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Dear HD readers: We had so much fun with the original version of this post, that I thought it might be fun to add a 3rd possible route to funding retirement at $138,000/yr. Of course, there is no reality in this, no real personal info, it is just a scenario. And, most important, any legal route that get you to your desired retirement income is the right one for you.
One of my friends is hitting 73 in August and we were discussing his need to do an RMD this year. I’m older and have been doing them for some years already. Our financial affairs have one major difference; he has a significant pension and I do not have any pension. I’d say that we are both comfortable. I think he likes his situation, and I like mine.
I thought it might be interesting to create a possible scenario where three people might arrive at the same retirement income through different routes.
Joe has a pension, SS and some savings split between taxable and tax deferred (25/75). He makes around $138,000 per year.
Bill has no pension, he has SS and savings split between taxable and tax deferred(25/75). He makes around $138,000 per year.
Paul has no pension, he has SS and savings split between taxable and tax deferred (67/33). He makes around $138,000 per year.
They are the same age, are retired receiving SS. The all receive $48000 per year in SS. Joe has a $5,000/Mo no COLA pension, and takes 4% of his $750,000 savings each year to reach his $138,000 income. Bill takes 4% of his $2,250,000 savings each year to reach his $138,000 income. Of course, as Bill ages, he will have to take larger RMDs, but he can lower what he takes out of his taxable account to try to keep his income the same as Joe and Paul. Paul has been investing in Dividend Kings and collects $60,000 in dividends from his taxable account. He also takes a 4% withdrawal from his approximately $750k tax deferred account. His dividends have been growing around 5% on the average each year.
All have a reasonable allocation to equities in their financial assets. They all own a home without a mortgage.
I suspect that Joe had some kind of government job and that Bill worked for a corporation. Bill might have had a higher income while he was working. Paul owned a small business.
We might be discussing Sally, Cheryl, and Elizabeth instead of Joe, Paul and Bill….the names are just for convenience.
So, which might you like to be and why?
Joe and Bill are about to have an ugly blind date named IRMAA.
Bill, even though I really like guaranteed income. So I would delay SS to maximize the COLA, perhaps buy a deferred annuity like a QLAC and use a TIPs ladder to mitigate inflation risk. (Not that different from what we are actually doing although we do have 3 small pensions, one with a diet COLA.
I suspect the responses maybe affected by recency bias. With the stock market doing so well for so many years, higher savings appears to have the stronger case. Would the responses change if we had just experienced a recession, or long overdue correction?
Where is the pension … In a rust belt school district teetering on insolvency or the federal government? Big difference
I did some quick back of the envelope numbers.
Joe: $750,000 savings 75% tax deferred, and $60,000 annual pension (no COLA).
Bill: $2,250,000 savings 75% tax deferred, and $0 pension.
Both have social security income.
If we assume the pension is the equivalent to a bond, and if $60,000 annual is equivalent to a 4% withdrawal, then the “bond” is worth $1,500,000.
Let’s assume Joe’s pension is taxable at 12% and Bill’s 4% withdrawal is also taxable at 12%. Joe’s tax is $7,200 and Bill’s annual tax is $10,800.
However, Bill can take from both taxable and non-taxable savings. If we use 25%/75% then Bill’s taxable account is $562,500 and at 4% the withdrawal is $22,500 and the 12% tax is $2,700.
My observations:
I’d assume Bill would use the tax advantaged approach, so his income per year would be $4,500 more than Joe’s, all other income being taxed equally (an assumption).
Bill’s tax deferred account is $1,687,500 which is larger than Joe’s pension if we think of it as a bond.
Bill can invest his $2,250,000 at get at least 5% annual return, or $112,500 annual return. This would exceed his hypothetical annual withdrawal of $90,000.
If the pension stops after 25 years of retirement with Joe’s death, then Bill’s residual account value would seem to be larger, possibly $2,000,000 or more.
One issue with pensions is they might not be cast in stone. For example, certain Public Pensions in Illinois are severely underfunded.
Just my 2 cents, on a 1 cent envelope.
I’d be very happy with either option. 138k is way beyond my expected income needs for retirement. If I had to pick I would probably choose the pension option, and after I had a nice cash reserve I’d go 100% stocks with that 750k savings, since that would probably more than make up for any (normal) inflation concerns long term.
Based on the comments here, i wonder why there is general angst over the demise of pensions. 😳 To many folks it seems they would rather go it alone.
Is there general angst over pensions? I don’t think so. If they were in high demand I think companies would offer them to secure better employees.
I can only speak for myself, but the fact that Joe’s pension has no COLA, and Bill has $1.5 million more in assets makes the choice easy. The OP asked us which scenario we’d prefer, not what we think of pensions!
Interesting. I guess I’m too conservative, but i like the $60,000 guaranteed income rather than face the markets for basic income. My pension doesn’t have a COLA either.
Of course, anyone would like $60,000, if it stayed $60,000, but it won’t in real terms. Inflation has been relatively tame for the last 25 years, but my pension has still lost nearly half its value. What if we had had 70s-80s size inflation?
I don’t think you’re too conservative at all; as they say, personal finance is personal. And I agree that the $60,000 in guaranteed income would be nice!
My thinking is that 4% isn’t an aggressive amount to be drawing down. If one follows the 4% +inflation guidance from the Trinity study, the purchasing power of the income (SS + investments) stays the same. I’d be worried that a pension with no COLA would result in a decrease in real income.
I think either approach has associated risks and both have pros and cons. At the end of the day, Bill and Joe are both well set-up for a wonderful retirement – however it looks to them! 🙂
I would much rather be Bill.
I’d invest the $2,250,000 in a 70/30 portfolio of index funds (e.g., VTSAX and VTBLX) and use either the Variable Percentage Withdrawal (VPW) or Total Portfolio Allocation and Withdrawal (TPAW) to determine how much to draw down.
If I was Joe, “only” 750K would make me a little nervous. However I would have my SS with COLA to partially keep up with inflation and would probably know that my $138K annual budget might decrease as I get older and travel and adventure less. But how much of that $138K is discretionary? However, a lot would depend on the terms of the pension. If married with no pension survivor benefits, then I would rather be Bill, especially if there are also kids. And if I were Bill with the extra $$ I would probably be more aggressive with at least a third if it, but less so with “only” $750K.
I’d rather be Bill, I’m just more comfortable owning the assets than depending on a pension.
That’s interesting. I never expected to hear that. If you had a pension and could take a lump sum, would you?
100% take the lump sum and that is exactly what I suggested to my children. First there are NO guarantees, as I have seen pensions come and go. And without COLA or the like if you lived to be 101 like my Dad that would clearly make you want to be able to invest the lump sum and be better off. I do not see the S&P 500 as risky, as you are talking about a long period of time.
I’d absolutely run the numbers of annuity vs lump sum when doing my own projections, the lump sum is almost always “better”, because there’s no admin expense built in every year. That said they’re also usually close enough to consider whether I’d prefer the income stream. (there’s also taxes, life expectancy considerations, if a legacy makes a big difference to you, etc)
So for me it’s not an emotional decision, it’s just how does that piece fit in with all the other pieces, and is most likely to leave me in the best circumstances in the full picture.
Would entirely depend on the maths of the commutation factor offered. 10x pension probably not. 40x pension you’d have to be extremely risk averse not to take it.
That would set by the plan sponsor actuarially to keep the cost as close to neutral as possible to the plan trust. They certainly aren’t going to give away more.
But even then the buyout depends on volatility in the annuity/bond market. Plus there is usually some juice as companies are willing to pay a premium to get the risk and admin cost off their hands.
It is absolutely not a matter of one is clearly superior to the other for all but the most extreme personalities.
Would you have said “I prefer secure income no thanks” if your employer had offered you a 40x buyout at retirement?
Not sure what you mean by 40x buyout? 40x pay or pension? They couldn’t even do that with a qualified pension.
It’s a thought experiment not a legal exercise. We know you are extremely risk averse. At what multiple of your annual flat pension would you have taken a lump sum instead (assume it were possible to put the entire lump sum directly into pre-tax 401K)?
Remember with US inheritance tax rules it’s a lot more valuable to have capital to pass on.
I think without presenting unlikely circumstances, we can say that assets can reduce the withdrawal pct needed, which allows an individual to weather poor equity markets and long term own the compounding advantage. That’s a major edge to assets over cash flow.
Aside: when you ask about 40x, wouldn’t someone just use part of that to buy the annuity they want/need (assuming they’re a cash flow person) and keep the rest? So I’m not sure it’s a thought experiment that gets you where I think you’re pointing. If we assume people behave logically, they’re always going to take a larger payout if it lets them buy that marketplace annuity.
See my response below – I priced the annuity Bill could purchase to replace the $60K. Bill gets the same cash flow with an extra $810K in his pocket.
I read it, you saved me the work of doing it myself!
A side benefit of not buying an annuity is flexibility. It has to be worth something to have the freedom to re-deploy capital in the way you need at some future date.
Interesting question. With a no COLA pension as you specified, I’d rather be Bill. I found Rick’s analysis below compelling. But if Joe had a COLA pension, it’d be a tougher choice and I’d probably lean more towards being Joe. There’s some non-mathematical aspects to an ERISA protected income stream that can’t be lost in a court judgement, mismanaged away, or just plain swindled out of. Also, while not in the hypothetical, a key consideration for me would be if there’s a spouse involved, the ability of the spouse to manage and safeguard an investment portfolio, and whether leaving a legacy to heirs is a concern. Nevertheless, a very interesting question. Thanks.
A very good point regarding the surviving spouse. Still, that could be addressed with a SPIA, and the insurance provided by the state guaranty corporations may be superior to the pension benefit guaranty corp.
But SPIA protection from court judgements vary by state and may well require legal costs to protect, if it can be protected at all. Meanwhile, an ERISA protected pension is protected by federal law and is widely recognized to be near impossible to take from someone due to a judgment.
I thought the state guarantee was generally lower than the federal. Certainly is in my state.
You are right, the states are much lower than the PBGC. In NJ the limit is only $200,000.,
I wasn’t familiar with NJ limits. I checked this link and it shows a $500K limit for annuities in the “payout” phase – excerpted below. I think a SPIA counts??
“Annuity benefits are subject to the higher $500,000 limit when they are in the payout or “on-benefit” stage, such as when you have elected to take a monthly payment stream from an annuity upon retirement.”
Someone can correct me if I’m wrong, but my understanding is that the state will cover the insurance/annuity in full, so long as you have not exceeded your states maximum premium, (which is/was as low as $100K in some states. In other words, you may have to buy multiple annuities to be fully insured).
The PBGC may only guarantee a percentage of your pension.
I bet Dick Quinn could shed more light on this.
PBGC has limits too, but for most people it will be full coverage, but the formula also considers early retirement too. I don’t recall the details, but having gone through my old employer buying annuities for a few thousand retirees in lieu of their pensions, I do know the state coverage is not as good as the PBGC in the event of insurance company failure. Varies by state though.
Thanks Dick. Your depth of experience is an asset to these conversations.
We’re like Joe. We both get SS and have COLA’d pensions.
Our annual income is tens of thousands of dollars less than either Joe or Bill.
But our income stream IS greater than our typical living expenses.
Mortgage Free Condo. We haven’t had to touch our tax advantaged (IRA) investments.
Blessedly, our post-tax investments have been more than sufficient to help pay for travel, a new car, spoiling our grandkiddies, hobbies, and various Home (Condo) upgrade projects.
Yet another great thought provoking question!
Thanks stelea99!
Bill for sure. Per ImmediateAnnuity.com, Bill could take $750,000 and buy an immediate annuity paying $5,513 per month for life – 10% better than Joe’s pension. He would then have $1,500,000 left in investments. He would need to take out $23,844 per year, or 1.59% of his portfolio to reach his goal of $138,000 per year. Lower risk, smaller withdrawal, larger portfolio.
Another option is Bill could take $890,000 and buy a $5,086 per month annuity with a 2% COLA (per Fidelity’s Annuity tool). He would still have $1,360,000 in investments. His initial withdrawal would be $28,968, or 2% of his portfolio.
Bill has $1,500,000 more than Joe in investments. Per ImmediateAnnuity.com, $690,000 would purchase a $5,000 per month life annuity, equal to Joe’s pension. This is basically the present value of the pension, giving Joe an effective worth of $1,440,000, compared to Bill’s $2,250,000.
Don’t know Rick are we talking about the same thing.
While the specific limits can vary and are subject to change by law, a recent bill signed into law in New Jersey increased the payout cap for annuity products held by insolvent insurance companies to $250,000. This means that if your annuity issuer fails, the NJLHIGA would typically cover up to $250,000 of the present value of your annuity benefits
We may not be. The data I referenced came from a NJLHIGA FAQ site. The site shows different coverage limits for different types of annuities/benefits. The site shows a $250K limit for cash surrender value. The Annuity Benefits Present Value Limit is shown as $500,000. Here is the FAQ defining the 2 types of coverage:
I am not surprised you did the math, Rick. LOL! Chris
How could I not. I understand there are non-quantitative aspects to people’s choices, but I don’t understand not wanting to know all the quantitative aspects as well, and then making your best choice.
Thanks for doing the homework Rick. I just guessed that it would take a million to match Joe’s pension. This is all the more reason to be Bill.
You’re welcome Dan. My older brother (a chemical engineer) always told me to finish my homework first.
Ye gads Rick, I was afraid to mention annuities, what ages did you use? 😀
70, male, NJ. Pure guess based on a quick read of the scenario. I was surprised you didn’t mention annuities. The scenario was a perfect setup for one as a comparison.
My non-COLAed pension, plus retiree medical, allowed me to retire early. But that pension is worth a good bit less now. In this specific scenario, especially if my health was good, I would prefer to be Bill, although that doesn’t negate my preference for pensions (or annuities) with COLAs.
Just curious, did your former employer offer a 401k with a match of any kind?
Not sure how that’s relevant, but yes, and I both met the match and contributed the maximum. Unfortunately, Roths didn’t arrive early enough for me. As I posted on a different thread, the year before I retired I saved 25% of my income. For the couple of years I worked part time I contributed to an IRA.
It’s relevant because the employer match is effectively your COLA in advance.
We gave an ad hoc pension COLA every several years, between 1970 and 1990, but we added a 401k in 1982 and several years later made the decision there would not be any further COLAs because employees could now receive 3.5% of pay from the company in their 401k.
Sorry, not the same thing at all, as far as I’m concerned. Would much prefer an actual, annual COLA, like Social Security. And my employer hardly ever did even ad hoc COLAs.
Are these down voters saying they would turn down a pension with proper COLA?
But that is the way companies think. It’s all an expense and employers don’t like commitments to rising costs they can’t control as with a COLA. – which is why you can’t buy an annuity with a real COLA.
I don’t know what the situation is now, but it wasn’t the way UK companies used to think, which is why it took a while to dawn on me that my US pension wouldn’t have a COLA. I was not pleased. Would be interesting to know the current situation in the rest of Europe.
Because there is no COLA you would really give up a pension for a nest egg subject to the markets and which you must manage and plan withdrawals?
Aren’t you, like me, some of both Joe and Bill?
I just wrote something I will post in a couple of days about inflation in retirement.
The age of Bill and Joe might make a difference, but yes, I would prefer the larger nest egg, suitably invested, over a non-COLAed pension, given the effects of inflation.
My pension has lost nearly half its value in the last 25 years. John Hancock says I could reasonably live another 20 years, what’s it likely to be worth then? Since it was frozen when I reached 30 years service, working longer wouldn’t have increased it.
I can’t image anyone would pick being Bill in this scenario – PBGC risk notwithstanding.
Bill always has more risk and uncertainty than Joe.
The one flaw in your analogy is assuming Joe did not or could accumulate the assets Bill did thus putting Joe in an even better place.
Plus, most government pensions do have a COLA.
Some people can be both Joe and Bill.
“I can’t image anyone would pick being Bill in this scenario – PBGC risk notwithstanding.”
“Bill always has more risk and uncertainty than Joe.”
Your comments above are clearly consistent with your long argued views on guaranteed income in retirement vs having a large asset base and managing that base to produce income. Even so, the comments are still surprising given the specific scenario presented in this article. All or almost all commenters clearly favor Bill’s option. They do so primarily because the math clearly says so. Much thanks to Rick Conner for laying out some straightforward ways Bill could recreate Joe’s pension (if desired) and still have a significantly higher asset base remaining.
Like many union thugs, I had always advocated for defined benefit pensions. However, my employer’s DB plan was frozen in 1988, and I think I’m better off as a result. The old pension was administered by an insurance company whose fees were ridiculous. The new 401K cost less to run, and it came with an employer match. Like many defined benefit pensions, my old one is now in the hands of the Pension Benefit Guaranty Corporation (PBGC), this is a hazard for Joe as well.
If Bill wanted to, he could take about $1 million of his IRA and purchase an income annuity (or several annuities in order to be fully insured by his state’s annuity guaranty association) that would match Joe’s pension, leaving him with half again as much in his IRA.
I wanna be Bill in this scenario.