Don't put all your eggs in one basket, even the pension backet.

Don't put all your eggs in one basket, even the pension backet.

What is a pension?

A pension, also called a defined benefits plan (which provides a defined monthly payment or benefit versus a 401k which employers contribute to, thus a defined contribution plan), provides a set of cash flows over a period of time.  Most pensions pay money on a monthly basis, and is funded by employers and employees to differing degrees.  This type of arrangement is also called an annuity if you pay the cash value for the future stream of monthly (or annual) payments.

The differences between an annuity and a pension is usually in who is the primary funder of the monthly cash flows and whether or not you (or your heirs) have access to only the cash flows or the entire amount.  Generally a pension only provides monthly payments during your lifetime, whereas some annuities and insurance products will have some left over cash that can be used or inherited (call residual value).  It is possible for married couples (and usually domestic partners) to have what is called a survivor option that allows the payments to continue for the life of the spouse as well, but the monthly payments over the entire time period (both for you and your spouse) are lower because of the math that at least one of you will live for a significant amount of time.

No pension? Make your own!

No pension? Make your own!

How do you create your own pension?

As mentioned above, a pension is just another name for a defined benefits plan and also for an annuity.  An annuity is usually the term for a payment now for a series of cash payments in the future.  In the most simple terms, the value of an annuity is equal to the discounted future cash flows.  What this means is that there is a price now for a series of payments in the future, because of inflation each future cash flow is assumed to be worth less, so eventually that future cash flow doesn’t change the price of an annuity much.  Think of the last payment of your mortgage.  In 30 years, it hopefully won’t seem nearly as much because of your additional earning, and specifically because of inflation making the value of each dollar worth less.  You can purchase these from insurance companies and other firms that specialize in annuities.  For more money now, you can also inflation protect your future cash flows.  Many pensions have this feature built in automatically (much like social security in the US and various state pension plans both in the US and in the United Kingdom and other various parts of Europe).

Some alternative methods to create a very pension-like set of cash flows in the future are via dividend paying stocks, bonds or other lending (such as person-to-person lending), and rental properties.  All these have the exact same set of features as a pension plan, however they generally are not government insured or guaranteed like pensions are.  Dividend paying stocks generally have an inflation protection mechanism built in, as many companies increase the dividend they pay each year.  Sometime this will be greater than inflation, and other times not.  Finally, rental properties, either residential or commercial, have the same properties.  Rental increases generally keep pace (at least) with inflation.  All of these, rental real estate, lending or bonds, and dividend paying stocks, require an investment now in order to produce those future cash flows.

What to retire early?  How?

What to retire early? How?

How to retire early?

The most basic answer to this is that you can retire when your expenses are fully covered by all the interest payments you receive, pension or annuity income received, and draw-down in investment accounts.  The trick to this is knowing exactly how many payments you’ll need (basically how long you’ll live) and knowing how much return you’ll receive via interest and capital appreciation.

The best we can do when planning for retirement and knowing whether or not we can retire early is to estimate each of the areas above, and then make sure we have a large enough margin of safety to account for our errors in the planning process such as faulty assumptions, things happening that were unexpected, and the expected average happening in a sequence that we can’t withstand.

  1. When we say margin of safety for error, this means being conservative overall when we are building our plan.  Think that 8% returns are the historic norm and will apply going forward, maybe use 6% instead.  Think that you can get by on 60% of your current expenses?  You should probably try 80% or 90%.  Think that you’ll build your nest egg big enough saving 10% of your paycheck?  Be conservative and try for 15%.  These type of planning ideas will keep you from eating cat food (and your cat) when your old and out of cash.
  2. In addition to being conservative, having a cushion for the unexpected will help immensely.  Thinking back over the last 15 years, the market has fallen by 50% twice.  Those types of declines aren’t supposed to happen in a market that follows a normal distribution curve.  Plan for the unexpected to happen, just like the boy scouts.
  3. Finally, as mentioned above the market has fallen 50% twice in the last 15 years.  If you choose to retire in the year 1999, then simply because of luck (or lack thereof) your retirement accounts likely didn’t provide you any capital appreciation in the last decade.  Even if the next 40 years provide the “average” return, because of the sequencing of those actual returns, you’ll likely need to go back to work as a Wal-Mart greeter.
Retirement of your dreams, or nightmares?

Retirement of your dreams, or nightmares?

Follow the above recommendations and you too can retire early, whether you’re receiving a state pension, a federal pension, or a pension of your own making.  Hopefully you’re one of the lucky ones that still has access to a pension.  If you’re looking for an employer that still offers defined benefits, you’d be wise to look for employment in various types of government.  This includes federal, state, county, city, and various utilities and transportation providers.  Some private companies still offer these as well.  The question for both however, is whether or not those pension plans are well funded.  Many are not, so even if you do the best you can right now, the future is still uncertain and as such, a pension should not be your only source of retirement income.

 

Readers, what are your thoughts on pensions?  Do you have one?  Do your parents?  Are you planning conservatively for retirement or do things need to work out perfectly?

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24 Responses to How to retire on a pension?

  1. WorkSaveLive says:

    I don’t have a pension but I surely wish I did! It’s such a huge benefit and most of the people that I work with for retirement planning (that have one) are doing great!

    About annuities – there are a FEW companies that offer increasing monthly payments (to help adjust for inflation). I know of one that offers a guaranteed 3% “raise” each year and I know another that is tied to a market index (S&P500 for example) and if the index increases then you’re going to get a raise as well that’s locked in for life.

    The only caution with annuities and retiring early is that MANY of them have rules about withdrawing money before 59 1/2. The reality is that most annuities are IRA’s which means you’ll have an early withdrawal penalty if you touch it before that age.

    • Karl says:

      No doubt that the inflation protected annuities are very expensive if you’re out in the market trying to purchase one. And yes there are many rules and tax implications when dealing with annuities and other insurance products.

  2. Bichon Frise says:

    I’ve never thought about dividend stocks as being a replacement for an annuity. They each have their own risks, but they are different risks. I would much rather have an annuity with a COLA than a DRIP.

    The fact is, annuities are expensive right now. But, I would still buy one if I was looking to retire early mainly for a foundation to cover basic expenses in retirement. I would happily swap consistency with the volatility the market brings.

    • Karl says:

      There are definitely various risks for all the different types of income and cash flow products. And yes, with rates so low, annuities are quite expensive right now. Which means that if you’re offered a lump-sum payment for early retirement or other reasons, you’re in luck.

  3. Modest Money says:

    I am quite tempted to try to change careers. It would be really nice to have a career where a pension is a possibility and I had more long term job stability. It sure would help a lot with planning for retirement. I’d like to think the Canadian Pension Plan would still be around when I’m old, but I always hear people saying how those government plans will likely run dry before our generation gets to use them. So it seems it’s all on my shoulders to prepare for retirement. Luckily it is still a long time away.

    • Karl says:

      Same thing with social security here in the US. Everyone my age or younger has basically written off receiving much from it. It will never go away, but the odds of reduced benefits are quite high. I have a retirement spreadsheet that you can determine what portion of SS you expect, and I think I’ve got an assumption around 40% right now. That seems like a nice conservative number.

  4. I wish I was able to receive a pension because it would a nice addition to my IRA’s

    • Karl says:

      Just start working for government. Ever wanted to be a firefighter? 🙂 How about elected office? What do you think Mayor Sean?

  5. Michelle says:

    30 kind of snuck up on me. I woke up one day and realized I was almost halfway to retirement age and had NOTHING saved up! We are really trying to save save save today so we can retire and travel together and not have to work at Wal-Mart til we’re 90.

    • Karl says:

      Michelle, from the looks of your blog and the information you have there I can’t believe that your not on the right path and will have buckets of money saved up by retirement.

  6. My mom has a pension…I can’t remember exactly but it’s 60-70% of her final salary. It’s pretty amazing. My boyfriend’s dad has a firefighter pension, which is even sweeter. They seem harder to obtain now but not impossible. If you were saving a big chunk of your salary on your own and contributing to a pension? You’d be set!

    • Karl says:

      That’s fairly common for folks that have worked for government for 30 years. Even today, after 30 years (in my state) you can still get a pension for 60% of your pay. Yes, they do contribute to their pension, so it’s not free.

  7. Shilpan says:

    Annuities also have big portion paid as commission to the agents in addition to early withdrawal penalties. I think dividend approach is the best.

    • Bichon Frise says:

      Not all annuities have a “big portion” paid as commission. SPIA’s through the likes of Vanguard or Berkshire tend to have very low cost to them. It’s just right now the interest rates are killing the payouts. But yes, some annuity products have high costs, just like some mutual funds have high costs. The logic doesn’t go that all annuities have big fees though.

      It is difficult to prescribe any one way to the entire population.

  8. No pension for me. I don’t know many companies who offer pensions anymore, outside of the government. When the time comes I will look into an annuity to create my own “pension-lite.”

    • Karl says:

      I read somewhere that 17 of the fortune 100 companies still offer pensions, but I think that was 2010 or 2011 data. So today that number is likely even less.

  9. Nick says:

    No pension for me either! I’m trying the DIY pension method by piling up as much money as I can…

  10. OK, that old guy in the last picture looks crazy!!!! Moving on…

    My husband’s employer (he’s got a government job in law enforcement) provides him with a pension, as well as a 401(k)/Roth IRA. I never thought about being able to create a pension, or an account that is pension-like.

  11. Garden Seed says:

    I was very pleased to find this site. I wanted to thank you for this great read!! I definitely enjoying every little bit of it and I have you bookmarked to check out new stuff you post. Big thanks for the useful info……

  12. Saving for retirement on your own is like a battle. There are times when you’re tempted to keep some and think of replenishing it the next month which doesn’t happen most of the time. I’m having the same battle with my savings account. Fortunately, I found out that there is an automatic salary deduction option where a portion of my salary goes directly into my co-op account before the salary reaches my bank account.

    With regards to retirement and pension, it’s along with this topic that I’m glad working for the government.

    Best regards,
    Belinda

  13. Brian says:

    Help…my employer had a pension and at retirement age 67 i would receive about $3400 an month from them,well they stopped the pension this yr and i am locked in at $1300 a month,I am 43yrs old and was working towards that pension,,everyone is upset and know one wants to continue working there…I am 43 can i retire from there and start collecting,this is my night job for the last 19 yrs,i do also have a day job for the last 7yrs..i want to quit and collect and keep the day job….is this possible

    • Karl says:

      You probably could retire from that employer, though you won’t be able to do so for some time. Odds are that if early retirement is allowed, you’d get essentially nothing due to the actuarial decreases before you’re 60 or so. So no you couldn’t “retire” and get 1300 a month for the remainder of your life starting tomorrow.

      • Brian says:

        Karl,one could only dream….but thanks for a logical answer..

        • Brian says:

          Ohh Karl,If i leave tomorrow or when i am 60 i will still get the same $1300..i am locked in at that…if i continued to work till 60 then it would have gone up to 3400 a month,so i think the 1300 is actuall now or at 60…but knowing the “a-holes” at my job they will have every stipulation written in(being funny here) have had worked for employer for 30 or more yrs,be over 6’3″ have red hair,have a sister name Athena,and have never called in sick,,then you can retire early..hehe

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