So why do pensions fail? Have you ever actually seen an example of what happens with a pension? How it works? How it is funded? Why it is unsustainable? Have you ever seen someone’s pension statement? Why can’t the system work?
I’m going to explain exactly why a pension fails. I have had the opportunity to examine my mom’s pension documents in depth. She wanted help in deciding which pension plan to take and what would be the most beneficial. I think it’s was really interesting and I’ll explain her decisions and rationale.
My mom worked for the state from age 22 to 55, 33 years of service + 2 years of sick leave accrued = 35 years of service. She was guaranteed a 2%/per year of service for a pension for life = 70% of her salary at the highest 3 years. She would also get her medical insurance premiums paid for her and her spouse for life. She only needed to contribute 7.5% of her paycheck for 33 years.
So what choices did she have? And what were the numbers.
Her salary wasn’t great starting out, and she got minimal raises along the way. Thus her “contribution” to her pension fund was around $250k when she retired. Not much right?
Well she was given the option to take the maximum benefit (70%) for the rest of her life and use her pension savings first. Or get the pension lump sum of $250k upon retirement and a smaller pension of 50% of her guaranteed pension for life, NEVER using her pension savings up.
My mom decided to use up her pension benefit because we calculated she would use up her pension savings in 5 years. She would make a guaranteed $4k/month for the rest of her life instead of $2k, and she would be living off the state pension fund after 63 months, or a little over 5 years! This Christmas will be 3 years for my mom and she’s 58 in extremely good health.
To give you an idea the people in my family die around 90-100 years old. So I am going to bet unless a freak accident happens she’s good to go for a long time. Her father died at 78 (only because he was a 2 pack a day smoker). He mother is still alive at 80 and healthy as a horse. Her grandmother lived to 100, her great-grandmother lived to 95, her grandfather died of cancer at 50, but her great grandfather lived to be 90. On her father’s side, most of her aunts and uncles are alive and kicking in their 80s and 90s. So let’s conservatively say she’ll live to 80.
In order to generate $50k/year (my mom makes $48k actually), with a 4% safe withdrawal rate, you need to have a pot of $1.25 Million dollars, assuming a 6% ROI. So my mom would never have saved that much probably.
Hence the unsustainability of the pension model. How can pensions keep funding people for life when they don’t take in enough to pay out?
This mathematical reason is probably why 401ks were created. You can live on what you choose to save, and more importantly there is no mistakes. You know how much you are saving and investing and can live on.
So in a couple of years, my mom will be living high off the hog on tax payers money. Truth is she probably is already. With the state covering her medical premiums, she likely already ran through her $250k “pension” savings in 3 years. And when she hits 65, she’ll have 100% medical coverage with her private insurance and medicare.
So how can we really move back to pensions or “private retirement insurance”. How will the math work out?
9 responses so far ↓
1 Kristy // Nov 6, 2009 at 8:50 am
Pensions were formed when people only lived for 5-10 years after retirment, so they were sustainable. However, now people are retiring young…like your mom at 55 and are expected to live a lot longer.
In order to keep pensions around, employees would have to contribute alot more to the fund, a heck of alot more.
2 Meg // Nov 6, 2009 at 10:38 am
Well, like other benefits, pensions in a way make up for lower salaries. I know a lot of people who wouldn’t be working government jobs if it weren’t for the health care and retirement because the salaries are so low compared to what they could get elsewhere. But for the government, pensions are one way to defer the costs. And remember, a lot of people don’t stay in the jobs long enough (for whatever reason) to get their pensions.
But, of course, sometimes pensions do fail. I definitely wouldn’t count on getting one. I don’t count on getting social security, either. But 401ks are bullet-proof, either.
3 amy // Nov 6, 2009 at 1:29 pm
Here in my HCOL city, the local state university branch clerical staff’s full-time salaries are so low they don’t even come close to supporting a family. These “breadwinner” salaries qualify workers for welfare benefits. I worked there for 11 years and many of us got to know each other at the local thrift shops, the food bank and the bus stops. State university employees, upon retirement, are constitutionally guaranteed a pension—like your mom’s, actually.
This just to illustrate further the two points made above: 1) pensions are a compensation for low salary, and 2) at their inception, most people didn’t live for very long after they retired.
Yeah, your mom might be living high off the hog now, but she probably wasn’t while you were growing up. If she was supposed to be living off her 401K in retirement, well, I am guessing she’d be in a world of hurt right now with the market down, or else she’d need to work until she was about 90. No easy answers here.
4 JoeP // Nov 6, 2009 at 3:23 pm
A lot of expenses should go down when you retire or get close to retirement age. For example, your mortgage should be paid off, so you can sell and buy a smaller place for cash and invest the rest in something conservative. Also, a smaller house will have lower taxes and lower utility bills. You won’t have the job commute any more, nor the mouths to feed if you have kids still in the house.
OTOH, some expenses will go up, but you have some control over that. Living a healthy life now gives you better odds when it comes to certain diseases (cancer, cirrhosis of the liver, weight issues), so you could end up spending less on medical bills. Obviously, if you end up deciding with your doctor that you will be on 10 drugs, then you will need more money.
Clearly, those with constitutionally-guaranteed pensions are getting a good deal at everyone else’s expense. This might not be guaranteed for long as taxpayers and clients may object to it after a while.
5 amy // Nov 7, 2009 at 2:00 am
Actually, Joel P, in 2007, our state legislature did away with the state-guaranteed pension and all employees hired since then are on a 401K plan. A little (but significant) catch is this: those of us with pensions do not qualify for social security; however, since 2007, those who do not get pensions and must now rely on a 401K don’t qualify for social security either. Subsequently, it has been proven that this cost-saving measure, will not, in fact, save any money. But it has been a political goldmine for Republicans!
As a result, our state has a very difficult time recruiting state nursing staff, teachers, and biologists (and we have the best-managed fishery in the history of the world—do you know where I live now?). We are at at tipping point—not in crisis yet, but it is soon to come. And when it does it will take decades of allocated money to resurrect us.
Allocated money that exists only in my imagination! We are a republican state that uses state government workers as political whipping boys. State salaries lose buying power every year.
So before you lament the pensioners living high on the hog (and there are some!), remember all the little people who make your lives possible—teachers, nurses, fire fighters, police officers, state biologists, social workers, and other government workers. We labor in the bureaucracy with the understanding that we will be rewarded with security. Take that away and we will go away too. No easy answers here.
6 LAL // Nov 7, 2009 at 5:57 pm
Kristy, definitely people are living a lot longer.
Meg, you don’t get paid that much less. Most of my friends who are government workers make a great income and way more holiday/paid time off than private sector. So while the salary is less, so is the hours worked.
Amy, we were stable. The biggest benefit is her medical premiums covered for life! That and my dad’s. That’s around $1500/month for the rest of their lives. This covers all medical costs above and beyond medicare! Plus it includes vision, dental, and prescription coverage.
7 LAL // Nov 7, 2009 at 5:59 pm
JoeP, definitely, but with my mom’s supplemental coverage on top of Medicare, she pays $0 OOP for any medical treatment. She isn’t on medicare yet, so she pays her portion, but my dad is 100% covered including his $77/month medicare premium.
Amy, definitely. And my mom was on the list of people you listed as low wage earners. I would not call her a low wage earner.
Anyway though, there definitely are less people sticking it out, so pensions are going to be less generous.
8 bogart // Nov 8, 2009 at 9:31 pm
Pensions fail for the same reasons 401Ks (etc.) fail –
1. People don’t invest enough.
2. People live “too” long (relative to 1).
3. People don’t plan effectively for inflation.
At the pension level, of course, the problem is basically institutional … somebody (or -bodies) has set up a “bad” structure that will affect beneficiaries (and/or that others will have to step in and cover). That this is/was the case may or may not have been something that the prospective beneficiaries anticipated and acted pro-actively to address. E.g. my DH’s (state) pension is structured only to replace 55% of salary, which anyone ought to be able to figure out isn’t enough, by itself. But the quote marks around bad reflect the fact that sometimes such things only become obvious in hindsight.
401Ks of course reflect similar short-comings and challenges. Because individuals make their own decisions (up to a point) about funding levels, it’s easy to say it’s the fault of the account owner if things go wrong; conversely, risk (e.g. of unusual longevity or poor investment return) is phenomenally concentrated.
9 LAL // Nov 13, 2009 at 12:22 pm
Bogart, still 55% guaranteed is a lot more than what most people save. Most people can’t replace 25% of their incomes!
Otherwise 401ks and IRAs would be better funded.
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