This page explains how to calculate the present value of a defined benefit pension. A defined benefit pension (sometimes called an annuity) makes monthly benefit payments to a recipient upon retirement. Defined benefit pension plans are common among state and federal employees and many public school teachers. They are less common in private business, where “defined contribution” retirement plans such as 401k’s and 403b’s are more common.
The size of monthly benefits in a pension is determined by formulas that vary from employer to employer. The value of the monthly benefit is not determined by the amount of money that has been withheld by the employer, or pooled in an account, but by formulas based on such factors as age at retirement, years of service, and level of salary during the final years of employment. Your retirement plan administrator or online calculators for different states or employers can calculate what your future monthly benefit will be.
In some cases, people want to know how much their future, monthly, retirement benefits are worth right now, while they are still working. This is often a question in cases of divorce. Spouses can agree to share the future monthly payments when the pension participant retires, or they can divide the value of the pension in the present. It is easy to divide a 401k or other retirement account in the present because the balance of the account represents the value of the account. It is much more difficult to figure out how much the promise of lifetime, monthly payments 20 years in the future is worth right now.
Figuring out how much a pension is worth in the present involves two basic steps:
First, one must calculate the value of the pension at the time when benefits begin, i.e., at the time of retirement. The question is, “How much would one have to pay to be guaranteed the monthly, lifetime benefits that the pension guarantees?” The answer depends on the size of the monthly payment, the age of the recipient, the likelihood that the recipient will survive each year, interest rates, and possible cost-of-living adjustments. The formula for this will be presented below.
Second, one must calculate the amount of money one would need right now to buy that annuity (lifetime monthly payment) in the future, when one retires. If one is 45 and plans to retire at age 65, one would be buying the annuity 20 years in the future. The present value of the pension is lower than the cost to buy the annuity at age 65 for two reasons: one might not survive until age 65 (and therefore one would not collect any benefit) and money in the present can earn interest for 20 years and grow to the amount necessary to purchase the annuity at age 65. So the value of the pension at age 65 is “discounted” with 20 years of interest and the probability that the pension participant might not survive those 20 years.