Valuing a Pension

May 7th, 2012 by Potato

Good news: I got a job offer this week!

The offer was laid out a little differently than I was expecting in that it comes with a defined benefit pension! These days a DB pension is a rare, nearly mythological thing, and it definitely adds value to the offer, possibly even more than a higher up-front salary. Being well, me, I decided to try to use a bit of spreadsheeting to come up with an approximation of how valuable that DB pension is to me. There are doubtless actual actuaries out there who would laugh at my attempts to do this from first principles, but if they do decide to correct my methods, I will welcome the learning opportunity :)

So without getting too far up into my business, let’s use some nice round fabricated numbers and suppose for the sake of argument here that I had a competing job offer with no pension but a $5k higher salary, and wanted to try to value the pension to compare (as much as is possible) the two offers. The DB pension involves taking some percentage of my salary from me to invest in the plan, and that is matched by contributions from my employer. Let’s say that my employer’s contributions would amount to $3.5k/year. That might be one quick way to value the DB: the amount of the bonus contributions from my employer. However, a pension is a little more complicated than that: I can’t actually use that money the way I would want to (whether for investing or spending), yet it’s also less risky than investing on my own in stocks/ETFs/e-series index funds would be.

If I go to the pension calculator provided on the website of the pension fund, I can see that with certain assumptions (namely that I’d continue to work for the same employer until age 60) that the pension would provide a stream of income in retirement, let’s say $26k/year here. A pension is a bit different than having a pool of investable assets in that it provides protection against longevity: no matter how old I manage to live to, the pension will continue to pay without running out. On the other hand, there’s less flexibility and no inheritance to leave behind if I do die early. Let’s be somewhat fair to the pension and assume I’ll live to a nice ripe old age of 89 (a few years longer than the actuarial tables might otherwise suggest).

What pool of capital would I need to provide that $26k yearly income? Assuming a conservative 2% real return, that would be roughly $594k saved at age 60. To get to that point, I’d have to save a fair bit every year between now and then. Using a slightly higher rate of return during the saving years (3% real) and assuming that the contributions increase at 1% per year (in-line with the raises I used in the pension calculator), that would be a hefty savings of almost $13k per year.

In other words, the DB pension could be worth a lot more than just the employer match being put up every year.

There are a few wrinkles though: the rate of return might be too conservative. I’m not too concerned on that point, since even if I use a more aggressive rate of return (3% in retirement, 5% in the savings years) the value of the DB plan still seems to be greater than the up-front salary of the hypothetical competing offer: I’d have to save $8.6k/yr on my own under those assumptions, which is still $5.1k more than the amount being taken off for the pension. Even if they gave me an additional $5k up front that I saved on my own, I might prefer the pension due to lower market and longevity risks (plus I’d lose out to taxes if I ran out of RRSP contribution room).

The other big wrinkle is that this is all assuming that I stay in the job (and that the pension plan doesn’t get significantly modified) until I turn 60. What seems to be weird about the pension calculation (which may be an artifact of the web calculator but I believe is actually in the payout calculation) is that there’s no time value to contributions: all that seems to matter is years of service. If I work from 33-36, that’s 3 years of service and seems to be worth the same as if I worked from 57-60. Yet clearly money saved while in my thirties should be able to compound and provide more monthly income in retirement than money contributed in my fifties. If I end up moving to a different job in the next few years, then my pension contributions won’t be compounding in the same way as if I had saved some money and invested it in an RRSP. That gets complicated though, since there is the option to cash out the commuted value to a LIRA, and I can’t find any way of estimating that. If I choose to leave the pension alone, then it looks like it’s still about as good as the amount I’m contributing and the employer match growing at 5% (then 2% during the payout years).

Though it’s tough to decide how valuable a DB pension is, it looks like it’s worth at least as much as the employer match, and possibly triple that. The older one is (and the longer one stays on the job), the more valuable the DB pension benefit becomes.

One Response to “Valuing a Pension”

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