I can honestly say, that until a year or so ago, I had no idea what my pension plan was worth or even how pensions worked. It wasn’t until March of 2015 that I finally took some interest. I was trying to decide if I should take a job back with my Fortune 50 employer, who had laid me off three months prior (see Why I Started This Blog). The other option was to purchase a local business that would generate a similar amount of income as my corporate job.
In order to help make the decision, I created a list of all of the types of compensation that I would be receiving if I accepted the job. I included the usual items like my base pay and my bonus pay. I also included the less common items like the 401k matching, insurance benefits and paid vacation days. Then it hit me. What about my pension? I decided to look into it and figure out how it worked.
How do Pensions Work?
A pension plan is a retirement plan set up and funded by your employer. With every paycheck, your employer makes contributions on your behalf into a pool of funds. The funds are invested by the pension plan administrator and the investment proceeds are used to make monthly payments to you in retirement.
What’s nice about these pension contributions, is that they are tax-deferred compensation. So, money put into a pension plan on your behalf is similar to money invested in a 401k. It’s compensation that you receive, but are not taxed on until retirement. If you don’t know why that’s a big deal, check out the brutal effect of taxes on your savings.
Usually, there is a vesting period that must pass before you will be eligible for a particular company’s pension plan. Ours was five years. That means that if you leave the company before five years is up, no pension for you. If you stay at least five years, you will receive at least some pension at retirement.
There are two types of pension plans. The first type is a defined benefit plan and the second type is a defined contribution plan. The defined benefit plan is better and these pensions work by guaranteeing you a certain amount of money each month, based upon a formula. The formula usually looks at your average salary over your last few years of employment in combination with the number of years of service you had with your employer. Having a guaranteed monthly income will be nice once you are in retirement.
The defined contribution plan is better than nothing, but this type of plan is more like a 401k. The defined contribution pension works by depositing a set amount of money on your behalf into an investment account. Your future payments, however, will be based on the performance of the investment portfolio. These plans shift the investment risk from the employer to the employee. That’s bad for you.
How Much Were the Pension Contributions Worth?
So, since I was trying to decide whether I should go back to my employer, I had to factor in the impact on my pension. Since I was already 100% vested in our current pension plan, I would already be receiving something when I retire, even if I didn’t go back to that company. But if I went back to my employer, they would keep adding to my years of service for the pension calculation as if I had never left. My pension benefit would keep growing and growing with each additional year of service.
In my research, I discovered that the pension contributions the company was making on my behalf were worth an extra 11% of my base salary each year – and, that’s tax-deferred money, just like a 401k. So, in addition to the 6.5% of 401k matching that they were already providing, add an extra 11% on top of that for the value they were putting into the pension. In total, they were giving me an extra 17.5% of tax-deferred money towards my retirement. That’s a big deal!
Do You Want a Pension?
If you don’t currently have a pension, luckily, there is a financial instrument that you can buy on the open market that behaves just like a pension works. It will provide you with guaranteed monthly payments for life, just like a pension. It is called an immediate annuity.
The primary difference is that a pension is funded by your employer as a benefit to you and an immediate annuity is something that you have to go out and buy with your own money. When people do purchase an annuity, it is usually because they are ready to retire and do not have a pension from work.
If you are interested, just go to an online tool like ImmediateAnnuities.com to find the best rate on an immediate annuity, or you could go directly to an investment firm, like Vanguard to see what they offer. But, how much does it cost to buy an immediate annuity and how much will you receive?
If you go to ImmediateAnnuities.com you can play around with their rate comparing tool to see the latest costs. According to their latest rates, if you are a 55-year-old male and invested $1,000,000 to buy an immediate annuity today, you would receive $4,488 each month ($53,856 per year) for the rest of your life.
That’s about a 5.4% payout rate on your money for life. So why doesn’t everyone buy an immediate annuity instead of sticking to the traditional 4% withdrawal rate? Because, once you buy an annuity, the million dollars is long gone and you can’t leave it to your heirs. Some people like the security of knowing they will have income coming every month, like a pension or annuity, and some people like to manage their own investment portfolios.
Why Pensions are Fantastic
Once I added up all of the compensation I was getting at my Fortune 50 employer, the value of the pension pushed me over the edge and I accepted the job to come back. I now have 15 years of vesting for the pension plan calculation and the value keeps going up each year that I am there.
The reason that pensions are so great, is that they provide guaranteed income for life. There are few ways to do that these days in such a low-interest-rate environment. The longer that interest rates stay low, the more that people will prize their pension plans.
If you think you might be sticking with one employer for a while, look into their pension plan to see what it might be worth to you at retirement. On the flip side, if you are thinking of leaving your long term employer and walking away from your existing pension plan, make sure you figure out how much you are walking away from. You might be surprised how much it is worth to you – especially as you start getting closer to retirement age.
How old were you when you first learned how pensions work? Are you covered by a pension plan at your current employer? Would you take the value of your pension into consideration when deciding whether to leave or join an employer?