Have you ever wondered how your pension is calculated? Not surprisingly it’s one of the most common questions from workers with pensions.
If you have a defined contribution (DC) plan, it’s pretty simple – it’s the market value of your DC account balance. However, if you a defined benefit (DB) plan, figuring out how your pension is calculated can be anything but straightforward.
It’s important to understand your pension plan formula because it can mean the difference between a monthly pension of $500 and $2,500 at retirement. My first couple posts set a good foundation for your knowledge about pensions. Now that you have a basic understand of pensions, it’s time to explore just how your employer puts a value on your DB pension.
Let’s take a look at the three most common pension plan formulas – final average earnings, career average earnings, and flat-benefit.
Final average earnings (FAE)
The FAE formula is the Rolls-Royce of pension plans. As the name suggests, your pension is based upon your credited services and an average of your final years of earnings.
Of the three plans, you’ll usually come out ahead with an FAE plan because your earnings are typically the highest right before retirement. FAE plans vary in length – some are an average of your last three years, while others average your last five years.
FAE3 formula example: 1.3% x [($60,000 + $61,000 + $62,000)/3 years] x 25 years = $19,825 per year or $1,652 per month.
FAE5 formula example: 1.3% x [($58,000 + $59,000 + $60,000 + $61,000 + $62,000)/5 years] x 25 years = $19,500 per year or $1,625 per month.
Generally, the FAE3 formula is more generous than FAE5, as it takes an average over a shorter length of time, resulting in a higher monthly pension at retirement.
Career average earnings (CAE)
If pensions were an apartment building, the FAE formula would live in the penthouse, while the CAE formula would live in the unit a couple floors down.
Unlike FAE formula, which takes an average of your final years of earnings right before retirement, the CAE formula takes an average of your earnings over your entire career. This can have a dramatic effect on the amount of pension you’ll receive at retirement.
CAE formula example: 1.3% x [($38,000 + $39,000 + $40,000 + $41,000 + $42,000 + $43,000 + $44,000 + $45,000 + $46,000 + $47,000 + $48,000 + $49,000 + $50,000 + $51,000 + $52,000 + $53,000 + $54,000 + $55,000 + $56,000 + $57,000 + $58,000 + $59,000 + $60,000 + $61,000 + $62,000)/25 years] x 25 years = $16,250 per year or $1,354.
We took the earnings for the same employee, except instead of limiting it to their final three or five years, we included their earnings spanning their entire career. This results in a substantially lower pension ($16,250 with CAE versus $19,825 with FAE3).
The flat-benefit formula is a lot different than the first two formula varieties.
While the FAE and CAE formulas rely on your earnings, the flat-benefit formula uses a flat dollar amount for each year of credited service to determine your pension. Although it’s the easiest formula to understand, it’s also usually results in the lowest pension of the three formulas.
The flat-benefit formula is typically found in collectively bargained plans or plans with hourly workers.
Flat-benefit formula example: $400 x 25 years = $10,000 per year or $833 per month.
As you can see, your pension formula has a big bearing on the amount of pension you’ll receive at retirement. You can usually find out your pension plan formula by reviewing your annual pension statement.
By having a better understand of your formula, you can better plan for the future and have an idea of the lifestyle you’ll have in retirement.