Pensions and the 4% rule

[CSdot]

I was just talking to a friend who has a pension through work. My comment was something along the lines of:

"I have my 401(k), SepIRA, Roths, but using the 4% rule, it takes a significant nest egg to replace a salary. Each million at 4% is only $40,000 annually. Meaning, I need $2.5M invested to replace each $100,000 in salary."

This got me thinking. My friend makes 6 figures, and I have worked as an outside consultant with government entities where a large number of the employees make 6 figure salaries. We have all heard the news stories about people working overtime, or gaming the system during their last few years of service, so they vest with VERY handsome 6-figure pension salaries for life.

Using the 4% rule that all of us in the private sector face in providing for our own retirements, how in the world do pension administrators do it? Are they not subject to the same math and finance rules that us in the investment market face?

Using the Social Security retirement system as an example (which we all know is not funded by interest coming off of an investment secured in a lock box), at least the SS Administration has enough sense not to promise people lifetime pay based on what they were earning. Even a person who made $1M a year during his working years (you contribute based on your first $142,000 of earnings) is only entitled to receive a maximum SS payment at retirement in the mid 5-figures.

Yet pensioners will get a retirement benefit based on their last few years of salary. How do the pension administrators pull this off? How do they steer clear of the laws of math and reality that the rest of us face?

 

[NW-Bound]

Yet pensioners will get a retirement benefit based on their last few years of salary. How do the pension administrators pull this off? How do they steer clear of the laws of math and reality that the rest of us face?

As explained by George Orwell in his book Animal Farm, the logic used by those in charge is:

"All animals are equal, but some animals are more equal than others".

 

[CSdot]

As explained by George Orwell in his book Animal Farm, the logic used by those in charge is:

"All animals are equal, but some animals are more equal than others".

PERFECT ANSWER!!

We might be able to stop the thread here.

 

[chassis]

The 4% rule applies to a portfolio. It is one interpretation of a "safe" withdrawal rate on the portfolio. The portfolio could be $10, or $10 million dollars.

The actual withdrawal rate depends on living expenses, "other" income for example pensions, SS, rental or business income, etc. Any living expenses not covered by the aforementioned income sources would go into the withdrawal rate calculation and be compared against 4%.

So pension administrators don't need to worry their pretty heads.

 

[Gumby]

Pension administrators are working with an infinite lifetime and continue to have new deposits into their portfolio. They can invest accordingly. As an individual, you have neither of these things and cannot. So, for example, you face a sequence of returns risk. Pension administrators do not.

 

[RobbieB]

My Pops had a pension based on last 5 years of earnings, but it was not 100% of average, somewhat less.

 

[NW-Bound]

... We have all heard the news stories about people working overtime, or gaming the system during their last few years of service, so they vest with VERY handsome 6-figure pension salaries for life...

The practice of saving up paid sick days and vacation days, then claiming it all on the last year of work in order to drive up the pension is called "pension spiking". Sadly, this practice is quite common among state employee pensions all over the country.

In AZ, when a taxpayer watch group filed a lawsuit in 2013 to stop pension spiking, the government obliged, but then was taken to court by various state employee unions. "Hey, this has always been the way we do things around here".

A lower court initially sided with the unions.

Just last year, in 2020, the AZ Supreme Court issued the final ruling to stop this shameful pension spiking.

PS. The taxpayer watch group caught notice in 2013 when it saw that the pension cost went from $7M to $129M in under 10 years.

PPS. It was reported that pension spiking can get one a pension raise of 60%. Some animals are definitely much more equal than the rest.

 

[NW-Bound]

While pension spiking is obviously wrong, and makes one wonder how it could be allowed in the 1st place, here's a different case that's not as clear cut, also in AZ.

As part of a pension reform, AZ judges would have their pension reduced, and they also had to contribute more.

In 2016, AZ Supreme Court ruled that changes made to judges' pension after they were appointed was not legal. They cited AZ Constitution that says that "public retirement system benefits shall not be diminished or impaired.” This sounds reasonable to me.

There's nothing in the US Constitution that gives the same guarantee to SS benefits. Again, some animals are simply less equal.

 

[pb4uski]

I was just talking to a friend who has a pension through work. My comment was something along the lines of:

"I have my 401(k), SepIRA, Roths, but using the 4% rule, it takes a significant nest egg to replace a salary. Each million at 4% is only $40,000 annually. Meaning, I need $2.5M invested to replace each $100,000 in salary."
....

I don't think so. If you have $100k in salary for a single, you only end up with $77k to spend after social security and federal income taxes. And if you're saving 15% in a 401k or similar then you only have $65k left to spend. Let's say SS is $30k, then you only need $35k from the portfolio. So to replicate the spending for $100k of income it's only about $1m and SS.

 

[Out-to-Lunch]

Please let's not devolve into petty anti-public-sector rhetoric.

The question was asked, and Gumby has come close to answering it.

A key difference is risk pooling. It is no different for pensions than for a garden-variety annuity. The 4% rule essentially assumes that the individual will live the whole time. You have to oversave to make sure you don't run out of money. On average, people using the 4% rule will leave a large estate.

OTOH, a pool of people may assume that some will live a long time, while others will die early. This facilitates a larger "withdrawal rate" if you will.

 

[NW-Bound]

OK, I was answering only one item raised by the OP, and not addressing the others.

He was wondering how pension managers were able to provide better benefits than individuals could with their individual funds. And two of the above posts addressed one reason for it. That is, in risk-pooling the short-lived members of the group subsidize the long-lived ones.

And yes, an individual can get the same thing by paying for an annuity. With the 4% rule, he has a fairly good chance of leaving a substantial fortune to his heirs. But with an annuity, the money flow stops after his and his spouse's deaths. Same with a pension. There's no free lunch.

But I think I need to point out that many pensions compute their payouts based on optimistic projections of future returns. They don't necessarily get a better market return than individuals do with IRAs. They just think they can. The late Bogle used to rant about this. Their numbers look good during market bull runs, but the pension coffers may get empty after a stretch of bearish years. A few city or town pensions did go bankrupt leaving their retirees high and dry. And some private pensions also had the same fate. Not all pension funds get the backing of taxpayers, and they have to manage with whatever their investment returns give them. An individual will reduce his IRA withdrawal in bad years, while pension funds still have to pay out the same.

And it was revealed that some of the surviving pensions took to speculative investments in an attempt to boost returns. They felt they had to take more risks, because it was a way out. Nowadays, they may just pile onto Dogecoin and meme stocks.

This used to be a hot topic right after the subprime meltdown. We had many threads on this forum about this subject. Since then, with the market running hot the last few years, nobody seems to remember that episode. It will resurface again with the next market downturn. Right now, we are too busy with blowing dough.

 

[RobbieB]

Blow the dough when the iron is hot!

 

[skipro33]

One way pension managers are able to pay out their pensions based on an individual's final X number of years, for me it was highest 36 month average, is that when the pensioner dies, so does his principal. Poof!! That imaginary $2.5M to fund a 6 figure pension is now the property of the pension fund. A 4% withdrawal rate pretty much guarantees the principal of the retiree's funding is going untouched and the payout is strictly year-to-year growth. Except for very limited and restricted conditions, no one inherits any remaining principal that funded the retiree's pension.

Let's say a state employee with a pension gets $5,000 a month before taxes. That's $60,000 a year. Let's say that pensioner lives to draw on that pension for 20 years. That's a withdrawal of $1.2M total The pension manager averages 8% a year because he's not obligated to anything with new members paying in and old retirees dying off. The actual amount needed to fund the pension from the start is only $420,000.
In otherwords, $420,000 earning 8% annually will pay out $5,000 monthly for 123 months before running out of money. Long enough to last the pensioner's 20 years expected life.
Also, if the pension manager can't make 8% annually, he simply bills the retiree's employer for more funds. The government agency then is on the hook for any amounts needed to fund the retirement not met by the pension manager's ability to grow the principal.
Also remember, pensions can be super funded. Mine was for many years I think in the 80's or 90's. The pension fund was growing so fast, that new deposits from employees or their employers if they did any matching was not necessary to meet the financial goal of the pensions going out. However, funds were still required, so these accounts grew and grew, only to revert to the pension fund at the death of the retiree.

 

[rothlev]

One way pension managers are able to pay out their pensions based on an individual's final X number of years, for me it was highest 36 month average, is that when the pensioner dies, so does his principal. Poof!! That imaginary $2.5M to fund a 6 figure pension is now the property of the pension fund. A 4% withdrawal rate pretty much guarantees the principal of the retiree's funding is going untouched and the payout is strictly year-to-year growth. Except for very limited and restricted conditions, no one inherits any remaining principal that funded the retiree's pension.

Let's say a state employee with a pension gets $5,000 a month before taxes. That's $60,000 a year. Let's say that pensioner lives to draw on that pension for 20 years. That's a withdrawal of $1.2M total The pension manager averages 8% a year because he's not obligated to anything with new members paying in and old retirees dying off. The actual amount needed to fund the pension from the start is only $420,000.
In otherwords, $420,000 earning 8% annually will pay out $5,000 monthly for 123 months before running out of money. Long enough to last the pensioner's 20 years expected life.
Also, if the pension manager can't make 8% annually, he simply bills the retiree's employer for more funds. The government agency then is on the hook for any amounts needed to fund the retirement not met by the pension manager's ability to grow the principal.
Also remember, pensions can be super funded. Mine was for many years I think in the 80's or 90's. The pension fund was growing so fast, that new deposits from employees or their employers if they did any matching was not necessary to meet the financial goal of the pensions going out. However, funds were still required, so these accounts grew and grew, only to revert to the pension fund at the death of the retiree.

The other factor is so many contribute to the pension but either do not vest at all, or do not put in enough years to collect a significantly large pension. They are back ended.

 

[ERD50]

Please let's not devolve into petty anti-public-sector rhetoric. ....

Where is the "anti-public-sector rhetoric" (petty or otherwise)? It's math and economics. Don't shoot the messenger because you don't like the message.

OP asked

"How do the pension administrators pull this off? How do they steer clear of the laws of math and reality that the rest of us face? "

The reality is they have access to opium (O-P-M, Other People's Money, and it is addictive). Many of these pensions don't fully fund themselves, they rely on taxpayer revenue for the difference. Illinois state pensions are way underfunded. DW worked for the local school district, her smallish pension is administered by a group (IMRF) that managed to keep the politician's hands off of it (it's member-managed, like a Credit Union), and it is well funded.

While private pensions paid into the PBGC for insurance, and compliance monitoring, and will pay if the corp cannot, those benefits are capped in that case (also no inflation adjustment on the pension). The public sector in IL has no such cap, and unless the State constitution is changed, the taxpayers (those who are left) will be charged with the bill.

Those are the facts (as I know them, correct me if I'm wrong), not a judgement.

-ERD50

 

[Time2]

Where is the "anti-public-sector rhetoric" (petty or otherwise)?

Oh, probably good to say that, I was about to go off on my 5 day a week mail man, that suddenly went to 7 days a week. I got a Sunday Amazon delivery from him and said something about him working a lot, he said 7 days a week. I suspected something and ask him if he was getting ready to retire. He denied that at the time, but he no longer delivers the mail.

 

[Aerides]

Mod Note:

There are few topics more tiresome or argumentative than public pensions, and this is not the place to hold that debate.
If you can contribute to the OP question, fine, but ranting about pensions, in general, is not helpful.

 

[MichaelB]

Getting back on topic,

Using the 4% rule that all of us in the private sector face in providing for our own retirements, how in the world do pension administrators do it? Are they not subject to the same math and finance rules that us in the investment market face?

They do it just like we do. They project future liabilities, project the contributions from both employee and employer, and factor in the investment growth. They just do it for many individuals instead of one.

Using the Social Security retirement system as an example (which we all know is not funded by interest coming off of an investment secured in a lock box), at least the SS Administration has enough sense not to promise people lifetime pay based on what they were earning. Even a person who made $1M a year during his working years (you contribute based on your first $142,000 of earnings) is only entitled to receive a maximum SS payment at retirement in the mid 5-figures.

SS is not managed like a pension fund or individual retirement plan, so it’s not a useful comparison,

Yet pensioners will get a retirement benefit based on their last few years of salary. How do the pension administrators pull this off? How do they steer clear of the laws of math and reality that the rest of us face?

How the final pension is calculated is specific to each plan. Some allow salary spiking, others do not, some use final years of salary while others une different formulas. In every event, the projection of future pension obligations is based (in part) on those rules, so the amount to be paid is not a surprise.

 

[stepford]

Statistics is much more reliable for large numbers than small. Individual investors trying to fund their retirement on $X may obtain widely varying results. But take a few thousand investors together and the average result is MUCH more predictable. This means that individuals must build in a lot more padding to safely fund their retirements than a pension manager working with thousands of accounts.

 

[MichaelB]

Statistics is much more reliable for large numbers than small. Individual investors trying to fund their retirement on $X may obtain widely varying results. But take a few thousand investors together and the average result is MUCH more predictable. This means that individuals must build in a lot more padding to safely fund their retirements than a pension manager working with thousands of accounts.

Exactly.

 

[brett]

Very easy.

Based on projected rate of return on the pension fund. Projected average life span. Drawdown of principal and interest over the term.

Some pension recipients live to 100, others to 68.

My father retired early at 58 in 1979. Incredibly, the average lifespan of a pensioner in his company was only 68/69 at that time.

He drew a pension for 30 years, and my mother had 60 percent of it for another 4 years.

It was not indexed. Hence the purchasing power was greatly reduced by the final pension payment.

 

[CSdot]

Mod Note:

There are few topics more tiresome or argumentative public pensions, and this is not the place to hold that debate.
If you can contribute to the OP question, fine, but ranting about pensions, in general, is not helpful.

Sorry for any trouble my question caused. Was an honest question. Not having a pension myself, I don't click on pension threads, so I was wholly unaware of the prior drama.

It certainly was not my intent to cause trouble.

 

[NW-Bound]

Statistics is much more reliable for large numbers than small. Individual investors trying to fund their retirement on $X may obtain widely varying results. But take a few thousand investors together and the average result is MUCH more predictable. This means that individuals must build in a lot more padding to safely fund their retirements than a pension manager working with thousands of accounts.

Even then, pension fund payouts are still based on a projection of future returns, and also the future number of participants. Back during the subprime fiasco and the resultant market meltdown, there was a lot of media coverage of pension shortfalls, and also many threads here in this forum about the subject.

I remember that CALPERS (California Pension) was brought up. Having some relatives in this plan, it got my attention. Previously, I read that CALPERS was one of the better funded pensions, so why was it in trouble now? Looking further, I read an analyst who disputed several actuarial assumptions made by the pension management, regarding both the future return and plan participation. He said retirees would live longer, while there would be fewer state workers to pay into the system. And the investment return did not have to be that good. Suddenly, things did not look so rosy.

For individuals living off of the return of their IRAs or 401k, they face the same problems too. And that's why there have been endless threads about whether 4% is still safe, or perhaps it's better to go to 3% or less.

But when the market goes gangbuster as it has been doing the last few years, things get quiet down and people just want to forget about this. Man, it's been more than 10 years already.

What have I kept bringing up about human nature? We all want to be the happy grasshopper, rather than the fretting ant.

 

[brett]

I used a retirment financial program until my early fifties. It was very good. Once I got to the place where it said I had enough money I switched over to my own method.

Strictly back of the envelope based on after tax money, an inflation factor, conservative investment returns, and a built in fudge factor for expenses-living and travel.

After ten years the 'back of the envelope' method has certainly proven to be as accurate as the retirement program.

I suspect many on this forum are somewhat conservative and realistic when it comes to retirement planning. This in itself leads to success. We certainly did not break down, nor do we follow, our expenses down to the last restaurant meal, can of soup, or pizza. We could have but I strongly suspect that even if I had spent hours spreadsheeting the results at the end of ten years would prove to be just as accurate as the 'back of the envelope' method.

 

[MichaelB]

Sorry for any trouble my question caused. Was an honest question. Not having a pension myself, I don't click on pension threads, so I was wholly unaware of the prior drama.

It certainly was not my intent to cause trouble.

No need to apologize, it’s a legitimate question and topic and can be discussed free of rants.