Calculating Your Pension’s Worth … Ain’t Like Dusting Crops
Anybody else exhausted from Part 2 of the Pension Series? I know I am. At 3200+ words it wasn’t concise. Amongst all those words, you may remember my promise to help you determine your pension’s worth in future posts. Well, the future is now, or at least partially. Unlike Part 2 though, I intend to break up the discussion over the next several posts. How many? I don’t know yet; at least two, maybe more. Since calculating your pension’s worth is more of a “how to process”, I hope the articles don’t need to be overly verbose. I understand people don’t have time to read 3200+ word posts every week, and frankly, I don’t have the time to write them.
For this post, I will examine the three key inputs in determining your pension’s worth. I will also examine some of the basic mathematical formulas used to calculate your pension’s worth. I will keep it simple because I am not a math genius by any means (liberal arts major here!), and more than likely you are going to use a pension calculator to make the calculations anyway. However, you should understand the inputs and formulas because like Han Solo said in “Star Wars A New Hope”:
“Traveling through hyperspace ain’t like dusting crops, boy! Without precise calculations, we could fly right through a star or bounce too close to a supernova and that’d end your trip real quick, wouldn’t it?”
We don’t want your retirement trip ending real quick, do we? Fortunately, determining all three inputs is not hard. In fact, if you’ve done any sort of retirement planning at all, you probably calculated or accounted for these inputs already. Due to their overall importance in your retirement and Financial Independence (FI) plans, I’d be surprised if you had not at least considered them. The three inputs are the initial dollar amount of your pension, your pension’s interaction with inflation, and the immediacy of your pension. Let’s tackle each of these inputs in order.
The Initial Dollar Amount
I think it’s important to note (again) that when I refer to pension throughout this article, I mean a Defined Benefit Plan (DBP). Investopedia states:
“In a defined-benefit plan, the employer guarantees that the employee receives a definite amount of benefit upon retirement, regardless of the performance of the underlying investment pool. The employer is liable for a specific flow of pension payments to the retiree (the dollar amount is determined by a formula, usually based on earnings and years of service), and if the assets in the pension plan are not sufficient to pay the benefits, the company is liable for the remainder of the payment.”
I’d like you to focus on the portion in the parentheses, and note there is typically a formula involved. This means you need to find out what your company or organization’s retirement formula is, prior to moving any further. That is easy for some of us because the formula is posted online, and/or fairly well understood. For others, it might require a trip to Human Resources (HR) or research in your original hiring documentation.
Being in the military, I fall into that former category. I am under the High Three model, which means I earn a pension at 20 years of service worth 50% of the average of my highest three paid years of base pay (base pay means our taxable pay, not including allowances and special pays). Thus, my formula would look like this:
[(X+Y+Z) / 3] x .5 = annual pension dollar amount at 20 years of service.
X, Y, and Z represent my three highest-paid years of base pay. There is an additional consideration. The government adds 2.5% for each year over 20 years of service. Thus the complete calculation looks like this:
[(X+Y+Z) / 3] x [.5 + (.025 x Yo)] = annual pension dollar amount at XX years of service.
In this case, Yo represents the number of years over 20 a person served, and XX equals the total number of years served. Thus, if you retire at 30 years, you will earn 75% of the average of your three highest years of base pay.
In preparation for this article, I ran an unscientific survey on my Facebook Group (Golden Albatross / Golden Handcuffs). It turns out that within my group’s (50 or so) members the most common formula for determining a pension’s initial dollar amount was the average of your highest 3 to 5 paid years multiplied by a specified percentage. Pension plans that linked the percentage by which the salary average is multiplied, to the number of years worked, also appeared common. Typically these pensions require a minimal number of years in the job in order to become vested in the retirement scheme. A few examples include:
- Highest consecutive 5-year compensation average x years of service x 1.35%
- Final average compensation (FAC) x 1.5% (pension factor) x years of service (YOS)
And the best of the lot for 25 years of service:
- [(X+Y+Z) / 3] X .66 = Initial yearly pension with 2% bump in the multiple for each year of service over 25 years; maximum of 100%
Holy cow, I thought I was well compensated! These examples do not include Other Earned Benefits (OEB) that may be part of a retirement package. We are strictly talking monetary compensation. Even so, it’s easy to see how powerful a tool a pension could play in your retirement plans if you can make it to the vesting point. Often times that is a big IF though. Full vesting periods might require 20 years or more of work. Only a few of the pensions from my Facebook group had vesting periods under 20 years.
A lot of people, and especially those seeking Financial Independence Retired Early (FIRE) status, might struggle to work the same job for that long. For them, the decision to stay may come down to a worth vs. a “worth it” decision like I address in Part 2 of the Pension series. The initial dollar amount, while an important component in determining the answer to the “worth” part of the equation, is not the only factor. Determining the effects of inflation on your pension is just as important.
What is inflation? The Bureau of Labor and Statistics (BLS — the U.S. government agency that tracks inflation) states inflation is, “defined as the overall general upward price movement of goods and services in an economy”. In layman terms, it is the word used to describe the general trend that typically sees a year-over-year price increase of the stuff you buy. That change may not seem like much in any single year but added up over decades it changes the cost of goods dramatically.
For example, Star Wars (A New Hope) grossed $307,263,857 in domestic U.S. theaters when it originally debuted in 1977. Straight numbers wise, this is only fifth on the list of top-grossing movies in the franchise. The number one film on that list is Star Wars VII: The Force Awakens which grossed $936,662,225 domestically in 2016.
This seems like a huge difference, but consider how the cost of movie tickets rose over those 39 years. According to Box Office Mojo, a movie ticket in 1977 cost an average of $2.23. In 2016 that same ticket cost $8.65. Thus, when you look at inflation-adjusted lists of top grossing Star Wars films, you’ll find the original Star Wars grossed approximately $1,268,905,400 in 2016 dollars. That inflation-adjusted figure moves the original Star Wars from the fifth to the top-grossing Star Wars franchise movie. This is what you would expect from the cultural changing phenomena that was the original Star Wars film.
So what does inflation do to your pension? Well, if your pension’s initial payment amount is not inflation adjusted, inflation slowly devalues your pension over time. If each year you go to the movies and the tickets keep getting more expensive, but the amount of cash in your pocket remains constant, you’ll quickly realize you can’t afford to go to the movies anymore. Which sucks, because you’ll want to see Star Wars Episode 20 (Grandson of the Last Returned Jedi Who Struck Back) when it’s released in 2045.
A few of my well-informed readers might have heard utterances about the death of inflation. It is true inflation, as measured by the BLS in what is known as the Consumer Price Index for all Urban Workers (CPI-U), has remained below the historical average (3.22%) since the Great Recession. The below chart displays the year-over-year change in CPI-U inflation rates since 2007 by month and annually. The information is from the BLS’s website.
A quick glance at the chart seems to indicate CPI inflation stands at approximately 2% since 2007. Certainly, that is good news, right? Your money is devaluing much slower than the historical average. However, even a 2% inflation rate can bite into your pension’s initial value fairly quickly. For instance, a 2% inflation rate over 20 years would reduce a $60K annual pension to $40,378 in today’s dollars — that is a reduction of almost one-third. Or in other words, you would need $89,156 twenty years from now to equal the same purchasing power as $60K in today’s dollars. Either way you slice it, that’s not good. If you are interested you can play around with the effects of inflation on your initial pension amount here.
Hopefully, though, this is not the case with your pension. Ideally, your pension has a Cost of Living Allowance (COLA) linked to CPI-U for your entire initial payment amount. This is the current formula for U.S. Military retirees under the High Three system. Luckily that means the value of our pension will never erode due to inflation.
However, starting in 2018, a new system called the Blended Retirement Solution (BRS), will come into effect for all new military recruits. Not only will the new system reduced annuity payments to 40% of base pay at 20 years, but early iterations of the BRS proposal also included a COLA calculation of CPI minus 1% — which permanently locks in a 1% inflation rate. I haven’t verified if CPI-1% made into the final version of the BRS plan. Supposing it did though, a 1% inflation rate reduces a pension’s value by approximately one-quarter in 25 years. Of course, the upside for new military members is they get access to a defined contribution scheme with up to 5% government match that members of my era never received. Those changes will certainly impact their calculation of worth vs. “worth it” as they hit the inevitable struggles in a military career.
Again, the results of a completely unscientific poll from my Facebook group showed about one-half respondents had a full CPI-linked pension. One-third of respondents had no COLA of any kind. The remainder of respondents had their first $15K linked to a CPI COLA, with the rest subject to inflation — which was a first heard arrangement to me. One other popular COLA arrangement I’ve discovered in my research, but not represented by my FB respondents, is a flat percentage increase each year such as 1% or 2%. In some years this may cover all inflation, and in others, it won’t. At best a flat percentage slows down inflation’s destructive effect, but can’t stop it.
Hopefully, you now have a better understanding of inflation’s impact on the overall value of your pension. As stated previously, I hope everyone’s pension has a CPI-linked COLA, but I know that isn’t the case. For those of you with some or all of your pension at the mercy of inflation, understand that time is not on your side. The further you get from the start date of your pension payments, the less purchasing power it represents. Thus the value of your initial pension amount is a far cry from the value it will hold in your 70s, 80s, or 90s. Your movie ticket gets more expensive, but the amount of money in your pocket stays the same.
There is one more time-related consideration you must understand when trying to determine the worth of your pension, which is how quickly the payments start. Honestly, I only learned about this phenomenon recently. I can partially, but not fully, explain it. The bottom line is the further removed your retirement date is from the date your pension payments start, the less meaningful those payments become.
This is especially true when analyzing the potential success or failure of your investment portfolio’s ability to sustain your retirement spending by utilizing the 4% Safe Withdrawal Rate (SWR) up to the point where your pension payments start. For those of you who don’t remember, or haven’t read it, I discuss the 4% SWR in my article on how to calculate your Income Gap. Understanding the impacts of the 4% SWR is vital if you intend to retire early and live, at least partially, off the proceeds from your investments.
Part of the explanation for the immediacy phenomenon is due to inflation, which after our discussion above, should be easy enough to understand (I hope). Let’s say you retire at 55 and lock in an initial pension payment amount of $3000 a month. However, let’s also say your pension payments do not start until age 62 (which is a fairly common pension feature in some sectors). Furthermore, if those initial pension payment amounts do not have a CPI-linked COLA, or some other ability to grow with inflation, then what happens? Well, that equals seven years of inflation-linked devaluation against your pension payments before you ever receive a dime. At a 3% historical inflation average, that equals 21% (a full 1/5) of your pension gone before you ever get to use it.
This obviously makes that pension less meaningful to you and makes you more reliant on your other income streams (like your investment portfolio). If you retired early, and your investment portfolio took some significant drops at the beginning of retirement (known as sequence of returns risk), the inflation caused devaluation of your pension might impact you even harder.
Of course, the solution to that problem is to increase your initial payment amount in line with inflation, like a CPI-linked COLA. This mitigates the inflation linked immediacy effect. In the above scenario that means your pension payments retain the same purchasing power as the day you retired, even if your payments do not start for seven years because they will increase by 21% (i.e. your $3000 monthly payment is now $3630). The problem is that CPI-linked COLA is typically something that your employer decides to offer, not something you get to negotiate. If you find yourself in a pension program without an inflation-linked COLA, and your payments don’t start immediately, then (again) understand that time is your enemy. Thus, ensure you devalue the worth of your pension accordingly when making a worth vs. a “worth it” determination to stick around for that pension.
There is another aspect to this immediacy phenomenon that a CPI-linked COLA does not mitigate. Unfortunately, I don’t really understand the math to explain it well. However, I know someone who does, and that is Big Ern McCracken at Early Retirement Now (ERN). In fact, it was his article that clued me into the immediacy issue in the first place. So instead of waffling on about some math that I don’t understand, I will simply refer you to his excellent article on the interplay between Social Security, Pensions, and the 4% SWR.
If you decided the math in Ern’s article is too intimidating (I don’t blame you), and simply want to press the easy button, just understand this: The further from your (early) retirement point your pension payment begins, the less positive impact the payments will have on your employment of the 4% SWR. Thus, you would need to exercise due caution in the period prior to your pension starting. In other words, due to the funky effects of compounding interest and some other math related stuff, don’t overspend early in retirement thinking your late start pension payments will repair the damage to your investment portfolio. If you want a more in-depth explanation, you will have to read Ern’s article.
Damn. I meant to write a much shorter article than this. Even with edits, this will be a 2500+ word post. I recognize I’m too verbose and need to work on it. However, prior to ending this post I want to sum up my findings. Unfortunately, my main thought centers on the idea that some pensions are clearly worth more than others. The better ones carry certain features, most notably they:
- Vest workers after short periods
- Calculate initial pension amounts using formulas with high-income averages and percentage multipliers
- Start payouts immediately upon retirement
- Provide CPI-linked COLA for the entire pension amount
The values of these pensions never change since they rise with inflation, and maintain the same purchasing power. This makes a worth vs. “worth it” decision a lot easier when making retirement calculations. Obviously, this assumes your pension fund is in sound financial shape, but since I already discussed pension safety in Part 1 of the Pension Series, I won’t retread old ground.
Not everyone is fortunate enough to work a job with access to a pension that meets all the criteria above. I am afraid to say it, but the less a pension resembles the above points, the less it is going to be worth in retirement. How that impacts your worth vs. a “worth it” decision will come down to individual circumstances as pointed out in Part 2 of this series. However, at least you now understand the fundamental inputs to consider when determining the “worth” side of that equation. Whether or not we can actually translate those inputs into a specific value by using calculators is something I intend to discuss in the next post for this series.