By Brad Wright
Looking back, workers from earlier generations tended to remain with the same employer for most, if not all, of their careers. Retirement would arrive with a cake, perhaps a watch, and a monthly check for life. It didn’t matter if you held a corporate, union, or civil service job. I hail from a family of civil servants. My father retired as a fire chief. My uncle was a police officer turned fire fighter. My brother is a fire lieutenant.
You can imagine that I’ve heard a lot over the years about the almighty pension that will support families after retirement at age 55. Yes, 55! The goal was to get 30 years of service in as close to age 55 as possible and then retire.
A critical question (that none of them has ever asked me) is, “Will my pension be enough to support me and my family?” My response would be that it probably would not. Of course, there are several variables, including lifestyle and expected life span post-retirement, but in many cases a pension alone will not be enough.
The concept of a pension can be elusive. A pension is a fund into which a sum of money is added, by an employer, during an employee's working years. During retirement, the individual draws payments from the fund in either the form of periodic payments for life or a lump-sum distribution. A pension is a "defined benefit plan," where a fixed sum, or benefit, is based on salary and number of years worked.
Don’t confuse this with a "defined contribution plan," where the employee is typically the primary contributor and retirement payments will vary depending on how much was contributed to the plan as well as how the investments performed. For the purpose of this article, the focus is on defined benefit plans: the fixed-sum regular payment.
The pension idea sounds like a good deal, however, unlike previous generations, only about 10% of U.S. companies offer any type of pension today. Civil service and union jobs typically continue to provide them but most companies no longer want the financial burden of pension plans. With interest rates so low and people living longer, funding requirements are much higher than they once were.
So, let’s say you’re one of the lucky ones who will receive a pension payout when you retire. If you’re like my father, you may think you’re all set and that your pension will cover your retirement living expenses with no need to save anything additional.
Let’s do a quick calculation. I’ll use a Massachusetts example from FireRescue1.com, which is based on someone who retires at age 57 with 30 years of service.
· We’ll assume the average of the five highest earning years was $70,000.
· The benefit factor (percentage of salary received for each year of service) is 2.5%.
· The equation is 2.5 x $70,000 x 30 = $52,500 or 75% of salary for the first year of retirement.
Receiving 75% of salary, without working any longer, sounds pretty sweet, but it’s important to account for a few other points:
Inflation: Only a small portion of the annual payout will be indexed for inflation. In Massachusetts, the State legislature decides on the annual Cost of Living Adjustment (COLA) for eligible retirees. For FY 2020, the recommendation by the Governor, the House, and the Senate was a 3% increase on the first $13,000 of a member's annual pension benefit. That means $390 or an extra $32.50 per month. As retirees live longer, pensions don’t keep up with inflation and that results in lost purchasing power, meaning what is affordable initially will inflate faster than the pension income.
Social Security: Retirees with a pension may or may not also receive Social Security. For example, Civil Service jobs normally do not pay into Social Security, so retirees with Civil Service pensions will not be eligible. (See Windfall Elimination Provision and Government Pension Offset.)
Marital Status: If you’re married when you retire and would like your spouse to continue receiving your pension after your passing, your annual $52,500 will be reduced because of the presumed longer payout period.
If you’re squirming a bit, there are steps you can take now to mitigate potential pension shortcomings. The best thing you can do is take personal responsibility to save additional money. Many pension-providing employers also offer a defined contribution option in the form of a 401(k) plan or 457 plan. These are retirement accounts that employees can contribute to directly from their paychecks. The money grows with taxes deferred until you take distributions from the account during retirement, then ordinary income tax applies. If you take distributions prior to retiring and before age 59 ½, you will also pay a penalty.
If your employer does not offer a defined contribution plan, you can open an IRA (Individual Retirement Account) at any custodian or bank. Whether or not you get a tax break for contributing to your IRA will depend on your income. Don’t skip your due diligence on fees and costs to help determine where to open the account. You could also simply open a savings account at a bank, but banks aren’t offering much interest these days.
The bottom line is that we all need financial education and the ability to take care of ourselves. The days of someone else completely covering our retirement are nearly gone. Don’t wait until you retire to find out that you could and should have been doing more for yourself all along.
About the author: Brad Wright
Brad Wright, CFP®, is co-founder of Launch Financial Planning, LLC, a fee-only fiduciary firm located at 2 Dundee Park, Suite 303-B, Andover, MA. 01810. He is also a frequent contributor to WCVB-TV and Mix 104-1 Radio. Brad is Chapter President of the Financial Planning Association of Massachusetts. Learn more about Brad at www.LaunchFP.com
The opinions penned here are for general information only and not intended to provide specific advice or recommendations for any individual.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Any opinions are those of Brad Wright.