Price on Your Head

Jonathan Clements

WE’RE WORTH SO MUCH more than the value of our homes and our financial accounts. But how much more? Forget your car and household possessions. Unless you have a Chagall hanging in the living room, it’s safe to assume all this stuff will depreciate and eventually be worth little or nothing.

Instead, our three assets with potentially significant value are our regular paycheck, our Social Security retirement benefit and any traditional employer pension we’re entitled to. Admittedly, question marks hover over each. What if we lost our job, Social Security benefits were cut or our employer got into financial difficulty?

Those are reasons to discount the value of these assets, but not to ignore them entirely. Indeed, we should factor these three assets into our portfolio’s stock-bond split—and knowing their worth can be a source of solace when stocks plunge and home prices take a hit.

But how should we value them? Each is a stream of future income for which we can calculate a present value—with the help of an annuity pricing service.

For instance, a paycheck is like a “period certain” immediate annuity, paying income for a fixed number of years. Insurers sell such annuities, typically with a maximum payout period of 25 years. Over the payout period, you’ll get back your initial investment, plus a certain amount of interest. One important difference between your paycheck and a period certain annuity: Your paycheck will likely rise with inflation and probably also with merit increases.

Meanwhile, Social Security is like an inflation-indexed immediate annuity—or, if you aren’t yet retired, an inflation-indexed deferred annuity, meaning payments don’t start until some future date. A traditional pension plan is similar, except most pensions aren’t inflation-linked.

Now, imagine you’re a 45-year-old woman, live in Maryland, earn $70,000 a year and plan to retire at age 65. At that juncture, you figure you’ll receive $20,000 a year from Social Security and $12,000 a year from a traditional employer pension.

Based on numbers I pulled from, the $70,000 a year for 20 years would cost almost $1.1 million if you purchased a 20-year period certain immediate annuity. Meanwhile, the $20,000 a year starting two decades from now would cost some $250,000 today if you bought an inflation-indexed deferred income annuity, and the $12,000 a year starting two decades from now would cost some $90,000 if you purchased a deferred annuity with fixed payments.

These crude estimates tell our hypothetical 45-year-old what she is worth today: an additional $1.4 million on top of whatever her home and financial accounts are worth, minus any debts. They don’t tell our 45-year-old what she’ll be worth upon retirement. That will depend, in part, on how much of her income she manages to sock away between now and age 65, how much her investments increase in value and whether she pays down any debt.

As our 45-year approaches age 65, her stream of paychecks will come to an end and have no value. But her Social Security and pension “annuities” will be worth more—not because their expected payments have necessarily increased, but simply because they’re closer to the time when they’ll start generating income. Indeed, our now 65-year-old might count the present value of her Social Security and pension annuities as part of her bond holdings—and take that into account when she decides how to split her financial accounts between stocks and more conservative investments.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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