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Retire Early: Should I stick around for 40 years to collect a pension ?

Should I stick around for 40 years to collect a pension ?

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This article was first posted on January 1, 1998.

While they're becoming less and less common, many large companies still offer "defined benefit" pension plans. Defined benefit plans are arrangments where your annual pension benefit is determined by years of service. Typically, you would multiply the annual salary in your final year of employment by the number of years of service times 1%. For example, if you worked for a company for 40 years, your pension would be equal to 40% of your final salary. Just about everyone who's been able to weather the mind-numbing boredom of working in a large bureacracy long enough to collect a pension thinks it's a fabulous deal.

But is it? Suprisingly, you could fund a pension equal to those offered by big, blue chip companies (i.e. General Motors, General Electric, Exxon, etc.) by saving and investing just 2% to 3% of your salary. And if you do it yourself, you don't have to worry about getting "downsized" six months before your pension vests. The money already belongs to you.

Let's look at a specific example:

  • A 25 year old male hopes to work for 40 years at a Fortune 500 company. His starting salary is $50,000 per year. He averages a 4% annual salary increase each year until age 65. He participates in a defined benefit pension plan that uses the formula of final year's salary times years of service times 1% equals annual pension benefit. Assume an interest rate of 6.5% for calculating the present value of his retirement annuity. Assume a 10% annual tax deferred return on his self funded retirement savings. How much would he have to save from his salary each year to equal the amount, at age 65, of the present value of his retirement annuity?

    First, calculate the annual salary at age 65: $50,000 (1+0.04)^40 = $240,051.

    Next, calculate annual persion benefit: $240,851 (40 years) (1%/year) = $96,020

    Then, the present value of the retirement annuity: $96,020 (10.13) = $972,687

    Select the proper annuity factor from the table below:

    Annuity Factor - single immediate annuity, 0% inflation, 0 years deferred.
    . Male . Female
    . ----- Interest Rate ----- . ----- Interest Rate -----
    Age 5.0% 5.5% 6.0% 6.5% 7.0% . 5.0% 5.5% 6.0% 6.5% 7.0%
    50 15.17 14.34 13.58 12.89 12.27 . 16.24 15.29 14.43 13.65 12.94
    55 14.09 13.38 12.74 12.14 11.59 . 15.26 14.44 13.68 12.99 12.36
    60 12.85 12.26 11.73 11.23 10.77 . 14.11 13.41 12.77 12.18 11.64
    65 11.41 10.95 10.52 10.13 9.75 . 12.75 12.19 11.67 11.18 10.74
    70 9.85 9.51 9.18 8.88 8.59 . 11.22 10.79 10.38 10.00 9.65

    Finally, back calculate the percent of salary that must be saved each year to equal the present value of the retirement annuity. Assume a 10% tax deferred return for these retirement savings. Answer: 2.37%.

Run your own scenario

Retire Early has developed a simple Excel spreadsheet that performs the calculation in the example above. It allows you to enter your own figures to calculate the present value of your retirement annuity and how much you'd have to save to build up a retirement account of equal value on your own. Upon seeing the results, most people agree. Their employer could be a lot more generous.

Download Excel Spreadsheet (pension.xls 7kb file)


filename = pension.html
Copyright 1998 John P. Greaney, All rights reserved.

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