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.