We’re going to switch gears this week and talk about retirement planning a bit again, specifically: pensions.
In my prior posts based upon retirement, I touch upon pensions a little bit.
I also briefly mentioned that you should consider pensions when you are Choosing Your First Job
However, I didn’t realize that I had not really discussed what a pension entails, or my opinion on them. So I am going to take the time to discuss them today.
So… tell me about Pensions.
Ok, first things first. I think most people kind of vaguely know what a pension is, however, I am going to take the time to explain it in a bit more detail.
The general definition of a pension is “a regular payment made during a person’s retirement from an investment fund to which that person or their employer has contributed during their working life.” These were pretty common about 20-30 years ago, so your mom or dad and/or grandparents may have a pension. For example, my dad has a pension since he is a professor in the California State University system. However, I think most jobs nowadays for physicians won’t have pensions. They will usually have a combination of a 401k/403b and/or 457.
Because pensions are not very common nowadays, I think that pensions are undervalued, especially for physicians.
As I stated before, the practice types which have pensions are usually: large academic systems, certain Permanente groups (Kaiser), and the federal government (VA or Military-based).
Now the definition above is pretty vague, but essentially a certain % of your salary goes into a fund every year. After paying into the fund a certain amount of time you are entitled to “regular payment” at the time of retirement at a certain age. What this payment amounts to is usually dependent on three aspects:
Years of Service
% of Salary per Year
I think a pension plan which is pretty transparent and easily accessible is the federal government pension plan, which is Federal Employees Retirement System (FERS).
All of that information can be found here. You can read it at your leisure.
For simplicity’s sake, I’m going to paraphrase the important points and assume there is no Civil Service Retirement System (CSRS) component [the old pension].
For FERS, it is based on 3 years salary, <20 or >20 years of experience, and 1% or 1.1% depending on years of experience. (assuming retirement > age 62)
Let’s assume you make $200,000 a year as a physician for the VA. You may or may not get a raise during the course of your career. However, let’s just make some guesses that you get a few inflation adjustments and maybe became Chief of your department over your career. The highest 3 years salary you had is $225,000.
You worked since you were 32, and will retire at 62. You put in 30 years of service (>20 years), and will retire at the minimum age of 62. As such you will receive 1.1% of your salary per year of service.
$225,000 x 0.011 x 30 = $74,250 a year from the age of 62, until you die.
Not bad right? However, just remember inflation still exists and $74,250 a year in 2046 is not worth the same as it is now.
Ok, so back to the original question.
How to Value a Pension?
There are many schools of thought on this topic. There is a good discussion on bogleheads about it. Once again, you can read at your leisure. Here is my take on it:
When choosing a job, be aware that the pension exists, but do not consider it in your retirement plan. Your retirement plan should still mostly be based on on your 401k/403b contributions and IRA contributions. I do not think it is a good idea to rely on a pension from the beginning. You are paying into the pension whether you like it or not, but when just starting a job, don’t worry about what your pension will be when you retire in 30 years. You may not be with this job still and therefore you should not consider it in your calculations.
Now fast forward 10-15 years into your job. So now you’ve been with this job for 10-15 years. You like it and you have no reason to leave. Now is a reasonable time to try to value your pension. However, if you did what I said above, you will have put away money anyways and now when it comes time to value your pension, this can almost be considered a windfall of unexpected retirement money.
Let’s go back to our example above.
Started working at 32, retire at 62, top three years salary is $225,000, 1.1% a year.
Now you have to do some somewhat morbid calculations. When do you think you will die? Some of this is genetic, when did mom/dad and grandma/grandpa pass? Closer to 80? or closer to 90? Some of this is based on your health. Are you healthy? No diabetes or anything like that? Once again, not an easy thing to estimate when you are 32 or 42, or even 52. So the most objective way is:
According to the Social Security Administration (SSA):
A man reaching age 65 today can expect to live, on average, until age 84.3.
A woman turning age 65 today can expect to live, on average, until age 86.6.
So let’s split the difference and use 85. You can tinker with your own numbers later.
If you retire at 62, and die at 85, that’s 23 years of retirement. So $74,250 x 23 years = $1,707,750
That’s how much your pension is worth if you live until 85. Not bad right?
Alternatively, you can just pretend the pension doesn’t exist until you retire.
If you think about it like this, then it truly is a windfall of money when you retire. Extra money owed to you every year that you never knew you had and never relied on.
Wait.. what about taxes?
Payments from private and government pensions are usually taxable at your ordinary income rate, assuming you made no after-tax contributions to the plan.
However, you may also be taxed by the state. I discuss this in my Best Bang for Your Buck Retirement Locations.
Is there anything else I should know?
Yes, there is something called a Survivor Benefit.
This may be different for different plans. However, the long and short of it is that your pension payment takes a penalty in order to provide some benefit to your spouse in the event you die before them.
Let’s say you have the above pension and would receive $74,250 a year, but you would like your spouse to have a percentage of your benefit in the case of your untimely death, then (for FERS):
If you are married, your benefit will be reduced for a survivor benefit, unless your spouse consented to your election of less than a full survivor annuity. If the total of the survivor benefit(s) you elect equals 50% of your benefit, your annuity is reduced by 10%. If the total equals 25%, the reduction is 5%.
So, if you had the $74,250 benefit, and you would like your spouse to receive half your benefit if you die before him/her, your payment is reduced 10%.
$74,250 x 0.10 = $7425 and $74,250 – $7425 = $66,795 until you die.
This is your new payment. However, in this event of your death, your spouse would receive half of that, which is $33,397.50 until he/she dies.
Lump Sum payment is also something to consider, but that discussion is outside the scope of this post. It will probably need its own post another day.
I think pensions are undervalued because they aren’t common anymore.
You can value your pension as I discussed above, but I wouldn’t rely on it.
Work your expected pension into your retirement plan once you have been with the job for 10-15 years.
Alternatively, pretend it doesn’t exist, and just deal with the extra money when you retire.
Survivor benefit is a personal preference, just realize you will need to take some penalty for it.
I work for the VA, and I like my job and don’t plan to leave so I will probably have a pension. However, like I say above, I am not relying on it and am putting away money as if I didn’t have it.
What do you guys think about pensions? Do you think they are undervalued or overvalued? Did this article change your mind?
Will you look for a pension when you look for a job?
Agree? Disagree? Questions, Comments and Suggestions are welcome.
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