Ch. 16: Pensions

16.0 Introduction

            In Chapters 12 through 15, we discussed the most common tax-sheltered investment vehicles.  Vehicles like 401(k) plans, IRAs, and HSAs allow investors to buy stocks and bonds inside an account with significant tax privileges.  These accounts generally require the investor to make many important choices:  How much to invest, what assets to buy, and when to withdraw their funds.  Like these plans, pensions serve as retirement accounts that allow today’s workers the opportunity to reduce their current income in order to increase their future wealth.  But that’s just about where the similarities end.

  Pensions are the unicorn of the retirement planning world, err… maybe the dinosaur. A few decades ago, most workers contributed to pension plans, but today it is rare for private firms to offer a pension.  Thus, there is a clear generational divide.  About 66% of retirees over age 65 are currently receiving pensions payments, while only 22% of current workers have access to a pension.[1]  Most of today’s pension contributors work for a local, state, or federal government, but there is still a smattering of for-profit firms that administer a pension, such as Coca-Cola, Exxon, and Proctor and Gamble

  Truth be told, you probably won’t have a work-based pension.  But nearly all U.S. citizens are a member of the Social Security system, which is effectively a nationalized pension plan.  Chapter 16 will broadly investigate pensions and their role in the financial planning process.  Chapter 17 specifically focuses on Social Security.

16.1 Basics of a Pension 

            Pension plans can be divided into two groups of individuals.  One group (current employees) pay into the system and second group (retirees) receive payments.[2]  As an employee, you might be required to contribute 3% of your salary into the pension system.  So, each month, you will find that 3% of your salary is withheld and contributed to the pension plan.  Since you are not earning this income, this 3% reduction reduces your income taxes (but has no impact on Social Security or Medicare taxes).  Your contribution is then passed along to current retirees.  So, to explain it as simply as possible, a pension is merely a system where current workers give money to current retirees.  Usually pension plans include a sizeable company match so the amount you need to contribute seems small relative to what you will receive during retirement.  When you reach retirement, you can then receive monthly pension payments until death. 

            In section 16.0, I stated that pension plans are not investment accounts.  That’s a bit of a simplification.  Truth be told, a portion of the money you contribute to your pension will be held in an investment account to be eventually disbursed to retirees.  Thus, pension systems often hold stocks, bonds, and other assets, so that the pension account can gradually amass money to pay to future retirees.  But your future payment is not (or at least shouldn’t be) connected directly to the performance of this investment account.  A pension is a type of defined benefit plan, where the future payment you receive is “defined” by a formula and is thusly not impacted by the performance of underlying investments.  The only time this defined benefit is altered is when the company issuing the pension plan has severe financial trouble and doesn’t have adequate funds to pay out retirees.

            Once you retire, you’ll begin receiving pension benefits, usually in the form of monthly paychecks.  How much you receive and at what age you begin earning these payments depends on the rules specific to your plan.  Generally, employees that earn more money (paying more into the pension system) and work more years are rewarded with larger pension payments than their peers.  So, once a person has worked a decade or two with a pension-providing employer, there is usually an incentive to stay with that company until retirement to maximize pension benefits.  For this reason, pensions are sometimes called “golden handcuffs”, which gives a good indication of the double-edged sword of pension systems.  Yes, pensions are good to have, but they tend to "force" you to stay at a job that you might otherwise leave.

16.2 Case Study—The Teachers Retirement System of Georgia

            If you don’t mind, I’m going to talk about myself for a bit.  Back in 2013, I landed at job at a public university in Georgia.  As with any new professorial hire, I was given the option to have either a 401(a) plan or to become a member of the pension system.  I chose the pension plan and became a member of the behemoth Teacher’s Retirement System of Georgia.  Here are key details related to the plan:

• Contributions:  I contribute 6% of my salary to the pension plan.  This 6% has not changed during my 11 years of employment.  My employer (the University System of Georgia) contributes 19.98% of my salary.  This value has changed many times over the years to ensure that current retirees receive the funds they were promised.  Thus, if I earn $100,000 in 2025, $6,000 will be withheld from my salary and contribute to the pension system and my employer contributes an additional $19,980 on my behalf.  Remember that the company match doesn’t directly affect my bottom line.  My pension benefits are defined by a formula and the company match is not a variable in said formula.  

• Eligibility:  While there are specific and complicated rules about acquiring benefits, my pension plan has a couple of key cutoff points that may affect employees’ decisions.  Firstly, this pension plan is not vested until the employee has ten years of employment (“years of service”).  If an employee works fewer than ten years, they are not eligible to receive a pension.[3]  Secondly, there is a large incentive to work exactly thirty years.  Once I have completed 30 years of employment, I am eligible to fully receive benefits—I can retire and start collecting pension payments, regardless of my age.  But I don't have to quit working.  I could start collecting pension payments after thirty years of work while simultaneously working elsewhere... the ole' double-dip.

• Benefits:  Payments provided by my pension system are a function of working years and salary.  Upon retirement, my employer will consider only my two top-earning years of salary.  Consider the table below:

  Suppose the table above indicates my salaries during my 30-year working career.  My salary gradually rises over time, primarily due to inflation.  The benefit I receive is based upon (a) the number of years that I work and (b) the average of my two highest earning consecutive years.  For me, and for many, these highest two years are my final years of employment, when I am 56 and 57 years old.  I have 30 years of employment and an average salary of $155,000 during my two best years.  To determine my yearly pension payment (pmt), my employer employes the following formula, where 2% is a constant.[4]

Annual Pension Pmt = (2%)*(Years of Service)*(Average of Best 2 Adjacent Years of Salary)

Annual Pension Pmt = (2%)*(30)*($155,000) = $93,000

Thus, based on the salaries I have earned, I can retire after thirty years of employment and receive $93,000 each year from retirement until death.  That’s a solid chunk of change coming in every year!  But remember that this was not a free lunch.  I paid 6% of my salary into the pension system for 30 years.  If I had, alternatively, invested this 6% in stocks, that also would have resulted in a big future payout!

  There are lots of important details and caveats to consider, but this gives you a good general understanding of pension systems since most pension systems are similar to mine.

16.2 Incentives Created by a Pension

            While not all pension systems are created equal, most are similar to my plan discussed above.  I’m going to do everything I can to take advantage of this system.  I’d be stupid not to, right?  If you end up working for an employer that offers a pension, here are some key incentives that you would be wise to consider:

1.       Number of working years:  Most pension systems have important inflection points.  For me, I can start receiving benefits after 25 years but will receive a benefit reduction if I do so.  Alternatively, I can work 30 full years to receive my full pension benefit.  For those with a shorter tenure, anyone can receive their full pension benefit at 60 years of age.[5]  Do not ignore these numbers.  For example, it would be financial idiocy for a 54-year-old to retire after 29 years of employment since attaining one more year would unlock the full pension benefit.

2.       Maximizing salary for two years:  Given that my pension plan only considers my two best consecutive salary years, I should do everything I can to ensure that I have two high-earning years.  Because of inflation, salaries naturally peak near the end of careers.  To maximize my benefits, I will scratch and claw for every money-making opportunity at the end of my career.  If I can increase my salary by $1,000 during one of those two key years, I can increase my pension payment for the entirety of my retirement.  Keep in mind that only salary connected to your pension-providing employer impacts pension benefits.  Earning $5,000 from a side gig does not impact pension contributions or benefits.

3.       Staying at your job:  For most folks, the highest-earning years occur near the end of their careers.  For this reason, there is usually a strong incentive to stay with your current employer if they offer a lucrative pension.  Consider the aforementioned salary table.  If I left my job after my 51st birthday, my best two years of salary would only be $105,000 and $110,000 and I’d only have 24 years of employment (annual pension payment = $51,600).[6]  By sticking around for just six more years, my pension payment increases by more than 80% to $93,000!  While working more years with my current employer increases my pension benefit, it might mean turning-down lucrative job offers from competing firms… golden handcuffs. 

4.       Banking sick days:  Many pension plans allow workers to bank their sick days.  This means that employees can add their unused sick days to their years of service.  This is admittedly easiest to take advantage of when you have a job like mine; I only teach two days a week, so it’s pretty easy to go an entire year with no sick days.  After thirty years of employment, I will likely have a full year of unused sick days, which will increase my years of service from 30 to 31.  If you have a pension, try to hold on to those sick days, if feasible.

5.       Vesting:  If you have a pension plan, you’ll want to carefully consider the vesting rules.  In my plan, I become vested after ten years of employment.  If I leave my job before completing ten years, I am not eligible to earn pension benefits.[7] It would be dumb to work for eight or nine years and then quit.  There’s typically a large incentive to work at least long enough to become vested.  A couple of notes here:  For some pensions, you may be eligible to return to your place of employment and continue your contributions without losing years of service.  For example, I could leave my job after nine years, work somewhere else, and then return back to my current job and continue adding years to my pension clock.  Also, for state government jobs in particular, an employee can typically change jobs and stay on the pension clock.  For example, in 2016, I quit my job at Dalton State College (a Georgia state university) and begin working at Georgia College (another Georgia state university).  My pension clock continued unabated.  So, the golden handcuffs feel a little looser when you work for a state government and have many employers available.

6.       Pensions are bond-like:  Pensions provide fixed payments to the retirees.  Thus, pensions are bond-like in nature.[8]  The pension basically does the work of a bond, so I don’t need to allocate much of my investment funding to bonds.  As a result, my investment portfolio is nearly 100% allocated to stocks. 

7.       Tax Sheltering:  Upon retirement, pensioners receive regular income from their employer.  This income is taxed as income (but not Social Security or Medicare).  As such, pensioners generally have relatively high retirement income.  From a tax planning standpoint, this improves the value of investing via Roth accounts today.  Obviously, there are many other factors to consider, but individuals working for an entity that offers a pension are often wise to contribute to Roth vehicles during their working careers to reduce their taxes during retirement. 

16.3 Pensions and Risk

            While pension systems are bond-like in nature, pension members still face substantial risk.  For example, consider an employee at Proctor and Gamble.  While they may contribute to a pension for their entire career and anticipate a substantial pension income during retirement, there is no guarantee that they will see a dime.  Pensions are typically funded by current employees and the employer.  If the firm experience financial troubles, there will be fewer employees and less revenue to provide to pensioners.  Worst case scenario, the firm declares bankruptcy and it’s feasible the pensioner receives absolutely nothing!  Pensions are ultimately a legal version of a Ponzi Scheme.  While it may take decades, centuries, or even millennia, at some point, a given pension plan is bound to fail.

          And when would such pension collapses occur?  Usually this would happen during an economic downturn.  Imagine retiring at age 65 and simultaneously losing your pension, experiencing a substantial drop in your investment accounts, and trying to re-enter the workforce during a recession.  Ouch.

          Is this likely?  Of course not.  But it’s possible, especially for smaller firms and local governments.  In 2009, the pension program of a small town in Alabama—Prichard—ran out of money and stopped paying-out promised pension funds.[9]  While Prichard was breaking state law, there was no easy answer to Prichard’s problem.  It simply didn’t have the cash.  Such a scenario is unlikely for large firms like Proctor and Gamble, which have carefully developed a low-risk pension plan.  Likewise, state government employees are probably safe.  And in the rare case of a pension default, there is a good chance that the federal government will step in and provide the pensioners with at least a portion of their promised payments.  But there is never a guarantee.

          If you happen to work for a firm or government that offers a pension, I recommend that you view the pension as a likely, but not guaranteed, source of funds.  To reduce risk, save and invest additional money in tax-sheltered accounts just in case your employer experiences financial turmoil.  It’s always good to have a backup plan.

16.4 Conclusions

            In the coming decades, employer-provided pensions programs will become increasingly scarce.  Was this chapter a waste of time?  Absolutely not.  Remember that Social Security is a pension plan!  Learn more in Chapter 17.

End Notes

[1]Source.

[2] This is typical, but there are some firms and governments that do not require employee contributions.  Coca-Cola, for example, provides a pension that is fully funded by the employer.

[3] But they can take a lump-sum payment.  This lump-sum is small compared to how much I have been contributing.

[4] When I say it’s a “constant”, I mean it’s a set value that does not change from person to person.  My employer has set this 2% value and is unlikely to change it.

[5] But “full pension” doesn’t necessarily mean “loads of money”.  Remember that the pension formula is based on years of service.  Comparing two otherwise identical employees, a person working 15 years will receive half the pension benefit of someone that worked 30 years. 

[6] Annual Pension = (2%)($107,500)(24) = $51,600

[7] However, workers are often eligible to collect a lump-sum payout.  For example, I could forfeit my pension account and collect an $80,000 payment (I could earn this money as income or roll into an IRA).  That’s a crappy deal, so I would be much better off completing 10 years of employment to become vested.   

[8] The concept of bond-like vs. stock-like is discussed in Chapter 9.

[9] Source. 

Key Terms

Defined Benefit Plan:  Retirement system where the funds provided to retirees is based on a formula so that the money received by retirees is “defined”.  Comparatively, other investment vehicles like 401(k) plans, may have “defined contributions” but the benefits are unknown since the value of the account is dependent upon investment earnings.

Pension:  Read the chapter, you bum

Ponzi Scheme (Pyramid Scheme):  Nefarious investment scheme where plan leaders lure money from new investors, who in turn, must also lure money from new investors.  As long as more investors (suckers) can be found, the plan can continue to work, but eventually there will be no suckers left.  Critics of pension plans often note that pensions are effectively large-scale Ponzi schemes.

Practice Problems

1. Given what you learned about my pension plan, explain why it would be dumb for me to leave my job after nine years.

I’m only vested after 10 years of employment.  If I quit  my job after nine years, I’m no eligible for my pension.

2. Given what you learned about my pension plan, explain why it would be dumb for a 55 year-old to retire after 29 years of employment.

My pension allows an employee to retire and receive full pension benefits after 30 years of employment, regardless of their age.  It would be smart for me to work one more year, then quit.

3. Grayson is single and earns $92,000 in 2025.  He contributes $8,000 to a 401(a) and is obligated to contribute 5% of his salary to a pension.  Solve for his…

a.       Federal Income Taxes

Notes: 401(a)’s are always traditional in nature.  5% of his salary is $4,600.

Income = $92,000 - $8,000 - $4,600 = $79,400

Income Taxes = $12,382

b.      Medicare Taxes

$92,000*0.0145 = $1,334

c.       Social Security Taxes

$92,000*0.062 = $5,704

4. Liam is single and earns $130,000 from his job at Proctor and Gamble, which requires Liam to contribute 2.5% of his salary to the pension plan.  He also earns $20,000 from a side gig as a wedding photographer.  Solve for his 2025 Federal income taxes.

The 2.5% pension contribution only applies to his salary from his job at P&G.  He will contribute $3,250 to his pension.

Taxable Income = $130,000 - $3,250 + $20,000 = $146,750

Income Taxes = $28,067

5. Joshua is single and earns $82,000 in 2025.  He contributes $12,000 to a Roth 401(k) and $3,000 to an HSA.  He also is obligated to contribute 4% of his salary to a pension.  Finally, in a brokerage account, he earns $8,000 in ordinary dividends and $4,000 in qualified dividends.  Solve for his…

a.       Federal Income Taxes

Pension Contribution = $82,000(0.04) = $3,280

Income = $82,000 - $3,280 - $3,000 + $8,000 = $83,720

Income Taxes = $13,332.40

b.      Medicare Taxes

Medicare Income = $82,000 - $3,000 = $79,000

Medicare Taxes = $79,000(0.0145) = $1,145.50

c.       Social Security Taxes

SS Income = $82,000 - $3,000 = $79,000

SS Taxes = $79,000(0.062) = $4,898

6. Haley, who is 62 years-old, is single and retired.  In 2025, she earns $58,000 from her pension plan.  She also withdraws $10,000 from a traditional 403(b) and $20,000 from a Roth IRA.  Finally, she uses $8,000 from her HSA to pay for medical expenses. Solve for her…

a.       Federal Income Taxes

The pension earns are taxed as income.  Likewise, her withdrawals from the traditional 403(b) is taxed as income.  Roth withdrawals are not taxed.  And the HSA spending is not taxable since it’s used on medical expenses.

Taxable Income = $58,000 + $10,000 = $68,000

Income Taxes = $9,874

b.      Medicare Taxes

There’s nothing taxable here.  $0.

c.       Social Security Taxes

There’s nothing taxable here.  $0.

7. Emma and Avery are both single and 50-years-old.  They both earn $100,000 from their job and both have $500,000 in stocks held in a brokerage account.  There is a key difference, however.  Emma is set to earn $100,000 from a pension upon retirement.  Avery does not have a pension.  If these two folks decide to contribute to a tax shelter, who is a better candidate for using Roth investments?  Explain.

Emma.  Since she has a pension, she will receive income during retirement.  Since she already has taxable income during retirement, it is relatively better to contribute to Roth accounts today, compared to Avery.  Note that this doesn’t mean she definitely should contribute to Roth accounts today.  Rather, it’s simply clear that Emma is a better candidate for Roth shelters than Avery.

8. Explain why pensions usually incentive maximizing one’s salary near the end of a career.

Read the book!

9. Why are pensions sometimes called “golden handcuffs”?  Explain.

Once a person has been working a long time for an employer that offers a pension, there is usually a huge incentive to stay with the firm and to keep working more years (delay retirement).  So, the pension is valuable, but serves to "imprison" the employee.

10. I’m working for a state government that offers a defined benefit plan, where I contribute 3% of my salary and my future pension benefits are based on a set formula.  Last year, my employer (the state government) provided a 16% salary match on pension contributions.  This year, they will provide a 21% salary match.  How will this change in employer match affect me, if at all?

It has no direct effect on me.  My pension benefit is based on a formula.  My employer is increasing their match just to make sure all current retirees get their promised pensione payments, but this increase in match does not change my benefits.

11. Are pension benefits stock-like or bond-like?  Explain.

Bond-like.  Pensions offer stable value to the employee, so they are more like a bond.  Thus, it's generally wise for a pension-holder to take-on more risk with the rest of their investing portfolio.