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Alternative approaches for determining the present
value of earned pension income

Consider these other methods for determining how much a right to receive $1,200 per year ($100 per month)
of pension income adds to net worth. Each approach has its own simplifying assumptions.

■ Present value of a perpetuity with growth: Assume that pension payments start at $1,200 per year
and increase by 3% each year due to a cost-of-living adjustment (COLA). If you assume a rate of return
on retirement savings of 6%, then the present value of this perpetuity is $40,000 ($1,200 ÷ (6% – 3%)).
But note that a perpetuity is assumed to continue forever, so this valuation method would overstate
net worth.
■ The 4% rule: You could use the 4% rule that is so commonplace in the financial press. This rule states
that the retiree can make annual withdrawals of 4% of the beginning balance of his or her retirement
savings and expect them to last 30 years. Therefore, the amount of savings required to safely withdraw
$1,200 of annual income would be $30,000 ($1,200 ÷ 4%). However, according to actuarial tables at the
Social Security Administration, additional life expectancy for those who were 65 years old in 2017 was
approximately 18 years for men and 21 years for women. So, it is probable that this valuation would also
overstate net worth.
■ Nominal value of payments: You could assume that retirement savings would earn nothing at all.
Making this assumption means that savings would have to equal withdrawals, so retirement savings
of $24,000 would be needed to make annual withdrawals of $1,200 for 20 years. Of course, the
lower interest rates fall, the greater the value of guaranteed pension income becomes because you
would need more savings to be equivalent to the guaranteed income, but assuming zero returns
is unreasonably pessimistic and again results in overstating the value of pension income and thus
overstating net worth.
■ Purchased annuities: Rather than calculate the present value of pension income, you could simply consult
a financially sound broker for a quote on how much it would cost to buy a guaranteed annuity equal to
earned pension income. Suppose the quoted rate is $210,000 per $1,000 of monthly annuity income. Then
a $1,200 annual income ($100 per month) would cost $21,000. However, note that over time this valuation
method would capture all the volatility in year-to-year market conditions, which would make changes in
net worth much more difficult to interpret.
■ Present value of an annuity: The recommended approach to pension valuation is to make the simplifying
assumptions necessary to compute the present value of an annuity due. For example, assume a 20-year
pension annuity, a 6% return, and 3% inflation. For an annuity of $1,200 per year, the employee would need
savings of approximately $18,000 at retirement.

the employee’s amount of heritable wealth, then this rule, the amount of earned pension income an
the value of the pension may be as little as zero. It employee has at any point in time is based on the
depends on the terms of the pension agreement. employer’s pension formula, the employee’s current
However, if the concern is not transferable wealth earnings, and the time spent on the job to date.
but retirement income, then net-worth estimates While other methods exist, this rule of thumb
should be increased by the present value of expected may be the best option for estimating the amount
future pension payments. In other words, calculate that defined benefit plans add to net worth. (See
what the person would need in retirement savings the sidebar, “Alternative Approaches for Determin-
in order to provide the same retirement income ing the Present Value of Earned Pension Income.”)
as provided by his or her pension. A good rule of Of course, changing the assumptions regarding life
thumb is that the retiree would need $18,000 in expectancy, rates of return, and inflation to reflect
retirement savings for every $1,200 per year ($100 your own professional judgment will change the
per month) of earned pension income. In applying savings needed to provide any particular level

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