How Much Is a Pension Worth?

Disclaimer: I’m not your financial advisor, and this is not financial advice. This post only considers US pensions.
One unique benefit of a government job is a pension. But its value can often be a little inscrutable - how much more is a job that includes a pension really worth?
Should you turn down a private sector job that offers to double your salary solely because it doesn’t have a pension? What about a job that offers just 10% more than your current salary?
In this post, I estimate the value of a pension by comparing it to an equivalent synthetic pension.
The answer: a pension is worth a 25-35% salary premium.

How do pensions work?

Pensions, formally “defined benefit plans”, are plans where you get a predefined monthly income upon retirement. This contrasts with “defined contribution plans”, where your employer puts in a fixed amount of money into a savings account.
Pension plans commonly have the following characteristics:
  • Some minimum number of years of service (common values: 5, 10, 20)
  • An assumed age of retirement, with a penalty for retiring earlier
  • You get paid out via the formula (rate * years of service * highest pay)
  • Cost-of-living adjustment (COLA)
Some examples:
  • MaBSTOA (the pension system of NYC’s transit system - MTA, $3.8B of assets under management) [benefits]
    • Min 10 years of service, assumed retirement at 63
    • Pay rate: 35% + 2% for each year above 20 worked
    • COLA: lower of 1.35%, or 60% of inflation
  • CalSTRS (the California teachers’ system, $367B AUM) [benefits]
    • Min 5 years of service, assumed retirement at 62
    • Pay rate: 2% for each year worked
    • COLA: 2% flat, non-compounding
  • CalPERS (the California pension system, $560B AUM) [benefits, investments]
    • More of a pension platform than a pension plan - offers many different pay rates, COLA and more to different employees.
  • MRF (the military pension system)
    • Min 20 years of service
    • Pay rate: 2% for each year worked
    • COLA: tracks inflation, uncapped
These plans are in fact structurally quite similar: hovering around 2% per year worked, and a retirement at 62. Older plans that employees may be grandfathered into tend to be more generous.
For a quick worked example, consider John Smith, who retires at 62, after 30 years of service, making $100k/y for his last few years, and has a pension plan that pays at 2% per year of service.
He’d get an overall rate of (2% * 30) → 60%, and thus earn 60% of his highest pay each month, around $5k.

Synthetic pensions

Pensions pay out for the entire life of the pension-holder. The most similar instrument to this is an annuity - which is purchased with a lump-sum payment, and then pays out for the life of the policy-holder.
Thus, the following steps create a synthetic pension:
  1. Create a retirement savings account, and save money in it earning an investment yield
  1. At retirement, cash out the savings account, and purchase an annuity
For John Smith from our above example, he’d expect to get an annuity of around $610/mo if he purchased it at the age of 62 with $100k. If he opted for one with a 2% COLA (i.e., monthly payments grow by the lower of inflation or 2% annually), he’d start out at $480/mo instead.
Thus to calculate the synthetic pension that’s fully equivalent to a pension he’d earn working for the government:
  1. Calculate the size of an annuity equivalent to his pension
  1. Calculate the additional income he would need to save, in order to purchase that annuity at retirement
I ran those numbers in a spreadsheet here, with some other key assumptions:
  • his final wage is $100k, after growing 2% year-over-year, adjusted for inflation
  • his investments grow at 5% year-over-year, adjusted for inflation
The conclusions:
  • John would need an annuity with a principal of $1.02M to match his 2% rate pension
  • John would need to save approximately an additional 20% of his salary to save $1.02M by retirement.

Complications

Taxes (pension ⬆️)

If John is fully able to invest these additional savings into a tax-advantaged 401k or IRA, the above 20% number holds.
If not, he’ll be taxed when he saves and must save 30-40% more, i.e., 26-32% instead.
Notably, the 401k limit of $23k is enough for it to work out for John and most Americans, but the IRA contribution limit of $8k is lower than John’s target of $20k/y.

Shenanigans (pension ⬆️⬆️)

Pensions have loopholes, for example, many pensions historically did or still do count overtime or holiday pay towards income.
Thus, for a pension that uses your highest year of earnings, or your highest 36 months, you can substantially increase your pension by stacking hours in your final year(s). This might a pension behave much more like a 60-70% income premium - and this specific tactic was once widespread.
A law was signed in 2013 preventing this in California, but employees who began a CalPERS supported job prior to 2013, or employees elsewhere might still be able to pull these tricks.

Disability insurance (pension ⬆️)

Many pension plans often include special provisions for disability. For example, CalSTRS will pay you 50% of your last compensation in perpetuity if you’re disabled, if you had at least 5 years of service.
I wasn’t able to easily estimate the costs, so I’m assuming it might cost anywhere between 1-10% of pay to get an equivalent private alternative.

Investment surety (pension ⬆️)

One issue with a synthetic pension is the variance of investment return. You could account for this by dropping your expected real rate of return to 3 or 4% (instead of 5%).
Pension funds solve this by pooling assets better and being backstopped by the government. For example, a pension fund is likelier to be bailed out than an individual following a stock market crash.

Bundling (pension ⬆️)

It’s possible to substitute a pension with a combination of financial products, but it’s kinda a mess, you pretty much always want {investment, annuity, financial planning}, and maybe also want to add in {disability insurance}.

Life insurance (pension ↔️)

Pensions usually have an option to take a smaller benefit, in exchange for the policy lasting for the entire of your and your spouse’s lives.
However, annuities also allow this, thus synthetic pensions can emulate this quite easily.

Wage growth (pension ↔️)

Pensions index most on your highest wages, whereas when investing in a synthetic pension, your earlier investments have longer to compound.
Thus: if you’re in a career where you expect your wages to rise earlier, but then maybe plateau, a synthetic pension performs better than estimated.

Pay-ins (pension ⬇️)

Some pension plans require you to pay into them while you’re working. For example, the MaBSTOA requires that you pay up to 6% of your wage into your pension.
Thus, the premium of the pension drops by that amount.

Career lock-in (pension ⬇️)

This is the classic downside of a pension - you’re locked into a single employer, and don’t see benefits for a long time. A synthetic pension has none of this downside, as 401ks, IRAs and regular brokerage accounts are portable.

Time discounting (pension ⬇️)

A pension is worth as much as investing an extra 25-35% of your salary into a synthetic pension.
But that’s not the only use for money! You might prefer to have more money now than later, for example, if you’re having kids soon.
A job with a 25% premium over a pensioned role might be preferable, if you care about access to money sooner rather than later.

Financial flexibility (pension ⬇️)

Most investment accounts let you withdraw money at any time. Even tax-advantaged ones only come with a tax penalty instead of prohibition on withdrawals (eg: a 10% 401k penalty), and they often allow free loans against your principal.
Pensions are often more inflexible here, and this might limit your ability to deal with short or medium term financial changes. This might ultimately be good for you if it helps you abate financial impulsiveness though.
 
Thanks to Janna Lu and Jay Luxeed for feedback on this post.
 

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