The value of a pension: Three considerations

August 4, 2015

Not all pensions are alike. Here are the three ways to consider the value of a pension when physicians are planning for retirement.

Many individuals are employed in occupations that come with a pension in retirement. Here, I define pension as an income for life, usually based on years of work and salary. For example, most government jobs come with military or civil service pensions.

There are a number of characteristics that can be different among pensions - for example, some can adjust for inflation. Most pensions have the choices of different joint and survivor options. This means that if the primary worker dies, their spouse receives some percentage of the pension over their remaining lifetimes (usually 50 percent or 75 percent). These joint and survivor choices reduce the primary pension payout in proportion to the extra cost in insuring the surviving spouse.

I'm often asked what a pension is "worth." The question is pertinent, adding to the assessment of a family's ability to retire comfortably.  There are three ways to consider the value of a pension. The first would be to consider the value of the cash flow.  For example, take a retired executive with a pension of $80,000 a year. It may be that this, along with Social Security, allows the couple to meet their lifestyle expenses. Having money in a retirement portfolio is just icing on the cake. Whether or not the pension is inflation adjusted becomes important in this assessment, as decades of inflation might markedly reduce its worth.

Related:Balancing today's spending against saving for tomorrow

A second way to value the pension is to consider what you would need to have in a retirement portfolio in order to generate the pension income. For example, you might say that at a 4 percent distribution rate, a $40,000 annual pension would require a portfolio of $1 million. This is acceptable to value the pension for the retirees, but the portfolio assets are potentially worth more than this as they may remain after death- whereas pensions stop. In addition, most portfolio distribution plans include adjustments for inflation, but a pension may not.

The final and perhaps most accurate way to value a pension is to compare what it would cost to buy an immediate annuity that would pay the same income starting at the same age. Take the retired couple with the $80,000 annual pension mentioned above. To receive the same joint lifetime guaranteed income from an insurance company would cost just over $1.5 million.

One important variable to consider is the safety of the pension. Many corporate and some municipal payers of pensions have defaulted on their promises due to financial distress (see Detroit recently). A promise to pay an income for decades is serious business. I'd consider only the U.S. government itself as a totally safe source of pension income (military and U.S. civil service pensions), as they can always print the money to pay you with.