Perhaps the most ubiquitous measure of financial health is net worth, and despite its conceptual simplicity, it is often poorly understood by those lacking a background in finance. Two of the easiest mistakes made when calculating net worth are (1) the improper valuation of future income from pensions and (2) the improper comparison of personal net worth with published figures, such as national averages. Making either mistake can lead to unnecessary anxiety about retirement.
A retirement plan is a contractual arrangement obligating an employer to provide retirement benefits to employees. Although there is considerable variability in their structures, features, and benefits, most employer-sponsored retirement plans can be described as either defined contribution plans or defined benefit plans.
Defined contribution plans
Defined contribution plans are employer-sponsored retirement plans with accounts maintained separately for each participating employee. Some types of defined contribution plans allow the employee and the employer to contribute to the employee's account (e.g., 401(k) and SIMPLE plans), and some allow only employer contributions (e.g., SEPs).
Defined benefit plans
A defined benefit plan is just what it sounds like; the benefit to the retiree is defined by the terms of the plan. Although some plans with defined benefits, such as cash balance plans, are actually hybrids, the majority of defined benefit plans obligate the employer to pay a certain amount of retirement income as an annuity that continues until the employee's death. In fact, most of these plans include lifetime income support for surviving spouses as well. A defined benefit plan is often referred to as a pension.
In defined benefit plans, employers bear all the risk associated with the fund's adequacy because the employer must pay the prescribed pension income to each retiree regardless of the accumulated size of the fund. Because of the risk and the fact that defined benefit plans are more expensive, employers have been shifting away from defined benefit plans toward defined contribution plans.
INCLUDING RETIREMENT PLANS IN NET-WORTH CALCULATIONS
A person's net worth is equal to his or her assets minus his or her liabilities. Net worth can be positive or negative. It fluctuates over time, and properly understood, it provides a good snapshot of financial health at a point in time. There are many types of assets, and they all increase net worth, but some tend to have larger effects than others. For most people, one of the largest and most important components of their net worth is their retirement plan.
Defined contribution plans' effect on net worth is easily calculated
With a defined contribution plan, the retiree's future income stream is the unknown. Income will depend on making reasonable withdrawals from the retirement savings account where reasonableness is based on the account balance at retirement, the expected rate of return on the invested funds, and the life expectancy of the retiree.
The important thing to note for retirement planning is that the value of a defined contribution plan at any point in time is equal to its balance at that time. This is because employers are not obligated to provide benefits beyond the contributions required by the terms of the plan. In other words, employees bear all the risk that the fund may be inadequate to meet their retirement needs, so a realistic withdrawal rate is critical. Including the value of defined contribution plans when calculating a person's net worth is easy, though. Because the present value of the benefit earned at any point in time is equal to the account balance at that time, you simply look up the balance and add it to net worth.
Defined benefit plans' effect on net worth is harder to assess
In a defined benefit plan, retirement income is guaranteed and is usually calculated by multiplying three variables: (1) the number of years worked for the company, (2) salary (typically an average of a specified number of years), and (3) a specified percentage, such as 2%. For example, suppose A worked for his employer for 20 years, and for each year of service his pension plan offered retirement income of 2.2% of his average salary over the last four years, which was $150,000. A's pension would be $66,000 per year (20 × 2.2% × $150,000).
Although annual retirement income earned by any point in time can be easily calculated, defined benefit plans present a challenge when calculating net worth because they only represent a stream of potential future income. That is, the employee must live in order to collect, which is why defined benefit plans are often omitted from total assets. This, however, presents a very incomplete picture of financial health for workers who have been on the job for a while. So how should a future stream of income from a defined benefit plan factor into net-worth calculations?
First, it must be understood that pension valuation is dependent on how the net-worth figure is being used. For example, if you want to determine the employee's amount of heritable wealth, then the value of the pension may be as little as zero. It depends on the terms of the pension agreement. However, if the concern is not transferable wealth but retirement income, then net-worth estimates should be increased by the present value of expected future pension payments. In other words, calculate what the person would need in retirement savings in order to provide the same retirement income as provided by his or her pension. A good rule of thumb is that the retiree would need $18,000 in retirement savings for every $1,200 per year ($100 per month) of earned pension income. In applying this rule, the amount of earned pension income an employee has at any point in time is based on the employer's pension formula, the employee's current earnings, and the time spent on the job to date.
While other methods exist, this rule of thumb may be the best option for estimating the amount that defined benefit plans add to net worth. (See the sidebar, "Alternative Approaches for Determining the Present Value of Earned Pension Income.") Of course, changing the assumptions regarding life expectancy, rates of return, and inflation to reflect your own professional judgment will change the savings needed to provide any particular level of income. However, when valuing future streams of income, historical data suggests that despite its simplicity, it is reasonable to assume that each $100 per month of defined benefit plan pension income is worth approximately $18,000. In other words, each $100 per month of defined benefit plan income reduces the amount of wealth needed at retirement by $18,000.
As an example, examine how much an earned pension income of $30,000 would add to a person's net worth. A defined benefit plan income of $30,000 annually is $2,500 per month, which is 25 times $100. Therefore, it follows that funding such a pension benefit with a 401(k)-style defined contribution plan would require 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
Another issue that arises is comparing net worth to inappropriate benchmarks. For instance, because the financial press is replete with figures describing average net worth, it far too readily invites the comparison of individual net worth with the average. There are several problems with this comparison. First, if you want to know how you compare with the middle of the pack, average net worth is very misleading. According to the 2019 Survey of Consumer Finances published by the Federal Reserve, the average net worth of U.S. families is approximately $747,000, but median (50th percentile) net worth is only 16% of that amount at about $122,000. The average is highly skewed by extremely large net worths at the top of the distribution, so the median is a far better indicator of where the middle of the pack is.
In addition, median net worth changes over time with the normal pattern being that net worth increases with age. For example, the median net worth of those ages 35—44 is $91,000, while those 55—64 have a median net worth more than double that amount at $213,000. Median net worth also varies considerably with other demographic variables, like race, education level, home ownership, and more.
Finally, returning to the issue discussed earlier, net-worth comparisons must properly count defined benefit plans. The two largest assets included in the net worth of most families are their home and retirement savings accounts, such as IRAs and 401(k)s. However, when it comes to net worth, most published averages ignore pension income. If you are lucky enough to have a defined benefit plan, any meaningful comparison with published averages that include savings accumulated in defined contribution plans will require including the present value of future pension income in your net worth.
Note that the same is not true of Social Security income because those benefits are never included in published averages. All these comparability problems should make it obvious that comparing your net worth with others' is a perilous endeavor.
A FINANCIAL REPORT CARD
Net-worth calculations are valuable when properly performed and used. By providing a sort of financial report card, changes in net worth can help your clients see trends in their financial health and help them better understand the process of wealth building, which will in turn facilitate financial decisions that help them reach their long-term financial goals. Begin helping clients by calculating a target net worth based on their estimated income needs in retirement, and then carefully monitor progress toward that target.
Alternative approaches for determining the present value of earned pension income
Consider these other methods for determining how much a right to receive $1,200 per year ($100 per month) of pension income adds to net worth. Each approach has its own simplifying assumptions.
- Present value of a perpetuity with growth: Assume that pension payments start at $1,200 per year and increase by 3% each year due to a cost-of-living adjustment (COLA). If you assume a rate of return on retirement savings of 6%, then the present value of this perpetuity is $40,000 ($1,200 ÷ (6% — 3%)). But note that a perpetuity is assumed to continue forever, so this valuation method would overstate net worth.
- The 4% rule: You could use the 4% rule that is so commonplace in the financial press. This rule states that the retiree can make annual withdrawals of 4% of the beginning balance of his or her retirement savings and expect them to last 30 years. Therefore, the amount of savings required to safely withdraw $1,200 of annual income would be $30,000 ($1,200 ÷ 4%). However, according to actuarial tables at the Social Security Administration, additional life expectancy for those who were 65 years old in 2017 was approximately 18 years for men and 21 years for women. So, it is probable that this valuation would also overstate net worth.
- Nominal value of payments: You could assume that retirement savings would earn nothing at all. Making this assumption means that savings would have to equal withdrawals, so retirement savings of $24,000 would be needed to make annual withdrawals of $1,200 for 20 years. Of course, the lower interest rates fall, the greater the value of guaranteed pension income becomes because you would need more savings to be equivalent to the guaranteed income, but assuming zero returns is unreasonably pessimistic and again results in overstating the value of pension income and thus overstating net worth.
- Purchased annuities: Rather than calculate the present value of pension income, you could simply consult a financially sound broker for a quote on how much it would cost to buy a guaranteed annuity equal to earned pension income. Suppose the quoted rate is $210,000 per $1,000 of monthly annuity income. Then a $1,200 annual income ($100 per month) would cost $21,000. However, note that over time this valuation method would capture all the volatility in year-to-year market conditions, which would make changes in net worth much more difficult to interpret.
- Present value of an annuity: The recommended approach to pension valuation is to make the simplifying assumptions necessary to compute the present value of an annuity due. For example, assume a 20-year pension annuity, a 6% return, and 3% inflation. For an annuity of $1,200 per year, the employee would need savings of approximately $18,000 at retirement.
About the authors
Charles R. Pryor, Ph.D., is a professor of accountancy, and Stephen S. Gray, DBA, is an assistant professor of finance, both at Western Illinois University in Macomb, Ill. Nicholas C. Lynch, Ph.D., is a professor of accountancy at California State University—Chico in Chico, Calif. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.
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In this four-part narrated PowerPoint presentation, Tom Tillery discusses contributions to, and distributions from, various types of retirement plans, enabling you to better review your client's existing estate plan or create an estate plan, which may be even more critical than the assets themselves.
Designed for practitioners who want a thorough understanding of retirement planning, the AICPA's Retirement Planning Certificate Program is a series of courses covering the retirement planning life cycle, including planning for aging and chronically ill clients.