A pension is a form of retirement plan where your employer sets aside money for you, invests it, and then pays you a certain amount per month when you leave the company.
Defined Benefit vs. Defined Contribution Plans
Pensions can also be referred to as a “Defined Benefit Plan” because you are paid a specific benefit amount when you leave the company. In comparison, 401k’s are an example of a “Defined Contribution Plan” because you contribute a defined amount of your own paycheck (say 10%), and the amount that you receive from this in retirement depends upon the total amount invested.
If you are entitled to a pension at your work, count yourself lucky. The percentage of American private sector workers covered by a traditional pension has been slowly decreasing over the last several decades, from 38% in 1979, to 13% in 2014. In comparison, the percentage of workers covered by a defined contribution (e.g. 401k) plan at work is increasing, now up to nearly 50%.
If you don’t have a pension at work, don’t despair. You can make your own pension. Here’s how:
Step 1: Resolve to take matters into your own hands
In the past, your employer would do all the planning and investing for you in order to give you a payout in retirement. If you don’t have a pension, you need to take the initiative to do this on your own. This is okay. It will make you a stronger, more educated and independent person.
Step 2: Understand the math behind making your own pension
Creating your own monthly payout in retirement basically involves saving enough money that your expenses can be covered by withdrawing just 3% of your savings each year.
For example, if you need a monthly payout of $5,000 to cover your expenses in retirement, then this would require $60,000 per year. $60,000 is 3% of $2 million, so you will need $2 million dollars in savings to comfortably receive a $5,000 monthly payout in retirement.
Step 3: Save!
If the numbers in the right column of that chart above look formidable, it’s because they are. Nothing good in life comes easy; you have to work for it. Even those employees with a traditional pension generally need to put in 20+ years of service before they receive a pension of $2500 to $3000 per month.
To hit those high net worth numbers, you will need to eliminate all debt and aggressively save a large portion of your income. Here’s the general framework:
- Get the Employer Match in your 401k
- Fill up a Roth IRA each year ($5500 in 2017)
- Fill up the rest of your 401k (max $18,000 employee contribution in 2017)
- If you don’t have a 401k, 403b, TSP or any other sort of employer-sponsored retirement plan at work, then fill up your Roth IRA and use a good old taxable account to save the rest.
- Invest aggressively. Lack of knowledge is not an excuse.
Step 4: Understand that there are complicating factors to this discussion
The calculations in step 2 are conservative and will generally support a pension payout (retirement duration) of 40+ years. There are several complicating factors that may reduce the amount you need to save to create your own pension.
- Length of Retirement: If you only need your pension to last 20 or 30 years (for example, if you retire at age 65 to 70), then you could probably use a larger percent of your portfolio each year, such as 4%. In that case, for example, you may only need to save $1.5 million to get a $5,000 per month payout.
- Other Sources of Income: If you have real estate income or plan to work part time in retirement, then your pension need may be reduced. For example, if you can make $20,000 per year in retirement working at a fun part-time gig, then you would only need a $40,000 per year pension payout, which would reduce your required nest egg even further, to around $1million.
What About Social Security?
Social Security is another example of a defined benefit pension plan. Instead of being funded by your employer, it is funded with taxpayer dollars and administered by the federal government.
There is a lot of debate about what will happen with social security in the future. If I had to take a guess, Social Security taxes will go up, the average Social Security age will go up, and monthly benefit payments will go down.
Personally, I am 30 years away from being able to collect social security, so I prefer a conservative approach. I don’t necessarily plan for social security, but if it’s still around when I get there, the vacations will be a little bit sweeter.
There’s no need to lament the fact that your employer doesn’t offer you a pension. There’s also no need to stress over whether social security will be around when you retire. Take matters into your own hands. With discipline and planning, you can make your own pension.