Pension managers and corporate treasurers deploy a funding strategy that matches the maturity of an asset to the maturity of a liability so they know they will have the cash needed to pay off the debt when it comes due. If you think about this technique, you could use it to do the same with your own pension or retirement liability. Many of us no longer have the company sponsored pension plan for our retirement. That obligation has been transferred to us in one of the most egregious transitions ever of corporate responsibility to the employee. The alternative is now the self funded 401k account.
With the withdrawal of the corporate pension you know what else went away? The resources that calculated the future value of the pension, the investment managers who took care of the portfolio and managed risk and the insurance company that would have been the source of your pension payments through an annuity purchased for you by the company. All of this you now have to do for yourself. And getting good financial help isn’t easy.
So let me give you a bit of help starting first with computing your retirement liability. It is not complicated to do if you have basic knowledge of the time value of money concepts. I’ll do this in two steps: (1) illustrate how to compute the liability and (2) calculate the funding gap to isolate any longevity risk.
Step 1: You have to come up with an income in retirement that will maintain your standard of living.
Let’s use a current income of $60,000 and your age is 40. Your goal is to retire at age 65. You want you money to last until age 100 – the appropriate age for planning purposes so you don’t incur any longevity risk. Longevity risk is the possibility you may outlive your retirement assets.
Today’s $60k income will not buy the same stuff 25 years from now so we have to factor in inflation. Let’s assume 3%. At age 65, the inflation adjusted income is $125,627. Computed by a standard future value calculation using a financial calculator where N (the number of periods) is 25; I (interest rate) is 3% and PV (present value) is $60,000. Solve for FV (future value) and you get the result: $125,627.
We’re not done yet. Next we compute the pension liability. You need $125,627 per year to last 35 years; we must still factor in inflation at 3%. Now the tricky part. The expected rate of return on investments. You can write a whole book on how to figure this out. I’ll skip that and go right to 7%, what I consider to be reasonable for long term returns in our present market environment.
From these two numbers we compute the inflation adjusted rate of return. It’s simply the factor of dividing 1.07 by 1.03 and subtracting 1. In this case the factor is 3.883% – the rate which will tell you the value of the pension liability at age 65 adjusted for inflation. Enter N=35, I = 3.883%, Payment = $125,627, FV =$0 and solve for PV: $2,474,997 (calculator set to beginning of period to be more conservative).
To start retirement at age 65, maintain your current standard of living with an income of $60k today adjusted for inflation to last 35 years, accounting for inflation of 3% when in retirement and earning an average return of 7% you need assets to mature with a value of $2,474,997 at age 65. This is your pension liability.
One last calculation. The amount we just calculated is what you need 25 years from now – would you like to know what the value is today when you are 40? The value is $456,017 calculated as follows: FV (future value): $2,474,997, N = 25, I = 7% solve for PV = $456,017. This is the amount that if deposited as a lump sum today would grow to be $465,017 at age 65 at 7%.
We’re done with step one. You now have an estimate of your own pension liability 25 years into the future and its present day equivalent amount.
Step 2: Find out if you have a funding gap that will expose you to longevity risk after you retire.
A step of ordinary arithmetic. Take the current account balance in whatever retirement account you have – 401k, SEP, Simple, IRA, Roth IRA, money purchase, 403b, 457, profit sharing or any other any account you use to accumulate money for retirement. Subtract it from today’s pension liability amount. This is your funding gap or surplus if that’s the case.
Let’s assume it’s a gap. This is when the financial planning starts.
Thanks To : annuity lead generation future value annuity buy an annuity
Check it out: How Are You Doing With Your Retirement Liability?
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