Pensions & Retirement Planning: What You Need to Know

Considerations for pension holders as they prepare for retirement: liquidity, taxes, and the Social Security Windfall Elimination Provision.

For anyone with a pension, understanding your plan's various facets is imperative to successfully planning your retirement. In this discussion, we will delve into pensions and their significance in retirement planning, highlighting three essential considerations for pension holders as they prepare for retirement: liquidity, taxes, and the Social Security Windfall Elimination Provision.

Pensions & Your Retirement

While there has been a significant shift in the marketplace to 401(k)s and 403(b)s in lieu of pensions, pensions still exist largely in unionized public and private organizations. You are likely familiar with pension systems for federal and state public employees such as teachers and law enforcement in addition to the Military Retirement System that serves our armed services personnel.

In the private sector, industries such as auto workers and airline employees often have pensions. (Note, sometimes Social Security is referred to as a pension, but it is more accurately a social insurance program and operates differently than a pension system; as such, our discussion does not include Social Security.

If you are anticipating receiving a pension in retirement, it's very important to understand how your benefit is calculated, and how your pension impacts your overall retirement plan.

How They Are Calculated

Broadly, pensions are a promise by the organization to pay a retiree a certain amount each month for a certain period of time, typically your lifetime. The amount the retiree will receive is based on factors such as the salary and years worked at the organization. Each pension plan has its own formula in calculating this income so if you have a pension you will want to obtain that formula to accurately calculate your projected benefit. Some pensions plans, such as the Federal Employee Retirement System (FERS), offer an online calculator that will provide an estimate for you.

Pension Calculation Example

Let's say a pension plan offers a benefit formula of 1.5% of the average salary for each year of service. If an employee retires after 30 years of service with an average salary of $50,000 during their highest earning years, the pension calculation would be:

• Pension benefit = (Years of service) × (Percentage of average salary) = 30 years × (1.5%) = 30 years × (0.015) = 0.45

So, the pension benefit would be 45% of the average salary, which would be $22,500 annually in this example, or $1,875 per month.

Why Understanding Your Benefits Formula Is Imperative

If you are employed at a job that offers a pension, it is important you understand how you pension is calculated and that you update it in your retirement planning projections on a regular basis. Changes to your income and length of time you are working at your employer will impact your pension projections.

How Your Pension Impacts Your Retirement Plan

Regardless of the organization you work for or your pension formula, there are three aspects all pension holders need to consider when planning for retirement with a pension: liquidity, taxes, and the Windfall Elimination Provision.

Liquidity

Part of a healthy retirement plan considers not just the income you anticipate receiving, but ensuring you have access to sufficient liquidity. Especially in retirement, liquidity is crucial for meeting unexpected costs or to adapt to changes in circumstances without forcing you to resort to high-cost borrowing.

You may have a very healthy pension income, but what happens if suddenly you need to replace your roof, buy a new car, have an unforeseen medical expense, or something else arises that your pension income—while sustaining your everyday lifestyle—cannot cover.

When you are planning to retire with a pension, be sure to plan ahead and build some liquid assets that you can dip into as needed as part of your overall retirement strategy.

Taxes

Pensions are generally taxable income. Meaning, if you receive pension income, it will be treated similarly to your current W-2 income. This is important to consider when building your savings for retirement because you will want to diversify the type of money you hold in retirement.

If you are planning to receive taxable income in the form of a pension, other types of assets such as Roth or even a non-retirement investment account will help reduce your tax burden if you utilize those monies for your lifestyle in addition to your pension.

I recommend that if you have a pension plan through work, build some Roth money to compliment that asset. Roth monies allow tax-free withdrawals, which would not compound your tax burden in retirement when you are receiving your pension.

For example, you have a pension of $50,000 per year in retirement, you know you will pay income tax on that pension. However, if you need to do some unexpected home repairs costing $15,000 and you have that available in Roth money, you could withdraw these monies without adding to your taxable income.

Windfall Elimination Provision

The Windfall Elimination Provision (WEP) is a rule that can affect how much Social Security you may receive because you receive a pension through work not covered by Social Security. Typically, this situation arises when receiving a pension from a government job, and it is rare.

However, it is important to understand if your organization was excused from contributing to Social Security on your behalf and instead funded a pension. If that is the case, you may have reduced or even no Social Security benefits.

If you are working with a financial planner, this is something they will confirm as well when reviewing and planning for your pension.

Conclusion

Your pension may play a significant role in your retirement plan so it is important to understand its intricacies, including its calculation formula and potential impact on retirement income. Regardless of how robust your pension is, be sure to plan for sufficient liquidity and tax management throughout your retirement. And make sure you understand if the Windfall Elimination Provision applies to your pension and plan accordingly.