Does a Pension Have a Value When it is a Pension?
By: Marvin Snyder
After an employee has retired and is receiving monthly pension payments, is there a value to this pension in pay status, and if so, how is the value determined? YES. There certainly is a value that is mathematically computable for an existing pension. Think of it as a guaranteed stream of future payments of a known monthly amount. The only unknown is for how long the stream of payments will continue because we don't know how long the pensioner will live to receive it.
Actuarial science provides the tools for the answer to this problem.
In many ways, the calculation of the value of a pension in pay status is easier than it is in the case of a person not yet retired. If the employee is not yet retired, the actuarial assumptions must include a future retirement age, a discount for interest from the future retirement age to the present and a discount for probable mortality to reflect that the individual may not survive to ever retire. Those assumptions vanish when the person is already retired. The only assumptions remaining are interest and mortality, and in certain cases an allowance for a potential future cost of living adjustment (COLA).
As is the case for active pension plan participants, not yet retired, the Pension Benefit Guaranty Corporation (PBGC) announces interest rates and a mortality table from which the present value of an existing pension can be computed.
An example follows: Person #1 is a male employee aged 45 in a defined benefit pension plan with retirement age 65, and an accrued pension benefit for service so far of $1,000 per month to become payable at age 65. The PBGC factor is 2.2287. The present value is 12 x $1,000 x 2.2287 which is $26,744.
Next, consider a retired male aged 67 who is receiving a monthly pension of $1,000. The PBGC factor is 8.7556. The present value is 12 x $1,000 x 8.7556 which is $105,067. BUT, as the retiree gets older each year (if interest rates do not vary), the value of the existing pension decreases. For example, at age 70 the PBGC factor is 8.0070. Then the present value is 12 x $1,000 x 8.0070 which is $96,084.
For an active employee, on the way to retirement, the value of the pension increases each year as the individual gets closer to when it will mature and become payable (if interest rates are level), but for a retired employee the value of the pension decreases with age, assuming no change in interest rates.
Pension values are very sensitive to interest rates. The standard inverse relationship between interest rates and present values is important to remember in pension work: the lower the interest rate, the higher the present value; and conversely, a higher interest rate results in a lower present value.