The article “Should you include your pension in your net worth?” was originally published in MoneySense on July 4, 2023. Photo by Kampus Production from Pexels.
Whether to include a pension in your net worth statement is up for debate. If you choose to do so, know there are a few ways it can be calculated.
“I recently retired from the public service here in B.C. and have a defined benefit plan pension. Is there a method that is commonly used to determine how much a defined benefit pension plan factors in towards your total net worth?” Ed
Net worth and your pension
This is a good question, Ed, and I cannot say there is a universal answer. I personally think of a pension as an income stream, like a salary. But I suppose a key difference is you need to go to work in order to earn your salary. It is a future income stream, but it is contingent (on working).
A pension is also payable in the future, but it is not contingent on anything—at least not the pension you have earned to date. It is a promised, pre-determined monthly payment received as of a certain age, payable for life, and possibly beyond (to a surviving spouse as a survivor benefit, for example).
How to calculate your net worth in Canada
A net worth statement is a simple concept but an important part of personal finance. It is calculated by taking your assets and subtracting your liabilities. As your assets rise, or as your liabilities are paid off, your net worth—the difference between the two—increases. This is a goal of financial planning.
What is the commuted value of a pension?
When you get your annual pension statement, Ed, there may be different values listed, or possibly none at all. Beyond the projected future income, there may also be a commuted value. A commuted value is a present value for the pension, calculated based on the future monthly payment, the number of months until that payment begins, and interest rates.
A commuted value may be payable to a pension plan member if they leave the pension plan. If a plan member gets a new job or retires before a certain age (subject to the plan rules), they may be able to forgo their pension and instead take a lump sum commuted value payment. Some pensions will be eligible to go into a locked-in retirement account (LIRA), and some will generally be taxable.
Some pension statements will list a value for the pension based on other criteria. For example, it is common to see a value on a pension statement for contributions with interest. The future income stream is similar to a registered retirement savings plan (RRSP) contribution that has “earned interest” or grown in value since the contributions were made.
A long-time defined benefit (DB) pension plan member may have a pension so valuable that another saver with only an RRSP would need more than $1 million to generate a similar retirement income.
Should you include CPP and OAS?
The Canada Pension Plan (CPP) and Old Age Security (OAS) are government DB pensions that are not much different from a workplace DB pension. I have never seen CPP or OAS listed as assets on a net worth statement.
So, on this basis, Ed, could your DB pension be included on your net worth statement? Sure, it could. Putting a value on your pension could be difficult, though. Most pensions do not list a commuted value on their annual statements. And if a pension statement lists your contributions with interest, that may understate the pension value—particularly if your employer’s contributions with interest are not also considered.
How do interest rates affect pension payouts?
Interest rates are an important factor when determining the present value of a pension. When interest rates are low, present values are high. There is an inverse relationship. Now that interest rates have increased, despite having another year of service, some pensioners may find their commuted value for their pension has gone down over the past year. The reason is that the present value is determined based on the assumption that the lump sum would be invested at current interest rates to generate the future pension income. When rates are high, you do not need as big of a lump sum to invest to provide the same future income.
To take your question a little further, Ed, some people take into account their DB pension when they are assessing their investment asset allocation. In other words, because of the fixed, guaranteed nature of a monthly pension payment, it could be considered like a bond or fixed income investment. Some investors invest more of their savings into stocks as a result, on the basis that their DB pension is like owning a bond.
I can appreciate this logic and think that a DB plan member could consider taking on more investment risk, but there is a drawback. In particular, if an investor’s risk tolerance is such that they could not stomach a certain percentage decline in their investments, the notional nature of a future pension as an asset today may not be much solace when they look at their investment statement.
If being overly exposed to stocks and more volatility causes a knee-jerk reaction to sell stocks at the wrong time, this fixed income treatment of a DB pension could backfire.
So, should you include your pension in your net worth?
In any event, Ed, there is merit to your question. Whether or not you should specifically list your pension on your net worth statement is up for debate. As is the valuation method you should use. It’s not as simple as adding up the total payments you would receive, for example. The future value is less than the cumulative payments on the basis that a lump sum today could be invested.
If nothing else, your pension is a footnote on your net worth statement, and something to consider when thinking about your overall wealth and investment strategy.