Retirement Series, Pensions - Guest Writer BowTiedRetire Takes The Pen
How To Save 6-figures if you have a Pension
This weeks free post is by BowTiedRetire. He has some important news on end of the year deadlines that can save 5- or 6-figures for anyone with a pension (if not you, your parents or other family).
BTR knows his stuff here and is one of the accounts who understands probability, investing, and all things retirement. Shoot him a follow here @BowTiedRetire
Retirement Series - Pensions
Welcome everyone. First off, I’d like to thank BowTiedEffer for letting me contribute to his ‘Retirement with the ‘Tism’ series.
Although it has become the weakest leg of the proverbial retirement Three-Legged-Stool, pension plans still play a meaningful role in the retirement calculations of millions of Americans.
Sadly, pension plans are dying out, and even those lucky enough to have one often have a poor understanding of what they actually have, much less how to get the most value from them. To help remedy that, I’m going to briefly outline how a pension plan works and then discuss the main decision points that plan participants can use to get the most value from their benefits. Remember, even if you don’t have a pension, there’s a decent chance one of your parents does.
TL;DR
Pension benefits are valuable
The value provided is generally poorly understood
Your employer has experts advising them to maximize the value of the plan, and you should too
What is a pension plan?
So first off, what exactly IS a pension plan?
In the simplest terms, a pension plan is a retirement benefit sponsored by an employer that pays a defined benefit to the participant upon retirement (and often death or disability, but we’re going to focus on retirement for today’s post).
Most often these benefits are payable as a monthly check to the participant for the rest of their life. The most familiar pension plan for Americans is Social Security. This is a good starting point to keep in mind when thinking about pension plans.
A pension plan is NOT the same as a 401k plan. In fact, besides being primarily used to fund retirement benefits, the two could not be more different. In a pension plan, the plan sponsor (most often your employer) bears all of the investment risk (and reward). If the market tanks, the plan sponsor is on the hook to make up for the poor investment performance.
In a 401k plan, you’re responsible for your own investment choices, for better or worse. Additionally, a 401k plan tracks your total investment balance, and when you retire, that balance is the money that is available to you to withdraw when and in the amount that you want.
Once you’ve withdrawn all of your money from the 401k, it’s gone. If your money runs out at age 80 and you live to 100, you’re going to be in bad shape. A pension plan pays out benefits over the course of the participant’s lifetime and never runs out prior to death.
Some pension plans allow for a lump sum option at retirement, which we’ll discuss more below.
Maximizing Your Benefits’ Value – When? and How?
So how is the pension benefit determined? Every plan has its own set of rules laid out in a plan document that defines the amount of your benefit, the eligibility conditions to qualify for a benefit, and the options you have to receive your benefits.
While each plan is different, benefits are typically based on your time spent with the employer and either a flat multiple or some percentage of your pay. If you’re still with me, then you’re likely one of the lucky ones out there who has or at least used to participate in a pension plan. Or alternatively, your parents may have a pension and you’d like to be able to help them in some way.
[F’er Note - Like BTR said, think of social security. Your benefit is based on years worked & contributions. More years working & higher salary => larger benefit]
When looking to get the maximum benefit possible from your pension, there are two decisions that can materially impact the value of benefits. These two decisions boil down to “When?” and “How?”
Note that if you have already started receiving monthly benefits you typically will not have the opportunity to change that decision (there are rare exceptions, but that’s beyond today’s post).
The first decision for someone who hasn’t already started their pension benefits is when to “retire” and start receiving benefits. Consider someone who is currently age 55 (this is the youngest early retirement age for most plans) and earning a pension benefit. Under most plans, if they decide to retire they can start their benefits at any age between 55 and 65 (or later if they keep working).
Now if the benefit is $1,500 per month, it is obviously more valuable to get this monthly benefit for life starting at age 55 than waiting 10 years and getting the same benefit for life starting at age 65.
Plan sponsors recognize this fact as well, and as a result nearly always have a reduction factor applied to benefits that start before age 65 (normal retirement age for most plans). These reduction factors vary significantly by plan and can have significant subsidies built in. The decision point here is at what age does the increased value of receiving the benefit for longer outweigh the reduced value from having the base benefit reduced for early retirement?
Unfortunately, this is a fairly complex actuarial determination based on expected future interest rates and mortality assumptions (how long are you going to live?). To further complicate things, more than just math needs to be considered here. For instance, if you’re in poor health and have lots of relatives who died before age 75, you’ll likely benefit from starting your benefit as early as possible. On the other hand, if you had four great aunts who all lived to their late nineties and grandma just turned 100, there’s a good chance you’ll be collecting benefits for a long time and may need to maximize the absolute dollar value of each monthly check by working longer.
The second decision, and the one that can make an even larger difference in some circumstances, is the decision of how to receive your benefits from the plan. Every pension plan offers an option to receive your benefits for the rest of your life (a single life annuity) as well as the option for married participants to receive benefits for the rest of your life as well as the rest of your spouse’s life. Again, this is where reduction factors generally come into play. It is obviously more expensive to pay a benefit until the later of a husband and wife die than it is to pay that benefit until just the husband dies (at best it’s a push).
As a result, most plans have reduction factors for benefits that are payable for the lives of both the husband and wife (this form of payment is listed on election paperwork as a “Joint and Survivor” annuity). Most often the joint and survivor form of payment is the more valuable option, even with the plan reduction factors.
Beyond the selection between a single life annuity and a joint and survivor annuity, some plans offer variations on these options including certain periods (benefits are paid even if the participant and/or beneficiary are dead), pop-ups (benefit amount increases if the spouse dies before the participant), and partial lump sum options.
It’s the lump sum option that really has the possibility of maximizing your pension plan benefits.
The assumptions used for determining the minimum amount of the lump sum option are defined by law and can’t be arbitrarily set by the plan sponsor, unlike the reductions for early retirement or optional annuity forms of payment.
These assumptions use a set of interest rates based on high quality corporate bond yields, and these rates have been extremely low for the last 5-10 years prior to 2022. Since I know you all paid attention when BowtiedEffer laid out the mechanics of the time value of money, you know that using low interest rates to discount a series of cash flows results in a higher present value.
What this means in plain English is that when interest rates are low, the lump sum option is often more valuable (sometimes much more) than the associated stream of annuity payments.
For a variety of reasons, the option of receiving your money NOW can be very attractive.
Beyond mathematical considerations, the freedom of having control over your funds instead of having someone else slowly dole your money out to you has obvious appeal.
Now imagine for a minute that we find ourselves in a situation where CPI is running at 8%+ with no clear end in sight. In such a hypothetical situation, any money you receive from the plan in a year from now will be worth 8% less than if you’d received it today. To rub additional salt in the wound, you weren’t able to invest those funds because someone else was holding them for you. Now extrapolate that out for 5, 10, or 20+ years. That $1,500 at age 85 doesn’t seem so valuable compared to having $1,000 in your hands today, does it?
Does that mean that you should always take your pension benefits as a lump sum if given the option?
Unfortunately, while it often makes sense to do so, that isn’t always the case. Some plans use a different (and more punishing) set of reduction factors for lump sum purposes that ignore early retirement subsidies.
Additionally, you have to know yourself. If you’re going to rush out and spend your retirement savings on a new bass boat and then find yourself destitute in ten years, the forced discipline of monthly pension checks can be beneficial. I’d still probably lean towards getting your own money now vs later, but that’s a personal preference (you’re going to be feeding yourself from all the fish you catch from that awesome boat, right?).
What you need to do NOW
All that’s great, but why is it so important NOW?
The short answer is that 2023 brings a “Great Reset” to the lump sum interest rates for most pension plans. This isn’t another nefarious WEF plot, but it can cost you a few bitcoin worth of cash.
Retiring in 2022 instead of waiting until 2023 can result in a lump sum that is 30-40% larger – this can be well over a $100,000 difference for someone who has worked at the same place for a long time.
Realistically, anyone on the fence about retiring has about 30 days (and earlier is better here) to decide to pull the trigger in 2022 and qualify for a December 1, 2022 payment date. If you (or one of your parents) sleep on this you’ll get pushed to January 2023 and end up with a significantly lower lump sum benefit.
If you’re confused by any of this, reach out. Don’t just keep scrolling or put your head in the sand. Real money is at stake, and timing is tight.
Parting thoughts To avoid having to split this into two posts, I’ll quickly sum up the high points related to pension plans. First, they are a valuable retirement benefit, and you should be thankful if you have one.
The mechanics behind these benefits are difficult to understand, and most participants don’t appreciate the value of what they have (the value of $1,500 per month for life is much more difficult to conceptualize and determine than opening up Fidelity and seeing your 401k balance of $250,000).
Because of this complication, there are opportunities to affect the value of your benefits based on WHEN and HOW you take them. If you or one of your parents are coming up on one of these decisions, or if you just want to better understand the benefits available to you from your plan, reach out.
Wrap-up
F’er back. Thank you BTR for the great post on pensions. End of the year always leads to inefficiencies as benefits of all sorts roll over into updated numbers. BTR is a G so take him up on the offer to chat if you have specific questions on pensions. (and again, lots of good info on retirement so you’ll want to shoot him a follow on twitter)
Later this week our paid post is going to be answering our latest twitter poll question. Go Vote before it closes, then read the comments as some astute readers nail it (BTR being one of them).
Good Luck Anon