overall portfolio. The goal of my long term portfolio is funding retirement and I don't see why I should ignore DB in the assessment.
For asset allocation purposes perhaps, but for net worth? They are distinct and different, and pensions have highly variable net worth values, e.g. age, mortality, etc. My pension has a net worth of approximately 0 if I fall dead at the PC in the next 2 minutes, and not a lot more if I fall dead next year.
I think one has to consider why they want to know net worth in the first place. If for estate purposes (such as those raised by the "fall dead" arguments), I agree they have limited value beyond survival benefits.

If to give a snapshot of the relative health/strength of one's current financial situation, I think excluding value of DB gives the wrong snapshot. When i left my previous employer, I left with about 80k in a LIRA from some 4 years of DB accumulation. Did my "net worth" go up overnight or was i simply failing to take the value of the DB into consideration up to that point? Including it without qualification can also give the wrong snapshot as the money is only accessible in strict circumstances as an annuity. I tend to take it for what I think it is to me....present value of a bond-like investment that will pay off an income stream under set circumstances, so very significant to my retirement planning which is the basis of my long term investment strategy.

The main reason to consider DB is for asset allocation purposes and I use commuted value as a rough indication of present value of the bond-like allocation. Beyond that though, if one just wants a snapshot of one's financial situation I think excluding present day DB value presents a situation that is farther from the actual situation than including it -despite it's particularities, it remains a financial asset that has (present day) value and I think the commuted value is good enough an approximation to use.

Basically, beyond retirement planning, considering DB has little use. For retirement planning (which is the goal of my long term investments), I think it is very pertinent.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by AltaRed »

Rooster wrote:I tend to take it for what I think it is to me....present value of a bond-like investment that will pay off an income stream under set circumstances, so very significant to my retirement planning which is the basis of my long term investment strategy.

The main reason to consider DB is for asset allocation purposes and I use commuted value as a rough indication of present value of the bond-like allocation. Beyond that though, if one just wants a snapshot of one's financial situation I think excluding present day DB value presents a situation that is farther from the actual situation than including it -despite it's particularities, it remains a financial asset that has (present day) value and I think the commuted value is good enough an approximation to use.
Which is essentially what I said.... albeit I also agree with your last point if the pension is vested and one can 'walk' with a LIRA, etc. on one's way to a new adventure whatever it may be.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by Rooster »

AltaRed wrote:
Rooster wrote:Which is essentially what I said.... albeit I also agree with your last point if the pension is vested and one can 'walk' with a LIRA, etc. on one's way to a new adventure whatever it may be.
All in all (sorry for being so wordy), I think it is a particular beast that needs to be considered on it's own (but still considered). I mentioned that I consider it bond-like for asset allocation purposes, but really I consider the default risk to be higher with the DB than gov of Canada bonds (even if the DB is from a fed crown corp). Push comes to shove, governments can "default" on promised annuities with less consequences than defaulting on bonds. Actuaries seem to link discount rates to 10 year bonds, so I figure they consider them as risky as bonds, but I don't quite see it the same -albeit default rates should not be much if any different.
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Re: Net Worth Calculations: How to Value a Pension Plan

Post by parvus »

AltaRed's point remains valid. The DB doesn't count as net worth.

As for the asset allocation and the default risk, you have to consider the rationale for the calculation. The corporate bond rate is not used so much as an indicator of the possibility of default, but rather as a proxy for the growth in liabilities, assuming high-quality (AA) corporate bonds reflect inflation expectations and economic growth (including salary and benefit increases).

The Towers Watson report cited in the link notes that the discount rate assumption in Canada is 3.52%. So the pension plan needs to earn at least that much, which is roughly in line with the somewhat standard pension goal of CPI + 4%.

Whether assets will grow faster than liabilities is, of course, another matter.

(And whether a plan is fully funded, given current liabilities, is another kettle of fish -- or lobsters brought to boil.)

And again, a LIRA is not a DB plan: the CPI + 4% risk/liability has been shifted from the employer to you.
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