4 Simple Ways to Include a Pension in your FI Plan

So, you’re fortunate enough to have a pension. You’ve also heard that pensions are in danger. How do you balance the opportunity a pension provides with the uncertainty? Let’s look at 4 simple ways to include a pension in your financial independence planning.

Overview – Pension Uncertainty

A pension is a defined benefit retirement plan. This is different from what is more common today – defined contribution plans such as 401k and 403b options. In a pension, you are promised a set payout on retirement, typically after working enough time to vest in the plan. The benefit often goes up with time in service. Payouts are not as dependent on market performance. This can make pensions quite valuable for anyone who has one.

Pensions used to be much more common in the United States. Sources vary in the exact percentages. Despite different numbers, everyone agrees that beginning in the 1980s, the percentage of American workers with pensions began declining. Private-sector pensions are an endangered species.

This decline is due to a number of things. Defined benefit systems cost more for employers than defined contribution options. There were a number of regulatory changes in the 1980s. And, the corporate/worker loyalty dynamic has shifted dramatically.

Government workers, and therefore many educators, often still have access to a  pension. There are a variety of reasons for this. One is the relative stability of government as an employer compared to corporations (a government can’t just go bankrupt.) A second is that government employees are still unionized at a higher rate.  Finally, courts have typically found that pension obligations are a contract that governments can’t easily break.

That said, all pensions, both public and private are under significant pressure.  Pensions are being eliminated or reduced wherever possible. In fact, in 9 Reasons Educators Aren’t Wealthy, I highlighted the danger of counting on pensions.

All of this leads to understandable uncertainty about pensions. So, how (and should) you include one in your plan?

Know Your Benefits

As with everything, to best understand your options you have to understand your pension benefits. This is especially critical with your pension. The devil is truly in the details. How do you learn more? Here are some options:

• Your Human Resources office-  Try this first. But, be cautious. Pensions have changed enough that it can be difficult for less-complex HR offices to keep up. At the very least, your HR team should be able to point you to your plan documents. In one district, I was fortunate to work with an experienced HR office that had one of the preeminent pension experts in the state. Start here.

• Your pension plan administrator – If you are nearing your retirement, you can and definitely should request a benefit estimate. These often aren’t available directly from the plan until you are within a certain range of retirement eligibility. You may be able to see a benefit estimate online. At a minimum, there should be documentation that explains your available benefits and the calculation used to determine them.  It is worthwhile to read and understand this.

• A credible financial planner with specific knowledge – If you are uncomfortable doing the research yourself, or have and are not comfortable with your understanding, this can be a valuable resource. As always, I prefer a fee-based consultation. Ask for recommendations from other educators or do your research to find someone with a specialty in your pension system. Before meeting with them, ask them to provide references from other clients and to demonstrate their knowledge of your system.

This may seem like a lot of work, but it’s worth it. I was able to build a basic knowledge of my local pension system by meeting with my HR representative for less than an hour.  I’ve since built more knowledge by spending a few hours with plan documents. Knowledge is power in all things.

4 Options To Include a Pension in Your FI Plan (and the pros and cons)

Okay, now that I have information about my pension, how do I use it?

Below are four (relatively) simple ways to factor in a pension. You can choose which to use based on your personal risk tolerance, assumptions about pension availability, and priorities in financial planning.

1. DON’T.  (conservative)

This is the easiest of all the options. Simply don’t include your pension in your financial assumptions. Treat it as a bonus if it’s there when you retire.

There is good justification for this choice. Private-sector pensions are disappearing. Bankruptcy can cause your pension to evaporate. United employees counting on their pensions would certainly have an opinion about this.

Public pension health varies widely.  I always find this chart to be instructive:

Some states are funded relatively well. Others…not so much. Even in well-funded states, public employee pensions are not politically popular and under constant attack.

Many pensions, even if still available, have changed dramatically. In some cases, employees new to the profession have a lower tier of pension benefit. I cringe when I hear young teachers talking with more experienced teachers about pensions. They often get an overly optimistic picture.

All of this may reasonably lead you to just assume you’ll get nothing as a pension benefit. You can build your financial plan without it. You won’t consider yourself financially independent until you’ve hit your FI target without including this asset.

Pros:  Least risky. Any benefit will improve your FI lifestyle and give you more options.

Cons:  You could work much longer than needed to reach FI.

2. Count as Future Income (optimistic)

In this option, you embrace your golden handcuffs, assume your pension will still be there, and use your future pension payout estimate.

I definitely wouldn’t use this option if working for a private-sector employer. If you are a government employee this may be reasonable. In general, courts have found that governments have to honor their pension obligations. For the larger government entities (federal and state) you have a good chance of receiving the benefits to which you are currently entitled. For smaller entities (municipal and county,) the risk goes up substantially depending on who holds the pension obligation.

If you choose this option, the easiest way is to calculate your FI target using the pension payout as additional income at FI.

An example:  

• You do your research and estimate you’ll receive a pension of $2000/month in retirement.
• You’ve calculated your expected spending in retirement as $6000/month. (please factor in inflation!)

Quick math ($6000 – 2000) says you’ll need other assets to generate $4000/month.  If you are using the 4% rule, your calculation looks like:

((expected expenses) – (pension income)) *12 (to annualize it) * 25 (to apply 4% rule)

6000 – 2000 = $4000/month needed in addition to pension income.

4000 * 12 =  $48,000 additional annual income needed.

48,000 * 25 = $1.2 million in non-pension assets needed.

Your FI target, including your pension, is $1.2 million. If you had taken option 1 instead (not including your pension), your FI target is $1.8million. That’s a $600,000 difference – significant!

Pros:  Includes a pension as an asset. Allows you to reach financial independence earlier.

Cons: Highest risk. If your pension is unavailable or reduced, you will face a shortfall. If your pension payout is not indexed for inflation, you may fall behind over time.

(Note: If the calculation didn’t make sense to you, read more at Setting Your Financial Independence Target.)

3. Use cash-out value (data-based)

This is almost as simple as option 1, but not available in many pension plans. Some plans allow you to cash out an amount, usually related to actual contributions. By doing so, you would give up the future defined benefit. Of course, the amount is typically much less than the potential value of the future benefit.

This number, if available, can typically be found through your pension administrator or online portal.

As an example, I reviewed a plan for an educator friend. He has an expected benefit of approximately $2500/month ($30,000/year) if he works for about 7 more years. He also can see that he could withdraw $138,000 right now if he separated from the system.

If you don’t want to neglect your pension entirely, but also don’t want to embrace the optimistic golden handcuffs, you can choose to use this number as an asset and include it in your net worth calculation. Just do not include it both in net worth AND future income.

The advantage of this is that it is very likely you’ll be granted this sum even should the system change going forward. So, it is realistic. It doesn’t require estimation. It allows you to include your pension as an asset.

Don’t forget that you will pay tax on the withdrawal.

(Important note:  I don’t recommend you withdraw from your pension unless you are relatively certain that it is going under or you have a strong financial plan that includes this action.)

Pro:  Real value is easy to determine. Your pension is included as an asset in your planning.

Cons:  Does not recognize the full potential value of the asset.  May lead you to work longer than necessary. Tax obligation at withdrawal may be substantial.

4. Hybrid model – Dual FI targets (balanced)

You believe that you will receive some level of benefit, but are uncomfortable assuming the full value? You also want to retain some flexibility in case of future job loss or career change. This approach may work for you.

In this approach, you consider two different tiers of FI:

• Ideal FI target
• Minimum acceptable FI

As an example, assume that you’ve talked extensively about your ideal FI experience. It includes significant charitable giving and extensive travel. Your target ideal FI income is about $95,000 annually.

You then review what your minimum FI happiness would require. Let me reiterate the happiness portion of that sentence. This would not be a survival number. I believe a key aspect of financial independence is enjoying your choices.

After working through it, you decide your travel and giving can be reduced to lower amounts and still be satisfying. Perhaps you’ll road trip and volunteer instead of jet set and donate. You also change your assumptions about housing to include downsizing and relocating.  

After this, you calculate a minimum FI happiness future number as $74,000 annual income.   This is what you shoot for in non-pension assets.

Assume you have an expected pension of $3000 a month ($36,000) a year.  You believe you’ll be getting some of this, but think there may be changes between now and when you’d retire. Or, perhaps you may lower the amount by working fewer years. You have no way to assign a degree of certainty.

What you’ve done is create a FI that you can live with at $74,000.  This is $21,000 less than you ideal FI life.  With a possible pension of $36,000 you now have a range of likely options ($71,000 – $110,000)  that will almost certainly keep you financially stable and has the potential to exceed your expectations. Flexibility is powerful in FI planning.

When we initially built our financial plan, we used option 3 to include our pension as a factor.  However, over time we’ve chosen to take this approach instead. It makes us comfortable that we won’t face a critical shortfall in retirement and possible or likely that we’ll experience our ideal (or better) FI life. We prefer this to Option 1, where we’d save for the full ideal FI target and could find ourselves working longer and even more dramatically overfunded. In short, we believe it balances the risk of not having enough money or working too long.

Pros:  Balances risk. Plans for acceptable financial independence, but doesn’t entirely discount the pension as a possibility.

Cons:  May work longer than necessary.  A chance of not experiencing your ideal FI life.

Bonus Approach  (Calculate a present value for net worth)

I’m not fully sure why one would need to calculate the current value of their pension into net worth, other than for a measuring contest. In my mind, it is more useful to count it as future income. That said, this post by Financial Samurai outlines a reasonable way to calculate the value of your pension. It requires you to make some assumptions about risk but will give you a current “net worth” number. If you are interested in this method, I recommend reading the full post.

It provides a framework and takes into account the uncertainties I’ve previously named. If you like to view your numbers from many different angles or are in an ego contest, this will work. If you absolutely need to attempt to include a full value in your current net worth (who are you competing with?!) then calculate away.

One final caution – remember that a pension is not a perpetual asset because the payout ends on death. In some cases, the benefit can pass to your spouse, but rarely longer than that. Consider this in your estate planning.

Summary

A pension can be a fantastic benefit in reaching financial independence. But, you need to be cautious about how you include it in your planning. I outline four ways (and a bonus) in this post:

• Don’t!  (conservative)  – Assume nothing, any pension is a bonus.
• Count as Future Income (optimistic) – Recognizes full potential value if everything goes your way.
• Cash out value (Easy, data-based) – Real numbers, assumes some value.
• Dual FI Tiers (balanced approach) – Design down from your ideal FI level to create a range of potential outcomes you’ll be satisfied with.
• Bonus – Calculate In Current Net Worth (Financial Samurai method) – A reasonable calculation to give you current value.

Do you have a pension?  What method do you use for your FI planning? Comment below or share your thoughts directly with me.

If you haven’t had a chance yet, check out our Educator on FI/RE interview series, or read about how educators can multiply income by using the educator career ladder.