How Do Pensions Work?

How does a pension make money for you in retirement is the most important “how does it make money” question of your lifetime.

Unfortunately, if you are normal, your eyes glaze over when the topic of pensions come up. I mean seriously, when you are young you are imagining yourself as Zuckerberg, not like your mom, all worried about the price of beans. And then when you get old, you have the financial media droning on about 401ks and employer matches and saying “it all depends on your circumstances”.

Pensions are simple. After you finish working for money, your pension is your money working for you.

How does a pension work

Image: JD Hancock

A brief history of being able to afford it

The German chancellor, Otto von Bismarck was the father of the pension. He even has his own page on the US Social Security website. It took money from the employee, employer and the state to create a safety net for retired people over the age of 65.

At the time this cost the state hardly anything – because the average life expectancy was 45!

The UK introduced its state pension in 1909. The United States enacted Social Security in 1935. Looking after retirees financially is morally right and critically important.

They just never guessed that people’s life expectancy would shoot over 80 in Europe and the States. There is even a village in Italy where four hundred out of its twelve hundred inhabitants are over 100 years old.

Most countries (notable exception Greece) can deal with their retirement commitments, because what they have committed to pay is a pittance.

The UK recently moved to a flat system. This makes the state pension easy to calculate. Each year you contribute earns you an income of £4.43 per week, up to 35 years. This maxes out at £155 a week or £8k a year (approx. $11,600).

The US system is more typical, with how much you contribute in dollars influencing the amount you end up with. However this makes the social security calculators read like Double Dutch. The maximum possible benefit is $31k.

In contrast the average benefit is $16k a year, and virtually impossible to know until you are about to retire.

A brief history of not being able to afford it

The fifties and sixties were very different that today. Although Elvis lives (just like today :), the relationships between employers and their employees have undergone a sea change.

Economic growth at the time was dramatic – and there were simply not enough workers to manufacture all the new cars and washing machines getting invented.

This is the period where Europe welcomed migrants, with over 3 million Turks moving to Germany because of labor shortages. Workers and their families from all around the British Empire came to the UK to fill factories, not simply their asylum applications.

The landlord of a pub (English beer house) I frequent, tells stories about the sixties. Like when he was able to ice skate on the Thames. Or when he worked as a bus conductor, a librarian and as a mechanic in a two month period.

Because businesses struggled to hire staff, workers got to choose what to do with little regard to their experience.

General Motors was one of the leading companies in the world at the time. And to get workers, they had to pay up. Not only in salary increases, but in health care benefits and retirement income.

This was the era of companies promising their staff two thirds of their final salary if they worked there for forty years.

Unfortunately they could not afford these promises.

General Motors went into Chapter 11 bankruptcy in 2009, partly to slash away at the pension and healthcare benefits they had promised decades before.

Making someone else pay for it

What do you do when you can’t afford something?

You get somebody else to pay for it. And that somebody is YOU.

401k money dynamite

Image: Richard Stephenson

That is why pension schemes, defined benefit and final salary plans (all the same thing: a promise made to you) have become 401ks, money purchase and defined contribution plans (all the same thing: you saving for the future).

I’m going to focus on the second set of 401ks and DC pension plans, because the first set are history.

As I’m not going to delve into the regulatory details, you can assume that in this article 401ks = defined contribution pension plan. India’s National Pension Scheme is a defined contribution system with both tax deductions and optional employer matches, but unfortunately its too complicated to go into each countries individual characteristics.

It is possible to fund these new retirement schemes to exactly the same level as a final salary scheme. Pensions are a hugely advantaged investment type for two reasons.

Why 401ks plans are great investments

  1. Pension savings coming out of your pay check is not taxed or receive a tax deduction. Once you have bought the big things in life like your house, this is a great reason to put the majority of your savings into your pension. Typically when you retire you will be in a much lower tax bracket, so you beat the tax man twice on a bigger pot.
  2. Employer match. This is where your company pays you free money because you are saving for your pension. To repeat, employer match is FREE MONEY. Read the rules, and do what you need to, to get this FREE MONEY. This is probably the only time you will see this phrase on the internet and it not be a scam.

However 401Ks and DC plans are worse than what they replaced for two big reasons.

Why 401ks and Defined Contribution plans are less generous

  1. No one has promised you what you are going to get when you retire. The old plans had a financial promise. The promise might be worthless, but it was still a promise.
  2. Employers used to subsidize the management of your pension. Investment management fees tend to have risen after the move to 401ks.
  3. Employers typically put significantly less into 401ks compared to the old plans. Data has shown that for some of the old final salary schemes, companies were putting in 22% compared to the 3-7% employer match more common today. The old schemes received more FREE MONEY.

How do 401ks work?

  1. You pay in a slice of your salary (and suffer less tax).
  2. The employer matches part of it according to a defined scale.
  3. It is invested in a variety of assets, like equity or bond funds. A good 401k has a diversified default option, most likely a Target Date, Glide Path or LifePath fund.
  4. Your money is trying to work for you and grow.
  5. If you withdraw money early it may be subject to a significant penalty charge.
  6. From a set age (for example 59½ in the US) you can access your funds. Options include direct lump sum withdrawals or using some of the money to buy an annuity.

Yuen, you have already lost me. Please simplify

Sorry, I get like that sometimes. Saving is simple. It is like planting an acorn in the garden.

The longer it is planted, and the more you look after it, the bigger it gets. The math of this is crazy.

Imagine a tree that doubles in size every year. If it is an inch high the year you planted it, in ten years its 42 feet tall. That’s a four story apartment block.

But if it grows for twenty years, it isn’t 84 feet tall, it is in fact 43,690 feet tall.

pension is a tree

Image: Oldest living tree in the world (Iran), Yuen Lo

These are ridiculous numbers. Money doesn’t grow like a weed. But the math really does work this way. This is the magic of compound interest.

$100,000 that increases by $5,000 a year for 30 years is $250,000. Nice right?

$100,000 growing at 5% a year for 30 years is $432,000. That’s 72% more. And all because compound interest is your friend.

5% twice is more than $5k twice – and the gap just gets bigger and bigger.

Retirement is the moment you stop cultivating the tree. It is time for the tree to look after you.

Unfortunately, you probably won’t be eating its fruit, you will actually need to slice off the branches for firewood. But the tree knows this, it knew that this was its purpose.

One aspect that can get confusing is how no one stays in the same job.

It is common for you to have grown more than one tree over your lifetime. That’s okay. Having more than one tree is cool, if a little confusing. It just means you have to remember where they are all planted.

How to make your 401k grow

What does the 401k God of Investing look like?

Every year s/he switches one hundred percent of their assets into the asset class or fund that rises the most. Being completely infallible, this God quickly becomes worth a trillion dollars. In other words even richer than Donald Trump.

The Economist wrote an article on a fictional character Felicity Foresight at the turn of the century. Starting with a dollar in 1900, she invested it perfectly every year for 100 years. In the year 2000 she would have been worth $1.3 quadrillion dollars. That’s the number 13 followed by 14 zeros.

What do real human beings do? They typically split their money evenly between three or four funds. Alternatively they do nothing at all and stick with the default.

If you are in a low fee Target Date or LifePath plan, with the correct retirement year, then you’re probably doing the right thing.

Target Date funds generally invest in risky equities when you are younger, and shift this to bonds as you age.

If you choose to do something different, just be aware even professionals struggle to get this right. Good luck and God bless.

Annuities

retirement make money couple

After you retire, you have a tree. Big or small, what do you do with it?

You could buy an annuity. Factually this is an investment product you pay for, where an insurance company promises you monthly payments until you head up to heaven.

In other words you exchange your tree for a regular delivery of firewood. That is all it is.

In the UK right now, a single person aged 65, after a flat pension, would have to deliver twenty tonnes of tree to get a promise of one tonne of firewood a year for the rest of their lives. This is a 5% rate, or a twenty times multiplier.

If you want firewood based on both your lifespan and your spouse’s lifespan, then you need to hand over more wood. The multiplier rises to twenty five tonnes of tree.

The word flat is critical. Flat means it isn’t adjusting for inflation. Inflation means many things, but here it means the price of stuff going up.

Price of bread goes up, you are poorer. The price of gasoline goes down, you are richer.

Mostly the price of stuff goes up. You have to pay up to protect against this. Say you want a 3% annual increase in the amount of firewood you receive, and for it to cover your partner’s life. The multiplier goes to thirty three tonnes of tree.

How do you pick an annuity? You do it the same way you buy anything. You shop around. Get everyone to quote you how much firewood they will give you. Then have a think about which you trust the most. This is a horrible chart showing you how much annuity you get for £100,000 declining.

How an annuity makes less money

Image: sharingpensions.co.uk

Because the yields on bonds have kept going down, the price of annuity has gone through the roof.

Retirement isn’t what it used to be

In the 1990s, $100k bought a $15k income. In 2008 this was $10k. Now it is nearer $5k.

Flip this around. You are 65 years old and you will probably live until 85. If you bought an annuity in 1990, then you could be confident that you’d get your money back in 7 years. In 2008 you’d get it back in 10 years. Now its going to take 19 years.

Almost half of annuity buyers will no longer live long enough to get their money back.

Why should I buy an annuity if this is the case?

The fact is, when retirees are surveyed, the more predictable their income, the happier they are.

Conversely there is a good argument to delay buying an annuity after retirement. Basically, the older you are, the higher your annuity gets.

Do I suggest you NOT buy an annuity?

No way, it will drive you nuts. If you have the savings, the best strategy is to buy an annuity that ensures you have a decent life style, and keep the rest in a wrapper that both lets it (1) continue to grow and (2) lets you access it freely.

The key however is mentally separating your stress and your finances. If you cannot do that then your retirement has taken the wrong turn.

How much do I need to retire?

Sick and tired of hearing “it depends”, or receiving the reply “how long is a piece of string?”

Everyone’s situation is unique. However I believe my wife and I can retire on an income of £20,000 (equal to $28k) of today’s money

The phrase “today’s money” means we need it to grow at the same rate or higher than inflation. I calculate that this requires personal retirement savings of £100,000.

This isn’t chicken feed. But we live in one of the most expensive cities in the world, London, so conventional wisdom would suggest I am being ridiculous.

As mentioned above, the state pension or social security is £8k per year, or £16k between my wife and me. I expect this to rise by more than the rate of inflation.

Note that using the 4% or 25 times annuity multipliers discussed above, I consider this retirement income to be worth £200k per person.

This leaves a gap we need to fund ourselves of £4k. Again using the 4% number 4,000 / 0.04 = £100,000.

Most stuff you read on the internet tells you you’re not saving enough and you need 70% of your current income to sustain your lifestyle. In our case this happens to be true if we were earning £28k.

The 70% number is like when someone tells you your diamond engagement ring should cost you two months salary. If you can afford it great. But most of us can’t, so thank you there, you have been no help at all.

If you are lucky enough to have a pension pot that exceeds your minimum retirement income, then keep that excess in the pot. But remember, that pot is extra. Don’t lose sleep over it, because the whole point of this extra savings is to use it to make yourself more happy.

The importance of the roof over your head

Finance is an area where averages are meaningless. I have a friend living a great lifestyle on £1k a month, or £12k a year.

The key to what he is doing, and to what I assume about my retirement, is owning our own property.

Property prices in the US, UK, Sweden, China and India are all ridiculous. Consequently so are rents.

Here is something not said enough about retirement: You must not be paying a mortgage or rent by the time you retire.

If you are you are screwed. This is my pension rule of thumb. Own the roof over your head? Live in accommodation freely provided by the State? Then your retirement will be comfortable.

A one bedroom flat in London easily costs £1,100pcm in rent, or £13,200/year.

At a 4% annuity rate that is £330,000.

There are pros and cons to buying a home versus renting when you are young. But at some point if you have saved money instead of buying, you MUST now buy your house before you retire. Imagine you had the financial smarts to rent and save. You already face risks around regular inflation. Do you want to face the risk of rising rents? What will you do at seventy if your landlord terminates your lease?

There used to an alternative in the UK related to state funded housing called council housing. The Conservatives (Think Republicans but posh) have ended this by selling it all off.

Owning your home is key to keeping your costs down after you stop working. It is another unexpected price the millennial generation is going to have to pay because of our over inflated housing markets.

The other aspect to keeping our costs down is NOT saving after retirement.

Whatever you are saving now, you don’t need it when you are old. Spend it and have some fun.

Retirement is more than money

Image: opensource .com

I use a £20k base expense number, and I think that includes a short holiday or two. Maybe it is just EasyJet (think SouthWest airlines) to the south of France. But what I definitely don’t assume is any saving.

I know that maybe you have grand kids you want to look after. You want to leave them a legacy. That is fair enough. They could do with a leg up. But don’t tear yourself up if you can’t. I am sure they have the smarts to look after themselves

Retirement is scary and complicated. But it doesn’t have to be. Find a way on the property ladder. Get some money in your 401k or pension scheme early in life. Most importantly hold on tight to someone you love deeply 🙂

If you liked this, a related article is this one on the stock market.

If this was a bit boring but you’re still here, maybe AirBnB is another way for you to generate some extra income.

If you really want to turn the excitement on, you need to look at Kickstarter.

Yuen Lo

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