Most people categorize pensions in the same bucket as eight-track tape players, rotary phones, oversized shoulder pads and cathode-ray tube TVs — out of date. But, pensions just might become the latest retro craze — especially those you can create for yourself!
NOTE: If you are lucky enough to have a pension, the NewRetirement Planner is one of the only online tools that give you sophisticated pension controls. And, if you don’t have a pension, the tool helps you think about retirement income needs.
While No Longer Widespread, Pensions Solve the Retirement Income Problem
According to the Bureau of Labor Statistics, only 13 percent of U.S. workers had access to a defined benefit plan (also known as a pension) in 2018, and the majority of those people are local, state or federal government employees.
In the private sector (the vast majority of jobs), only 4 percent of workers have access to a pension.
However, pensions are great in that they solve a big problem: how to turn your savings into income after retirement.
Defined contribution plans like 401ks or 403bs don’t solve for income and how to safely withdraw assets.
So, even if you have saved sufficiently, knowing how to minimize risk and efficiently draw down those savings to last your lifetime is very tricky.
As Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at the New School, in New York said to Barron’s:
“What the 401(k) did was pin a hundred $1,000 bills on the jacket of an old person, and tell them to go on the bus and be careful—with a pamphlet of financial literacy with tips of do’s and don’ts in their pocket.” With a pension, you didn’t worry about running out of money.
No matter how many of the financial literacy do’s and don’ts you are (or are not) familiar with, it is very difficult to guarantee your desired income with an investment and withdrawals strategy.
Pensions Were Once Seen As a Necessity of a Well Ordered Society
Pensions for the military have been around since the Roman Empire, and pensions for civil servants became widespread during the 19th century.
However, in modern times, private company pension plan growth didn’t take off until the early 20th century.
After the upheavals of the Great Depression and two World Wars, policymakers in the U.S. and Europe decided lifetime income, whether through a company-sponsored plan or a government plan like Social Security, was necessary to a well-ordered society.
Pensions are one way that societies ensure that an aging population is sufficiently cared for and that recipients have the income to last through the end of their lives.
If They Are So Great, What Happened to Pensions?
As economic historian Stephen Sass has written, “The pension had been the creature of big business, big labor, and big government. In the years since 1974 the power of each has declined.”
The decline of pensions began around 1978. In that year, the Revenue Act created section 401k of the IRS tax code that said individuals could put aside pre-tax earnings to grow in an invested retirement account. That policy shifted the risk of retirement from companies that paid experts to create a functioning pension system and transferred it to individuals that now had to manage their assets themselves.
Part of the reason companies and individuals turned away from pensions and to defined contributions plans was because pensions were generous in nominal dollars, but the inflation of the late 1960s and the 1970s reduced pensioners purchasing power to one-third of what it was when you retired if you retired in 1969.
Defined contribution plans not only shifted the risk in retirement to the savers from their employers, they also appeared to be a hedge against inflation because the returns on stocks, for example, have historically beaten the rate of inflation.
Pros and Cons of Pensions
Pension Advantages
Pensions have numerous advantages for retirees:
Pensions Reduce Risk: Now that the COVID-19 pandemic has ended the longest bull market in history, savers with 401k accounts that are investment-only vehicles are experiencing huge losses. And the stress of trying to figure out how to manage money is overwhelming to many.
Pensions May Have Better Returns: This may surprise you, but most people are crummy investors. A lot of research done from the late 1970s to the present by behavioral psychologists and economists has proven that retail investors are much more likely to act on their emotions, selling when the market is tanking and buying when the market is going up.
Consequently, the average retail investor gets a return of less than 2 percent because of their behavioral biases. (This is much less than the 6-7% that most people think they get in investments.)
Takes the Guesswork Out of Retirement Planning: Pensions take the decision-making out of retirement income planning for individuals. Because pension fund managers are professionals that can move money into different vehicles, you get the benefit of equity investments married with things that are issued by insurers that have the benefit of a broader time horizon and optionality. Retirement income security is what these managers are trying to solve for.
Access to Better Investment Vehicles: Right now, retail customers of financial products don’t have access to products that reproduce the value of pensions. The closest you can get to it is a target-date fund. But what’s really at issue is smoothing out your savings against your spending and consumption.
Expertise: Kevin Hanney is the senior director of pension investments at United Technologies. His work has been to develop a lifetime income strategy that is not simply a fund, it’s a portfolio built for an individual based on your age with an optimal path where your savings pattern is combined with the expected behavior of an investment portfolio and your money remains invested for your whole life.
At a certain point, Hanney’s strategy introduces insurance guarantees, and the specific vehicle for that is a variable annuity with a guaranteed lifetime withdrawal benefit. Pensions take a lot of expertise to put together and maintain.
Listen to Hanney talk about pensions (where they are now, and how they may inspire a new kind of retirement savings in the post-pandemic world) on the NewRetirement Podcast.
Disadvantages of Pensions
Lack of Control: Pensions are great because you can’t fiddle with them. On the other hand, pensions are frustrating because you can’t tinker with them. They are called “defined benefit programs” because your income is defined or set, when you vest into the system, and if things have changed by the time you retire — like inflation has made your pension income a shadow of what you thought it would be — you can’t do anything to fix it.
Lots of Variables to Consider: Pensions run by governments or private corporations employ an army of actuaries, accountants and investment pros to make sure you get the money promised you. They figure out what your life expectancy is and balance your risk against the risk of thousands of other people in the system. Assessing your own risk is very complicated, which makes DIY pensions more difficult to manage. And not having to be your own financial advisers is the advantage of a pension over a 401k in the first place.
Very Real Possibility that They Run Out of Money: Pensions aren’t personal savings accounts. You might get more out of pension than you put in, if you live long enough. Like an insurance company, a pension spreads out risks like longevity among the participants: their number crunchers estimate some people will live longer than the money they put in, but others will die before they get all their money out. But what happens if everyone starts living longer? Or what happens if new contributors stop contributing, like when younger employees opt out of the pension? Or, what happens if the money is mismanaged? In those cases, the pension runs out of money, and the pensioners are left high and dry.
How Do You Get a Pension? (It is Not Too Late)
If you want to guarantee retirement income, pensions are the way to go. However, even if you are 30 and have time to vest into a pension, finding a job with a pension will be difficult. And, if you are older, you probably don’t have the time to put in at a public sector job.
However, you do have options!
Talk to Your Employer
Fortunately, many employers are just beginning to offer pension-style investment options that are focused on retirement income instead of investing. Relaxing the requirements for multi-employer plans will give employers and professional organizations the ability to pool their resources, and this will push the retail side that much harder to create these sources of stable, reliable, secure retirement income.
There has been an explosion of technology in the financial retail space because the margins are a lot wider in the retail market than they are in the institutional market. But there’s nothing that Mr. Hanney and his team are doing that hasn’t been around for the better part of 15 years. The only difference is they put together the different pre-existing elements in a way that is difficult for the current retail saver.
The analogy Mr. Hanney likes to use is pop music in the 1960s. From 1962 to 1967, music went from Frankie Valli and the Four Seasons to The Jimi Hendrix Experience. Wouldn’t it be great if we could make the same type of revolutionary change within the retirement industry? We can do it. We just have to get out there and take a chance.
Make Your Own Pension
Many savvy retirement planners are creating their own pensions. Here are a couple of ideas:
/Lifetime Annuities: A lifetime annuity is really like a pension you buy yourself. In exchange for a fixed sum of money, you can purchase a guaranteed income stream — for life. You can try out a lifetime annuity as part of your comprehensive retirement plan using the NewRetirement Retirement Planner.
Try scenarios with and without cost-of-living adjustments (we generally recommend you try to keep pace with inflation) and more. See how much income your savings can buy and how that changes how long your money lasts, your expected cash flow, and where you can improve.
Use the Retirement Planner or learn more about lifetime annuities.
Bucket Strategies: Many retirees are using a bucket strategy and purchase annuities for some of their retirement spending.
When you concoct a bucket strategy, you figure out different categories for different types of spending. You then fill some buckets with higher-risk investments in the hopes of greater gains. Other buckets are invested more conservatively or in an annuity to guarantee your income.
Learn more about bucket strategies or take a deep dive into how one retiree set up his bucket strategy — including investing part of his money into his own pension (lifetime annuity).
Focus on Retirement Income: The beauty of pensions is that they put the focus on retirement income instead of retirement savings. Explore 18 Different Retirement Income Ideas for Lifetime Wealth and Peace of Mind!
What Kind of Lifetime Income Will You Need in Retirement?
Knowing how much you need and want to spend in retirement is one of the most important aspects of retirement planning.
The NewRetirement Planner allows you to specify different levels of spending over time and you can even set up what you want to spend vs. what you need to spend.
It is easy to get started!
