Whenever the topic of retirement planning comes up, it is often associated with building as much wealth as possible so that you can reach that time when you no longer have to work to create income. Building wealth, accumulating assets, investing money are always the centres of discussion.

What about your pensions? What if you have a Defined Benefit Pension Plan? What about Canada Pension (CPP) or Old Age Security (OAS)? How do these streams of income factor into your net worth?

## What is net worth?

A few weeks ago, we talked about the term net worth. Your net worth is equal to all of your assets less all of your liabilities. Your net worth serves as a financial benchmark to understand wealth.

## Valuations for streams of income

One of the challenges in calculating net worth occurs when you deal with assets that really represent a stream of cashflow like a pension plan. How do you account for these assets in your net worth calculation?

I talked to Rein Selles, one of Canada's most respected Professional Retirement Planners (PRP). Rein believes that the retirement planning industry largely ignores the value and importance of pension plans as an asset. Rein uses a simple rule of thumb when it comes to valuating a pension or a stream of cashflow,

“For every $100 per month of income, you have an asset worth $18,000.”

If you have a pension that pays you $3,000 per month, that pension is worth $540,000. If you get $800 per month from CPP, then that is worth $144,000. $500 per month from OAS is the equivalent of $90,000.

While this is a very simplistic approach it helps people to understand the value of pensions, government benefits and other streams of income.

## A cornerstone of retirement income planning

In wealth planning, pensions are often ignored but Rein believes that they are incredibly important, “Defined Benefit Pension Plans and Government Benefits form the cornerstone of retirement planning. If you work for an employer that offers a defined benefit pension, you have an incredible asset because your employer contributes the same, if not more money to your pension the longer you work for the company.”

If you use Rein's rule of thumb, someone who does not have a pension plan needs to save $18,000 for every $100 of monthly income. For example, someone who desires $4,000 per month (in today's value) will need to accumulate $720,000. Factor in inflation and you have an even loftier target.

The unfortunate reality is that there are going to be fewer and fewer defined benefit pension plans offered in the future because they are more costly and complicated to administer and the employer bears more risk and responsibility.

If you are part of a defined benefit pension, remember that the value in these types of pensions really comes with tenure and time. Your pension plan can be more valuable than you realize. Use Rein's formula to help you understand the value of your pension plan.

Jim, This is a great article, but I can’t get the math in your article to work.

“For every $100 per month of income, you have an asset worth $18,000.”

If you use Rein’s rule of thumb, someone who does not have a pension plan needs to save $18,000 for every $100 of monthly income. For example, someone who desires $4,000 per month (in today’s value) will need to accumulate $720,000.

Could you please give me a formula? I must be doing it wrong because I’m multiplying $100 X $18,000. I’m sure this isn’t what you meant.

($4000/$100)*18000=720000

Sarah: 4000/100 = 40, meaning that they earn 40x $100 per month. You multiply that number of increments by $18000, in this case yielding 40 * 18000 = 720,000.

It seems that Rein is assuming an interest rate of zero percent and an expected lifetime in retirement of fifteen years. The Time Value of Money formula calculates this nicely. I’m using my trusty calculator.

If Future value = $0, Payment = $100, N = 180 (15 years * 12 months per year) and I = 0%, then Present Value = $18,000.

However, I think it’s overly conservative to imagine an interest rate of 0%. That’s the equivalent of stuffing your money in the mattress. Or, if you factor in inflation, the equivalent of investing in bonds that just keep up with inflation.

Historically, the broad stock market returns about 8%, so if you were to assume a relatively conservative return of 5% per year (0.42% per period), then your $18,000 savings commitment is reduced to $12,642.19.

Jonas,

But shouldn’t we ignore the discount rate since with a government pension you don’t have the option to invest the present value in another asset with a higher rate of return? If we were “purchasing” such an annuity discounting the FV would make sense. Here it does not.

Also, a big point this article fails to acknowledge is that government pensions are pegged to inflation. This raises the value a lot.

Ryan

Money Sense suggests a 4% rule for withdrawing from a retirement fund, if you want your funds to last 30 years at a conserative rate of return. At a 4% annual withdrawal rate one would draw $4,000 from each $100,000 in the pool. This means to determine what you pension is worth you need to multiply the annual pension by a factor of 25 to achieve the value. This is a lot greater than your 15 figure.

Yes, I have the same thoughts on this. It seems we are assuming a 10% return over the long term in this article. (3.5% inflation adjustment + 6.5% return). While the market is famously said to have “averaged” 10% over the last 80+ years, this statement can be a bit misleading and leaves no room for a down turn early on in your retirement.

Taking $3,000 a month, from a $540,000 nest egg, equals a 6.6% withdrawal rate. If the market does well for the first 5-7 years of your retirement this withdrawal rate might workout just fine, if you invest aggressively in stocks. You would need 60-70%, or higher, invested in stocks to see this kind of return. And the chances of this income stream lasting 30 years or more, if you retire in a downturn or correction period, drops significantly even with a very aggressive, majority stock, portfolio.

The 4% rule is a much more conservative approach, $3,000 a month in pension money, inflation protected, then becomes more like having a $900,000 nest egg.

At a 6.5% withdrawal, your risks including coming up short deep into your retirement. At a 4% withdrawal rate your risks include working longer than you really needed to.

My wife feels that if a person is currently retired, then the net worth of their defined benefit pension is equal to zero since if you die, you receive nothing. What is your view on this?

I see your wife’s view on this… Using pensions in a net worth statement is similar to life insurance. My life insurance is not a part of my net worth statement, but it is a critical component of the net worth statement for my wife. My pension is reduced to a little over 50% when I die and my wife survives. So I calculate my pension on the value to my wife when calculating the amount of retirement savings she will require to afford a comfortable lifestyle on half DB pension. This has greatly assisted in retirement and financial planning.

Depends on the DB pension plan and options. In my own case if I had died after the first month I had collected my pension, my estate would have received my monthly pension amount X 179 months(14 yrs 11 mths)as a lump sum payout. This is because I took a 15 year guarantee option when I retired.

Also of note, when I did the arithmetic my situation does work out to about $17100 per $100 of monthly pension and 15 years of guaranteed pension payments also works out to approximately the same amount. Of course to get a guarantee period I had to take a slightly lower pension amount which both in foresight at the time and hindsight now may years later, was the correct decision. Even if I die after 15 years it will still have been the correct decision at the time because I wanted to provide for my wife and kids.

Great info here. One quick question I have. I am on track right now to receive $4,000 per month when I retire from my Pension plan. I have another 17 years before I reach retirement age…From the math you have provided, I have roughly $720,000 pension worth…do companies offer “buy outs” or “cash outs” very often? Also, if my company would offer that what would you advise I ask for as a lump sum, assuming that I will work here another 17 years?

Thanks,

Tom

I disagree totally. My pension plan will pay me apprpxately 40% of my earnings when I retire. Considering that I earn $200k this would equate to $80k per year. Since I’m eligible to receive this at age 55, then I figure I will live another 30 years. So $80k x 30 years = $2.4 million. That’s how I value my pension. Of course if I live longer than the 30 years after I retire @ age 55… Then this number will be higher. Seems fairly sime and straight forward to me.

“Of course if I live longer” has to be said with “of course if I die at 56……

I value my pension on what amount invested it would take to realistically provide the monthly pension income.

I would value 80K per year at 1.6 M using a return rate of 5%.

Also if you had the cash in hand to buy an annuity to provide the monthly pension , How much would it take. Answer approximately 500 per month per 100,000 invested = 1.3 to 1.4 M (500 x 13.5 x12 = $81 K per yr.).

Great discusson. I am a follower of Money Sense logic in terms of 4%, but see the value in how others are calculating pension value. In our circumstance, our net worth changes depending on whether I am alive or not because of the change in pension, (about a 50% drop), but this is adjusted by life insurance that is of no value to me, but is to my spouse but only when I die. Question…. Are these calculations based on net monthly income or gross monthly pension…? I am using gross.

Gross. Tax is not taken into account here

On average most people will die 3 years after they retire.

At age 68. The trend is higher rates of cancer. Another trend is working later in life. People will think they live forever. But they eat meat at the top of food chain for toxins. They eat vegetables which are cheap and laced with toxins. Need to be realistic.

Take the cash now. Buy a nice car.

I agree with And0101. Every one here is talking as if they are all going to live to be 98 years old. This is very unlikely, especially in men. The average life span of a male today is still only about 77 years old. Then there are the elderly years, where you’ll be too old to do anything, so you won’t be spending nearly as much money as you were in you fifties and sixties. I say retire while you’re still relatively young. You can’t taker it with you when you die!

The best and most honest (with yourself) way to “value” an income stream that starts at a given date (assuming it is not going to adjust with inflation/COLA)is to simply ask “What will an average,stable insurance company charge me to buy an annuity paying that monthly amount, for life?”. Not at all the same as asking how much you would need in your 401K to make the same number withdrawing at 4%, since you don’t have the money in hand and it dies with you and doesn’t go to heirs.