Factoring Pensions Into Your Retirement Plans
If you have a traditional pension plan at work, you have nothing to worry about—you’re retirement is covered, right? Maybe not. The world is changing and like a lot of other things, they’re just not making pensions the way they used to. And even if you do have a pension plan…well, again, the world is changing. Moral of the story: don’t take anything for granted, least of which a pension.
The long and short of traditional pension plans
One of the principal problems with employer pensions is that relatively few people have them anymore. Up until the 1970s most workers were part of traditional plans, also known as “defined benefit pensions”, so named because benefits are based on metrics such as income level and years of service, and are completely funded by the employer.
During the 1970s the government created several “defined contribution plans”, such as 401Ks and IRAs, that are fully funded by the employee and depend largely on the size of the contributions and investment return. While these were welcome creations for the self-employed, few realized at the time that they would eventually replace the cherished traditional pensions that workers had grown accustomed to. Defined contribution plans cost employers less to maintain and fund, and put the burden of retirement planning on the employee. Simply put, traditional pensions are not part of the typical retirement planning profile.
Government employees: the exception - for now
There is one class of employees who are an exception to the pension rule, and that’s government employees. Traditional defined benefit plans are still the order of the day for most employees of government, whether they work at the federal, state or municipal level. While it may be comforting to assume that your retirement needs will be fully met by a government pension, recent events are calling even these into question. Many state and municipal employee pension plans are facing substantial shortfalls to cover future obligations, providing more than a hint that such pension plans will be less generous as we move forward. It’s probably not yet time to panic, but it’s an excellent time to start making some other plans.
Get the full scoop on your employer’s retirement plan
If you do have a traditional pension plan through your employer, the first order of business is to contact your human resources department to determine what kind of income level you can expect at retirement. This is usually based on a percentage of your income, and that percentage increases with the number of years you work for your employer. Once you have that projected monthly income number, you can add it to your expected monthly Social Security benefit to determine if the combination of the two will be sufficient to provide the income level you’ll need to afford the type of retirement you’re expecting. If not, you’ll have to look at defined contribution alternatives, such as traditional and Roth IRAs, to make up the difference.
You don’t control your employer’s pension plan
As great as having a traditional pension plan is, you have to consider that you don’t have any control over it. Your employer has absolute control over a defined benefit plan (subject of course to federal law), and that means that they can change benefit calculations, reduce benefits or even terminate the plan. That last point is critical. Since the 1970s thousands of employers have terminated their traditional pension plans in favor of defined contribution plans. Sometimes they’ll arrange a payout to employees for their portions of the plan to date, but in other cases they can leave the funds in a poorly managed account that will pay meager benefits until the last pensioned employee dies.
Either way, you won’t get the expected monthly benefit if this happens. Still another issue here is that of tenure. Truth is, most employees today don’t (or can't) stay with their employers for the 20, 30 or 40 years it takes to earn a generous monthly pension benefit.
There is also the possibility of your company's pension plan failing. There are some protections in place to help preserve a portion of your pension plan. Whenever possible, you want to ensure you your pension is a portion of your expected retirement income, and not everything.
Watch out for inflation
Inflation is the “X Factor” in retirement planning. No one knows what price levels will be decades from now, but the problem is magnified with traditional pensions. Most private employer pension plans establish a fixed monthly benefit at the beginning of retirement that they’ll pay out for the rest of your life. While that might be very generous in the early years of retirement, you’ll begin to feel the pinch in ten years or so when your monthly benefit just doesn’t buy as much as it did. Government pensions typically have some type of cost of living adjustment (COLA), which at least partially addresses this concern. But again budget problems are becoming a factor, and an even bigger concern is the definition of inflation itself.
COLAs are generally based on the Consumer Price Index (CPI), which is a general purpose index that doesn’t address specific prices. For retirees, for example, healthcare is a major component of a household budget and price levels in that sector are rising much faster than in the general economy. If the CPI is 2%, but your personal rate of inflation is 5%, you’ll fall behind even if you have a COLA provision. Again, some type of supplemental provision needs to be made even if you’re expecting a government sponsored, COLA-adjusted pension plan.
Fund your retirement, and think of a pension as a bonus
Perhaps the best course of action in regard to pension plans is to consider them to be a bonus. Establish and fund self-directed retirement plans, such as 401Ks and 403Bs if your employer offers them, or traditional or Roth IRAs if they don’t. Still another way to prepare for retirement is to build up non-retirement investments (stocks, mutual funds, investment real estate), work to get out of debt and even investigate the possibility of post-retirement career opportunities. A traditional pension is great if you have one, but never assume that your employer has your retirement fully covered. Ultimately, the quality of your retirement is your responsibility first and foremost.
Photo by iJammin via Flickr