Today’s short post involves calculating the present value of my pension. Present value is a formula used in finance that calculates the present day value of an amount that is received at a future date. The premise behind the calculation is the concept of the “time value of money” or in other words, that it’s more valuable to receive something today than to receive the same value at a future date (which is why it’s important to get started saving your first $100,00 dollars).
Before I go any further, I imagine most lawyers reading this are surprised to see that I have a pension that needs to be calculated. Believe me, I felt the same way when I discovered I had a pension during a job change. Pensions are typically from a bygone era and I didn’t even realize I was accruing a pension (how’s that for my firm not doing a great job of advertising your benefits).
As part of my exit package, I was handed a statement of my pension amount, the date that the payments would begin and the percentage that had vested. Not one to leave money on the table, I’ve done my best to keep good records of the pension benefit. Why? Because it won’t begin payment until April 1, 2046. But that’s not going to stop me from collecting!
The amount I’m slated to receive on that great day is a payment of $1,300 a month, which I will then receive each month until my death. It’s hard to say how much $1,300 a month will be worth 30 years from now. Obviously inflation will eat away at its purchasing power (the pension is not linked to inflation – I will receive a fixed $1,300 a month).
Using the federal government’s inflation calculator, I can see that $590 in 1986 has the same buying power as $1,299.66 today. If I work backwards, I could guess that $1,300 in the 2046 will be equal to $590 a month in 2016. While I won’t be living the high life on $590 a month, that’s enough to easily cover my grocery bills for a month for a family of two. So I better keep great paperwork!
Next, I wanted to figure out how much my pension was worth today. In other words, how much money would I need today in order to provide a benefit of $590 a month in 2046?
To do the calculation, I opened up Excel and loaded up the trusty present value formula. Present value is calculated as PV = FV x (1 + i)^n, where the present value equals the future value times one plus the expected interest rate over “n” number of years.
You can see right away that the first thing I needed to know was the future value of the pension in 2046. Not too easy since all I know is that I’ll be receiving $1,300 a month in the future.
To calculate the future lump sum amount that equates to receiving $1,300 a month, I first tallied up the yearly value of the payments, which is equal to $15,600 ($1,300 x 12). Assuming that you can safely withdraw 4% of a portfolio annually without touching the principal, I would need a portfolio of approximately $390,000 in 2046 to withdraw $15,600 a year.
Now that I know the future value of the pension, I need to assume an interest rate. I’ll use 8% since that’s a reasonable return to expect from equities. I also know that there are 30 years between today and 2046, so I have my “n” number of years.
The formula is PV = FV x (1 + i)^n and with my numbers it is PV = $390,000 x (1 + 0.08)^30.
Adding the formula to Excel leads a value of $38,757.16. Impressive! That’s a lot of money for a benefit I didn’t realize existed. My firm really should have done a better job advertising this perk to associates. The only flaw in my calculation is that upon my death I won’t have the $390,000 to distribute to my heirs, but that’s okay – I’ll be dead anyway!
You can check the work by loading a compound interest calculator, inserting the current principal and your assumed interest rate plus the number of years to grow.
Let’s talk about it. What other uses do you have for the present value calculation? I suspect a lot of the personal finance bloggers are familiar with calculating present value, but it’s an important skill for lawyers given that Excel will do all of the work for you.