How To Help Clients Understand The Impact Of A Cut To Their Pension

Thursday, April 12, 2012 10:38
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How To Help Clients Understand The Impact Of A Cut To Their Pension

Tags: pensions | retirement planning | social security

Defined-benefit pensions used to be much more prevalent 50 years ago. Many of our grandparents and parents would work for the same company for decades and then count on a solid stream of pension payments once they retire. Even if their company went bankrupt, most of those who had pensions were covered by the Pension Benefit Guarantee Corporation (PBGC), a federal government agency.

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But times have changed. Today most people in the private sector do not have defined-benefit pension plans. Those who do still have the majority of their payments covered by the PBGC, but they do not have their health benefits guaranteed. This is a big problem for those workers who planned on paying next to nothing for medical care once they retire. As we found out with the Kodak bankruptcy, those medical benefits can disappear in the blink of an eye.

 

In some ways the pension situation for government workers can be even more stressful. Although government employees generally have much better pension benefits than private workers, their benefits are subject to the political winds. Laws that determine their benefits can generally be changed at any time.

 

It is important that clients who want to understand the risks to their retirement plan are made aware of just how big of an impact a cut to pension benefits can have. Let’s start with an employee of Kodak who is 60 years old and just saw his medical benefits in retirement wiped out. I created a sample plan in our retirement planner with the following assumptions: John and Jane Doe are both 60 years old. They have $700,000 in assets in IRAs, John plans on receiving $12,000 per year in pension benefits, full medical benefits paid by his company, and they will receive a combined $30,000 per year in social security payments starting at age 65. John will retire at age 62 and Jane is not currently working. Their recurring expenses in retirement are $50,000 and I have assumed they will live until age 95.

Given these assumptions we find the following:

Age When Money Runs Out

Never

Value of Investments at End of Plan

$372,000

 

This couple is in pretty good shape. They have a buffer of $372,000 at age 95 when their plan ends. But what happens if they are now responsible for their own medical bills? Let’s assume that without their company’s health benefits in retirement they will pay $15,000 more per year in medical expenses. Here is what I found:

Age When Money Runs Out

88

Value of Investments at End of Plan

$0

 

What a drastic change for them. This couple needs to be prepared for such an event as it will completely change how they can live in retirement.

 

Now what about a government worker who fears that his actual pension payments will be reduced? Let’s use the same couple except in this example except now their combined pension payments are $30,000 per year and their social security is $10,000. I ran some probabilistic scenarios on John’s pension payments being cut. I ran four scenarios as follows:

Scenario

Probability

Pension not cut

40%

Pension cut by 5%

15%

Pension cut by 10%

15%

Pension cut by 15%

15%

Pension cut by 20%

15%

 

 I then used our retirement planner to calculate the expected results from these scenarios and found these results:

Age When Money Runs Out (Expected Value)

Never

Value of Investments at End of Plan (Expected Value)

$155,000

 

This couple is still in pretty good shape as their money will never run out, from a probability-weighted perspective. However, the buffer they have at the end of their plan has been reduced by over 50%.

 

It is important to quantify risks for clients especially if they fear that their pension benefits might be cut. This will help them devise an action plan today so they are prepared for an uncertain future.

 

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