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Back in the good ol’ days, pensions were offered by many employers as retirement plans for their dedicated and hardworking employees.
The deal was, if you worked for a certain number of years, then you’d receive a guaranteed continuing income once you were ready to hang up your hat and retire.
Fast forward to modern times, where we find corporate and private employers not as generous as they were before. In fact, today, only 15% of private-sector workers have access to typical defined benefit pension plans, according to a 2020 National Compensation Survey from the Bureau of Labor Statistics (BLS). However, some public employees, such as teachers, police officers, firefighters, and railroad workers, still often have access to pension plans.
If you have a pension, then you’re in luck because it can be an especially beneficial source of financial security in retirement. But why? What makes a pension any different from any other type of retirement account, like a 401(k) or IRA? The answer is in how a pension provides your income.
Unlike a 401(k) or IRA, a pension offers a steady stream of payments that isn’t dependent on the market performance of your investments. So, regardless of what happens with the S&P 500 or your favorite stocks, you’ll have a guaranteed source of retirement income.
Not all pensions are created equal. And each plan has specific rules and payout guidelines. So, here’s what you should know about retirement pension plans and how they are often calculated.
Pensions can be broken down into a few different types based on how the plan is funded and how the benefit is paid to you when you retire. Here are popular options that may apply to you.
When most people think of a pension, usually the defined benefit plan is what comes to mind. In a traditional defined benefit plan, the benefit you receive is based on a formula that typically incorporates the number of years you worked for the company, your salary, and a benefit percentage. We will take a deeper look at the formula in a moment and go through an example.
You’ll generally have a few options to choose from when deciding how the benefit is paid. The standard payout is a fixed monthly payment for life. Other choices often include a survivor option that would provide a continued payment to a surviving spouse.
In addition to a traditional defined benefit plan, some pensions are cash balance pension plans. The main distinguishing feature that sets a cash balance pension plan apart from a traditional defined benefit plan is that the “defined” part isn’t a payment stream. As you may have guessed from the name, the benefit is a cash balance that is available at retirement. The final benefit balance is still based on a formula, just like it is with a traditional pension, so your benefit still isn’t dependent on market performance.
If you have a cash balance plan, you’ll likely have the choice to either take the money as a lump sum or purchase an annuity that offers a payment stream in a similar way that a traditional defined benefit pension plan would.
Defined contribution pension plans don’t provide a promised benefit amount at retirement. Instead, they guarantee that contributions will be made to an account based on a particular funding formula. Once the contributions have been made, employees can invest the money in a similar way to how IRA contributions are invested.
One potential drawback to a defined contribution pension plan is that the investment risk falls to you, the retiree. If the investments do poorly, you will not have as much money available to retire with. Of course, if the investments perform exceptionally well, then you would receive a larger benefit.
A pay-as-you-go pension plan is funded by employee contributions, and those contributions and the returns they generate are what will ultimately determine the benefit amount at retirement. Typically, when a non-governmental employer offers a pay-as-you-go plan, the employees get to decide how much they contribute and how they invest those contributions.
Public pay-as-you-go pensions, on the other hand, will often establish the amount that participating employees must contribute.
In either case, a pay-as-you-go pension plan is different from a benefit received due to a pay-as-you-go funding formula. An example of a benefit based on a pay-as-you-go funding formula that you may be familiar with is Social Security. Your Social Security retirement benefit isn’t funded by your contributions, but by the contributions of those currently working and paying into the system.
Because a defined benefit plan is the one we most often see, we'll focus on this type of pension for determining calculations.
Keep in mind, the details of each plan's calculation may differ; however, a common formula structure that many pensions follow consists of three parts:
Here’s how each of these factors is determined.
The length of time that you worked with the employer is usually expressed in years. This may seem straightforward, but you’ll want to make sure you understand how your plan counts a year; there are actually several different ways it can be done. Those ways include:
Don’t worry, there’s no need to study each method. You don’t really get a say in which option is used. The point here is to understand that if you don’t know how your plan counts a year, then that is certainly something to look into.
The formula will also incorporate some measure of your salary. The most common practice is to take an average of your final three or five years of employment. Assuming your salary has gradually increased over time, then averaging your last several years would hopefully result in a larger benefit base.
However, some plans use your highest three or five years. While those might be your final working years, that isn’t always the case.
The next element of the benefit formula is a multiplier expressed as a percentage to be applied to the salary figure. The typical range for the benefit multiplier is 1% to 2.5%, but your plan will plainly state the relevant value in your plan documents.
Sometimes, there may be more than one multiplier, and the plan applies each to a different range of creditable service periods. For instance, your pension may credit you with 1.7% for each of your first 10 years of service, but then credit you 1.2% for each additional year.
Now that we’ve laid out how a typical pension formula works, let's look at a nifty example. For the sake of the illustration, let’s say you’ve been credited with 35 years of service at your employer. Your pension benefit is calculated as 2% of the average of your final three years of service for each year you worked.
Your salary for each of your final three years is $105,000, $108,000, and $110,000, giving you a three-year average of $107,666.67.
Your benefit would be:
35 x 2% x $107,666.67 = $75,366.67 per year or $6,280.56 per month
Not too shabby!
Most pensions will allow you to either take your benefit as a monthly payment or all at once as a single lump sum payout. This is not a decision to be taken lightly.
If you choose to take the lump-sum upfront, the amount you receive will be the present value of your monthly payout option. You can roll that money into an IRA or simply take it as cash. However, if you do take the distribution as cash, you’ll have to pay income taxes on the entire balance all at once. Depending on how large your lump-sum is, that could create a hefty tax bill and even push you into a higher marginal tax bracket for the year.
If you choose to take the payout, you’ll likely have a few options there, too. Common payout options include:
So, this begs the question: Should you take the lump sum or the monthly payments? Well, that’s really up to you, depending on your needs.
You’ll want to consider how stable your other sources of retirement income are. Are most of your retirement savings dependent on market performance? If so, then the monthly payout option could be an excellent way to diversify your income and lower your retirement income risk. If you already have a solid foundation of retirement income, either from Social Security or an annuity, then the lump sum option could start to make more sense for you.
Of course, you don’t want to forget about taxes when thinking about your payout options.
Pension benefits are taxed as ordinary income when you receive the payment. That’s true whether you choose the lump sum or the monthly payout. Taking the monthly payout is a way of deferring taxes because you are only taxed on the value of payments received for the year, just like income.
Pensions can offer great retirement benefits. Getting the most out of your pension will require a little bit of leg work in making sure you understand how your benefit is calculated and how it fits into your total plan for generating income in retirement.
Working with an advisor who is familiar with not only pensions, but the details of your specific plan may help you identify the best course of action — the details can vary widely from plan to plan. For example, local government employees in one state or county may have very different pensions from the city employees down the road. University systems often have their own pensions with unique characteristics, as well.
At One Tree Hill Investment Advisors, we are well-versed in how pension plans work and may help you choose the best payout option for your needs, given all the aspects of your retirement plan and future goals.
We’d be happy to discuss your options with you and help you make the best choice possible. To learn more about how retirement planning can help ensure a smooth transition into and through retirement, watch for additional posts and planning tips in the weeks ahead, or contact us anytime to talk about your planning needs.
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