At one time I considered taking a job with the federal government. I had a competing offer in the private sector and set about comparing them based on various factors such as how much I’d enjoy the work, the commute, and total pay. A tricky part was placing a value on a public service pension. The value of a pension is very sensitive to the investment return we assume.
Let’s look at a simple example of a government worker:
– Starts work at age 23 making $40,000 per year
– Works for 35 years
– Retires at age 58 with an indexed pension of 70% of best 5 years average salary
– Pension is reduced by the amount of CPP benefits starting at age 65
– For first 20 years working receives raises of inflation + 4%
– For final 15 years working receives raises of just inflation
– Lives in retirement for 25 years until age 83
With the details in this example, we can calculate what percentage of this worker’s salary would have to be saved from each pay to cover the pension benefits. Of course, the rate of return on investments affects this calculation; the higher the investment returns the less you have to save.
The following chart shows the relationship between investment returns and how much we need to save to cover the pension. Keep in mind that we are talking about a “real” investment return, which means the return after subtracting out inflation.
At one extreme, if we could count on earning returns of 6% above inflation on saved money, we’d only need to set aside a little over 9% of the worker’s salary to cover the pension benefits. At the other extreme, if returns only match inflation, we’d need to set aside a whopping 49% of the worker’s salary!
At an investment return of inflation plus 4%, we’d need to save about 16% of the worker’s salary. This would be fairly reasonable: perhaps the worker could contribute 8% of pay and the government could match that dollar for dollar. Unfortunately, guaranteeing investment returns of 4% over inflation is a lot to ask.
Some commentators think that the expected future returns of stocks will be about 4% over inflation, on average. But this isn’t certain and will come with a lot of volatility. So, we couldn’t invest people’s pension money 100% in stocks. Adding a significant bond allocation drops the average return.
I actually invest my own long-term savings 100% in stocks, but I’m prepared to delay the start of my retirement if stock returns happen to disappoint. If I had taken the government job, I could have planned my retirement date without worrying about when stocks happened to take a slump.
Another thing to consider is that pensions do away with longevity risk. Even if our example worker lives to 110, the pension payments just keep rolling in every month. We have to save more to account for this possibility.
When I was comparing my two job offers, I settled on inflation plus 2% as a reasonable investment return to count on. Based on the chart above, this values the pension at 28% of salary, which is very valuable. In the end I still chose the private sector job, but the pension made the decision a lot closer.
For many people, even inflation plus 2% is not a realistic return expectation for their own savings given that most Canadians pay huge mutual fund fees in the 2-3% range every year. This makes a government pension look even more valuable to the average Canadian.
However, I’m confident in my ability to keep portfolio costs very low, so I think using inflation plus 2% as a safe return expectation made sense for me. Your mileage may vary. Whatever return expectation you think is reasonable, it’s clear that the value of a pension is very sensitive to this assumption. It’s also clear that pensions are very valuable no matter what reasonable returns you expect.