I recently worked with an individual who was going through a tough divorce.
Things were getting messy, and part of that mess was his state pension. This individual was well paid and had worked for 40 years, which meant he had built up a nice six-figure pension.
When a pension is part of a divorce, the individuals must figure out the present value of the pension.
In simple terms, the present value of a pension is how much liquid money an individual would need to provide the same income as a pension.
For example, let’s say an individual has built a pension benefit of $50,000 per year.
If an individual without a pension would like to have that same income, they would need to have saved $1 million. The present value of that pension would then be $1 million.
The above example is just a rough explanation. Other factors are used to figure the present value. Individuals usually hire professional actuaries to calculate the present value of pensions.
Figuring the present value of a pension is important because it will be a huge factor in the divorce negotiations.
If an individual decides they would rather have liquid assets versus a pension they will use the present value to help determine assets division.
The individual I worked with was surprised to learn his pension had a present value of more than $2 million. He was very committed to keeping his full pension and using other assets to pay his wife.
This desire created a problem.
To keep his full pension, he would be forced to give his wife every cent of liquid assets and take out a loan on his home.
This creates a predicament that we often call being pension rich and cash poor. This occurs when an individual relies mostly on a pension for their retirement yet lacks liquid assets.
This is a problem because life happens.
Individuals will always encounter issues that require substantial outlays of cash. Home maintenance, car problems, health emergencies are a few of the examples that may require cash.
I usually advise people with pensions to do their best to have $100,000 in liquid assets. Of course, this number can be much higher depending on needs.
If you find yourself in this scenario, set up your budget to allow for savings to build more liquid assets. Budgeting and liquid assets will also help you prepare for a possible pension benefit reduction.
Experts debate the likelihood of pension benefits being reduced in the future; I tend to think they will be.
Most pensioners in California get paid from either the teachers’ pension or the state workers’ pension, both of which are underfunded by billions of dollars. Before you panic, you should know that most pensions are underfunded.
There are worse financial predicaments you can be in than being pension rich and cash poor, but with proper planning and budgeting, you can avoid this problem.