Advice to a Young Man on Choosing an Employer

Advice to a Young Man on Choosing an Employer

All Pensions Look Alike in the Beginning ^{^[1]}

Alfred A. Brooks 10/18/05

It is difficult in one's twenties to be concerned with one's income in one's seventies or eighties but such concerns are becoming more commonplace as the rising cost of living deflates the value of the pension dollar and people survive longer. Most pensions are computed from some variation of the following formula:

P = M x A x Y

where

P = Monthly Pension

M = Multiplier Factor

A = Monthly Salary Averaged over Last N Years

Y = Years of Service

The value of M, usually in the range of 0.015 to 0.025, determines the initial 'quality' of a pension plan. Since salaries usually go up with time, as the value of N increases the monthly pension is slightly decreased. The foregoing looks pretty reasonable and assuming that M is reasonable (a large assumption) and monthly salaries were equitable and have kept pace with the Cost of Living Adjustments, the formula should produce a reasonable initial pension. The catchword is 'initial'; the formula says absolutely nothing about the ensuing inflation and its impacts on cost of living and future pension payments.

The impacts of inflation are documented annually by the Consumer Prices Indices (CPI) determined by the Bureau of Labor Statistics (BLS) and the Cost of Living Adjustments (COLA) adopted yearly by the Social Security Agency (SSA). The CPIs are a function of the marketplace, are controlled by no one and barring a depression are unlikely to be less than zero. Many, if not most, pension systems follow the lead of the SSA and adjust their pensions by the annual SSA COLA. These two effects add two important terms to the formula for pensions:

P = M x A x Y x PPAC/CPIC

where

PPAC is the annual Pension Plan Adjustment Compounded over the retirement period

CPIC is the annual Consumer Price Index Compounded over the retirement period

The compounding is given by the repeated product of (1+PPA) or (1+CPI) for each retirement year.

While the above does not account for unusual pension actions such as partial, limited adjustments with arbitrary caps and floors, it will account for the major adjustments and will apply to an individual's past pension where the actions are known.

The compounded CPIs are constantly increasing terms which if not compensated by appropriate COLAs will slowly and inevitably reduce the value of a pension plan with passing time. The intent in the future is often revealed in the actions of the past. The new employee is well advised to be aware of the behavior of the CPIs and ask to see the past COLAs used by the company to adjust pensions. Knowledge of the initial pension payment is not sufficient because employers vary considerably in adjustments for inflation; even multiple contractors for the same government agencies, such as, DOE.