Net Worth Calculations: How to Value a Pension Plan

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

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

Post by parvus »

Here's an interesting snippet from Air Canada, re: liabilities and asset allocation.
Air Canada provided today an update regarding its Canadian pension plans solvency status. Based on preliminary estimates and the factors outlined below, Air Canada projects its Canadian registered pension plans at January 1, 2014 to be in a small surplus position. The Canadian registered pension plans solvency deficit at January 1, 2013 was $3.7 billion. Final valuations as of January 1, 2014 will be completed in the first half of 2014.

The elimination of the previous $3.7 billion deficit is the result of several factors: (1) a 13.8% return on investments during 2013, (2) the implementation of previously disclosed pension benefit amendments which are estimated to have decreased the solvency deficit by approximately $970 million, (3) contributions made by the corporation for the year of $225 million in respect of the solvency deficit and (4) the application of an estimated prescribed discount rate of 3.9% to calculate its future pension obligations.

The discount rate used to value the pension obligations is determined pursuant to guidance of the Canadian Institute of Actuaries. The discount rate used at January 1, 2013 was 3.0%. Air Canada used an estimated discount rate of 3.9% at January 1, 2014. Every 10 basis points change in the discount rate would result in approximately a $150 million change to the solvency liabilities. The final valuation will be based on the guidance for January 1, 2014 expected to be confirmed in February.

Four years ago, Air Canada began a program with the objective of materially de-risking its pension plans, and a new investment strategy with liability driven initiatives was introduced. The strategy contributed to achieving a return over the four-year period of 11.8%, a first quartile performance (versus Canadian large pension plans), while lowering the overall risk profile. At present, 70.0% of the pension liabilities are matched with fixed income products to mitigate a significant portion of the interest rate (discount rate) risk. It is Air Canada's objective over the mid-term, assuming appropriate market conditions, to match 100% of the pension liabilities with fixed income products.
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
Rooster
Contributor
Contributor
Posts: 174
Joined: 16 Jan 2012 13:03

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

Post by Rooster »

I thought (could well be wrong) that discount rates matched gov of canada bonds as that reflected the "risk free" nature of the earned annuity to the beneficiary. Returns achieved by the plan, increase in liabilities, plan solvency, etc. is technically only pertinent to the employer, the employee simply has an earned right to a future annuity. From the employee's perspective, he has a right which is discounted at a risk free rate equal to gov bonds (so i thought). When I transferred my previous earned benefit to a lira (from a private employer), the rate was the then 10 year gov bond rate of 1.8% for 10 years and 2.3% thereafter. At that time, the plan solvency (on a liquidation basis) was in the neighborhood of 85% and the plan used return assumptions of 6%. Maybe the bond rates were used as a proxy for expected future increase in liabilities, but I don't really see the link between the rise in a plan's liabilities (which is pertinent for the employer) and the present day value of an earned benefit from an employees perspective. I saw it as "if i take this lira and put it in risk free 10 year gov bonds and buy an annuity at retirement age equal to what the plan provided, i should (in theory) come out neutral (minus the insurance company that would be selling me the annuity's profit margin).

As for the discussion on net worth, i really think we need to define what we mean by net worth otherwise we could all be right just talking about different things. To me, net worth (unqualified) simply means one's assets minus liabilities. An earned DB benefit is certainly an asset - an important financial asset at that (considerable amounts of capital are contributed into it every year by employee and employer -mine virtually eats up all my rrsp space). Now this financial asset has particularities that make it harder to valuate than other assets. This is fine, but doesn't mean it should be "forgotten" when looking at a persons net assets. A Lira is not a DB going forward, but the value of a lira at moment of transfer is an actuarial estimate of the present value of a DB. Does a plan, at a set point in time, have value if transferred but none is not transferred? A LIRA isn't really any more liquid and really liquidity should not be a determinant factor. I think what should be included/excluded from net worth calculations depends solely on why one is looking at net worth. Let's take a principle residence. Should it be included in net worth? When simply talking about overall net worth, why not? When talking about net worth with a view towards funding retirement, well principle residence (unless one plans to downsize) should probably not be considered but earned DB should probably be considered. When talking about net worth with a view towards estate planning, it flips as the house becomes pertinent and the DB not (beyond survival benefits).

All in all, I think a realistic view of one's financial situation (which is often why net worth is considered) should take into account accrued DB -as that will be a significant amount towards which significant capital contributions were made and excluding it really does not give an accurate picture of a person's situation. Beyond that, we need to look at why we are looking at net worth. For estate planning, remove it. For retirement planning, include it. I personally tend to think of my net worth in 3 buckets - personal residence, investable assets, DB each with their own particularities, but in the end all important assets in their own right.
User avatar
kcowan
Veteran Contributor
Veteran Contributor
Posts: 16033
Joined: 18 Apr 2006 20:33
Location: Pacific latitude 20/49

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

Post by kcowan »

Has anyone else encountered lenders who consider pension payments equally with salary but do not consider assets when granting a loan?
For the fun of it...Keith
User avatar
Peculiar_Investor
Administrator
Administrator
Posts: 13267
Joined: 01 Mar 2005 14:52
Location: Calgary
Contact:

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

Post by Peculiar_Investor »

I would concur with Rooster's line of thinking and underlying analysis that is presented.

Net worth = Assets - Liabilities. That's the simple part.

Deciding what to include as Assets and/or Liabilities is where the fun begins. Many investment discussions start with Asset Allocation, which generally focuses on "investable assets", which typically exclude things like principal residence, defined benefit pension plans and other similar items. I would most certainly include some calculated value of a DB pension plan in my net worth. But as kcowan points out, there are other uses for a net worth statement.

Another part of the investment discussion is planning for retirement income, after all, isn't that why we gather assets (capital) now, so they can be used to generate cash flow (income plus capital withdrawal) sometime in the future, typically when our employment income has ceased (aka, retirement). Certainly a DB pension plan is part of the assets to be considered in this context.

At the end of the day, there is a general framework that we've probably covered pretty well and individuals will need to consider how to apply it to their circumstances. I don't think there is a correct answer, except maybe the standard "It depends".

I'd rather have a comprehensive net worth calculation that includes everything and then let the person using the information decide whether to accept, remove or discount the parts they feel most applies in the circumstances, such as a loan application, divorce settlement, etc.
Imagefiniki, the Canadian financial wiki New editors wanted and welcomed, please help collaborate and improve the wiki.

Normal people… believe that if it ain’t broke, don’t fix it. Engineers believe that if it ain’t broke, it doesn’t have enough features yet. – Scott Adams
brucecohen
Veteran Contributor
Veteran Contributor
Posts: 13310
Joined: 20 Feb 2005 16:47

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

Post by brucecohen »

kcowan wrote:Has anyone else encountered lenders who consider pension payments equally with salary but do not consider assets when granting a loan?
I can see why they view it equally with salary -- actually it's likely more secure than salary. But I don't see why they would recognize it as an asset. They can't seize it in the event of default. They can only garnishee the benefits as they're paid.
SQRT
Veteran Contributor
Veteran Contributor
Posts: 5441
Joined: 01 Nov 2012 11:33
Location: Ontario/Arizona

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

Post by SQRT »

Rooster has said it all. Case closed.
User avatar
kcowan
Veteran Contributor
Veteran Contributor
Posts: 16033
Joined: 18 Apr 2006 20:33
Location: Pacific latitude 20/49

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

Post by kcowan »

brucecohen wrote:
kcowan wrote:Has anyone else encountered lenders who consider pension payments equally with salary but do not consider assets when granting a loan?
I can see why they view it equally with salary -- actually it's likely more secure than salary. But I don't see why they would recognize it as an asset. They can't seize it in the event of default. They can only garnishee the benefits as they're paid.
It was a bank considering the likelihood of mortgage payment for an impaired RE asset. So they did not want to get stuck with the RE without any other recourse.
For the fun of it...Keith
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

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

Post by parvus »

Rooster wrote:I thought (could well be wrong) that discount rates matched gov of canada bonds as that reflected the "risk free" nature of the earned annuity to the beneficiary.
Under IAS 19, discount rates are based on high-quality corporates unless (as in Australia!) the corporate bond market isn't very deep.
Returns achieved by the plan, increase in liabilities, plan solvency, etc. is technically only pertinent to the employer,
Not if you're an active employee ... and there may be complications if you're a retiree. Deficits, as we see above with Air Canada, can lead to increased contributions (from employer and employee), a curtailment of benefits (inflation indexing, early retirement options, extra health insurance for drugs and eyeglasses) to bring the plan up to funded status. This doesn't matter if you have a LIRA. You've forgone those benefits (and funding risks).
the employee simply has an earned right to a future annuity.
The present value of that annuity is dependent on age and years of service, and is thus a bit of a contractual artefact. It's not real unless the terms are specified. Which is to say that the company promises a certain annual payout based on years of service and salary, which are contingent until converted into a lump sum.

A LIRA is a lump sum. With wise investing, it will provide for an income replacement of what you were earning at the time that in effect you chose early retirement (at least from the plan). For the rest of your lifetime income replacement, you will have to rely on non-LIRA investments.

Even in the LIRA, you've lost the risk and mortality-experience pooling. You're on your own.
From the employee's perspective, he has a right which is discounted at a risk free rate equal to gov bonds (so i thought).
It seems to me that it is discounted to reflect the growth of plan liabilities, not to reflect a risk-free annuity for each employee individually, simply because no two employees are alike in their entitlements because of differential salaries, and, because a DB plan is a pool with differential mortality experiences -- some will die young. I think you are being misled by the notion of a "risk-free" rate. Even annuities (over a certain amount) aren't risk-free
When I transferred my previous earned benefit to a lira (from a private employer), the rate was the then 10 year gov bond rate of 1.8% for 10 years and 2.3% thereafter.
I think that's the present value of what the company would have to pay you, individually, in retirement, up to age 94 or so, based on your accumulated service to date. (Some other company is going to have to pick up the tab for future service.) In essence, your commuted value is a deferred annuity, and was probably priced as such.
At that time, the plan solvency (on a liquidation basis) was in the neighborhood of 85% and the plan used return assumptions of 6%. Maybe the bond rates were used as a proxy for expected future increase in liabilities,
Return assumptions are not liability calculations. The latter involves what has already been promised and accrued to date; the former involves how it's going to get paid for. One could, of course, make the liability accrual rate equal to the funding rate. For many companies, earnings would be underwater (see Air Canada). For public sector plans, taxes would increase, wages would be cut, or there would be massive layoffs. But that's on a windup basis, rather than as a going concern. (Hey, I said it was a whole other pot of boiling lobsters!) :wink:
but I don't really see the link between the rise in a plan's liabilities (which is pertinent for the employer) and the present day value of an earned benefit from an employees perspective. I saw it as "if i take this lira and put it in risk free 10 year gov bonds and buy an annuity at retirement age equal to what the plan provided, i should (in theory) come out neutral (minus the insurance company that would be selling me the annuity's profit margin).
You may come out neutral, according to your accrued service. But your annual payout will be much less than if you had stayed with the company until retirement. You will have missed out on pension obligations accruing to salary increases (be they average career earnings or final earnings). So your LIRA, invested in 10-year bonds, will provide you in retirement an annuity based on what you would be eligible for had you retired at say age 50, rather than age 65. It's really a deferred annuity. Your capital is stopped at age 50, but you can earn interest on it tax-free it till you start drawing on the annuity.

As I said, calculating liabilities and matching those with funding are different things, so funding the gap between age 50 and age 65 is up to you. It should be noted that in many pension schemes, DB pensions are a transfer of wealth from younger workers to older workers.

Anyway, just some thoughts. Bruce Cohen knows this stuff way better than I do.

And there's always Ask an Actuary. :wink:
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

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

Post by parvus »

Rooster wrote:As for the discussion on net worth, i really think we need to define what we mean by net worth otherwise we could all be right just talking about different things.
I'm going to be a little bit provocative here. Net worth is, in some sense, an irreal concept -- going back to the difference between stocks and flows.

For example, are you rich because you make more than $220,000 a year? That's where to 1% begins in Canada. Is that the same thing as having $1 million in investable assets (excluding a principal residence). That's the regulatory definition of wealth.
To me, net worth (unqualified) simply means one's assets minus liabilities. An earned DB benefit is certainly an asset - an important financial asset at that (considerable amounts of capital are contributed into it every year by employee and employer -mine virtually eats up all my rrsp space). Now this financial asset has particularities that make it harder to valuate than other assets. This is fine, but doesn't mean it should be "forgotten" when looking at a persons net assets. A Lira is not a DB going forward, but the value of a lira at moment of transfer is an actuarial estimate of the present value of a DB.
Yes, an appraisal establishes the value of the principal residence, a new cash round the value of a private corporation, mark-to-market prices the value of a stock and bond portfolio. To some extent (in the U.S.) there is also an after-market in life insurance policies. But DB pensions lack price discovery and a secondary market -- until commuted. At which point it is no longer a DB plan, but effectively a deferred annuity.
Does a plan, at a set point in time, have value if transferred but none is not transferred? A LIRA isn't really any more liquid and really liquidity should not be a determinant factor. I think what should be included/excluded from net worth calculations depends solely on why one is looking at net worth. Let's take a principle residence. Should it be included in net worth? When simply talking about overall net worth, why not?
Probably not. A DB pension throws off a lifelong income stream -- but it's not tradable, unlike a slow-growth utility that does throw off a reliable income stream, but is tradable. Theoretically, one could calculate the value of a principal residence on the basis of its imputed rent equivalent to establish a dividend-discount valuation. Back to the difference between stocks and flows. An asset may have a nominal book valuation; its value in net worth calculations depends, I would suggest, in figuring out the price to book. You don't know the value of the DB pension, but you can work backwards from annuity tables to establish its capital value. Similarly, you don't know the value of your principal residence, but you can work backwards from rental value.

Why would one do this? Because the DB pension dies at death. It has no permanent value. The principal residence is worth only what it fetches at sale, which is not now. Neither of the two is priced mark-to-market, unlike stocks and bonds.

Otherwise, there is measurement of net worth via incommensurable entities.
When talking about net worth with a view towards funding retirement, well principle residence (unless one plans to downsize) should probably not be considered but earned DB should probably be considered. When talking about net worth with a view towards estate planning, it flips as the house becomes pertinent and the DB not (beyond survival benefits).
Here again we stumble on the mark-to-market problem (and incommensurability). The DB plan value can be estimated from a dividend-discount workback, and the principal residence can be monetized though a reverse mortgage. That works for net worth purposes, but not for estate planning purposes, in which now insurance policies have to be considered (as well as back-to-back annuities). And what net worth should be assigned to them? :wink:
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
SQRT
Veteran Contributor
Veteran Contributor
Posts: 5441
Joined: 01 Nov 2012 11:33
Location: Ontario/Arizona

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

Post by SQRT »

Boy I think some of you guys are over thinking this thing, or you have way too much time on your hands.
Rooster
Contributor
Contributor
Posts: 174
Joined: 16 Jan 2012 13:03

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

Post by Rooster »

Interesting read parvus, thanks for taking the time.

A question, you mention (and i've heard before) that DBs are a wealth transfer vehicle from younger workers to older, but don't quite see it. Can you elaborate?
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

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

Post by parvus »

It depends on your years of service and your career mobility. George$ undoubtedly has some examples.

But the basic idea is that there are three sources for funding a DB plan: employer contributions, employee contributions and investment returns. As a younger worker, you are only slowly building up service credits, while still paying the same employee contribution, with the employer match. Effectively, your contributions, plus the employer contributions, are funding those who have higher service credits: same contributions, but different payouts.

But I'm not an expert.
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

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

Post by parvus »

SQRT wrote:Boy I think some of you guys are over thinking this thing, or you have way too much time on your hands.
Not me. I'm an iconoclast. :wink:
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
User avatar
ghariton
Veteran Contributor
Veteran Contributor
Posts: 15954
Joined: 18 Feb 2005 18:59
Location: Ottawa

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

Post by ghariton »

The most meaningful value of a liquid asset is its market value, what you can sell it for or what you have to pay for it. Those two measures (buying price or selling price) may differ, but if the asset is liquid, the spread should be quite small. Accordingly all liquid assets should be marked to market if one wishes to know what they are worth today.

I know that many people and institutions (e.g. banks) resist marking-to-market. They give a variety of reasons, e.g. that holding to maturity will eliminate losses, or that the market is irrational right now, or that "paper losses don't count". To my mind, these are merely rationalizations for not recognizing losses, and so for not admitting to their existence. There may be some defensible reasons for non-recognition, e.g. so as not to violate regulatory requirements or some covenants or not panic investors. But that is definitely second best.

What of illiquid assets? There may be no market for the asset, or a very thin market, with a large bid-ask spread. What is the value of those assets? There are two general approaches. The first is to look at the market value of assets that have traded and that resemble to asset in question as much as possible. Sometimes subjective adjustments are made, based on the estimator's experience and int6uition (which is really nothing than crystallised experience). For example, real estate appraisers look at the sale of similar properties. Similarly with works of art. The estimate may be more or less accuratem based on uniqueness. But in all cases it is trying to get at market value.

The second approach is to look at future positive and negative cash flows, or other benefits and costs, and discount to a net present value. This approach is based on the empirical observation that, for liquid assets, on average the net present value is equal to the market price. By analogy, we reason that the same must be true for illiquid assets. Of course, forecasting future cash flows is uncertain, as is the choice of discount rate, and so the resulting net present value has a degree of uncertainty. But again we are still trying to approximate market value.

All this applies to DB pensions. The first method involves looking at annuities that are as similar as possible and seeing what prices issuers are asking (and purchasers are paying). This can be done to value a pension as it stands today, i.e. the accrued benefits, or as the pension will stand at age 60 or 65 (if one is willing to forecast future years' salary.) For many pensions there is an active market. Even for indexed pensions, there is an active market in the U.K. and perhaps that is the most similar comparator, given the very thin Canadian market for indexed annuities.

The second way to value a DB pension, is to estimate a life expectancy and assume a discount rate. The discount rate should be based on the nature of the future benefits and their risk. That's why moving to a corporate bond rate for private sector DB plans made sense -- the annuity payments are similar to corporate bond coupons. However, using the corporate bond rate may lead to a discount rate that is slightly too low, as it does not recognize that most bonds are liquid to some degree -- they can be sold -- while annuities are not. In my opinion, a liquidity premium should be added to recognize this.

None of this is mysterious. DB pensions have a present value, just as other assets do. That value may be more difficult to estimate than for, say stocks or bonds. But it is easier to value than some other intangibles, e.g. the value of a patent. Yet in patent infringement cases, courts place a value on patents all the time.

George
The juice is worth the squeeze
Rooster
Contributor
Contributor
Posts: 174
Joined: 16 Jan 2012 13:03

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

Post by Rooster »

parvus wrote:It depends on your years of service and your career mobility. George$ undoubtedly has some examples.

But the basic idea is that there are three sources for funding a DB plan: employer contributions, employee contributions and investment returns. As a younger worker, you are only slowly building up service credits, while still paying the same employee contribution, with the employer match. Effectively, your contributions, plus the employer contributions, are funding those who have higher service credits: same contributions, but different payouts.

But I'm not an expert.
The contributions are a % of salary though, not fixed amount. Do you mean that since benefits will be based on highest salary for last x number of years (instead of salary at years at which benefit accrued) there is a skewing of benefit towards the oldest employees? In plans indexed for inflation (including on deferred amounts), would this not only be the case for people whose salaries rise above inflation?

In any event, is the "skewing" very material?
peter
Contributor
Contributor
Posts: 662
Joined: 10 Oct 2005 21:37
Location: Alberta

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

Post by peter »

parvus wrote:It depends on your years of service and your career mobility. George$ undoubtedly has some examples.

But the basic idea is that there are three sources for funding a DB plan: employer contributions, employee contributions and investment returns. As a younger worker, you are only slowly building up service credits, while still paying the same employee contribution, with the employer match. Effectively, your contributions, plus the employer contributions, are funding those who have higher service credits: same contributions, but different payouts.

But I'm not an expert.
I don't think this is obvious. My pension plan has as payout :
2% of highest average capped salary x pensionable service x reduction factor

Pensionable service is the number of years you've worked, simply linear. The reduction factor is 1 for 'normal' retirement and smaller for early retirement. I don't think this is relevant for the question in this post. The capped salary is $154,250 for 2014.

The 2% of highest average capped salary has a non-linear component because it considers only the average of the highest 5 years. The final payout doesn't care about the shape of your career trajectory (in terms of salary), which might in a typical case in this plan go from $90k to $190k in current dollars. It only cares about the total length and about the highest 5 years.

Contribution rates between YPME and the cap are 14.26% for employee and 14.26% for employer. 1 year of pensionable service when your salary is $160k at 60 years age gives ca. 2% * $154,250 in additional benefit when retired. 1 year of pensionable service when your salary is $90k at 35 years costs less in contributions but the additional benefit isn't known unless that $90k is the average of the highest 5 years. It could be the same benefit the 60-year old gets for a much higher contribution.

You could model the amount of contribution you pay for different career trajectories. The best possible case would be to have 5 years of $155k and 30 years of $90k, as that would give you the maximum pension for relatively low contributions. The most expensive case in terms of contribution would be to quickly rise to $155k and stay there or above $155k. A more typical case is initially relatively quick increases from $90k followed by increasingly smaller increases over a whole career.

An additional wrinkle in this plan is that the cap is $154,250 and there is a 1.17% contribution for both employee and employer for salary above that, with no benefit.

It's not obvious to me how this system would benefit people with more credits over those with fewer credits, where I assume benefit is relative to their contributions. Perhaps I missed something by not actually doing more models. Or perhaps the relative benefit is in the commuted value? I can calculate the payout based on salary, years of service, and retirement age (ignoring some subtleties with different spousal options) but I can't calculate the commuted value. Mine has gone up by what seems an unreasonable amount compared to my increase in years of service, but salary has increased as well and at the same time long bonds have gone down. I assume the discount rate actually has been a major factor in the significant increases in commuted value in the past few years.
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

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

Post by parvus »

Rooster wrote:The contributions are a % of salary though, not fixed amount. Do you mean that since benefits will be based on highest salary for last x number of years (instead of salary at years at which benefit accrued) there is a skewing of benefit towards the oldest employees? In plans indexed for inflation (including on deferred amounts), would this not only be the case for people whose salaries rise above inflation?

In any event, is the "skewing" very material?
I think it's a bit like bond convexity. Anyway, here's a reference from the U.S. Social Security Administration:
Pension wealth—the present discounted value of the stream of future expected benefits—grows slowly in typical DB plans for young workers, increases rapidly once workers approach the plan's retirement age, but then levels off or can even decline at older ages. Pension wealth is minimal at younger ages because junior employees typically earn low wages and have completed only a few years of service. In addition, if a worker terminates employment with the firm, benefits at retirement are based only on earnings to date, and their present value is low because the worker receives them many years in the future. The present value of DB benefits rises rapidly as workers increase tenure with their current employer, as their earnings increase through real wage growth and inflation and as they approach the time when they can collect benefits. Workers in traditional DB plans often lose pension wealth, however, if they stay on the job beyond a certain age or seniority level. Growth in promised annual retirement benefits typically slows at older ages as wage growth declines.
This, I think, is without explicit (pay-go) cross-subsidies. But there are often implicit ones, as this article notes:
Traditional DB plan designs frequently create situations in which one category of members effectively subsidizes another: younger subsidizes older, short service subsidizes long service, normal retirement subsidizes early retirement and single subsidizes married. Most of these hidden subsidies are a function of the plan design.

<snip>
The DB design and regulation should be such that the accumulated benefit for a particular year of service, and a prescribed normal retirement age, is consistent for all employees regardless of gender, marital status, job changes or target retirement age
.
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
User avatar
SkaSka
Contributor
Contributor
Posts: 727
Joined: 29 Nov 2012 01:21
Location: Raincouver

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

Post by SkaSka »

Thanks everyone for the vigorous dissection and debate!

I've come to the conclusion that I will "estimate" the "value" of our pension plans by using the pension formulas and the rule of thumb of multiplying the yearly pension amount by 15.

I will use this as a very rough rule of thumb on what our assets at retirement age look like. I will also use it as a very rough rule of thumb on asset allocation once our investing ramps up (2015 is the year!).

However, for more realistic purposes, I will ignore these rough pension estimates when it comes to looking at current assets.

I think that is my happy medium. Also, I've already changed my spreadsheet to reflect this so... :thumbsup:
Thomas77
Newcomer
Newcomer
Posts: 1
Joined: 08 Aug 2017 16:47

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

Post by Thomas77 »

What's the purpose of calculating net worth?

It's usually used as an indicator of financial health, a barometer or form of measurement. If the purpose is to put a value on financial health, then I'm not sure the rationale to not value pensions in net worth. Maybe a more productive way to figure it out would be to calculate net worth both with and without the pension.

I have a government retirement plan in which I will receive $6000 per month (with 3% increases per year) when I retire. If I pass away, then my partner gets it for a set amount of time. I also qualify for social security and have significant savings.
If I had 1 million extra in a 401K and I withdrew $6000 a month, it would last 10.7 years. If there was a stock downturn it would last less than 10 years, if there was an upturn then it would last longer. I personally would value a defined plan as worth more than the valuation due to the fact its not dependent on the variability of the market.

So in summary, your saying that my financial health is equivalent to someone else with the same savings minus the pension?
Post Reply