Should You Include Your Pension in Your Net Worth?

INCLUDING RETIREMENT PLANS IN NET-WORTH CALCULATIONS

A person’s net worth is calculated by deducting their liabilities from their assets. Net worth can be positive or negative. It varies over time and, when properly interpreted, offers a useful overview of one’s financial situation at any given moment. Although all asset classes boost net worth, some have a greater overall impact than others. For the majority of people, their retirement plan makes up one of the biggest and most significant portions of their net worth.

Defined contribution plans effect on net worth is easily calculated

In a defined contribution plan, the retiree’s projected source of income is uncertain. Income will be determined by taking reasonable withdrawals from the retirement savings account, with reasonableness determined by the retiree’s life expectancy, the account balance at retirement, and the anticipated rate of return on their investments.

When it comes to retirement planning, it’s crucial to remember that a defined contribution plan’s value is always equal to its balance. This is due to the fact that employers are not required to offer benefits above and beyond the contributions stipulated by the plan’s terms. Put another way, employees assume full responsibility for the risk that the fund won’t be sufficient to cover their retirement needs, which is why a sensible withdrawal rate is essential. It is simple to factor in the value of defined contribution plans when determining an individual’s net worth; however You just look up the balance and add it to net worth because the present value of the benefit received at any given time equals the account balance at that point.

Defined benefit plans have a more difficult time affecting net worth.

Retirement income is guaranteed under a defined benefit plan and is typically calculated by multiplying three variables: (1) the number of years one worked for the company, (2) salary (which is usually an average of a specified number of years), and (3) a specified percentage, such as 20% For instance, let’s say A worked for his employer for 20 years, and his pension plan provided a retirement income of $2 for each year of service. His average salary over the last four years was $150,000, or 2% of that amount. As pension would be $66,000 per year (20 × 2. 2% × $150,000).

Defining a defined benefit plan’s net worth is difficult because, while annual retirement income earned at any given point in time can be easily calculated, defined benefit plans only represent a stream of potential future income. That is why defined benefit plans are frequently excluded from total assets; the employee must survive in order to receive benefits. This, however, gives employees who have been employed for a while a very incomplete picture of their financial situation. So how should the potential income stream from a defined benefit plan be taken into account when determining net worth?

First and foremost, it is important to realize that pension valuation depends on how the net-worth calculation is applied. For instance, the value of the pension could be zero if you’re trying to figure out how much of the employee’s wealth is heritable. It depends on the terms of the pension agreement. However, net-worth estimates should be raised by the present value of anticipated future pension payments if retirement income rather than transferable wealth is the issue. Put differently, figure out how much money the individual would need to save for retirement in order to generate the same amount of income as their pension. As a general rule of thumb, for every $1,200 in earned pension income ($100 per month), the retiree would require $18,000 in retirement savings. According to this rule, an employee’s earned pension income is determined at any given time by taking into account their current earnings, the employer’s pension formula, and the total amount of time they have worked for the company.

This general guideline may be the most accurate way to determine how much defined benefit plans increase net worth, even though there are other approaches as well. (See the sidebar titled “Alternative Methods for Estimating Earned Pension Income’s Present Value.” It goes without saying that altering the life expectancy, rate of return, and inflation assumptions to reflect your own expert opinion will alter the amount of savings required to support any given level of income. Nonetheless, historical data indicates that, despite its simplicity, it is reasonable to assume that each $100 per month of defined benefit plan pension income is worth roughly $18,000 when valuing future streams of income. Stated differently, for every $100 in defined benefit plan income per month, the required amount of wealth at retirement is decreased by $18,000.

Consider the increase in a person’s net worth of $30,000 in earned pension income. A $30,000 defined benefit plan income is equal to $2,500 per month, or 25 times $100. Funding such a pension benefit with a defined contribution plan akin to a 401(k) would thus necessitate retirement savings of at least $450,000 (25 × $18,000). Consequently, the defined benefit plan adds $450,000 to net worth.

NET-WORTH COMPARISONS: THE IMPORTANCE OF BENCHMARKING CORRECTLY

A further problem that emerges is the comparison of net worth to unsuitable benchmarks. For example, the financial press far too easily encourages the comparison of individual net worth with the average because it is filled with statistics describing average net worth. There are several problems with this comparison. Firstly, average net worth is highly misleading if you want to know how you stack up against the middle of the pack. The Federal Reserve’s 2019 Survey of Consumer Finances states that the average net worth of U.S. S. Families make about $747,000. However, the median (50th percentile) net worth of that amount is only 2016% of the total, at about $122,000. The median is a far better indicator of where the middle of the pack is because the average is heavily skewed by extraordinarily high net worths at the top of the distribution.

Furthermore, the median net worth fluctuates over time, with the typical trend being an increase in net worth with aging. For instance, the median net worth of people in the 35–44 age group is $91,000, whereas the median net worth of people in the 55–64 age group is more than twice as high at $213,000 Along with other demographic factors like race, education level, home ownership, and more, median net worth also varies significantly with them.

Lastly, to revisit the previous topic, defined benefit plans must be appropriately included in net-worth comparisons. Most families’ net worth is primarily composed of their house and retirement savings accounts, like 401(k)s and IRAs. But most published averages of net worth do not include pension income. If you are fortunate enough to have a defined benefit plan, your net worth must take into account the present value of your future pension income in order to make any meaningful comparison with published averages that include savings accumulated in defined contribution plans.

Keep in mind that Social Security income is an exception to this rule as those benefits are never included in published averages. It should be clear from all of these comparability issues that comparing your net worth to others’ is a risky undertaking.

How Much is Your Pension Worth? Calculate its value to your net worth.