Monday, July 15, 2013

Pensions and opportunity cost


My favorite Chinese fortune cookie advice reads Hope for the best, but prepare for the worst.

Commenter and awesome long-time reader goldsmith raised some questions about my pension after my last post, in which I mentioned that leaving my job is a very expensive decision.  I thought it would be worthwhile to spend a little time explaining what I mean by that, as well as clarifying some of the factors around my pension that make it such an integral part of my financial decision-making.

At my job, I have both a 401k (mostly traditional, although I've been contributing to a Roth 401k ever since it was introduced five years ago) and a pension.  I fund my 401k myself, with my employer kicking in a deferred 3% match as long as I remain employed through December 31 of the contribution year.  If I leave for any reason before December 31, I won't receive the match for that year.

My pension is funded by my employer, and I vested five years after my start date.  About five years ago, my employer made a pension benefits calculator available to employees.  Like the dork I am, the first thing I did was calculate out what my benefit would be if I left on my hire date for every year of my employment up to age 65, and then plotted it on a graph.  The results were interesting.  Things I learned were:

--Pension growth was flat from vesting date until my thirteenth anniversary.
--My pension doesn't increase by the same amount every year.  2011 and 2012 were sweet spots in which my monthly benefit increased by more than $250.  The sweet spot gets smaller in 2013 and 2014, and from 2015 through 2019 the monthly benefit increase is less than $150.  By 2019, my pension will be worth $14,000 per year more than it is today.
--In 2020, which is my 25th anniversary year, my pension hits a major sweet spot and jumps by over $1000 per month.  That year alone, it will increase in value by $14,000.
--Growth from that point onwards levels out to about $175 per month for the next five years, stopping altogether at my 30 year mark.

I update the graph every year to account for my pay increase.  While the curve shifts upwards, the shape doesn't change at all.

The fun part comes with the actual numbers:  If I left my job today, I'd be able to collect just under $30,000 per year starting at age 65.  If I hang in there for another 12 years and never get another raise (unlikely), I'll collect just under $70,000 per year starting at age 60.  If I factor nominal raises into the calculations (which I'm doing via Excel, since the pension calculator doesn't do that), I think that figure will actually be between $80,000 and $90,000 per year from age 60.

Assuming a very conservative withdrawl rate of 2% per year, a guaranteed annual income of $30,000 represents 1.5 million dollars that I don't have to have in the bank at age 65.  (2% of $1.5M = $30,000.)   That's what I would get if I left my employer today.  Using the same conservative withdrawl rate, a guaranteed annual income of $80,000 represents 4 million dollars that I don't have to have in the bank at age 60.  (2% of $4M = $80,000.)  In addition, getting my pension at age 60 instead of at age 65 means an extra $400,000 in real cash.

This is why I say that leaving my company at this point is a very expensive decision:  I don't think a pay package elsewhere would be remotely competitive to what I'd be leaving behind in terms of retirement benefits.  As a result, the job situation has to be truly intolerable for me to voluntarily walk away.  At the very least, I should do everything I can to hang in there until I reach the year 25 sweet spot.

Of course, the caveat is that I'm assuming that my employer's pension program will not be cancelled (many have been), that I don't involuntarily lose my job, and that the company itself doesn't go bust.  If any one of those things happens, all bets are off.  I've actually seen colleagues who were counting on the pension as their only source of retirement income lose their jobs, and the sudden realization that their retirements will look vastly different than anticipated isn't pretty at all.   As a result, it's also critically important to keep saving and investing and not think of the pension as anything other than a nice side benefit to working hard for many years.

The take-away I'd hope other people get from all this is that if you have a pension with your current employer, make sure you understand when you vest, how benefits are calculated, what the growth curve looks like (you can usually work this out manually from the documentation if you need to.  That's what I did before the calculator became available, although it was a huge pain in the butt), and what the odds are that you'll actually be able to collect on it.  All of that information should be factored into decision-making and/or salary negotiation when looking for a new job.

That said, I still think that people with pensions should save, invest, and live like the pension doesn't exist, simply because unplanned benefits are in every way better than horrible surprises.


2 retorts:

goldsmith,  July 21, 2013 at 11:19 AM  

Hi FZ! Thank you so much for your extensive explanation. I really hope all works out as planned, but think you are wise to pile up other retirement savings as well. My manager's husband worked for many years in increasingly responsible positions in an aircraft maintenance company. He stayed, among other reasons, because he was so far along being vested in his pension. Anyway, in 2009, disaster struck: http://www.rte.ie/news/2009/0310/114964-srtechnics/ and he was out of a job in his mid-fifties and without the pension he had worked all his life for. Luckily my manager is on a very good salary by public sector standards, over 130k in USD, so she was able to pick up the slack. But it was hard for both of them. I think he's back in work now - he's a mathematician by trade, and after some freshening up his skills, he found another position.

My own pension rights are with the Irish state. But because my maximum pension is half of final salary *when combined with social security*, I too am currently on a flat stretch between year 14 and 20 (essentially, I have worked up to 1/4 of final salary now, but that won't change for the next six years), then it will slowly rise again. I sure hope the state keeps to its obligations! The only thing I can currently do is keep overpaying my mortgage and add to my cash savings, no money left for my AVCs (same as 401(k)) That's the way it goes when one's salary is down by 20%. I am just grateful that a lifetime of good financial habits means I am not in any real difficulty, like so many others in this country.

frugal zeitgeist July 21, 2013 at 9:18 PM  

Hi goldsmith,

A couple of days after I posted, the city of Detroit filed for bankruptcy, and questions started coming up about whether the city will be able to pay its retirees the pensions they've earned over the years. I'm sure you can imagine the reaction: The vast majority of these retirees counted on having a pension, and structured their financial planning around it. Since Detroit is a public entity, I'm sure the pension obligations will end up being covered, but this is exactly the point I was trying to make: It's dangerous not to have a backup plan.

With a salary cut of 20%, you're in a tough place, to be sure. I think you're doing quite well under some very challenging circumstances, and I'm glad your lifestyle made it feasible (although perhaps not easy) to adapt. I hope times get better in Ireland soon, and certainly for you personally. While I was out West, I saw really heavy television advertising from the Irish government directed towards business investment in creating facilities and jobs in Ireland. I hope it helps bring about better economic prospects.

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