How Much Difference Does a Pension Make in Retirement?

 

Today, I’m going to tell you a story about two retirees, Average Andy and Pension Pete. Each is 55 years old, earns the same salary, and saves the same amount each year.

However, there’s one difference between them: Pension Pete has a pension, while Average Andy does not.

We’d expect retirement to be easier for Pension Pete, but how much of a difference will a pension really make? Let’s find out. And be sure to read to the end where I discuss the slow extinction of pension plans in America.

Do Pensions Still Exist?

Today, around one in five workers participate in a pension plan, including 76% of state and local government workers and only 12% of private-sector workers. When the legislation creating the 401(k) plan was passed in 1978, private companies began a decades-long process of moving away from traditional defined benefit pension plans. Consequently, workers today are increasingly dependent upon their own retirement savings efforts.

According to the Pension Rights Center’s 2019 data, the median private pension benefit was $10,788 per year. For public sector employees, the median pension benefit was much higher. For Federal workers, it was $27,687 per year; for state and local government workers, it was $22,662 per year.

For our example, we’ll say that Pension Pete has a modest pension of $1,000 per month when he turns 65 years old. Will such a small pension make a big difference?

Assumptions

For simplicity and consistency, we’ll use the same assumptions we’ve made in prior blog posts in our calculations. Inflation will be 3% and our expected portfolio returns are 7%.

For income, we’ll assume they make $90,000 per year. To estimate their Social Security, we’ll simply input Andy and Peter’s income into the Social Security online quick calculator to arrive at a monthly benefit. We’ll also assume their stay-at-home spouses are eligible for spousal benefits.

As for retirement portfolio income, we’ll again use the 4% Rule. While there are limits to the 4% rule, it’s great for these kinds of back-of-the-napkin calculations.

Living Expenses

For both Andy and Pete, we’ll assume they save 7% of their gross income into a tax-deferred retirement account and 2% into an after-tax savings account.

pension assumptions web

After we calculate and pay taxes, let’s assume they spend what’s left. That leaves just under $6,000 per month in spending for each of them.

Retirement Savings

To determine what Andy and Pete will need to save each month for retirement, let’s make some assumptions about what they’ve saved up to this point. Let’s say they have:

  • Cash Accounts: $ 20,000
  • Stocks & Mutual Funds: $ 50,000
  • Retirement Accounts: $ 300,000
  • Total Investments: $ 370,000

The only real difference between Andy and Pete’s financial position will be Pete’s pension.

Total Savings Needed for Retirement

If Andy and Pete plan to retire in ten years, how much will they need to have saved between now and then? Let’s say that both of our retirees have a goal to keep their same spending levels in retirement. In other words, we’re not going to reduce their living expenses in retirement in this case. For both Andy and Pete, their monthly living expenses jump from just under $6,000 to just over $8,000 per month at retirement, thanks to inflation.

Of course, Social Security benefits will increase annually with a cost-of-living adjustment. For simplicity, we will assume that Social Security payments increase at the rate of inflation as well.

pension portfolio needs

For Average Andy, that leaves a shortfall of $3,756 per month that his investments will need to provide. Using the 4% Rule, we find that Andy will need around $1.13 million for retirement in ten years.

How does a pension affect these numbers for Pension Pete? Since he’ll be receiving $1,000 per month from his pension, the monthly income required from his investments drops to $2,756. Using the 4% Rule, we find that he will need a retirement portfolio of approximately $827,000 in ten years.

By the way, if you want to run these calculations for yourself, I’ve created an inexpensive, downloadable spreadsheet you can find at pranawealth.com/resources. You can even add pension income, just like we’re discussing today.

How Much Will They Need to Save?

Now that we know how much they’ll need in ten years, are Andy and Pete on track? Based on our assumptions, Pension Pete is good to go. He’ll have a little more than he needs when he retires in ten years.

However, Average Andy still has some work to do. If he wants to keep us his current spending in retirement, he’ll need to save another $1,600 per month. That’s almost $20,000 per year between now and retirement. That may not be feasible.

pension savings required

So, what happens if Andy is open to reducing his spending in retirement? How much will he need to cut back after he retires to make these numbers work? If we go back and update the math, we find that he’ll need to reduce his retirement expenses by 12% to make the numbers work. That’s completely reasonable.

According to these calculations, both Andy and Pete can make retirement work. But that small pension is the difference between keeping your current lifestyle and needing to cut back in retirement.

As we know, the 4% Rule has limitations. If we run a Monte Carlo analysis for Average Andy and Pension Pete using this data, we find that Pete has a very high 90% probability of success, while Andy’s probability of success comes in at 67%. That’s not terrible, but it means that Andy will have to be much more diligent with his budgeting and investment strategy during retirement as we’d expect. Of course, these numbers don’t factor in one-time expenses like home improvements, car purchases, nursing home costs, or simply changes in their retirement spending as they age.

pension monte carlo probabilities

Pensions Make a Difference

In comparing Average Andy and Pension Pete, we see that even a modest pension can make a big difference when it comes to retirement. Unfortunately, many private companies eliminated their defined benefit pension plans years ago. Not only are pensions expensive to administer, but the company also retains all the risks associated with the investments and payment obligations.

As soon as 401(k) plans became popular in the early 80s, private companies started shutting down their defined benefit pension plans. It was completely logical on their part. However, this took the costs and risks of retirement planning and put them squarely into the hands of the employees.

While public sector pensions are still widespread, they’re subject to risk too. Unsurprisingly, many states’ pension funds are woefully underfunded. Frontline ran a great documentary about Kentucky’s state pension fund in 2018 that illustrates the problem. I highly recommend it.

Since the legislation that created the 401(k) was passed in 1978, pensions have marched ever closer to extinction. At the time, it was impossible to understand how this slow-motion extinction event would impact retirement planning for Americans. Few workers understood the burden of preparing for retirement suddenly thrust upon their shoulders.

It’s one more reason to bring retirement planning to the front and center of our attention.

If you need help figuring out how much you’ll need to save for retirement, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.

As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.


The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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