A pension provides workers with regular income payments when they retire. You might have a pension plan at work or might have set up a self-employed pension for yourself. The general procedure for calculating the value of a pension is to figure its “present value.” This number represents an amount that, when invested at a set interest rate, provides the same value as the stream of periodic pension payments. Many factors can complicate the calculation, but the basic process isn't difficult.
Present Value at Retirement
You’ll need a spreadsheet program or a business calculator to figure present value. The calculation requires three data items. The first is the number of years that you will be receiving payments, which is equal to your life expectancy minus your retirement age. You’ll also need to know the annual payout you’ll receive and the current long-term interest rate. For example, suppose you plan to retire at 60, expect to live to 85, and expect to receive $25,000 a year. Assuming the long-term interest rate is 5 percent, you can input these numbers into the spreadsheet formula or calculator and compute the present value of $352,349.
Current Present Value
If you are 60 when you perform the example calculation, you’re all done. But suppose you are currently 45. That turns the $352,349 into a future value, because you won’t start receiving it for another 15 years. To get the pension value as of today, refigure present value by entering 5 percent as the interest rate; 60 minus 45, or 15, as the number of years; and $352,349 as the future value. The resulting present value of $169,486 is what the pension is worth to you today.
Cloudy Crystal Ball
Many assumptions attach to the number you calculate through the present value method. For example, the procedure assumes that you won’t be receiving any raises between now and retirement, that interest rates and inflation will remain stable, that you’ll remain employed until retirement, and that you’ll die at age 85. Clearly, any inaccuracy in these assumptions will put the calculated present value of your pension into question. You also must consider whether you’ll take the pension payments over time or as a single lump sum at retirement.
Actuaries are professional statisticians that calculate insurance risks and premiums. They use sophisticated methods to refine the basic information provided by the present value calculations such as the one to determine a pension’s value. For example, actuaries use precise estimates of life expectancies for women and men and can figure the likelihood that you’ll live until retirement. Actuaries often calculate a large number of values depending on varying assumptions. They are sometimes employed during divorce proceedings to figure the value of the party’s pensions and the amount, called the “coverture fraction,” that should be considered community property, subject to sharing between the ex-spouses.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.