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The present value calculation for a pension decision example

Choosing when to start a pension can provide an interesting example of how a present value calculation (PV), and the related concept of net present value (NPV), are used in decision making. The pension decision example also exposes some of the hidden assumptions that can influence decisions when using this approach.

Jumping right into our example decision, we have a fictitious person, John Summers, who is considering when to start taking his pension. His pension rules allow him to take his pension from a previous employer starting at any age between 55 and 65. He is currently 54, so he wants to know what to do before his 55th birthday.

Here is a summary of the John's pension decision information:
- John's current age is 54 and he is not married
- Earliest pension start date is when John reaches age 55
- Latest pension start date is when John reaches age 70
- Projected lifetime monthly pension payments for the following starting ages:

  • Starting at 55 is $2000
  • Starting at 65 is $4000
  • Starting at 70 is $6500

Normally there are additional complicating options with respect to payments for a surviving spouse, but making John single keeps the example simple.

What does a present value calculation tell us about this decision?

The present value calculation will tell us the value of each of the incoming cash flows for the payment choices in today's dollars. If you perform the calculation, you will find that each option above gives the same PV result. This is not very helpful in deciding which to choose. If the present values were different, you would choose the one with the highest present value (assuming you do not need to consider any of the cash outflows). Generally you should not expect to see differences in these numbers unless the pension provider is trying to generate additional profit on one of the options.

Missing information that is needed to determine the present value includes the assumptions made for the expected interest rate for the calculation of the pension payments, and the expected age of death. In this case the interest rate used by the pension provider is about 6.7%. The expected age of death is roughly 83 based on actuarial tables.

Exposing these assumptions creates the opportunity for a more informed decision. Both of these assumptions are based on statistics that the pension provider is applying to the large population that they serve. While these assumptions help the pension company develop a viable business, with respect to your decision, they contain choices (or beliefs) about the future that may not be representative of you as an individual.

The opportunity for a more effective decision actually resides in exposing the hidden information that underlies the decisions being made by the pension provider.

Additional help from looking at Net Present Value

Image of tax calculatorNet Present Value can provide added insight to the decision by adding the outgoing cash flows to the evaluation that are specific to the decision being made (present value only looks at incoming cash flows). In this case, the outgoing cash flow that can have a large influence on the decision outcome is the expectations for taxes for each of the monthly payment options. This will be specific to each individual's circumstances, suggesting the need for an individual financial analysis.

Net present value is sometimes considered a single criteria decision technique. For business decisions, the decision evaluation is reduced to a set of projected incoming and outgoing cash flows that are then represented as a single value in today's dollars. In theory, the choice becomes easy; choose the option with the highest net present value (NPV).

In reality, as in the case of John's pension decision, the assumptions for projected cash flows contain choices or beliefs about the future that can create significant disagreement among decision participants.

Exposing the success factors for our pension decision example

Returning to John's pension decision, looking at the assumptions used in generating the equal present value options (from the perspective of the pension provider) suggests some questions that can help with making a better decision.

  1. How long do you expect to live? Your individual health situation and family history gives you information that may be more reliable than the company's statistics.
  2. What do you expect for the interest rate over the pension payment period? Maybe you think you can generate a higher rate of return. If so, you may want to get the money sooner to place it in your own alternative investment.
  3. What do you expect for the solvency of the company or government that owns the obligation to pay your pension? If the mortality assumptions are wrong, what could happen to the promise to pay your pension? You need to evaluate the level of trust and control you want to have with regard to your pension cash flow.

Present Value and Net Present Value are just tools

Our simple example of John's pension decision shows us that a Net Present Value or Present Value Calculation can provide decision evaluation tools that can help in the comparison of financial options that reflect future cash flows. When using these tools remember:

  • Critical decision information is hidden in the assumptions. Examining the assumptions can expose factors needed to make an informed decision.
  • Projecting future cash flows is tricky business, just like predicting the future. As in our pension decision example, the factors important to the choice may be more related to trust and control.
  • Options from a insurance or annuity company generally will reflect equal options from the company's perspective. Applying your specific assumptions to the cash flow calculations can help you to make the choice best suited to your individual circumstances.

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