In a previous post, I discussed possible values for a military pension using some standard time value of money calculations. Something about my results bothered me though.
So, what bothered me?
It has to do with the discount rate. The discount rate is always subjective to say the least. It is easy in college and on CFA Level I exams, because it is always provided for you (directly or indirectly via calculation of provided data). In the real world though, if you ask three different people to come up with a discount rate, it is highly probably that you will have three different discount rates. I originally came up with a discount rate of 6.51% in my first post to value a military pension, by using the average 10-year-Treasury yield over past 40+ years. Is that realistic though?
The 10-year rate today, according to Yahoo! Finance is 2.42%. It is possible that the 10-year rate will reach 6.51% or more again, but what if you wanted to value a pension today?
In this post I want to take a different perspective on the value of a military pension. How much would you have to invest in a risk-free asset to generate the equivalent of a military pension? To simplify things, I am going to use a different risk-free asset this time – the 30-year treasury. A 30-year lifespan is probably (hopefully!) a bit short for the average retiree, which means I am low-balling the value once again. The 30-year yield is currently 3.23% according to Yahoo! Finance.
So, how much would someone need to invest in 30-year treasuries to create a synthetic-$100-per-month-military pension?
3.23% divided by 12 months = .26917%
$100 divided by .26917% = $37,151.24
Another item of note is that investors in 30-year treasuries have their principal returned after the bonds mature. This returned principal would have a value which should also be taken into consideration.
To account for this return of principal, the $37,151.24 needs to be discounted at 3.23% for 30-years and subtracted from the $37,151.24. It needs to be discounted because $37,151.24 will not be worth as much in 30 years as $37,151.24 is worth today.
HP 12C Keystrokes
n = 360
i = .26917
FV = $37,151.24
PMT = $0 (we already accounted for this when we came up with the original $37,151.24 value)
Calculate PV = $14,115.69
Calculate $37,151.24 minus $14,115.69 = $23,035.55
Violá, a completely different value of $23,035.55 per $100 of pension. In other words a $2,200 per month pension, collected for 30 years is worth approximately $506,782.10 today. Would you sell your pension for $500,000? Are you surprised your military pension may be worth this much?
Hmmm…..something else is bothering me. Military pensions are indexed to the CPI to protect against the ravages of inflation. If you just sold your pension for $500,000, you may have just undervalued your pension. Eventually I will get around to incorporating pension value with inflation indexing, but not today. Until next time…..