Understand Your Pension and You May Rest Easy

Pensions. No one talks about them. No one cares about them.

“Throwbacks,” they say. “Ancient history.”

Or, “It won’t do much for me.”

Not so.

Defined-benefit pensions are one of the least discussed and least understood benefits available to American workers at all levels of income. Not all companies have them, and not all workers will work long enough at a single company to receive one, but pensions will still be major resources for millions of people. A recent Bureau of Labor Statistics study showed that 56% of private-sector employees and 91% of public employees were covered by defined-benefit pensions. Many people get so caught up in the stock market and 401(k) plans that they forget that they even have pensions. Lower-paid employees in particular may not realize how much of their current income will be replaced just by Social Security and a pension. Sometimes it’s all their income.

For many people, a defined-benefit pension plan will be their most valuable asset.

Asset?

Yes, asset.

You and I live in a world of promises. The promises take different forms, but all arrangements of income, in the end, are promises.

Let’s start with what a defined-benefit pension is. It is a promise from a corporation or government entity to provide a lifetime income when you retire.

The size of the pension is determined by years of service and your final salary. A typical plan may pay 1.25% of salary per year of service. As a result, a 20-year career will provide a pension that will replace about 25% of final salary (20 times 1.25%). A 40-year career will provide a pension that will replace about 50% of final salary.

For the 94% of all employees who earn less than the Social Security wage-base maximum ($68,400 for 1998), the combination of Social Security and a single employer with a defined-benefit pension can provide a good retirement. Add home ownership and it can be a generous retirement.

Where is the asset?

It’s in the promise of income. It has value. It may not be money in the bank (another kind of promise) or securities in a 401(k) account (still another kind of promise), but it has value.

You can understand this by comparing two different assets, a bond and a pension.

If you own a bond, what you have is a promise. In exchange for lending your money, the borrower promises to pay you interest until the bond matures. When the bond matures, your original principal is returned. Suppose, for instance, you bought a 20-year bond with a face value of $100,000 that paid 6% a year in monthly payments of $500. You would receive 240 monthly payments of $500 and a check for $100,000 at the end of the period.

Because of the time value of money, the return of $100,000 in 20 years isn’t worth $100,000 now. (Inflation is a factor too, of course, but it would be reflected in the interest rate.) The value of that last $100,000 check today is only $31,180. For the same reason, the monthly payments are not worth $120,000 (240 times $500). The value of the monthly checks today is $68,820.

In other words, if money costs 6%, a buyer would pay $68,820 for the right to receive the income payments and $31,180 for the right to receive the original principal in 20 years. The total is $100,000.

What’s important here for comparison to a pension is that most of the value in the promise--nearly 70% in a 20-year obligation--is in the payments, not the principal.

In a pension, there is no principal. All you have is the promise of income, paid monthly. If you have a pension of $1,000 a month, you would need to have nearly $218,000 in investments to produce the income. The promise of monthly income is worth less than $218,000 because you don’t have the principal and never will. It also isn’t certain how long you will live and receive the payments.

Let me give you a big-number example.

Not long ago, an executive mentioned that he was worried about the stock market, where all his money was, and was thinking about shifting some money to tax-exempt mutual funds. Did I have any suggestions?

I mentioned several funds. Then I asked if he had considered how much he owned in de facto bonds.

“What are de facto bonds?” he asked.

“It’s what you have in promises of future income.”

It turned out that his corporation had a defined-benefit pension. It also had a long-term security agreement for top executives. The combination would provide him with more than $200,000 a year when he retired.

I told him: “With bonds yielding 5.5%, you’d need to have $3.6 million in fixed-income securities to produce that income. That means you’d need to have $3.6 million in equities to have an effective portfolio mix of 50-50, and $10.8 million in equities to have a more aggressive 75-25 mix of equities [and] fixed income. You might not be so overcommitted to equities after all.”

The numbers are smaller, but the same principles work for you and me. If you worked 10 years for a company that offered a pension, don’t forget about it--you’ve already earned a valuable asset.

If you work for a company with a defined-benefit pension plan, ask about it. See if you can get a projected retirement income. Factor it into your saving and investment plans. If you are fortunate enough to have a defined-benefit pension, your “portfolio” is probably a lot less risky than you think.

That can be a big comfort in markets like this.

*

Scott Burns writes for Dallas Morning News. He can be reached at scott@scottburns.com, or at his Web page at https://www.scottburns.com.