Tuesday, October 15, 2013

Pensions Are Worth Zero?

A recent Family Finance column in the Financial Post showed something strange about the way that financial planners calculate a person’s net worth. Apparently, having a defined-benefit pension plan does not add anything to your net worth.

The article profiled Doris, a grandmother with a simple balance sheet. She has a car worth $3000, owes $10,000 on her line of credit, and can begin drawing a $1400 per month pension in two years. For some reason, her pension just doesn’t count and her net worth is listed as -$7000. This isn’t an isolated case; I’ve seen this in many other net worth statements as well.

With a negative net worth at age 63, Doris appears to be in dire circumstances. However, a pension of $1400 per month plus CPP and old age security are more than enough to give her a modest but comfortable life. Without the pension, Doris would be far worse off, so why doesn’t the pension count as part of her net worth?

To value her pension we would need more details about the pension than the article gives. Let’s approximate its present value at about 15 years’ worth of payments, or about $252,000. This would make her net worth $245,000, which better reflects her true financial condition. We could add in the present value of CPP and old age security as well, but since most people get these payments, this doesn’t add much to our ability to compare Doris’s financial condition to other people’s financial conditions.

We could come up with a number of possible justifications for ignoring pensions on net worth calculations. Let’s try a few:

1. Pensions are hard to value accurately, so we don’t try.

The present value of a pension is somewhat tricky to value. You have to take into account indexing, current interest rates, mortality rates, and other factors. However, just about any kind of guess is better than guessing zero.

2. Doris’s pension payments are not guaranteed because she might die before receiving the first monthly cheque.

This is true, but Doris is seeking financial planning out of concern for her future. If she knew she was going to die soon, she wouldn’t be too worried about her monthly cash flow. In fact, if Doris wants to be sure that she will be okay financially until age 95, she should value her pension at even more than just 15 years’ worth of payments because she is presuming that she will collect for 30 years.

3. The value of Doris’s pension is not available to a financial advisor to increase his or her assets under management.

This is a pretty cynical possible reason, but it gets to the heart of the potential conflict here. From Doris’s point of view, her pension is very valuable, but to others such as financial advisors and heirs, the pension has little value.

What do you think is the real reason why pensions are not valued in some net worth statements?


  1. My money's on One and Three. Even if we accept that pensions are "hard to value accurately", a fair compromise - in my opinion - is to value until life-expectancy. As imprecise as that may be, so is most financial planning, which is more about reasonable guessing than it is precise valuations anyway. Now if we all just had a timer on our arm that told us how much time we had left, things would be so much easier...

    1. @Sandi: It sounds like you're a fan of being approximately right instead of exactly wrong. I'm with you.

  2. I would go straight to 3. I would not exclude OAS and CPP from the calculation. Further on, I would not even bother with the concept of net worth in this case, since this concept is only valuable, imho, when some one intends to borrow against future cash flow or current assets. This is not Doris' concern. She is interested in exactly the opposite: how much cash she will have in her pocket every month. In her case the answer is pretty simple: pension+OAS+CPP. This is personal non-transferable cash flow. Heirs and advisers are not interested interested in it. This is till banks figure out how to transfer debts of dead seniors to the rest of the population, similar to the way debts of bankrupt people are transferred. When this happens, and will not take long, I expect an explosion of "borrow against your future pension and make a nice present to your niece" credits. Bankers are mostly slow.

    1. @AnatoliN: Monthly cash flow is certainly important, but I think net worth can be a useful way to compare the financial state of different people.

  3. Good point, Michael. Obviously the pension has value, and I would argue it's not that difficult to figure out, either. An advisor worth his salt would look at the monthly payments, take note of the indexing, and say "Now Doris, your pension could be quite valuable to you. Let's get some quotes for how much an annuity paying $1400 per month is worth." Click on a couple websites, or call an insurance company, and presto, some amount much greater than zero.

    Or: "Doris, this pension of yours is worth something. Your employer can tell you how much money they would give you in lieu of collecting this monthly pension. It's call 'commuted value'. Now, I don't recommend taking the cash value, since it would add too much financial risk to you, but how about we call up your company accounting department to see how valuable this pension really is?" Non-zero!

    1. @Gene: You're right that we don't have to value a pension ourselves. No doubt we could find online resources to help.

  4. You're right, but #1 is a tempting reason. We should just write and publish a paper on a decent rule of thumb that's close enough to spark a massive flame war in financial planning journals but yet sets a precedent for people to have some basis for approximating it.

    Michael suggested a multiplier of 15X above. That would be the discounted cash-flow of roughly a 3% (inflation-adjusted) cost of capital on a fully indexed pension assuming a 20-year life expectancy. Sold. The rule of thumb is now 15X for someone near retirement. I'll draw up a table with a few more nice round number multiples (10X for someone in their 50's?), we can publish it, and hopefully take a step towards solving this problem.

    [del]Science![/del] Finance!

    1. @Potato: No doubt pension experts can do much better than just using 15X, but when you're just trying to get a better estimate than zero, life is pretty easy.

  5. What does the client learn by having the present value of her defined benefit plan and government pensions?

    I believe that her largest need is cash flow planning which would indicate on a year to year basis her income received versus her expenses indexed to inflation. She would then know how her income relates to her fixed expenses and the room she has for discretionary spending.

    I agree with option 3. There is no potential income for offering this type of advice.

  6. We (wife and I) both have government pensions. They increase every year at 3%. They are arranged that when one of us dies the survivor gets both pensions. If you have a 401K with the same value as the net present value of our pensions, you have to worry about the stock and bond market values - we don't. My wife has longevity in her family (father deceased at 97; mother at 88). Never know in life, but she probably will be collecting for many years to come with little financial worry partially due to our pensions. Your 401K may drastically drop in a recession, ours will not but will actually increase. I think most of us accumulate wealth for retirement security and it trumps a 401K any day. Our pension "asset" present value of cash flows gives us a valuable tool to compare with financial recommendations on "how much we should have saved." We are lucky, we also have a substantial net worth, but I wouldn't hesitate to calculate a 15 year net present value of our pension cash flows for a net worth statement. If you calculate net worth as a tool on how much you will leave your heirs then a pension will not be passed on after the last of us dies. But for all the reasons I have mentioned above, our pension far outweighs savings, a 401k, leaving its value to heirs, and similar retirement instruments. It is a more valuable asset. Oh, I vote for reason 3 above.

    1. @Anonymous: You make some good points about the value of defined-benefit pensions. I tend to value them quite highly based on some of the reasons you give.

  7. The social security website has actuarial tables. For a U.S. Government pension, payout is certain, and the pension is adjusted for inflation, so multiply the monthly pension X 12 X Expected Life Span = NPV of the pension.

  8. The following exchange is reproduced to remove broken links:

    ----- Sarah Holland November 13, 2013 at 4:57 PM

    Having done quite a number of financial projections, I wouldn't show it for one major reason - it is not an asset. Can she liquidate it? Can she use it as collateral? Does she own it?

    If I'm modelling an asset, I would show growth, or I could show withdrawals, or I could show liquidation. How would I show the asset's value over time? Would it go negative, at some point, if she lives longer than age X?

    Why not just simply show the pension as cash flow? Note that it's like having an asset of $X value, but don't pretend it's anything other than a promise of future cash flow.

    ----- Michael James November 13, 2013 at 5:28 PM:

    @Sarah: I think it comes down to what you plan to do with the "net worth" figure. If you use it to compare the financial health (or "retirement readiness") of two different people, then excluding a pension gives incorrect comparisons. If you're using the figure for other purposes, then excluding a pension (and possibly other difficult to liquidate assets) may make sense. However, when I think of the term "net worth" I tend to think of the things I have that are financially valuable. A pension certainly fits into this category.

    As for modeling, this is quite easy. Actuarial tables can tell you the life expectancy of a person who has already reached a given age. One's life expectancy goes down by less than one year each year. As an example with made-up figures, a 60-year old may expect to live another 26 years, and a 61-year old may expect to live another 25.5 years. In this case, the pension would pay out a full year of payments but only drop in value by about half this amount.

    I don't object to showing a pension as cash flow. Then a net worth would be $A plus $B/month. The problem comes in when you're comparing this net worth to someone else with $C + $D/month. Now you need to value the cash flow somehow to make the comparison. Alternatively, you can turn the lump sum value ($A and $C) into cash flow to make a comparison.

    Even if you're not comparing two people, you still need to make some judgment of the contributions of a lump sum and a pension if you are judging someone's retirement readiness.