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Scott Burns' Articles -- Recent and Archived

What Is My Pension Worth?

Q. I'd like to know what my pension is worth. I will receive $2,300 a month, fixed. What would it cost in the marketplace today to buy that level of pension? ---B.T., by email.

A. You can learn what it is worth to you by getting an estimate of what it would cost to buy a life annuity that provided the income you have, under the terms that you have. That last phrase--- "under the terms that you have"--- is important.

When you take a corporate pension, you are given a number of choices. You can take it for your life only, or for your life with 10 years certain. This means the payment will continue for your life or 10 years, whichever is longer.

If you are married, you will also have the choice of a "joint and survivor" pension. This will provide a lifetime income for you or your spouse, for life. It is also possible to choose 100 percent, 75 percent, or 50 percent survivor's benefits. When you take a joint and survivor option, your monthly income is lower than for your life alone to start, and your survivor will get the chosen percentage of that amount.

The website www.immediateannuities.com provides representative online quotes for different life annuity terms. Your annuity, assuming you are 65, would cost about $333,000 if it was life-only. It would cost as much as $387,000 if it was for life or 20 years certain. Add a 62-year-old spouse with 100 percent survivor benefits and it would cost about $415,000.

This isn't small change. Most workers don't accumulate as much in their 401(k) plans. Worse, extracting a lifetime income from a portfolio is a risky business.

Q. I'm confused about ETFs. Can you answer these questions? Are ETFs closed-end, open-end, or something else? How are the premiums or discounts of ETFs kept small? Why aren't closed-end funds ETFs? They are exchange-traded too. Why is the investment community enthusiastic about ETFs, while trying very hard to ignore closed-end funds?

Years ago, you wrote that you don't discuss closed-end funds because most people don't understand them. But it seems to me that your primary function is that of an educator, and your readers need you. I understand closed-end funds, but not ETFs. I suppose there are a lot of people the other way around. --A.P., by email from San Antonio, TX

A. No, you're not alone. The flood of weird new ETFs isn't making the learning any easier. Here are the basics.

Exchange-traded-funds are neither closed-end nor open-end. They are something else. Like open-end funds, the number of fund shares can be increased or decreased at any time. Like closed-end funds, ETF shares are traded on exchanges between buyers and sellers, rather than being issued or redeemed by the investment company.

The size of the fund is managed by third parties that create or dissolve large units of the fund. If the open market price of the fund shares rises to a premium or discount to the value of the underlying ETF portfolio, these third parties can arbitrage away the price difference. That's why the premiums and discounts tend to be fairly small.

In a sense, closed-end funds are early versions of ETFs. Their shares sell on exchanges for whatever price the market will pay. That can be a premium or a discount to net asset value. The big difference is that there is no mechanism for creating or dissolving closed-end fund shares. There is a fixed number of shares.

So there is no way to arbitrage away the premiums or discounts that can develop. The only way to "cure" a closed-end fund discount is for an outsider to make a takeover bid. That's pretty violent compared to constant creation and dissolving of units.

Closed-end funds get attention when they are an IPO. That's when the commission for selling them is largest. Since most closed-end funds sell at a discount to net asset value, no one in his right mind should buy a closed-end fund at the initial public offering.

Once issued, closed-end funds get little support from the brokerage community because (1) there is a new deal this morning and (2) they generate very little of the profitable investment banking work that makes Wall Street rich. So closed-end funds tend to sink to discounts to net asset value.

Open-end funds, on the other hand, have marketing budgets.

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Personal finance writer Scott Burns is syndicated by Universal Press. His twice weekly column appears in newspapers from Boston to Seattle. He is the Chief Investment Strategist for AssetBuilder, Inc. Readers can register at www.scottburns.com. Questions/comments can be posted directly. They can also be sent, without registration, to scott@scottburns.com. Questions of general interest will be answered in future columns and on this blog.

Click on the "Archive" navigation to see other columns. All comments are welcomed and appreciated.
Published Feb 07 2007, 06:00 PM by scottb
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Comments

 

ABModerator03 said:

Regarding the question about ETFs being confusing , Richard Ferri in his book "All about Index Funds" (2nd Edition)gives a good explanation of ETFs and how they differ from regular index funds and closed-end funds. He also explains the arbitrage mechanism that Scott discusses. Not sure I totally understand it, but it is now a lot clearer to me now than before I read the book.
February 8, 2007 2:46 PM
 

ABModerator03 said:

Mr. Burns-

I suppose your method of determining the value of a pension, finding out what an annuity will cost to produce the monthly income needed to match the amount of the pension, is the appropriate financial analyst's net present value approach.

I am not a financial analyst, but I have rule of thumb for calculating the value of my pensions, and it is derived from advice you give often- the 4% rule. Basically, I calculate the principle I would need to have invested so that a 4% annual draw would produce the amount of the pension.

For instance, in the case mentioned in the article, $2,300/month would require an investment of $690,000 ($690,000 x .04/12mos.= $2,300/mo). When I calculate my net worth, I use this approach to determine the value of my pensions and social security. I also use it to assess whether my total "portfolio" meets industry recommendations for the amount I need for a comfortable retirement.

This may be an unorthodox approach, but somehow it seems more real than the annuity approach, perhaps because I would never consider annuities with the downsides they have that you frequently mention.

Am I delusional, or does my method have merit?

Thank you.

From Scott Burns:

Using 4 percent as a valuation measure--- which means multiplying the annual income by 25x--- is a nice feel-good tool but I think it causes some overvaluation of your net worth. More important, it is likely to give you a false sense of security.

Why? Pension income is just that, income. You have no liquidity, no access to principal. One general rule of thumb is that annuity income is worth about 17x the income. I feel more comfortable with that, though it still makes no adjustment for the lack of liquidity and flexibility that comes with having an actual portfolio.

It's only variable annuities that I am consistently negative about.

If you check the column archive, you'll find that I have regularly suggested that some people should try converting a portion of their assets to life annuities and that there are times when fixed income annuities work well because the income can be deferred for predictable periods of time.
February 10, 2007 8:55 AM
 

ABModerator03 said:

Question? I have a defined pension plan that is being phased out. I can decide to either freeze the pension benefits at this time (17 yrs service) and get an increased match to my 403B,$1.50 per $1.00 up to 4% of my base salary. Or continue the pension plan over the next 14 yrs with an employer match of 0.25 per dollar saved in the 403B. I keep calculating a difference of $56,000 difference in the 403B. If I stay in the pension plan, I will get around $17,000 more a year in pension benefits. Am I wrong in concluding the pension plan is the best option? Any help would be appreceiated. Sincerely Renovator20

From Scott Burns:

For most workers who already have significant years of service, staying in the pension plan is the better option. There are two reasons for this. First, it is unlikely that the additional "sweetener" for your 401(k) plan will accumulate to an amount of money that would compensate for the freezing of the pension benefits. Second, knowing that you will have a good-sized fixed income sum from a pension will allow you to invest more aggressively in your 401(k) plan.

When my former employer decided to freeze entry to the company pension plan in 2000, I made a careful examination of how it would likely turn out. For the youngest employees--- those in their 20s and early 30s--- the sweetened 401(k) was a good option because they would likely retire from a different employer. For those in their late 40's and older, the pension plan was a far better bet.

It is not widely understood that funding a corporate pension plan requires an annual investment of about 7 percent of payroll. A typical 401(k) plan offers a 50 percent match up to 6 percent of pay. That amounts to 3 percent of payroll--- IF 100 percent of employees participate.
February 10, 2007 5:30 PM
 

ABModerator03 said:

Gooddog,

The "4% rule" is intended to be a very conservative safe withdrawl rate with inflation protection. Unless the pension is inflation protected, a better adjustment would be its current value exactly as Scott Burns has described. If you went into the market, how much money would it take to buy an equivalent fixed annuity from a company with equivalent credit rating as the pension.

2B
February 10, 2007 5:51 PM
 

ABModerator03 said:

I understan the annuity analogy, but my pension works a little differently. I am a retired Naval officer, age 50, and receive a pension of $2,074 per month gross. From this I have $136 deducted for my survivors benefit that covers my wife (age 49). When I die my wife will receive either 55 percent of my annuity of she is not eligible for social security benefits. Once she is elegible for social secuirty her benefit will be reduced based on the amount of social security she receives.

In addition to this my pension is inflation protected through annual COLA adjustments.

Any ideas on how to calculate the value of this more complicated pension?

From Scott Burns:

Vanguard offers inflation adjusted life annuities. So visit their website and put in the information for a "joint and survivor" life annuity with a 50 percent survivor benefit. That will give you an idea of the value of the pension. (Adjusting for any Social Security offset makes it a much more complicated problem, but the point is about the value of the Navy pension in lieu of Social Security income.)

If you go back to the "What is My Pension Worth?" column (http://assetbuilder.com/?p=973) you'll see that inflation adjustments make a life   annuity much more valuable.
February 12, 2007 8:31 PM
 

ABModerator03 said:

You had a recent column on figuring the NPV of a pension.

How does one do this for social security with the annual cost of living increase? My intuition is that this should make it easier.

From Scott Burns:

I think the quick and personal way to do it is to see what the equivalent inflation-adjusted life annuity would cost. I believe Vanguard is one of the only firms currently offering inflation adjusted annuities--- I've used their website for figures. The value difference, particularly for joint and survivor inflation adjusted annuities is striking--- close to 50 percent more than the fixed variety.

If you're interested in a broader look at the values, try this URL:http://www.urban.org/UploadedPDF/900746_USAToday.pdf Eugene Stuerle is one of the old hands in this area. You might also check the work of Jim Poterba at MIT.

Thanks for your helpful reply. The reason I asked the question is that Bernstein's Pillars book suggests taking such things into account as a part of ones bond portfolio when considering asset allocation.

I will look at these sites.

From Scott Burns:

Bill Bernstein, as ever, is correct to suggest taking such things into account. Unfortunately, I have yet to see a good tool for making the adjustments. I've tried it with estimates of how much you need to put aside to offset fixed pension incomes, but it's problematic. The real issue, I think, is liquidity loss and how you assess it.

If you have a life with no emergencies, no problem.

The hard part is finding, and having, a life with no emergencies.
February 26, 2007 1:51 PM
 

ABModerator03 said:

Scott, You have recommended putting Tips in Roth IRA's. How about putting CD's in Roth IRA's? My credit union CD rates are between 5.4% for 1 year up to 5.7% for 5 years. If I set up a five year ladder the average maturity would be less than 3 years. The last time I checked Tips the real return was 2.4% for a 20 year issue. That means inflation would have to exceed 3% to equal the CD's. I assume if inflation rises over the fed target that interest rates would rise and CD rates would rise along with them. For retirement accounts the CD's are insured by the NCUA up to $250,000 per person. Outside of retirement accounts the CD's are insured up to $100,000. The rates are higher than similiar maturity treasuries. Is there anything wrong substituting CD's for tresuries in the fixed income portion of ones portfolio? Am I missing something here?

From Scott Burns:

You're not missing anything if you focus on relatively short maturities, as you have. For longer periods, I prefer to reduce the uncertainty of keeping up with inflation by owning TIPS. I know it may seem hard to believe, but we have been through periods where the yields on older CDs and Treasuries were less than the rate of inflation.

With a 5 year ladder that is much less of a problem because 20 percent of the ladder matures every year.

Banks generally provide lower yields than comparable Treasury obligations if you go by the averages from www.banxquote.com or www.bankrate.com but Credit Unions are competitive. So go for it!
February 26, 2007 9:51 PM
 

ABModerator03 said:

You mentioned in a recent article (Feb 7th 2007) What is My Pension Worth? that "extracting a lifetime income from a portfolio is a risky buisness."

Would you please clarify this statement. What makes it so risky? What is a less risky way to receive lifetime income from a 401K/403B?

Thank you!

John

From Scott Burns:

There is risk because market values fluctuate. As a consequence, if you have a constant (or inflation adjusted) withdrawal rate you will be liquidating more shares in a down market than in an up market. Basically, you are doing the reverse of dollar cost averaging.

If you are new to this idea and subject, I suggest you visit my website, www.scottburns.com and read the category called "portfolio survival." The higher your annual withdrawal rate the lower the probability of long term survival. With joint life expectancies at retirement now running 25 plus years, this is a major issue.
March 4, 2007 7:52 PM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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