There are many types of pension plans, but those with organization and individual participation fall into two types:[1] The Defined Contribution Plan and the Defined Benefit Plan. Both plans call for employee contribution and matching organization contributions. However, the major difference is at payout time (retirement).
With a Defined Contribution Plan, the employee accumulates a sum of money and assumes the sole responsibility of managing that money to fund retirement. This individual may be a do-it-yourself person or hire a financial counselor, purchase an annuity, et al. Even during the course of accumulation, the employee has some jurisdiction to pick the type of investments. When retirement comes, the employee is free to do whatever he or she chooses to do. In many industrialized countries, government rules allow the employee to rollover, the accumulated cash into an Individual Retirement Account (IRA) where earnings in the account grow tax-deferred until withdrawn from the account. The employee ends up with is a bundle of cash that must be carefully invested in stocks (for growth) and bonds/cash (income and reserves). The responsibility rests with this retiree to arrange for a steady cash flow from bond interest or purchase of an annuity.[2]
Defined Benefit Plan (like the UN type Pension Plan) provides a specified amount of benefit at normal retirement age. Final amounts vary depending on the formulas used, years of service, and age at retirement. During employ with the organization or after retirement, the employee has no jurisdiction on the type of investments in the plan. Benefit plans have options where the employee can take a full pension, a lump-sum payment and reduced pension or a complete withdrawal. In the case of a complete withdrawal, the individual in this plan will be left holding the cash and deciding how to finance his or her retirement.
We are now ready to go into the main purpose of this essay, the Pension in an extended portfolio. To make it easy let us name two people: Jack who has just retired from a Defined Contribution Plan and Jill who has just retired from a Defined Benefit Pension Plan. Let us also assume that Jack has been a spendthrift and his only savings are the accumulated contribution plan money, think one million units of currency. On the other hand, Jill has been a smart spender and has accumulated one million in addition to the benefit pension. Let us assume that both these individuals are about the same age, 60 years old.
Jack from the contribution plan goes to a financial counselor to have his funds invested. After a careful analysis of retirement needs the counselor recommends to Jack a portfolio allocation of 600,000 (60%) in stocks and 400,000 (40%) in bonds as his portfolio allocation. Jack meets Jill and explains to her of his meeting with the counselor. Jill thinks that Jack had good advice.
Jill is a smart do-it-yourself type of person and has distributed her one million of savings by allocating 950,000 (95%) to stocks and only 50,000 (5%) to bonds. Jack has been bothering Jill to see the financial counselor has he thinks that Jill has oversubscribed to stocks and has put her savings at great risk. Jill does not think so and now begins to explain to Jack about the extended portfolio.
You see Jack, I get a monthly pension and you do not. To get an amount 4,500 a month for your standard of living you will need to invest in an annuity or some fixed income securities that will provide funds for your remaining life span. The question is how much you would need in a retirement account, so that you can receive 4,500 a month for 40 years, totally depleting your account at the end of that time. Now if you want to buy an annuity Jack, a financial planner will pose this same question to you. Now let us assume Jack that my pension is 4,500 a month. I assume these factors: Monthly pension 4,500 (PMT) Annual Percentage Return (APR): 7%. Duration: 40 years or 480 months (N).
Jill is still talking
To make this simple I have ignored inflation calculations or let me say that inflation is included in my modest 7% return, says Jill. Now, I need to estimate the Present Value of my pension fund based on those assumptions I just gave you Jack. Just give me a minute while I run the numbers on my financial calculator….PMT 4,500, APR 7%/12, N 480 and the answer is 724,135. Therefore, if you have those same assumptions Jack, the investment firm is going to ask you for approximately 725,000 to get you a monthly income of 4,500 or you will have to invest your portfolio in a mix of investments that will generate 4,500 each month. Do you not think that is big responsibility Jack? "I surely agree Jill.” Now you see Jack, when I capitalize my pension, it is equal to an annuity worth 725,000 and when I reach 100, I will have nothing left in the account. I hope you now agree that my pension has a present value of 725,000. Okay, now let us see how my diversification allocation looks like: ·Stocks 950,000 :·Bonds 775,000 that is, the present value of my pension plus the 50,000 already in bonds. Now my total portfolio is worth 1,725,000 representing 55% in stocks and 45% in stocks. You see Jack that is pretty close to what the financial planner recommended to you. Jack thanks Jill for this explanation and bids her good night.
Now this is Merrill writing, Jack and Jill are out of the scene. You have to think of your pension as an annuity, yes, that what it is, it is an annuity because you receive a periodic payment each month for as long as you live. In the UN Pension Plan, your spouse gets 50% of your full pension if you die earlier and once your spouse dies the payments end. I am not suggesting that you run out and purchase an annuity or reorganize your finances. That decision is between you and your financial counselor if you have one. All I am doing is providing some educational logic that your pension has cash value for diversification proposals. Many financial planners out there completely ignore pension and social security payments in diversification proposals and some do agree that the pension has a hypothetical cash value and could be capitalized to determine the proper allocation of high-risk (stocks, etc) and lower-risk fixed income investments (bonds, savings accounts, cash, rental income, etc). You can consider this pension fund capitalization and annuity analogous to a mortgage. Suppose you need to borrow 725,000 at 7% interest repayable in 40 years, the bank will say that you have to pay a monthly mortgage installment of 4,500.[3]
I hope this helps you understand better about the pension in the extended portfolio. I welcome your comments.
Merrill Cassell
Disclaimer
The explanations in this essay are only for educational purposes and are not purported to give financial advice. Please rely on other sources for financial advice to suit your personal situation. Merrill Cassell
[1] The objective of this essay is not to explain the different pension plans but to lead to the discussion of the pension in the extended portfolio with defined benefit plans.
[2] Real estate investments also provide cash flow for some people, purchase property and rent it out. Alternatively, start a business for that matter.
[3] You can use any currency you wish, you can call these units dollars, rupees, yen, and it makes no difference. If you are sitting in New York reading this, just put a $ sign in front of all these figures.
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