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Estimating "present value net worth"
Old 06-02-2009, 04:05 PM   #1
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Estimating "present value net worth"

I've been developing this post on other boards with help from REWahoo, Martha, CFB, Rodmail, James22, Michael, KCowan, & Mike.

I've been trying to put 2008's market meltdown in perspective alongside our total assets. Although it was no fun to watch our equity portfolio drop by over 50%, I was pretty sure that the loss is a minority of our overall balance sheet. All I had to do was to look spouse in the eye and come up with a convincing rationalization rationale.

Milevsky talks about our "human capital" of lifetime earnings power and pensions as well as savings, and I wanted to try to assess our income streams as equivalent lump-sum dollars. I don't know if CFPs even bother to try to convert cash flows to lump sums for retirement planning.

"Net worth" doesn't accurately describe income from pensions or Social Security, so I tried to calculate their annuity equivalent as part of "present value net worth". For example, I'm receiving my military pension now but its COLA is not easily equated to decades of inflation-adjusted dividend payments from a lump sum. Spouse gets her military pension in 13 years but that's not easily discounted to a present-value lump sum either. Payout options like survivor benefits have even more complications. Defined-benefit pensions have a number of variables. And then there's the financial & legislative uncertainty swirling around Social Security.

Annuity calculators used to be ubiquitous but they seem scarce since AIG's collapse. Vanguard no longer has a website annuity calculator-- instead it's now "Call us for a quote!" There's an annuity calculator at the TSP website (TSP: Annuity Calculator; 2008 Feb 26) and a net-present-value one at Time Value of Money Calculator. I'm still looking for more annuity calculators.

The interesting thing about an inflation-adjusted pension is that its payout is constant inflation-adjusted dollars-- they maintain their hypothetical buying power for the rest of the retiree's life. So the value of an inflation-adjusted pension is the owner's life expectancy. That's great for a military pension because veterans can plug their parameters into a retirement calculator (https://staynavytools.bol.navy.mil/RetCalc/Default.aspx) and multiply the result by the number of years they'll be collecting it. My results were close enough to the TSP annuity calculator, assuming I die in accordance with an actuarial table.

So active-duty military pensions are the simple case of converting cash flows to lump sums. Reserve/National Guard pensions and Social Security are a bit more complicated because we don't get them until later. However military pay is keeping up with the ECI so let's make another (hopefully valid) assumption that future pay dollars will have the same CPI buying power as 2009 dollars. The Social Security benefits calculator spits out its numbers in 2009 dollars, too, and benefits are adjusted at CPI so it doesn't need any discounting either. That means a Reserve/NG pension starts at age 60 and SS at age 62 in inflation-adjusted dollars for the rest of a life expectancy. Again my results were close enough to the TSP's annuity calculator.

The math gets messier for defined-benefit pensions that don't have a COLA. You'd have to take a pension-plan estimate for the year of ER and then discount it to 2009 dollars at some assumed rate of inflation.

After converting cash flows to lump sums, I added in the assessed value of our homes and subtracted the mortgages. I added in the college savings and our ER portfolio's value to get the total "present value net worth".

The interesting numbers are the percentages. As lump sums, my military pension contributes about 27% of our total and spouse's Reserve pension is a tad more. Our total SS is 13%. Our real estate is another 20%. Our equity portfolio has always been less than 20%, even at the 2007 market peak, and never dropped below 10%.

I thought spouse & I had a high-equity ER portfolio. The reality of "present value net worth" is that it's roughly 70% government bonds, 20% REITs, and only 10% equities. Not quite as recklessly aggressive as our brokerage account appears.

I figured that our earnings record, with its years of zeroes, would make our SS hardly worth the bother-- but it's over an eighth of the total. Maybe this is why Milevsky pushes "human capital" and "lifetime asset allocation" so hard.

ERs spend decades analyzing their stock & bond portfolios-- saving money, choosing asset allocations, and minimizing expenses. Then there's coping with the emotional sleep-at-night roller-coaster ride of market volatility. However that might only be a fraction of the reality. Young Dreamers expecting to receive a pension or SS should probably focus on maximizing their annuitized benefits. Because of those annuities, military retirees can easily be overweighted in federal pension bonds. Their other investments can be tilted extremely heavily toward equities, commodities, and real estate.

Our wild-eyed hard-partyin' mortgage debt is only 5% of the total. Military retirees don't need to pay off our mortgages-- we need to get bigger ones. Perhaps even Bernstein would agree that we should go back on margin and start trading options.

Anyway the conclusion is that a 50% meltdown of our equity portfolio isn't so nasty after all-- barely a 10% effect on our overall net worth. Golly gee whillikers, what a relief. I feel better about the market already!

I'm still looking for other annuity website calculators where we can get numbers without having to provide contact info. Post your links to this thread.
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Old 06-02-2009, 04:26 PM   #2
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Since the annuity pay out changes based on the annuitant's current age and the current interest rate environment, won't that affect your cash flow to lump sum calculations over time if you use annuity calculators? As you age or interest rates go up, won't it artificially shrink your NW? Conversely, given the fact that interest rates are abnormally low right now, are you sure you are not overestimating the value of your lump sums, hence taking more risk than you think you are? Just wondering... Since I don't have a pension and exclude SS from my calculations, figuring out my present value net worth is easy. Looking at percentages, stocks represent about 48% of my total net worth and a 50% meltdown hurts as bad as it sounds.
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Old 06-02-2009, 04:33 PM   #3
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By the way you can still have access to Vanguard's old annuity calculator here:

Vanguard Lifetime Income Program -- Request a Quote
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Old 06-02-2009, 05:28 PM   #4
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Wow... a long post Nords.....

But a lot of us will never have a COLA pension (except for SS)... or even a pension at all...

I can not do anything related to SS except to live long enough to get it (well, even then I can not do anything if the time comes)... so to me SS is not in my equation...

I do not put my house in my portfolio because I do not plan on living off the equity (which by the way is low since we just bought a place and now have a 30 years loan)...

SOOO, I am left with all of what is left which is stocks and bonds and cash value pension plan (which is not doing bad since it can not lose money as long as the company does not go the way of GM)....

With that, I got clobbered in the market... since the market is almost all of what I have.....
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Old 06-02-2009, 05:50 PM   #5
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So the value of an inflation-adjusted pension is the owner's life expectancy.

The math gets messier for defined-benefit pensions that don't have a COLA. You'd have to take a pension-plan estimate for the year of ER and then discount it to 2009 dollars at some assumed rate of inflation.
I'm going to get techy and say that for the inflation-adjusted annuity I would discount at something like the inflation adjusted rate on TIPS. For non-COLA annuities, I'd use some fixed rate like the yield on regular corporate bonds.

I doubt that would change your message - SS and COLA'd pensions can be a big part of your total "investments", and that lets you take more risks with invested assets.

I've seen an argument, probably from Milevsky, that working people should use the PV of future wages in this calculation. If you think you have a very safe job, you can take more chances with your investment. If your job is chancier, then you need safer investments.
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Old 06-02-2009, 06:14 PM   #6
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Interesting analysis and probably a useful exercise for those with pensions.
SS is 13 or more years in the future. It is not a trivial sum but not enough to live on. Nords what formula did you use to convert X number of SS payments 13 or maybe 17 years in the future into a NPV.

My house will paid for in 10 years. But for simplicity I simply subtract the loan balance from my fixed income to determine my real AA (a note with some satisfaction that virtually of all my fixed income investments are paying the same or more than my mortgages).

I have no pension period, no real estate other than house. So I am in the same boat as Texas. The market and some even riskier investments are all that I have.
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Old 06-02-2009, 06:18 PM   #7
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Nords, good job reframing the situation, should help you and hopefully DW have less upset about last year.

I did a similar exercise last year while the sky was falling. I looked at my portfolio currently 74/26, then I loaded my home equity in as REIT and the PV of my future pension payments (noncola) as govt bonds (took some liberty there as it's not a govt pension) and suddenly my equity stake wasn't anywhere near 74%. Made me feel a lot better and made it much easier to stay the course and even buy on dips as I considered AA from several different perspectives.
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Old 06-02-2009, 06:32 PM   #8
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In the real estate appraisal business for commercial properties, there are four or five courses based on the Income approach. Now how does this apply to Nords analysis? The income approach is all about cash flows and the capitalization of such or the discounting of the flows.

They spend what seems like an eternity on how to derive a cap rate. (divide the annual projected cash flow by the cap rate to get the value) You can get it from the market or another way is to build one. You take the cost of money about 1.5% and inflation 4% then risk of the project say 4.5% and you get a cap rate of 10%. This is similar to a bond valuation. divide interest amount by rate to get value. The biggest problem is considering the cap rate. For a non cola income stream I would think you could not use an absolute safe rate, like treasuries, as their may be additional risk. It depends on the company/gov. backing the pension.

For the cola pension, I use 4%. I guess for me it is the SWR. Seems to make since to me that if I need 1 million to generate 40K income this is a good start. On the back side, it does not take into effect that your investments will most likely leave a residual and your cola pension will most likely not. Some would say therefore that a higher rate should for the cola pension. Your choice.

Now when the real estate market was down the tubes in the 90's in Texas, the only way to get value was to do a 10 year cash flow. You took all the cash flows for a 10 year period and discounted it back to a present value. Spread sheets do this well. So for a future cola or non cola pension they would be plugged into the spread sheet in the year you get it. Then discount the whold mess back. The biggest problem here is what to use as a discount rate. I believe, it's been awhile, these two either come from other comparable projects, or are built up similar to the cap rate.

If you go to your local library and look for the Appraisal Institute's book you can pick up some decent knowledge about time value of money and evaluating cash flows.
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Old 06-02-2009, 08:27 PM   #9
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Personally, I'd use the risk free rate (treasuries) for discounting purposes on all normal annuity streams (just like they taught in finance class). For an inflation adjusted cash flow stream, I think the proper method is to discount the "real" cash flow by the appropriate "real" (TIPS) yield.

For me the math is easy . . . sum of $0 / (1 + i%) ^ t
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Old 06-02-2009, 08:59 PM   #10
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Nords - that seems like a fancy way of saying "having a COLA'd pension really insulates you from these damn market swings!"


Seriously though, Independent hinted at it but you seem to have this backwards.

Quote:
The math gets messier for defined-benefit pensions that don't have a COLA.
Not to get too technical but you don't need an inflation curve to discount a non-COLA'd pension, you need an inflation curve to estimate a future COLA'd payment prior to discounting.


But anyway an interesting post. For many of us estimating the present value is quite simple because almost all of our assets have observable market prices. I admit though that SS doesn't show up in my spreadsheet.
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Old 06-02-2009, 09:13 PM   #11
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I would assume the net present value of a COLA pension would be the future payments at today's payment amount discounted by the likelihood of future death ending the payments (mortality table by year for a person of your and your wife's age) further discounted by the appropriate interest rate -- Long term TIPS for COLA and Treasury bonds for Non-Cola'd. The termination would probably be at age 105 I'd think. From whatever that lump-sum calculation came out to their would need to be at least a 20 percent discount for unforseen risk.
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Old 06-03-2009, 06:53 AM   #12
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I don't fully agree with the concept that a COLA'd pension should be valued as bonds thus allowing a high equity ratio in the portfolio. It really depends on how much of an income stream you need from the portfolio and how much flexibility you have to cut back. Take, for example, someone who calculates he needs $80k/yr to live the life he he wants. He has a $40K COLA'd pension and $1M in his portfolio. He may not be in precisely the same situation as someone who has only the $1M and $40K in projected expenses but closer than you might first think. We talk about diversification and cash buckets to keep from depleting the equity portion of that $1M in down years. The same thing applies to our guy. If the $1M is 100% equities, he needs to quit spending (drop back to $40K) in a period like today or he will reduce the likihood that his $1M will keep funding a $40K income stream. Conversely, if he diversified his portfolio and had a few years of cash in his $1M he could more safely continue pulling out his $40K. By viewing his portfolio as supporting a $40K income stream he would allocate it the same way as anyone else. If he really doesn't need the full $40K he can adjust accordingly.
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Old 06-03-2009, 08:22 AM   #13
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Risk tolerance for any given individual depends on a lot of different factors. One of those factors would be the COLA'd pension you mentioned, and your belief (or lack of same) in the effectiveness of the COLA in keeping up with the true inflation of your expenses.

There are many other factors that can affect an individual's risk tolerance, some of which you mentioned, such as whether or not your house is paid off. Life expectancy, dependants, poverty experiences in early life, and a myriad of other factors also contribute to one's risk tolerance.

My point is that risk tolerance is not simply "is he more of a panty-waist than I am?" question. It is highly individual and all of these factors are inherent in determining your risk tolerance in the first place. Once you have figured out your risk tolerance, it doesn't seem too swift to then change it to something riskier because you have a pension or whatever. You already knew that.
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Old 06-03-2009, 09:10 AM   #14
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One calculator that I used when evaluating my pension freeze was:

www.immediateannuities.com

It gives you the cost today for various options, so if you are looking at present value it is helpful. If you are looking for future value then you have to make some kind of discounting assumptions.
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Old 06-03-2009, 09:24 AM   #15
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Originally Posted by FIREdreamer View Post
By the way you can still have access to Vanguard's old annuity calculator here:
Boy, they hid that sucker pretty well. Thanks for tracking it down. The more annuity calculators we can use, the more we can figure out their pricing and whether they're realistic. Of course that also leads to the annuity seller's worst nightmare: an unruly torch-waving mob of educated consumers.

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Originally Posted by FIREdreamer View Post
Since the annuity pay out changes based on the annuitant's current age and the current interest rate environment, won't that affect your cash flow to lump sum calculations over time if you use annuity calculators?
Yep, it'll change every time the interest rate changes, and the TSP website does it monthly. So I see calculating net worth this way as an annual exercise, sort of a reality check to wrench our eyeballs away from the streaming stock quotes.

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As you age or interest rates go up, won't it artificially shrink your NW?
Yep, especially without the survivor option. That's realistic because as I get older I have fewer years of income headed my way. And when I die my military pension dies with me.

Interest rates will definitely affect the annuity payout-- you'd hate to have retired on a lump sum in 1981 when interest rates were in the high teens. As interest rates rise I guess all stock & most bond investors are unhappy. (People with TIPS, I bonds, and commodities are probably happy.) But the point of the analysis was to put everything into common units for an apples-to-apples comparison. As interest rates fluctuate it'd be interesting to see how much the relative percentages of each type of asset changed. I think CFPs are missing the opportunity to print out a lot of cool 3D bar charts.

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Conversely, given the fact that interest rates are abnormally low right now, are you sure you are not overestimating the value of your lump sums, hence taking more risk than you think you are?
Could be. Considering the events that led to today's low interest rates, all stock holders are taking a lot of risk right now. But OTOH the value of our equity portfolio probably declined a lot faster than the dropping interest rates caused our pension lump sums to rise. I'll have to take a look at that. In any case, whether it's caused by overestimated lump sums or by portfolio losses, an asset-allocation approach would tend to encourage investors to buy more stocks just when they're cheapest. I wouldn't cash in an annuity or a college fund to do it, but I'd certainly avoid buying bonds.

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Looking at percentages, stocks represent about 48% of my total net worth and a 50% meltdown hurts as bad as it sounds.
Sure, but again the point of the analysis was to include assets that are significant enough to someday be converted to groceries. (Hence we left out our personal property.) I used to "exclude" SS from my calculations, but that doesn't make much sense to me if it's more than 10% of the total. Its lump-sum value is also pretty close to the value of our equities in our ER portfolio. If they're nearly equivalent then I can't logically focus on our equity portfolio's performance and ignore our SS benefits.

Milevsky makes the point that an annuity, even one supporting a poverty-level budget, can ease a lot of hurt. Look at Greaney's and Raddr's articles on their hapless ER who retired in 2000 with a 75/25 portfolio and a 4% SWR-- today I bet he wishes he'd bought an annuity too.

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Originally Posted by Texas Proud View Post
Wow... a long post Nords.....
Sorry. You guys are guinea pigs helping me think this through. My next post on discount rates is even worse.

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But a lot of us will never have a COLA pension (except for SS)... or even a pension at all...
True, but every one of 1.4 million military veterans (and their 1.9 million family members) has to work through the "stay or go" thought process, and currently only 15% of them hang around for at least 20 years. A few of the vets getting pensions today are 108 years old after retiring in their 30s or 40s. Maybe this type of portfolio analysis would cause some changes in current retention behavior. I don't think the pension should be the #1 reason to stay on active duty, but it would certainly get me through a lot of long, boring Reserve drill weekends and quite a few midwatches. And this might also extend to other people with federal/state pensions. I don't know of many other employers offering inflation-adjusted pensions.

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I can not do anything related to SS except to live long enough to get it (well, even then I can not do anything if the time comes)... so to me SS is not in my equation...
I do not put my house in my portfolio because I do not plan on living off the equity (which by the way is low since we just bought a place and now have a 30 years loan)...
SOOO, I am left with all of what is left which is stocks and bonds and cash value pension plan (which is not doing bad since it can not lose money as long as the company does not go the way of GM)....
With that, I got clobbered in the market... since the market is almost all of what I have.....
You can always ignore those assets, but wouldn't it seem prudent to have an idea of whether or not they're significant? I'd hate to be eating Friskies in my Trump McMansion because I don't want to get a reverse mortgage. And in the context of all those cash flows, a few percentage points of mortgage debt (or a reverse mortgage) might not be so bad.

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I doubt that would change your message - SS and COLA'd pensions can be a big part of your total "investments", and that lets you take more risks with invested assets.
Exactly. And maybe Social Security is significant enough to require more thoughtful consideration, too. 13% of our net worth for only a 24-year work history?!? Is America a great country or what! I just can't assess its political risk.

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Originally Posted by Independent View Post
I've seen an argument, probably from Milevsky, that working people should use the PV of future wages in this calculation. If you think you have a very safe job, you can take more chances with your investment. If your job is chancier, then you need safer investments.
A bunch of his research papers and at least his book "Are You a Stock or a Bond?"

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Originally Posted by clifp View Post
Interesting analysis and probably a useful exercise for those with pensions.
I have no pension period, no real estate other than house. So I am in the same boat as Texas. The market and some even riskier investments are all that I have.
Yes, and unless you're a steely-eyed killer of the stock market, then those risks (risk of loss, volatility, and single stock) can quench the resolve of anyone with lesser intestinal fortitude. Our riskier investments are a priceless tuition for our MBAs at the School of Experience.

My analysis shows that spouse and I should be able to handle an awesome amount of volatility. We should know, too, because we practice at least twice a decade. Last year we were in an even better financial position than 2000-2002. Bring it on!

Yet last year's stock market had a much harsher emotional impact-- even enough to make me haul my butt out of the recliner to do the analysis to craft this thread. I have no logical financial rationale to take some off the table. Emotionally, with a trembling investor psychologist's risk aversion, I point to the statistic that the longer we stay in the market, the higher the probability certainty of bad stuff happening.

For the average ER with no pension or faith in Social Security or even home equity, perhaps it makes a lot of sense to purchase a bare-bones annuity at retirement. I can't believe I'm saying that, let alone Milevsky. But his "Stock or Bond" book says that today's annuities are a much better deal than when he first researched them 15 years ago.

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Originally Posted by Rustic23 View Post
In the real estate appraisal business for commercial properties, there are four or five courses based on the Income approach. Now how does this apply to Nords analysis? The income approach is all about cash flows and the capitalization of such or the discounting of the flows.
I sure hope the Hawaii homeowner's market is more liquid (with better appraisal comps) than the commercial real estate market.

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Originally Posted by Maurice View Post
Nords - that seems like a fancy way of saying "having a COLA'd pension really insulates you from these damn market swings!"
Yep. But as a nuclear engineer, now I can point to a spreadsheet and invite people to come up with a better number!

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Originally Posted by Want2retire View Post
Once you have figured out your risk tolerance, it doesn't seem too swift to then change it to something riskier because you have a pension or whatever. You already knew that.
Two counterpoints. First, a few years ago I thought we'd already figured out our risk tolerance. I was wrong. This latest market meltdown didn't make me clutch the sheets over my head as I trembled in a fetal ball, but several times I thought "Crap, what a waste of good money." So risk tolerance apparently changes with time.

Second, the more I research these questions then the more I can decide whether or not to take on more risk. It seems like a koan-- if we don't need the money, then shouldn't we take more risk? Or if we don't need to take the risk, then why are we keeping the money? As spouse will attest, I don't have good answers to those questions.
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Old 06-03-2009, 09:29 AM   #16
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Discount rates are messy enough to merit a separate post. Maybe even a separate thread. I wish Gummy was explaining this. But here we go:

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I'm going to get techy and say that for the inflation-adjusted annuity I would discount at something like the inflation adjusted rate on TIPS. For non-COLA annuities, I'd use some fixed rate like the yield on regular corporate bonds.
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Nords what formula did you use to convert X number of SS payments 13 or maybe 17 years in the future into a NPV.
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Seriously though, Independent hinted at it but you seem to have this backwards.
Not to get too technical but you don't need an inflation curve to discount a non-COLA'd pension, you need an inflation curve to estimate a future COLA'd payment prior to discounting.
Discounting confused me quite a bit, and I still might not have it straight. I'll try a strawman analogy.

Let's suppose that your employer promises you a fixed (defined benefit) pension in 20 years. It's going to be based on whatever salary you're earning in two decades; nobody has any idea what that will be. The pension payout is not adjusted for any inflation. No survivor benefits.

At the beginning of your retirement, clearly that fixed pension needs lots of discounting to convert it to a present value. Every year that it pays out, it's going to lose a year's buying power to inflation. So you, the employee, come up with what seems like a reasonable average lifetime inflation rate and apply it by whatever number of years you reasonably expect to be alive to collect the pension. That gives you a lump sum which you could ask to collect at the beginning of your pension instead of a defined payout. To avoid "cat food cuisine risk", you're going to assume that you're living for an extraordinarily long life while your employer may want to assume an actuarial lifespan or even try to tailor it to people like you with your employment history. You're worried about high inflation but your employer is optimistic that the government will keep it under control.

As an employee I'd expect annual inflation of 5% (what it's been for the last 30-some years, skewed by the 1980s) and to live to age 110. An employer might offer a lump sum based on 3.5% average annual inflation (what it's been for the last century) and age 78. Your idea of a lump sum is going to be a lot bigger than their idea of a lump sum because you've been using a much higher discount rate for a much longer time. You think their pension is worthless because higher inflation will have a longer time to chew it to death.

Suppose your employer decides to sweeten the deal by offering to give you a lump sum today instead of 20 years from now. You're in charge of investing the money for 20 years to make it generate your pension lump sum. He expects you to invest it in a high-growth high-volatility microcap nano-bio-telcom stock that has a 95% expectancy of returning 10%/year over inflation for 20 years (with a 5% expectancy of being wiped out). You expect to be putting it into I bonds, where you'll be lucky to do better than inflation. When the two of you calculate the size of today's lump sum, you're asking for a much larger lump because you're using a much lower discount rate. (That's odd-- last paragraph you wanted more money because of a high discount rate. Now you want more money because of a lower discount rate.) The employer doesn't want to offer much of a lump because they're expecting the stock market to make it grow for you-- unless you're one of the unlucky 5%. At least this time the two of you have agreed that the time period is 20 years.

On the way home that night you stop by the military recruiter's office and learn that their pensions are adjusted every year for the CPI. If the CPI is not manipulated then you'll be protected against a lifetime of inflation! Your pension dollars have the same buying power every year. If you convert that to a lump sum, the dollars received in the first year of retirement have the same value as the dollars received in the second year… and the third year… and the fourth year… and so on until you die. (Thanks to Rodmail for pointing this out.) If you asked for a lump sum, you'd just multiply your life expectancy by the size of the pension. No one would be arguing about the rate of inflation. No discount rates required.

It's been a tough recruiting month, so the recruiter persuades Congress to raise the military's salaries every year for the ECI. If the ECI isn't manipulated then you might assume that you're protected against a career of inflation! Your salary dollars have the same buying power every year. If you convert that to a lump sum then the dollars received in the first year of employment have the same value as the dollars received in the second year… and the third year… and the fourth year… and so on until you die. If you asked for a lump sum, you'd just multiply your salary by 20 years. No one argues about inflation. No discount rates required.

I'm collecting the pension that the military recruiter describes. My spouse, who will start collecting her Navy Reserve pension in 13 more years, is dealing with the recruiter's salary situation.

In addition, the Social Security calculator spits out its numbers in 2009 dollars (thanks to REWahoo for pointing that out) and adjusts them each year for an employment index. (So my future salary adjustment is "$0 x ECI".) Then when we start drawing our SS benefits, every subsequent year is paid out with a COLA. When I'm trying to determine the net present value of our future Social Security benefits, no discounting is required before I start drawing them and no discounting is required after. They're already in 2009 dollars and they're adjusted every year for inflation.

The risky assumptions here are that the ECI will be equal to the CPI and equal to the actual rate of inflation. The reality is that they might lag inflation by a point or two… or three. So a more conservative approach might include additional "lagging" discount rates.
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Old 06-03-2009, 09:44 AM   #17
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I don't fully agree with the concept that a COLA'd pension should be valued as bonds thus allowing a high equity ratio in the portfolio. It really depends on how much of an income stream you need from the portfolio and how much flexibility you have to cut back. Take, for example, someone who calculates he needs $80k/yr to live the life he he wants. He has a $40K COLA'd pension and $1M in his portfolio. He may not be in precisely the same situation as someone who has only the $1M and $40K in projected expenses but closer than you might first think. We talk about diversification and cash buckets to keep from depleting the equity portion of that $1M in down years. The same thing applies to our guy. If the $1M is 100% equities, he needs to quit spending (drop back to $40K) in a period like today or he will reduce the likihood that his $1M will keep funding a $40K income stream. Conversely, if he diversified his portfolio and had a few years of cash in his $1M he could more safely continue pulling out his $40K. By viewing his portfolio as supporting a $40K income stream he would allocate it the same way as anyone else. If he really doesn't need the full $40K he can adjust accordingly.
Interesting post. I was just thinking about a calculation that might clarify this, but I haven't gotten around to it.

To me, the question is: How do you separate what you "need" from what you "want"? I would define "need" as the things that you really can't imagine doing without. Then I'd say that most of us have something called "target" spending, which is the amount we're planning to spend (the sum of needs and wants).

In your example, if both the $80k and the $40k are "needs", then I think they are in the same position. Both of them should invest so they have no (or extremely small) probability of not covering their needs. OTOH, if the $80k and $40k are both "targets", with room to flex spending down when things get tough, then they may or may not have different optimal investments.

I'd construct the example a little differently. Suppose both want to spend $80k, but both also feel that only $45 of that covers "needs", the remaining $35k will buy "wants". Now one person has $1 million in assets plus a $40k COLA annuity. The other has $2 million in assets and no annuity. Finally assume they have the same aversion to losing "wants". That is, they both consider losing out on $10k of spending "bad", but losing $20k is "much worse". Somehow, I think the person with the COLA annuity can invest more aggressively, but I haven't really worked it out.
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Old 06-03-2009, 09:52 AM   #18
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Risk tolerance for any given individual depends on a lot of different factors. One of those factors would be the COLA'd pension you mentioned, and your belief (or lack of same) in the effectiveness of the COLA in keeping up with the true inflation of your expenses.

There are many other factors that can affect an individual's risk tolerance, some of which you mentioned, such as whether or not your house is paid off. Life expectancy, dependants, poverty experiences in early life, and a myriad of other factors also contribute to one's risk tolerance.

My point is that risk tolerance is not simply "is he more of a panty-waist than I am?" question. It is highly individual and all of these factors are inherent in determining your risk tolerance in the first place. Once you have figured out your risk tolerance, it doesn't seem too swift to then change it to something riskier because you have a pension or whatever. You already knew that.
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Two counterpoints. First, a few years ago I thought we'd already figured out our risk tolerance. I was wrong. This latest market meltdown didn't make me clutch the sheets over my head as I trembled in a fetal ball, but several times I thought "Crap, what a waste of good money." So risk tolerance apparently changes with time.
That's right. Also, your situation will change and that can change your risk tolerance. All the more reason to consider and reconsider your risk tolerance, taking all factors that presently affect it into account.

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Second, the more I research these questions then the more I can decide whether or not to take on more risk. It seems like a koan-- if we don't need the money, then shouldn't we take more risk? Or if we don't need to take the risk, then why are we keeping the money? As spouse will attest, I don't have good answers to those questions.
I think that such questions demand revisiting your risk tolerance - - getting in touch with yourself and with all the factors that affect one's risk tolerance, evaluating your situation carefully, and nudging your asset allocation so that it is appropriate to your situation. I wouldn't expect risk tolerance to be a static value; it is dynamic IMO.

I think a lot of us realized during the economic collapse that we had misjudged our risk tolerance and that it was really lower than we had thought. When those who feel that way can nudge their AA without losing a lot, they probably will. But anyway, my point is that this economic collapse was something that very few of us had considered when determining our risk tolerance. It had never happened before in our lifetimes and wasn't *supposed* to happen. It did, providing most of us with something new to consider in our dynamic risk tolerance and AA.

Likewise, the fact that your daughter is growing up and heading off to college may (or may not) affect your risk tolerance. There are a lot of factors that affect it. Getting older is one that affects everyone eventually. Who wants to take a lot of risk with their assets when they are 95 years old?

My asset allocation used to be 100:0, then 70:30, then 60:40, then 50:50, and is now 45:55. I don't expect it to stay 45:55 forever, though I think it is fine there for what I anticipate during the first few years of ER.
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Old 06-03-2009, 10:09 AM   #19
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Nords, my guess is Hawaii, like most markets, use comps for residential. However, the Income approach is still the most used for income property.

I still think the discounted cash flow method is the best to use. You could create a different flow for each instance of income and for different times if necessary. If the income stream you are discounting has a residual value it is included in the last years income.

The problem is still how to determine a discount rate. If you search Google you come up with several articles on building a discount rate for investing and such. At the heart is a formula that the discount rate is equal to a core rate + risk. Some use inflation + risk. If a core rate is used it is most often something like the treasury rate. Risk would be assigned for each flow. I would say military pensions have low if any risk. While some may argue SS has higher risk. As I said excell makes discounted cash flow of an income stream easy. By using a cash flow analysis, it does not matter if it is cola'd or not. You are entering in the expected cash flow for each year. Your assumption on inflation will effect the value, however, for cola'd pensions it should be a wash as the same inflation rate in the discount rate should cancel the inflation in the income stream. It will have a divastating effect on the no cola'd pension, as you would expect.
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Old 06-03-2009, 10:20 AM   #20
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Sure, but again the point of the analysis was to include assets that are significant enough to someday be converted to groceries. (Hence we left out our personal property.) I used to "exclude" SS from my calculations, but that doesn't make much sense to me if it's more than 10% of the total. Its lump-sum value is also pretty close to the value of our equities in our ER portfolio. If they're nearly equivalent then I can't logically focus on our equity portfolio's performance and ignore our SS benefits.
I just find it daunting to try and estimate SS benefits that I may or may not receive in 30+ years. So many things can affect the payout amount that, at this point, I would simply be making a guess, and an uneducated one at that. So to be on the safe side, I'd rather ignore SS for now.



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Milevsky makes the point that an annuity, even one supporting a poverty-level budget, can ease a lot of hurt.
I plan on doing just that, i.e. get an annuity to support our most basic expenses. It should help relieve a lot of fears.
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