Monthly Archives: May 2016

The Pension Pitfall

There used to be a time when you knew that if you stayed with the same company your entire working career, there was an excellent chance that your loyalty would be rewarded with a generous pension.  Those days are long gone.  Over the past 30 years, the number of companies that offer pensions has declined dramatically as reflected in the chart below.  Even worse, a lot of the companies that still offer a pension have frozen benefits thus preventing employees from increasing the value with higher earnings later in life.

Pension DeclineOne of the few exceptions where pensions have been a mainstay is in the public sector (federal, state and local government employees).  Since these benefits rely on dependable revenue streams (i.e. taxes), they looked very safe.  Not anymore, at least for state and local government employees who don’t have the luxury of federal income taxes to pay their future benefits.  Over the past several years, we’ve seen a lot of high profile city bankruptcies, none bigger than the city of Detroit.  In fact, things are so bad in Detroit, the city is saying there’s no way they can pay the promised benefits the cities employees have earned.  For anyone who’s close to retiring and felt their financial security was solid, this news feels like a punch in the gut at a time where they don’t have enough years to make up for the shortfall.

This is a real problem that’s only going to get worse.  Over the past decade, we’ve seen cities and states negotiate with their public employees to transition future contributions away from a traditional pension in favor of a defined contribution style program (i.e., 403(b) or 457(b) plan).  These retirement plans, which are equivalent to 401(k) plans that are available to most private sector employees, would provide state and local governments a better way to budget their retirement expenses and have some certainty regarding their future financial obligations.  Compare this to a pension, where they have the almost impossible task of forecasting investment returns and life expectancies, and you can see the appeal to the benefit providers.  Although most people agree this approach makes sense, public sector employees are outraged and are fighting to ensure their level of promised benefits are guaranteed for themselves and future employees as well.

I truly believe this is a negotiation that public sector employees just can’t win.  In order for state and local governments to ensure these benefits, they will need to make drastic changes to their budgets.  And although there’s probably enough waste to protect a good portion of these benefits, they only way they can guarantee future pension liabilities is with additional tax revenues.  With most people feeling the pinch of a tight economy, trying to get people to agree to additional taxes to protect benefits that most employees don’t have is a losing battle.  Another approach, which has become popular recently, is to have public sector employees contribute a bigger percentage of their pay to help fund their pension.  Although this is a good idea, the contributions would probably need to triple in order to minimize the large unknown of future pension liabilities.

When it comes to pensions, another surprise for most recipients is the level of guarantee is not as iron-clad as you may think.  Private sector employees have their pensions backed by the Pension Benefit Guaranty Corp (PBGC), but this guarantee is only up to a certain dollar amount ($60,136 in 2016) for a 65-year-old retiree.  As for public sector employees, there’s no PBGC to guarantee pension payments.  In 2014, an analysis of 150 state and local pension plans by the Center for Retirements at Boston College found that pension plans had 74% of the funds needed to cover promised benefits.  This translates into a $1.1 trillion shortfall.  What’s worse is that over 30% of public sector employees aren’t covered by social security which means their pension is the only regular income source they may have in retirement.  Not real comforting is it?

If you’re one of the few people left with a pension, the best thing you can do for yourself is to not count on the full amount of promised benefits.  To be safe, you should assume that your pension could be reduced by as much as 25% to 33%.  I say this not to scare you but to prepare you now while you’re still working and have the opportunity to make up the potential shortfall with additional savings.  If you’re a public sector employee and have the option to contribute to a 403(b) or 457(b), take advantage of it by setting aside pretax dollars for your retirement up to the 2016 maximum of $18,000 plus an additional $6,000 if you’re 50 or older.  As for private sector employees, don’t rely on your pension as your key source of retirement income.  If you have access to a 401(k), which has the same contribution levels as a 403(b) and 457(b), use this retirement vehicle to set aside pretax dollars for your retirement as well.

I know planning for a reduction in your pension may sound excessive, but the last thing you need is to get within a couple of years of retirement and be told that what you were promised won’t get paid-in-full.  It’s imperative that you take a proactive approach immediately.  And if for some reason your fortunate enough to receive 100% of your promised pension, think of all the extra money you’ll have in retirement that can be spent on more appealing things.  Bottom line, if you expect the unexpected, you’ll never be unprepared if something happens down the road.