What’s a Pension Worth?

Someday I’ll write a blog post with the same title and I’ll wax poetic on the piece of mind that comes from fixed income, or the weak bonds that keep the pension system together (thanks PBGC). But today, I’m actually talking about the dollar value of a pension.

You’re a teacher, and you’re about to retire at 65 and get a $50,000 pension. You also saved some money in your 403(b), maybe half a million bucks. If you include your pension, how much have you saved?

In what is surely not a surprise, with a little clever math, we can put a value on it.

The first step is to figure out what you’ve got — a guarantee of $50,000 per year until you die, and usually increasing by the CPI each year. An inflation-adjusted pension.

Someone who worked somewhere that doesn’t have a pension isn’t out of luck, they can buy what you’ve got. It’s called an immediate annuity. They can even buy one with an inflation adjustment. What would they have to pay? Right around $1,200,000.

That’s similar to another rule of thumb we could use to back into a value — how large of a portfolio would you need to be able to withdraw $50,000 per year using the 4% rule? $1,250,000.

So then, we have a value. What does that mean? Well, if we want to, we can reverse-engineer an estimate for what you would have had to have saved over time to get that lump sum.

Let’s imagine you started saving for the last 30 years of your career, from 35-65. If your savings had compounded at 2% per year (quite low), you’d have been putting away $29,580 each year to have $1.2 million at age 65. On the other end, if your savings compounded at 10% per year (quite high), you’d have been putting away $7,295 each year.

That $50,000 per year pension you’ve got was worth something like $7,000-$30,000 per year. Probably quite a hefty portion of your salary.

 

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We Already Have UBI

Edit: This podcast from Econtalk on the same subject came out a day after this post (coincidence? I think not) and was a worthy listen.

Universal Basic Income (UBI) is a concept that has gained significant momentum over the past few years, and is ubiquitous enough that most people are now at least passingly familiar with the concept.

I’m here to break the news that we already have it. Social Security is effectively a UBI that is limited to the elderly (perhaps that means the “U” in UBI needs an asterisk).

According to the SSA, nine out of ten individuals over 65 receive benefits, and I’d wager a few more tenths are waiting to claim either at their FRA or at age 70. Most of the others who don’t qualify probably receive another pension.

Most UBIs have a flat payout, not a formulaic one, but if I were a gambling man, and I am, I’d bet we see flattening payouts as part of the solution to the demographic problems the Social Security system is on track to have. Benefits for high earners are already significantly lower relative to amounts paid into the system thanks to the “bend points“. It would be a natural extension to have earners over a certain amount pay in but not increase their benefit, or to change the current bend points, or both.

This would exacerbate the “problem” of social security alone not covering pre-retirement cost of living, but would allow using social security as a ‘floor’ for the standard of living that we want to allow people to live at.

And, a natural extension of not wanting Grandma living under a bridge eating mustard sandwiches is that we don’t want anyone under a bridge eating mustard sandwiches. There are a lot of subtleties in moving from Grandma to everyone — e.g., if Grandma is eating mustard sandwiches she might not have any viable way to earn an income, while someone younger might, and maybe there are a few 20 year olds who would not work if you guaranteed they did not have to live under a bridge. This is the danger of making UBI equal to the cost of rent + food + netflix. This is called retirement, and most people find it perfectly acceptable from age 65+.

So the question, then, is: Do we wish to allow everybody, if they wanted to, to retire and watch netflix all day? It would certainly make some people better off, but the costs would have to be absorbed by others.

If the answer is yes, we have a fairly easy framework to implement with, simply allowing earlier and earlier (perhaps at more and more reduced amounts) filing for social security.

Retirement Savings Checkpoints

One of the most common questions that I wonder about is what sorts of savings ‘checkpoints’ people should be aiming for, especially early on in their careers.

The Inspiration

I was recently pointed in the direction of the J.P. Morgan Guide to Retirement, which I found to be a thoroughly enjoyable, if not always actionable read. It includes a slide with the same name as the title of this post.

Page 15 looks like this (and do visit the entire page at the above link):

Retirement Checkpoints

I found this to be very practicable (if it is a truly useful approximation). If a 30 year old makes $100,000, and wants to retire at age 65 that same standard of living they should have saved $130,000 by now.

The Assumptions

This obviously opens the door to questions about what the other assumptions are:

  • Retire when?
  • Portfolio returns?
  • Inflation?
  • Retirement age?
  • Years of retirement?
  • Future contributions rate?

J.P. Morgan kindly provides us with some of those as well (though I have no idea what confidence level “80%” means).

Retirement Checkpoint Assumptions

They also include data on the assumed income replacement rates (if you make $200,000 and pay $100,000 in taxes, you have to replace only $100,000 (50%) of your income to live the same lifestyle in retirement (actually, $100,000 minus annual savings). If you make $30,000 and pay $3,000 in taxes, you have to find a way to replace 90% of your income. They also factor in social security (which has the opposite effect, as it replaces a much higher % of lower earners’ income).

Building My Own

Like any red-blooded nerd, I realized that if I wanted to play with the model I would need to rebuild it, make it stronger.

Pretty quickly it became apparent that even if I take the other assumptions at face value, the question of tax assumptions looms large, especially:

  • Are all contributions being made to retirement accounts?
  • Is there a static or dynamic tax assumption (at withdrawal or other)?

Another small question, are contributions inflation-adjusted? E.g., does a 5% contribution go up by 2.25% and mean a 5.1125% contribution the next year? Equivalent to 5% on an income that increased with inflation.

So, as close as I can figure (without doing anything smart like actually asking the authors [stay tuned]), basically eyeballing the data here, assuming the below is a pretty reasonable start:

  • Yes, contributions are increased to keep up with inflation, and;
  • All contributions are made to retirement accounts, and;
  • All distributions are taxed at 28%

(Click for side-by-side)

MyVersion2

New Scenarios

So now that I have my own model that works under some reasonable conditions, I can start playing with the inputs.

First, I like the flexibility, but prefer to keep returns equal pre and post-retirement. I think 6.5% is still reasonable. Then, what about retiring at 55 instead of 65? And what if my annual contribution rate is actually 15%?

New Scenario

New checkpoints! Now, there is not a linear relationship here, because of the higher savings rate, the earlier checkpoints are more forgiving, while by 55, they are much higher. Since we changed multiple inputs at once, it is hard to see from the table how much of the change came from the extra 1.5% return in retirement versus the (opposite) forces of earlier retirement and a higher contribution rate.

We also run into a problem with the income replacement rate — because J.P. Morgan was assuming age 65, Medicare was in play for all of retirement, and they assumed that social security was being taken as well. For someone retiring at 55, we need to go back and add some excess draw for those ten years. We’ll save that for another post.

Age 65 Retirement Scenarios

So without backing into some assumptions for how much income to replace in the years before age 65, we can still play with other scenarios.

Here is 15% savings rate with 6.5% returns.

15and65

It doesn’t take much teasing of the data to find an interesting conclusion – if you are going to retire at 65 and are able to consistently save 15% throughout your working life, it’s important to get started by 35, but it is okay if you haven’t made much progress yet.

On the flip side of the coin, if you’re approaching 50 and make $200-250k (and want to maintain that lifestyle), you best be closing in on a million dollars, or planning to save even more going forward.

The Limits

This model is incredibly simple, major variables like taxable accounts are omitted entirely. I’ll probably revisit this at some point, including inquiring about the actual assumptions the folks at J.P. Morgan used, building in better ‘early retirement’ capabilities, making my own estimates for income replacement rates, etc..

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Retirement Doesn’t Mean It’s Time for Social Security

Retirement != Social Security Time

One of the biggest false constructs people have in their minds about social security is that they have to take it once they retire. I’m still not entirely sure if they think it is a literal requirement, or just an ironclad rule of good financial management, but it is overwhelmingly common.

Part of the problem probably lies with the most common language used around social security, “full retirement age”. Most people who turn 62 begin to educate themselves on their options, at least enough to know that every year they wait up till 70, they will increase their benefit (unless they are going to claim a spousal benefit, in which case they top out at 66 or 67 or some point in between).

For single people, especially healthy, wealthy ones (the kind that retire at 60 so they can travel Europe and hike while they have two good knees), it often makes sense financially to draw a little more from the portfolio from 62 until 70 for the enhanced benefit starting at age 70.

Why? Because the increase to social security is mostly risk free (some political risk, but the odds that two people of the same age won’t get grandfathered in because one started benefits and the other didn’t strikes me as tiny), and that increase is close to 8% (the math changes part-way through), which you would be wise to note, is much higher than that other risk-free return, treasuries.

Yield Curve

Yes, that’s 2% at the top of the graph. And yes, it does feel different to have a social security benefit that is growing at 8% per year versus having a portfolio with a balance that you can see growing at 8%, but the math is pretty much the same, and math doesn’t care how you feel about it.

The other nice thing about social security is that it is a form of insurance (in fact, your benefit at full retirement age is known as your primary insurance amount (PIA). If you do the riskiest thing in finance (well, besides invest with this guy), live a long life, the returns on delaying social security just compound and compound. If you die early (e.g., 72), yes your decision to wait sucked, but it turns out you didn’t need that money anyway!

Now, obviously there are cases where someone has saved next to nothing for retirement and can’t continue to work past 62, and they will draw social security as soon as they can, but for people who don’t fit into that bucket, just remember, you don’t have to take social security when you retire, you can file for medicare separately, and you’ll probably be better off to wait.

Couples is a more complicated issue as far as when they should begin taking benefits, although it got simpler/more complicated with the elimination of file & suspend. I haven’t taken the time to flesh out my new preferred rules of thumb (RIP to my file & suspend spreadsheet, you were so beautiful), so I won’t conjecture. But couples have the same option as single people, waiting to take benefits, even if they consider themselves “retired”.

So please, old(er) folks, don’t feel pressured by your friends or colleagues or CNBC (do they talk about social security?) to begin your social security benefits the day you walk out the door from your retirement party.