How is the Pension Amount Calculated?
Updated On Aug 30, 2022
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In today's low interest rate climate, a pension is more useful than most people give it credit for. With a pension, you won't have to lower your safe withdrawal rate in retirement like those of us who don't have pensions.
When you retire, you will begin receiving a monthly pension payment based on a formula that takes into account both your pensionable earnings and pensionable service.
Knowing How Your Pension is Calculated
Pensionable earnings for the last 120 months prior to termination, retirement, or death are averaged to determine your greatest average earnings. You will receive a pension based on your best average wages for the plan years in which you have pensionable service, if that number is less than 60. In general, your retirement income will be bigger if you make more money on average.
The sum of all the years in which you or your employer made contributions to the Plan is your pensionable service. It contains any service you may have bought or into which you may have transferred. The total number of years in which you or your employer made contributions to the plan is the number of "pensionable years" you have. All the services you've ever bought or transferred to are included.
Instructions to Calculate the Pension
The steps below outline how a pension is determined:
Step 1: First, calculate the employee's average compensation. The calculation uses the employee's final wage before retirement.
Step 2: The average wage will be largely based on the highest-paid years and 3 years or more based on company policies.
Step 3: Add the salaries and divide by the number of years.
Step 4: Determine the company's pension percentage.
Step 5: Multiply step 3's value by step 4's factor.
Step 6: Determine the employee's years of service for eligibility.
Step 7: Multiply step 5's values by step 6's years to get the pension amount.
Step 8: Divide step 7's value by 12 to get a pre-tax monthly pension amount.
How to Calculate The Amount Of Pension?
The present value of a pension is calculated as follows:
The present value of the pension =
{(Annual pension amount) /(Fair rate of return)} * Percentage probability that the pension will be provided till death as promised.
Let’s understand this better with the help of an example -
Say, Annual pension is Rs.67,500 and 2.55 percent is a good rate of return.
Let the chance that the pension will be paid until death be 95%
Value of pension = (Rs.67,500 / 0.0255) * 0.95 = Rs.2,514,706
For instance, if you are pessimistic and in bad health, you might increase the final value of the pension by 50%. In this case, a pension of Rs. 2,514,706 becomes about Rs. 1,250,000.
If you have a pension, you want to live as long and as well as you can. The more years you live, the more your pension is worth.
For better understanding, let's have a look at one more example:
- A professor is leaving his college after 25 years of service.
Here's another example of how to figure out how much a pension is worth, with some explanations at the end.
- Over the last four years, the average income was Rs. 90,000.
- Annual pension: Rs. 67,500
- The fraction of 2.55% is a reasonable rate of return.
- Chance that the pension will be paid until death: 95%
- Value of pension = (Rs. 67,500 / 0.0255) * 0.95 = Rs. 2,514,706
- What do you think? After 30 years of service, this professor will have a pension worth about Rs. 2,514,706 on top of any other assets he may have. Not bad for someone whose average salary for the last four years of his career was Rs. 90,000.
- Let's say this teacher joined the college when he was 25. He is still young enough that he could start a second job and make more money on top of his Rs.60,000 pension. Talk about the best way to retire early so you can follow your dreams without fear.
Conclusion
One needs to follow the above steps in order to calculate the amount of pension. The average salary will be mostly the highest-paid years and generally an average of 3 years or more.
Also read: Pension Schemes for Businessman
