If you have a traditional, defined-benefit pension plan at work, you have nothing to worry about—your retirement is covered, right? Maybe not. The world is changing and, like a lot of other things, they’re just not making pensions the way they used to. Even if you do have a pension plan…well, again, the world is changing. Moral of the story: Don’t take anything for granted, least of all a pension.
Use this article to start planning where your pension fits into planning for retirement in today’s economy. As you’ll see, it’s dangerous to rely on any pension—even a generous one—to cover all your retirement needs.
Traditional Pension Plans: A Blast from the Past
Pensions are terrific, if you’re lucky enough to still have one. Until the 1970s most workers were part of traditional plans, also known as “defined-benefit pensions.” That’s because the benefits are based on metrics, such as salary history and years of service, and are completely funded by the employer. They were originally designed to encourage employees to make long, even lifetime, careers at one company. The employee was rewarded for loyalty and the company benefited from having a stable, experienced workforce and low recruitment costs.
During the 1970s the government created several “defined-contribution plans”, such as 401(k)s and IRAs. These get their name because they are funded by employee contributions. What employees receive at retirement depends largely on how much they contributed and the return on what their contributions were invested in.
While these were welcome creations for the self-employed, few realized at the time that they would eventually replace the cherished traditional pensions that employees had grown accustomed to. Defined-contribution plans cost employers less to maintain and fund, and put the burden of retirement planning on the employee.
For most people, traditional pensions are not part of the retirement planning any longer.
Government Employees: The Exception—For Now
Traditional defined-benefit plans are still the order of the day for most government employees, whether they work at the federal, state or municipal level. While it may be comforting to assume that your retirement needs will be fully met by a government pension, recent events are calling even these into question. Many state and municipal employee pension plans are facing substantial shortfalls to cover future obligations, providing more than a hint that such pension plans will be less generous going forward.
Even government employees should be making additional plans to save for retirement.
If You Do Still Have a Pension
If you do have a traditional pension plan through your employer, the first order of business is to contact your human resources department to determine what benefit payment you can expect at retirement. This is usually based on a percentage of your income that increases with the number of years you work for your employer.
It also depends on whether you have worked long enough at your company to be “vested” in your pension. Leave before that magic date and your pension rights disappear. Even after you’re vested, tenure is important for future income. Most employees today don’t (or can’t) stay with their employers for the 20, 30 or 40 years it takes to earn a generous monthly pension benefit.
Start by determining whether you are vested and getting that projected monthly income number. Add the number to your expected monthly Social Security benefit to determine if the resulting figure will be sufficient to afford the type of retirement you’re expecting. If not, you’ll have to look at defined-contribution alternatives, such as Traditional and Roth IRAs, to make up the difference.
You Don’t Control Your Employer’s Pension Plan
A pension that looks good now can change—especially if it’s not part of a union contract or other mandate. Your employer has absolute control over a defined-benefit plan (subject, of course, to federal law and any contracts). That means your company can generally change benefit calculations, reduce benefits or even terminate the plan.
That last point is critical. Since the 1970s thousands of employers have terminated their traditional pension plans in favor of defined-contribution plans. Sometimes they’ll arrange a payout to employees for their portions of the plan to date. In other cases they leave the funds in a poorly managed account that will pay meager benefits until the last pensioned employee dies. Either way, you won’t get the expected monthly benefit if this happens.
There is also the possibility that your company’s pension plan could fail. There are some protections in place to help preserve a portion of your pension plan, but not necessarily all of it.
Whenever possible, you want to ensure that your pension is a portion of your expected retirement income, not all of it.
Watch Out for Inflation
Inflation is the “X Factor” in retirement planning. Most private employer pension plans establish a fixed monthly benefit at the beginning of retirement that they’ll pay out for the rest of your life. While that might be very generous in the early years of retirement, you’ll begin to feel the pinch in ten years or so when your monthly benefit doesn’t buy as much as it once did. Government pensions typically have some type of cost-of-living adjustment (COLA) that partially addresses this concern.
The definition of inflation that triggers a COLA can work against seniors, however. COLAs are generally based on the Consumer Price Index (CPI), a general-purpose index that doesn’t address specific demographic needs. For retirees, for example, healthcare is a major component of a household budget and price levels in that sector are rising much faster than in the general economy. If the CPI is 2%, but your personal rate of inflation is 5%, you’ll fall behind even with a COLA provision.
Again, you’ll need some type of supplemental provision even if you’re expecting a government sponsored, COLA-adjusted pension plan.
Think of a Pension as a Bonus
Perhaps the best course of action in regard to pension plans is to consider them a bonus.
In addition to your pension, establish and fund defined-contribution retirement plans—a 401(k) or 403(b) if your employer offers one, or traditional or Roth IRAs, if it doesn’t. Other ways to prepare for retirement include building up non-retirement investments (stocks, mutual funds, investment real estate), working to get out of debt, and even investigating post-retirement career opportunities.
A traditional pension is great if you have one, but never assume that your employer has your retirement fully covered. Ultimately, the quality of your retirement is your responsibility.