How to calculate net present value of a future pension

Written by michelle friesen
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How to calculate net present value of a future pension
A nest egg can include a pension, which requires some calculations to determine its present worth. (Hemera Technologies/AbleStock.com/Getty Images)

Retirement planning is a planning method to determine how much money you will need in order to retire comfortably. When organising and planning for retirement, determining the actual current monetary value of your accounts requires a certain amount of work. This is especially true for pensions and annuities. However, with a little information about a pension and a few calculations, you can estimate the current value of the monthly or yearly income. Determining the present value of a pension requires two calculations: first, determine the value of the pension at the time of retirement, then determine the present value of that amount of money.

Skill level:
Moderate

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Instructions

  1. 1

    Write down the amount of each payout, how often it occurs and the year at which it will start to pay. For instance, most pensions are paid monthly, but yours could pay yearly. Also make an estimate of how long you expect the payment to be made. If you expect to retire at age 65 and live until you are around age 85, then you expect to receive the pension for 20 years.

  2. 2

    Calculate the value of the pension at the time of retirement using the following equation:

    PV = PMT * [ 1 - (1 + i) ^ -n ] / i

    Where: PMT = yearly pension payment i = yearly interest rate (if unknown, use an estimate) n = the time period in years PV = present value

    If you plan to retire at age 65, expect to receive £7,800 per year in retirement from a pension and expect to live until age 85 on the pension, then the values would be:

    PMT = £7,800 i = 5 percent (you would need to use an estimate since the rate is not given) n = 20 years PV = £7,800 x (1 - (1.05) ^ -20) / 0.05 = £97,205.24

  3. 3

    Discount the rate to your current age. If you finished step two with an age of 65 but you are currently only 40 years old, then you will need to determine what the current value of the pension is. The value found in step two is the value the pension will have when you reach age 65.

    This formula gives the present value of a set amount of money:

    NPV = CF/(1 + r) ^ n

    Where: NPV = net present value CF = cash flow r = interest rate n = time in years

    Using the previous example, you would find:

    NPV = £97,205.2 / (1.05) ^ 25 = £28,704.97

    In this step, the value of n changes to the number of years until you reach your retirement age, which was set at age 65 in the beginning of this example.

Tips and warnings

  • If you receive a pension monthly, which is common, the same equations can be used; simply convert all values into monthly values. For example, "n" is currently given in terms of years, so to find the value in terms of months multiply it by 12. Additionally, "i" is given as an interest rate per year. In order to use it for a monthly pension, divide "i" by 12. This will give you the amount of interest accrued each month.

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