Discount Rates

Balian of Ibelin: How much is Jerusalem worth?
Saladin: Nothing...  Everything!
--Kingdom of Heaven

As previously noted, I'm currently pondering a lump sum buyout offer from a previous employer's pension plan. There are many factors to take into account when deciding whether to take a lump sum or stick with the monthly payout. Some of these factors include life expectancy, size of the pension compared to other prospective retirement income streams, desire to manage retirement funds, financial health of pension plan, and number of years remaining before monthly payments would kick in.

Another factor that is vital to consider is known as the discount rate. The discount rate is the interest rate used to calculate the present value of future annuity payments. It is usually based on an estimate of yields that can be obtained from so-called 'risk free' investments. Theoretically, if you can get, say, a 4% annual return on a particular investment instrument with little or no potential for loss, then that return provides a good benchmark for evaluating the attractiveness of other investment alternatives.

For better or worse, many people regard the 10 Year US Treasury Note as such a risk free investment. This is because people tend to believe that, no matter what, the US government will make good on its bond payments. As such, the risk free discount rate commonly employed in determining how much a future stream of monthly pension payments is worth today is the yield on 10 Year Treasury bonds. A long term graph of 10 Year yields appears below.

Here is the issue: what yield to choose for the discounting operation? The most recent one? An average of the last 20 years? An extrapolation of the current trend? It turns out that in present value calculations, the lower the discount rate, the larger the present value of a future annuity stream. As you can see from the graph, 10 Year T-Note yields are near historic lows. Using current 10 Year yields as the discount rate will cause the present value of a pension to look unusually large.

Let's consider an example. Suppose that you've just turned 65 years old, and you can begin drawing a pension of $1000/month. You expect to live till age 85. How much is that income stream worth today in a lump sum? Using the current 10 Year Treasury yield of ~ 1.7%, the present value of that twenty year monthly income stream is about $206,800. What happens if we use a higher discount rate? Well if we use a 3% rate--a level that 10 Year yields were at just one year ago--then the present value of the pension declines to $185,700--about 10% lower than the initial estimate above.

Here are some historical average 10 Year yields (source here):

Last 10 yrs: 2.43%
Last 20 yrs: 3.47%
Last 30 yrs: 4.54%
Since June, 1984 peak: 5.26%

If we were to use the avg 10 Year yield for the last 30 yrs in our example situation, then present value of twenty year monthly pension falls to about $164,700--20% lower than the value estimated using current 10 Year yields.

Hopefully you get the message: choice of discount rate matters. Higher discount rates result in more conservative estimates. In my personal pension analysis, I want to err to the conservative side.

Another thing that we need to discuss related to this matter: inflation. Coming soon...