Determining Total Dollar Value (TDV)
My original intent for Part Four of this series was to write about good pension calculators found on the web that could help you place a Total Dollar Value (TDV) on your pension. In fact, I was building up to it from Part One onward. I felt my topics had a nice and natural progression beginning with pension safety, moving on to whether or not your pension is worth it, and then analyzing the three most important factors in determining the your pension’s worth: the Initial Dollar Value (IDV) formula, inflation’s effect, and the Immediacy Effect.
However, it turns out that most generic pension calculators on the web stink, if you can find one at all. It also turns out, that most pension plans have their own calculators. In hindsight, that makes sense because as we discussed in Part Three, each pension plan has its own formula to calculate IDV. My oversight aside, it doesn’t decrease the importance of determining the TDV of your pension. In fact, there are several good reasons for doing so, even if the process might prove different than I first imagined.
The most import reason for calculating your pension’s TDV is to ensure your Human Resources (HR) and/or pay department give you what you are entitled to upon retirement. This may seem like obvious advice, but I am not so sure. The Department of Labor’s (DOL’s) Employee Benefits Security Administration (EBSA), the federal office designed to protect employee’s retirement benefits, has a web page with the 10 Common Causes Of Errors In Pension Calculation. It’s worth a read, especially since 2 of the 10 most common errors are due to simple math.
I doubt the EBSA would waste time stating the obvious in a list of 10 Common Errors if it was not happening, so make sure the administrators are doing the basics correctly. It so happens that I have a pension administrator in my Golden Albatross Facebook Group and after I sent her the link she advised:
…I would definitely recommend that everyone … do their own basic pension calculation. I’ve had very few people I’ve worked with over the years do this … Our process is to have our outside administrator do the calculation … we also independently do the calculation before we review theirs. The idea being that it’s unlikely both will make the same error, so if we match we’re good to go. If not, we investigate until we find the error. This has worked well for me … Still, while this makes me confident that we’re providing accurate calculations, I think everyone should understand their own calculation and be able to challenge it if they’re not confident in the accuracy. — Michelle
I think that is great advice, especially since I doubt everyone’s organization has someone as conscientious as Michelle looking out for their best interest. Also, I presume it’s hard, if not impossible, to fix an error in your pension calculation after you’ve retired, signed all the paperwork, and started to receive checks. Which means it’s probably best to save yourself a headache, if not a heart attack, and calculate your pension’s TDV before you sign anything.
The second reason why it’s important to determine a TDV for your pension is the issue of survivorship. If you are married or have children, then by law your pension plan must offer some sort of survivorship plan. Survivorship essentially acts like an insurance policy, allowing you to elect a certain percentage of your pension to pass to your spouse and/or minor children when you die. In turn, this reduces the total monthly payment to you while living (akin to a monthly premium).
Thus, if you don’t know the TDV of your pension, you’ll have no idea if electing the survivorship benefit is good value for money. Or, if alternatively, you might find better value for money through something like term insurance. It’s not a direct apples to apples comparison, as inflation plays a role in this determination as well. This is a topic probably worth exploring more thoroughly in a future post, but until then just keep in mind that some of the values you calculate when determining TDV can help you decide when to elect survivorship.
Another topic definitely worth exploring in a future post is that of the lump sum. It also happens to be the third major reason why I think it’s important to calculate a TDV for your pension. Many pension plans these days, including public pensions, offer the opportunity to take some, or all, of your future pension’s value in form of a lump sum payment immediately upon retirement. As discussed in my Pension Safety article, there is a good reason why pension plans do this.
Primarily they do it to reduce future financial liability in order to shore up their finances. This means it’s cheaper to pay you a reduced amount of money at retirement in order to reduce or eliminate the liability of paying you (or your survivors) a larger amount of money spread out over the remainder of your lifetime. Now, there might be good reason for you to take a lump sum (which is why I’d like to explore the issue in further posts), but without knowing your pension’s TDV, you’ll have no idea as to just how much money the pension plan stands to save (and you stand to lose) from their lump sum offer.
Inflation Paced Calculations
So if those are three good reasons as to why it’s in your best interest to calculate your pension’s TDV, let’s see if we can actually do it. As you will recall from Part Three of the Pension Series, the first thing we must do is calculate Initial Dollar Value (IDV), which is based on your pension formula. Since different pension systems have different pension formulas, best to check your pension’s website or annual literature to find out what yours is.
While on the website, you will hopefully find a calculator that will at least calculate the IDV for you. If not, go back to Part Three of this series, and review how to draft a mathematical formula in order to do it yourself. Even if you find a calculator, you may still want to conduct the calculations by hand just to be safe. Who knows how the calculator on the website was programmed? This is your pension, after all, no one besides you and your family has more of a vested interest in ensuring the calculations are correct.
|Grumpus’s Calculator||Before Taxes|
|Years Out||Year||Monthly Pay||Annual Pay||Cumulative|
When you calculated your IDV did it come out in a monthly or yearly amount? The U.S. military’s pension calculator spits out results like the above chart. It provides both a monthly and an annual value as highlighted in the red text in the chart. If your calculator only provides a monthly amount, go ahead and calculate the annual amount since it is what we will need for our calculations below. Ignore the rest of the chart for now, I will refer back to it as needed.
If you are one of the lucky ones I described in Part Three of this series whose pension starts immediately upon retirement and has a Cost of Living Allowance (COLA) linked to inflation as listed in the Consumer Price Index (CPI), your task is simple. You can calculate TDV in today’s dollars by multiplying the yearly total for your IDV by the number of years you think you are going to live. So if I were to take the annual amount highlighted in red text above ($56,778.47) and multiply it by 40 (putting me at the ripe old age of 85) my TDV in today’s dollars would be $2,271,138.80. Notice that is a different amount than the cumulative value calculated in green in the lower right-hand corner of the chart.
Why? Well, an inflation-linked COLA is built into the military pension calculator, so the payments increase by some nominal amount representing inflation every year. The calculator doesn’t tell me what value is used for inflation, but in truth, it doesn’t matter. Since my pension payments will keep pace with inflation, it essentially eliminates the need to consider inflation’s effect. And since my pension starts immediately, I don’t need to discount it for the immediacy effect either. Thus, in any circumstance where a person has a CPI-linked COLA pension that starts immediately upon retirement, IDV multiplied by your expected life-span equals TDV (minus any survivorship payments one elects to make).
This is especially handy when comparing TDV to any lump sum offer. It allows you to make a dollar for dollar comparison in today’s dollars, without the need for any funky inflation calculations. So if your pension has a CPI-linked COLA and your work’s lump sum offer is $200K, but you just calculated a $1 million TDV (without survivorship), that means the offer is 80% less than what you are owed over your expected lifetime.
Non-Inflation or Partial Inflation Paced Calculations
Non-COLA pensioners, and pensioners with some sort of flat rate COLA, it’s your turn. My big hope is that your pension’s website has a calculator that does all this for you. If not, get ready to do a little more math. I’ve given this a lot of thought and caveated by the fact that I was not a math major at university, I think the easiest method may be somewhat similar to what I described above for the CPI-linked COLA pensioners, with one added step.
In other words, let’s first take the annual IDV and multiply by whatever time horizon you want to use for your lifespan. I will use the same 40 year calculation again as my scenario above ($56,778.47 x 40 years = $2,271,138.80). Remember that did not include the effects of inflation eating away at the value over time because the CPI-linked COLA nullified inflation’s effect. Thus, if we want to know what a non-COLA pension is worth in today’s dollars, we need to find some way to devalue it accordingly.
We are in luck because the calculator I linked to in Part Three of this series does exactly this — devalues money over time according to whatever inflation rate you set. After I click on the calculator link, I enter my $2.271 million figure from above, set my inflation rate to the CPI historical average of 3.22%, put my time horizon at 40 years, and press the easy button. What comes out is the significantly smaller dollar figure of $639,277.38! While significantly smaller, it represents a non-COLA pension’s TDV in today’s dollars assuming the inflation rate is accurate. If my math is correct, this is also the value I would use to compare to any lump sum offer for this scenario.
Of course, if your pension has a COLA that is linked only partially to CPI, or some other method like a flat rate COLA increase of 1 or 2%, then you need to modify your inflation rate accordingly. For instance, in Part Three of this series, I pointed out that the new U.S. military retirement system from 2018 onwards will have an annual COLA that is minus 1% of CPI. This essentially subjects future pension payments under this system to a 1% inflation rate in perpetuity.
Thus, if I were to calculate the TDV of my $2.271 million figure again using a 1% inflation rate over 40 years, it would equal a $1,525,417 TDV in today’s dollars. Again that is a lot less than the $2.271 million in my CPI-linked COLA pension scenario but is also a lot more than the 3.22% inflation-adjusted TDV of $639,277.38 in my no COLA pension scenario. The $1.5 million TDV is what I would use to compare to any lump sum offer that came my way in this scenario.
About the only scenario I’ve not discussed is that of the delayed pension payout. This is the type of pension which is vulnerable to the Immediacy Effect. For those of you who’ve yet to read Part Three of this series, the Immediacy Effect is a term I use to describe the mathematical formula and calculations behind an important discovery made by Big ERN McCracken over at Early Retirement Now. His calculations show that the further from your (early) retirement point your pension payments begin, the less those payments will mean to your successful employment of the 4% Safe Withdrawal Rate (SWR).
As with the scenarios above, there are different considerations for pensions that have CPI-linked COLAs, and those that don’t. I describe those in detail in Part Three of the Pension Series, so I won’t repeat them here. What is worth repeating is that I am not a math genius, and I still don’t entirely understand all the nuances of the Immediacy Effect. As such, I have yet to figure out how to appropriately discount the TDV of a pension which starts in the future. I believe I will have to reach out to Big ERN, and see if his math ability can help figure something out. Until then, I recommend anyone with a pension offset by a significant chunk of time from their retirement date, read Big Ern’s article describing his discovery and testing of the Immediacy effect.
That’s all I got this week folks. It took a while for this article to gel, but I think I got there in the end. Turns out that even without a calculator, determining the Total Dollar Value (TDV) of a pension is not all that hard. Not only that, but I identified several important uses of TDV which includes ensuring your pension administrator pays you the correct amount and valuing any lump sum offer that may come your way. By writing this article I also identified several potential future article topics for the Pension Series including survivorship calculations, lump sum decisions, and developing a calculation for the Immediacy Effect. Look for articles on those topics (and more) in the future. Until then, I hope you found this article useful. Feel free to comment, email, look me up on Facebook, or tweet me on Twitter.