A present value of a pension calculation has 5 basic variables that affect the final present value computation. They are (1) duration of the payout period, (2) mortality, (3) dollar amount of benefit, (4) the participant’s tax bracket, and (5) the assumed interest rate discount. These variables become a chain of assumptions that are supported only by the weakest link. Meaning, if one variable is inappropriate for your case, the entire valuation is affected.
Of the five variables used, three of the key factors should be of particular interest to you in determining whether or not the valuation is suitable for your client. The key factor that has the most effect on the valuation is the interest rate discount applied. The second most important factor affecting the end result is the tax discount followed by the life expectancy or probability of the payout period. A key relationship for the attorney to understand is that the higher the interest rate assumed the lower the present value, while the lower the interest rate used the higher the present value. The longer the duration or payout period, the higher the present value of a pension and the shorter the payout period the lower the present value. Therefore the earliest retirement age assumed, will also yield the highest present value regardless of the fact that the pension may be discounted for early retirement. The tax discount applied varies from case to case and is fairly easy to ascertain. Once these variables are understood, the relationship between the short and long payout periods, the high or low interest rates and the tax rates, becomes apparent.
The Chart below illustrates the common variables that affect pension valuations and shows the outcome.
|FACTORS AND ASSUMPTIONS||AFFECT ON PRESENT VALUE|
|High Interest Rate||Lower Present Value|
|Low Interest Rate||Higher Present Value|
|Early Retirement Age||Higher Present Value|
|Normal Retirement Age||Lower Present Value|
|Shortened Life Expectancy||Lower Present Value|
|Cost of Living Adjustment||Higher Present Value|
|Marriage Coverture adjustment||Lower Present Value|
|Larger Tax Discount||Lower Present Value|
Other issues can and will affect the valuation including: vesting, cost of living adjustments (COLA), coverture fraction formulas, shortened life expectancy, survivorship benefits, control point and tax discounts.