Social Security and Pension Benefits - How Much Are They Worth?

Social Security and Pension Benefits - How Much Are They Worth?
By Joe DelCasino

As investors watch their investment portfolios dramatically shrink, they have come to realize that their social security and other pensions have become a more significant part of their financial security in retirement. But how do you compare monthly life-long payments with other lump sum asset totals shown on your financial statements? It is helpful to estimate the upfront, lump sum value of that life-long stream of monthly benefits. That estimate will answer the question: How much money would you need today in a lump sum to generate that same monthly social security or pension benefit for the rest of your life?

First, you need to make some assumptions: What is your monthly social security or pension benefit? What is your life expectancy? Those two assumptions indicate how much and how long your lump sum must provide benefits. What interest rate should you assume that lump sum earns while it's rendering those monthly payments? Finally, and for the sake of simplicity, let's assume that the benefits end with your death. A simple example illustrates these assumptions in action. Let's say your monthly benefit is $1,000 and you expect to live another 25 years. Generally, you would select as your interest rate a long-term treasury rate equal to or greater than your life expectancy, because you would want to invest your lump sum to insure the safety of principal and interest for the rest of your life. In this example, you might select a 30-year treasury rate, which currently yields nearly 4%.

Armed with your assumptions, there are two easy methods for performing the actual calculation. The first method is to use a sophisticated hand calculator that has financial function keys and do the same calculations you would do if you were calculating mortgage payments. With mortgage calculations, you typically enter the mortgage balance, mortgage rate and mortgage term and solve for the monthly mortgage payment. In order to calculate the lump sum value of your social security benefits, you enter the interest rate (instead of a mortgage rate) and your life expectancy (instead of the mortgage term). You then enter your monthly benefit (using the mortgage payment key) and solve for the lump sum amount (obtained from the mortgage balance key). With a typical mortgage calculation, you enter the mortgage balance and solve for the monthly mortgage payment. With the lump sum calculation, you enter the monthly benefit and solve for the lump sum balance. Don't forget to use monthly interest rates and express your life expectancy in months, if you use monthly benefits in your calculation. Otherwise, use annual interest rates, your life expectancy expressed in years and your annual benefits in the calculation.

The second method is to use a present value ordinary annuity table and find the annuity factor that corresponds to your interest rate and life expectancy assumptions. In our example, we assume a 4% rate and a 25-year life expectancy, which according to the table, indicates an annuity factor of 15.6. Multiplying your annual benefit of $12,000 by that 15.6 factor indicates an estimate of $187,200 for the lump sum value of social security benefits in this example. Either method works, so you decide which to use.

Lump sum value estimates can be useful in your investment allocation planning process as they allow you to translate guaranteed monthly income streams into upfront totals that can then be easily compared to the amounts of other assets in your portfolio. They also offer additional insight into the potential net worth of your investment holdings. However, you should realize that those values are intangible, analytic in nature and exist only on paper, i.e., you can't cash them in at a bank. They are also likely to change as interest rates, your life expectancy, and social security benefits inevitably change during your lifetime. Due to their tentative nature and potential volatility, such estimates may be useful in formulating a long-term strategy for your finances, but less useful in making specific, tactical investment decisions.

Source: For a Present Value Ordinary Annuity Table, go to Annuities-Financial-Planning.com

More articles by this author are available at http://joedelcasino.blogspot.com Books are available at http://www.Xlibris.com