Whether you’re in the public or private sector, you’re most likely to get a pension if you work full-time for the same employer for most of your career. Pensions are designed to reward longevity. Benefits increase the longer you’re with the company.
With news about a possible pension crisis in the United States, you may very well be concerned about your retirement plan.
A report from the Pew Charitable Trusts shows state budgets, responsible for paying pensions to public sector employees, have a combined $1.4 trillion deficit in their pension funds. As a result, government workers may not get all their promised benefits.
This sounds alarming, but will it affect your retirement security? How much do state governments really contribute to pensions? And do you need a pension at all, or is another retirement fund a better choice?
What is a pension?
A pension is a source of retirement income provided (almost always) by an employer to a qualifying employee. You’ll have to work a certain number of years for the company before you’re eligible for a pension. The amount usually increases for each additional year you work. The Department of Labor has rules about pension plans for both the public and private sectors indicating how much your company should save for pensions.
Since a pension offers guaranteed payments at a set level for the rest of your life in retirement – not a bad deal – it’s known as a “defined benefit” plan.
Why do you need a pension?
Saving for retirement is one of the smartest financial habits you can develop. A pension plan means guaranteed income in retirement, giving you peace of mind in the present and future. In addition, many pension plans give the option of adding joint and survivor benefits for a spouse.
Employer-provided pensions were designed to reward loyal employees, so if you’ve been working for the same company long enough to qualify, why not reap the rewards of your hard work?
Anticipating your needs when you retire
It can be tricky to know exactly how much to save, especially when retirement seems like it’s years and years away.
At a minimum, you’ll want enough to cover living expenses like food and housing for several years. Ideally, you’ll have enough saved to cover both essentials (those pesky medical bills, which tend to get higher once you get older) and non-essentials (any travel you’ve been putting off until you can finally stop working).
Our guide to retirement saving benchmarks estimates figures based on your age and income. Here’s a hint: you should be on track to have at least a year’s worth of salary in retirement savings by age 40.
How large will your pension be?
Your pension may or may not meet all your retirement needs. In the calculator above, you can plug in a few numbers – age, income, and previous retirement savings if you have any – to find out how much you’ll need to stay on track.
Since each employer calculates pensions slightly differently, there’s no universal pension sum. Most employers calculate pension amounts based on your age, salary, and length of time with the company. Usually, your pension is a percentage of your salary. If you stay with the company, theoretically your pension percentage should increase as you grow older.
Pensions are not the same as Social Security benefits, which are funded through payroll taxes and usually offer less extensive coverage.
Who is eligible?
Pensions are most common in public sector jobs: government jobs at the federal, state, and local levels. In 2018, for instance, 86 percent of government workers had a pension plan.
The public sector includes jobs like:
- Police, firefighters, and other protective service workers
- Teachers in primary and secondary public schools
- Instructors at public universities
- Natural resources
- Maintenance and sanitation
How are public pensions funded?
The funding from public pensions comes from three sources.
- Investment earnings. This is the source of most pension funding – up to 65-70 percent of the total.
- Employee contributions. Public employees have a certain amount taken out of their paycheck every month to fund their pensions. This is only about 10 percent of the total.
- Taxpayer or employer contributions. This source makes up the remaining 20 percent of the total.
Any job not with the government or civil service is considered a private sector job. Pensions are much less frequent in the private sector. Only about 17 percent of private industry workers had a pension plan in 2018.
But some industries are more likely to offer pensions than others, including:
- Utility companies
- Credit firms
- Insurance firms
- Construction and manufacturing services
- Information and technology services
- Transportation and food services
Large companies with 500 or more workers are more likely to offer pensions. They’re also common in workplaces with high union representation where workers can bargain collectively for benefits.
How are private pensions funded?
Private sector plans are funded by employers. They tend to offer fewer benefits than public sector plans, which may include perks like coverage for a spouse. And more employers are transitioning to a 401(k) model rather than a pension model.
Will the pension shortfall affect me?
That depends. Government workers who are eligible for a pension may or may not see some of their benefits reduced; it’s too early to tell. And the state where you work matters, too. New York, Wisconsin, and Tennessee, for instance, have most of their pension funds intact. You can look up your state’s status here.
Since state contributions make up a small number of public pensions compared to investment earnings, however, your state budget might not be as large of a factor.
If you’re concerned your full pension may not be available, it might be wise to look into the many other options for retirement accounts as a backup. Or you can beef up your personal contribution if you’re able to do so.
Private pensions may be protected by the Pension Benefit Guaranty Corporation, which insures pensions even if the company goes out of business.
Other investment options to replace your pension
There are other ways to save for retirement if you do not have a pension nor ever think you will have one.
Pensions are actually becoming a lot less common. Most private employers are replacing them with plans more similar to a 401(k) structure. Some states are shifting public pensions to this model too.
A 401(k), like a pension, is a retirement plan offered through an employer. While a traditional pension is set up as a “defined benefit” plan, a 401(k) is a type of “defined contribution” plan.
With this kind of plan, you’re only guaranteed to receive the contributions you make to the fund. Your employer may match the contribution or they may not. The average employer contribution is up to half of six percent of your pre-tax income. Any returns you earn in the stock market will be added to the total as well. And unlike pensions, 401(k) accounts leave responsibility for the investment in your hands.
The upside is that a 401(k) is much more likely to be offered by a variety of employers, and is easier to qualify for than a pension. You make pre-tax contributions; the funds you deposit in a 401(k) won’t be taxed, allowing you to save even more. 401(k)s also have high contribution limits once you’re comfortable putting away more money into the fund.
If your employer doesn’t offer a 401(k) your best option is an IRA or individual retirement account. You can choose to open a traditional IRA or a Roth IRA. For the best return on your investment, we recommend the Roth IRA. This account allows tax-free withdrawals after you turn 59 ½, a benefit the traditional IRA doesn’t provide.
But a traditional IRA is still a solid choice. With this IRA you get tax deductions every year you contribute funds; if you’re making contributions on a lower income, this perk often helps with cash flow.
Self-employed and freelance workers can open an SEP or “simplified employment pension” IRA with much higher contribution limits than a traditional IRA (contributions are also tax-deductible the year you add them to your account).
You can open an IRA through almost any bank, credit union, or online broker. A full-service broker like TD Ameritrade lets you open and manage multiple types of accounts, including an IRA, Roth IRA, or SEP IRA.
Ally Invest is also an ideal place to get your retirement savings started since it lets new investors start out with small contributions. You can open a robo portfolio if you want more guidance or a self-directed portfolio if you want less.
If you have an established account or a larger fund already set up, Empower provides wealth management to grow your investment even more.
This broker tracks your retirement account as part of your overall financial health.
(Personal Capital is now Empower)
General investment options
Since you’re already planning for the future, why not funnel some money into a well-rounded investment portfolio? Funds will grow through compound interest, giving you even more cash to draw on later in life.
Online investment advisors or “robo-advisors” are good options if you’re new to investing or starting with a small amount (under $1,000).
Betterment is one of our favorites for many reasons, but mostly because of their hands-on management and low minimum investment requirement. They’ll even help you set up a retirement account.
Another great platform is Wealthfront, which has a $500 minimum requirement and the huge bonus of no fees until your account hits $10,000. You can build off one of Wealthfront’s existing investment portfolios by adding or deleting ETFs. Or, you can choose to build a customized portfolio from scratch. You can also tax-efficiently move ETFs over from an outside brokerage to Wealthfront.
Wealthfront comes with free financial planning as well, including the option to set up a 529 college savings plan if that’s one of your investment goals.
Those who prefer to be more hands-on with their investing might consider an online stockbroker like TD Ameritrade, or Ally Invest.
Not everyone can receive a pension, but those who do should absolutely take advantage of them. They provide guaranteed income for life, with the employer taking the investment and longevity risk, rather than the employee.