We have been studying pensions in my Advanced Financial Analysis class at Creighton University, and it made me think about how much a military pension is worth. It is fairly easy to calculate how much a military retiree will receive each month, but that is not the value of a pension. The value would be the monthly pension payment amount multiplied by the number of payments received (in other words, all of the future payments), discounted back to the present moment. Sounds like fun!
So, how much is a Pension worth?
The answer is not simple. If I retire today and get bit by Suarez the following day, contract the Ebola virus and drop dead, the pension is worth nothing. If instead I get bit by Lestat, and receive the gift of immortality, my pension can be quite valuable. There are other big variables other than the number of payments received (lifespan) such as: the amount of the pension payments, and what discount rate to use. Other items such as taking the REDUX bonus option or not (future post subject), the pension is indexed to the CPI to protect against the ravages of inflation (yet another future blog post subject), and the Survivor Benefit Plan are going to be ignored for now. I just want to focus on the present value of the future stream of pension payments. There are three elements we need for the calculation:
- How long will we receive the pension payments? I always joke with my wife about keeping me alive no matter what to keep collecting the pension payments. I would even be willing to have my head preserved in a jar if it meant I could keep collecting the pension. I could even be on the shelf next to Lestat, or Tom Cruise. I am going to be using 20 years (240 months), 30 years (360 months), 40 years (480 months) and 50 years (600 months) for the calculations here.
- How much will the pension payment be? I am going to attempt to make this useful to as many people as possible and just use $100 dollars. I know the pension amounts will be much more than this for any military retiree, but this does something practical. For example, if your military pension is $2,500, you can simply multiple the result I get here by 25 to come up with your value (25 X $100 = $2,500).
- Lastly we need to come up with a discount rate. Assuming Paul Ryan never gets his way, the military pension is very close to a risk-free investment. I am going to use the average 10-year-US-Treasury rate from January 1962 until July 2014, which is 6.51%. This value is a bit high by current standards, but it is difficult to know what the rates will be in 2017, let alone 2027. This higher value will decrease the present value of pensions, so arguably I am low balling the value here.
Drum roll please……..and the results according to my trusty HP 12C calculator are:
- For 20 years (240 months) the value is $13,401.92 per $100 of pension.
- For 30 years (360 months) the value is $15,804.63 per $100 of pension.
- For 40 years (480 months) the value is $17,059.92 per $100 of pension.
- For 50 years (600 months) the value is $17,715.73 per $100 of pension.
- n = number of months shown above
- i = 6.51divided by 12
- PMT = 100
- FV = 0
- solve for PV.
I will revisit this subject soon and update this because there is much more to pensions than the above.