I’ve been thinking a lot lately about income during retirement. In the personal finance “blog-o-sphere” it’s always about hitting that financial independence milestone, where your annual expenses are 4% of your total investments, so you can live off of entirely passive income.
That’s a nice idea. But who said you had to rely just on dividends and withdrawls from your investments in retirement? There are other options. Today I’m going to be comparing and contrasting two other options we have available.
I work for a huge employer that still offers an honest-to-god pension. So the pension has always been a part of my retirement planning. And so it is for everyone else who works for this employer. In fact, from the way they talk, you’d think they were all planning to be completely reliant on the pension to cover their living expenses!
The talk is always about how many years they’ve put in, or how many years they “have left.” Like it’s some kind of prison sentence. I don’t know if this is an actual reflection of people’s financial standing, or just a misunderstanding of how pensions work, but everyone seems dead set to work at least 30 years, no matter how old they would be by that point.
The basic pension rules
Under our pension system, for up to 20 years of work, you get 1.66% of your final salary for each year worked. Once you hit 20 years, you get 2% for each year. And then at 30, it drops down to 1.5% for each additional year. So between years 19 and 20, you get a jump from about 31% to 40% of your income. Then it becomes less lucrative to stay longer than 30 years.
Pensions aren’t paid until you’re at least 55, and there is a penalty if you don’t have at least 30 years at that point. That penalty is reduced for each year you delay taking a pension until age 62, when you are not penalized at all.
But what does it practically mean to take a pension early? Let’s look at someone with a salary of $70,000:
Taking retirement at age 55:
|15 Years of Service||$12,770|
|20 Years of Service||$20,440|
|25 Years of Service||$25,550|
|30 Years of Service||$42,000|
Taking retirement at age 62:
|15 Years of Service||$17,493|
|20 Years of Service||$28,000|
|25 Years of Service||$35,000|
|30 Years of Service||$42,000|
According to my calculations, there is no incentive to delay taking your retirement until age 62. Even with a 27% penalty, it’s worth it to take the pension for those seven years.
In our 15 Years example, after seven years of saving all of the $12,770 at 7% interest, it would total nearly $115,000. At that point, the $115,000 at 7% would be generating $8,000 a year, turning that $12,770 pension effectively into a $20,770 pension.
But if you held out on collecting retirement until age 62, you’d be waiting seven years to turn that $12,770 pension into a $17,493 pension. That’s an extra $4,723 a year. So, in a way, you’re losing money by not taking the penalty!
As someone planning for an early retirement, I’m looking to skew towards the lower end of the Years of Service spectrum. But is it worth? Am I leaving so much more money on the table by quitting at 20 instead of 25, or 15 instead of 20?
Savings needed to replace a pension
Now that we know that it’s not worth delaying taking a pension from age 55 to 62, we’ll forget collecting at Age 62 and just focus on the Age 55 chart. How much money in savings would it take to replace the annual income from working a few more years for a pension? Using a 4% withdrawl rate, here’s how much you would need to have saved up to replace each five year increment:
15 Years vs 20 Years
|15 Years||20 Years||Income Gap||Savings Needed|
|$12,700||$20,440||$7,740 / year||$193,500|
20 Years vs 25 Years
|20 Years||25 Years||Income Gap||Savings Needed|
|$20,440||$25,550||$5,110 / year||$127,750|
As expected, the jump from 15 to 20 years is bigger than the one from 20 to 25 years because of the bump at Year 20 from 1.5% per year to 2%.
For working from year 15 to 20, you get an additional $7,740 in income. That would require an additional savings of $193,500 in the bank to replace.
But don’t forget, that pension doesn’t kick in until age 55. Say I’m retiring at age 40. We don’t need $193,500 right now to make up the gap. In fact, $70,142 invested at age 40, left alone and growing at 7%, turns into $193,500 by age 55. Why, that’s just one year’s income for our $70,000 earner! Or, if you like, two years with a savings rate of 50%, like we saved last year. Suddenly that 15 year pension turns into a 20 year pension through your own shrewd investing!
Hmmm… maybe a pension is not as much of a golden handcuff as I had thought. Let’s look at another example.
Rental Property Income
Our first investment property income statement is forthcoming, so right now, let’s use our very optimistic income projection as a basis. In our example, with a 2-unit property, we are bringing in $5,525 a year in cash. When it gets interesting is when the mortgage is paid off. Without mortgage payments, that would leave another $10,440 in cash flow for us! That’s nearly $16,000 a year total.
You can probably see where I’m going with this. One fairly simple income property bringing in $16,000 is worth more than a 15 year pension! By buying one more similar investment property, we’d have $32,000 a year, which would cover almost all of our living expenses in 2015.
But unlike stocks, bonds, and a pension, an investment property is not entirely passive income. Things need to be fixed. Tenants need to be vetted and apartments need to be filled. But after not hearing a peep from our tenants for the last two months, I’d say it really is close to passive income. And besides, don’t you need something to do in retirement anyway?
Real Estate, Savings > Pension
But the one big advantage the Savings and Rental Property methods have over the Pension for early retiree wannabes like you and me is that the income is happening now instead of at age 55. No need to wait. This is something the pensioners at my work don’t seem to get. Dividends will show up in your bank account right now. Withdrawls from a 457 Plan can happen right now. And you don’t have to wait until age 55 to have access to rent payments. You can create your own pension. Call it a DIY pension, or a “pensionhack” if you’re nasty.
So if you don’t have a pension in your future, and most Americans hired today won’t, don’t worry! By owning a rental property or squirreling away your money, you’re basically creating your own pension! Sure, a rental property is just a little bit more work. But if you look at it another way, by not putting in all those years at a workplace to secure a pension, in the long run, owning an investment property requires far fewer work hours.
Not that there’s anything wrong with a pension
This is not to put down the pension at all. The one big benefit it has other the other methods is that it is a defined benefit plan. What you receive every month is not affected by the stock market or by unexpected expenses at a rental property.
And not everyone is as financially astute as the readers of Ridinkulous. People like the security and “sure thing” nature of pensions or Social Security. We know that people have a problem saving for retirement on their own and I think the disappearance of the private sector pension is going to be hugely economically damaging in the near future. People just don’t save on their own. Politicians would count the disappearance of the pension and the rise of the 401(k) as an indicator of our economic freedom. Yes, it’s true! People are now free to save nothing for their retirement! We also have the freedom to be ripped off by investment advisors and fund managers!
I believe in saving people from their worst impulses, and that includes not saving for retirement. Many people just don’t see the value in it since the payoff seems so far down the road. That’s exactly why pensions are important. It’s the long view that causes people to put it off until it’s too late.