When I got my first job they offered a 401k. I didn’t really know about 401ks at the time, but I started to look into them. My mom has a pension plan that she talks very highly of so I was curious about pensions as well. I have a goal of achieving financial independence and possibly one day retiring early. So I decided to look into how a pension plan affects financial independence and early retirement.
After doing some research I learned that achieving financial independence with a pension plan is possible but there are some things to keep in mind. There is a degree of uncertainty with pension plan returns as you are not in full control of your money but you will get the lump sum or the annuity in most cases, but not all. If you want to play it safe you could look at the pension plan as income that you are not going to rely on at retirement. Save and invest like you don’t have a pension plan to fall back on. That way, you will be even better off after retirement or you can retire earlier than expected without having to go job hunting later if you are in a tough spot and are too young to access your pension.
Throughout this article I will be using numbers such as 4% and 7%, keep in mind that investing carries risk in both the short and long term. These are hypothetical rates that are used to create hypothetical scenarios. All described scenarios below are hypothetical. Please consult with a financial professional before making any serious financial decisions.
First off, retiring early probably isn’t going to help your pension. However in some cases the negative effects of retiring early isn’t something you should worry about. One key thing to keep in mind when looking at your own situation is that the earliest that you can withdraw from a pension is 55. If you are into FIRE, you will probably be very wealthy at 55 and not need to worry about your measly pension. There are three different types of defined benefit pension plans you could have . They are the flat defined benefit plan, the unit defined benefit plan, and the variable defined benefit plan. I’ll go over each and how your pension on those plans would likely be affected by early retirement. In each of these plans I tried to create some examples and look at the opportunity cost of retiring a year early at a younger age.
Flat defined benefit pension plans are very straightforward. You take the number of years you have worked for your employer and multiply it by the predefined flat compensation figure in your plan. For example, say you work 10 years and your flat compensation figure is $50 a month. You would get $500 a month at retirement from your pension (calculation below).
The flat compensation figure will remain the same regardless of your number of years of employment. Imagine you are 27 and thinking about retiring but you are wondering if you should keep working in order to increase your pension. Every additional year you work would provide you another $50 a month or $600 a year at 57 . Using the 4% rule, in order to withdraw the additional $600 a year, you would need $15,000 (calculation below).
So, if you decide to retire a year earlier at 27 (instead of 28) then you miss out on what would essentially be $15k at 57 years old. For my personal situation, this doesn’t sound that bad. If I had $2,000 (calculation below) at 27, by the time I would be 57, that would grow into $15k (assuming a 7% return).
So you could think of the benefit of a $50 a month flat pension plan as the equivalent of an extra $2,000 a year from your employer . If I am in the position to consider retirement at 27, I don’t think $2,000 is a large enough amount of money to sway me into working an additional year. If your plan (any plan, not just flat defined benefit plan) is not inflation adjusted, your age is also a very important factor in deciding whether you should keep working. Imagine you are working at the same company as the 27 year old above but you are 56 and wondering if you should work another year. We know that one year of this company’s pension plan is worth $15k at 57. So, if you decide not to work that extra year, then you will essentially be giving up that $15k. The difference between the two is that the 27 year old’s compensation figure will be worth less due to inflation.
For a unit benefit pension plan, the amount of pension income you will receive at retirement varies on a combination of your years of service with your employer, your plan’s compensation percentage, and your average compensation with that employer . The compensation percentage is a number that your employer picks to use to calculate how much you will receive for your retirement. That being said, say you worked with your employer for 40 years, your compensation percentage is 2%, and your average compensation was $100,000. You would receive $80,000 a year in pension (calculation below).
If you retire after 10 years on the job (keeping the same average salary) you would receive $20,000 a year in pension (using above formula where Y = 10). Assuming the same average salary, you would have an additional $2,000 in your pension for each additional year you work. You can take your average salary since you have started working there and multiply it by your compensation percentage and it will give you the amount you are adding to your pension each year . So, looking at this unit benefit pension plan with the same scenario as the flat benefit pension plan, at 27, each additional year you work would provide you another $2,000 a year at 57. Using the 4% rule mentioned above, in order to withdraw the additional $2,000 a year, you would need $50,000. So, if you decide to retire a year earlier at 27 (instead of 28) then you miss out on what would essentially be $50k at 57 years old. So, if I had $6,600 (calculation below) at 27, by the time I would be 57, that would grow into $50k (assuming a 7% return).
Variable defined benefit pension plan are much less common in the United States. While unit defined benefit pension plans that have a set return every year, variable pension plans fluctuate with the market. Unlike the unit pension plan, the variable pension plan sets a goal each year for the percentage return on their benefit plans. If the returns are higher than the goal, the employer can increase the participant’s benefits. But, the employer can also decrease the benefits if they come in below their goal for the year. The issue many unit defined pension plans encounter is lacking funds to apply to retired employees pensions. When the market drops, the employer is solely responsible for the pension pool and the employer invested poorly, it results in a shortage of funds to pay out. This causes employees benefits to be changed, policies on unused vacation and sick time pension contribution to be changed, and minimum contribution amounts to rise for new employees. The variable defined benefit pension plan is much more secure than the unit defined pension plan and is rarely underfunded.
Employers may also use vesting with their pension plans. Vesting in regards to a pension plan means ownership of your retirement account. If you are 75% vested in your account balance, you own 75% of it and the employer can forfeit or take back the remaining 25%. If you are 100% vested, you own all of the funds in that retirement account including any employer contributions. Your employer cannot forfeit or take any of the funds back for any reason.
In terms of early retirement, I would aim to be 100% vested in your account before planning on retiring. I say that because it is common to be fully vested in your account after 4 to 7 years with your employer. But if you are making this decision yourself you should consult with a professional. An employee is required to be 100% vested by the time they attain normal retirement age under the plan or when the plan is terminated . It is also important to keep in mind that even if you are fully vested, you may not be eligible based off of your age to make withdrawals.
While pension plans sound appealing, there are a number of drawbacks. One problem is the lack of access to your funds. You have no access to your accumulated pension funds until you are 55 at the earliest for people without disabilities . In 401k plans, you have access to your retirement funds at any time but there are penalties if you withdraw before 59 ½. While the penalty isn’t great, you still have access to your funds if you really need it. Another problem is not having control of your money. There is a possibility of poor returns which can cause a shortage of funds in the pension pool. This can cause a change in employee’s benefits, an employer’s policy on unused vacation and sick time in regards to pension contribution, and minimum contribution amounts to rise for new employees.
Now for the glass half full view. The first major positive of defined pension plans is the tax relief. One way your employer does this is by taking your pension contributions from your salary before deducting tax. You then pay tax on the remainder of your salary. If you are paying into a personal pension, you do pay income tax, but later the pension provider reclaims the tax from the government and it goes back into your pension. Another way is to claim the tax relief in your tax return. Compound interest is also a big plus (as it is in other retirement plans and investments -- big fan of compound interest here --). Employer contributions are definitely a positive as well. Employers will sometimes match your pension contributions each month to a certain level . So this means free money basically. And last but not least, you can choose to have an annuity which pays out your pension monthly until you decide to kick the bucket. You can also elect to have the pension be paid out to your spouse after your passing so they are taken care of until they also kick said bucket.