The retirement savings landscape has changed a lot over the past few decades.
It used to be that if you held a steady job for most of your adult life, you could count on receiving a pension in retirement that provided a consistent monthly income based on the number of years you worked and the salary you earned.
But that kind of security is rare these days. According to the U.S. Bureau of Labor Statistics, the percentage of private industry employees with access to a traditional pension plan has decreased from 42% in 1989-1990 to 15% in 2016. And many of the pension plans that do exist are no longer accruing benefits.
Those traditional pension plans have largely been replaced by 401(k)s and other employee-driven plans that put the onus on the individual to save and invest intelligently. In other words, it’s now up to you to create your own retirement security.
But that doesn’t mean that you have to leave your retirement plan entirely up to the whims of the market. There are some ways to mimic the traditional pension plans of old, giving yourself at least some of amount of reliable income in retirement.
Here’s an overview of how you can create a DIY pension plan.
How Traditional Pension Plans Work
First, let’s back up and talk about how traditional pensions have typically worked.
Most pensions provided a guaranteed income in retirement that was dependent on three main factors:
- The number of years you worked for the company
- Your salary
- A pension multiplier
As an example, government employees still have access to a traditional pension plan under the Federal Employees Retirement System, with annual retirement income calculated as follows: 1.1% x Years of service x High-3 average pay (your highest average salary over any three consecutive years).
So if you worked for the government for 20 years and your highest average 3-year pay was $75,000, you would be eligible to receive an annual pension payment of $16,500.
Unfortunately, there’s no good way to replicate that kind of guarantee when you’re still years away from retirement. The best you can do is save at a high rate, make smart investment decisions, and put yourself in a position to have enough money to make whatever choices you’d like to make down the line.
But if you’re either at retirement age or getting close, there are a few different ways to give yourself a reliable and consistent stream of income similar to what you would receive from a pension.
Here are three of the biggest.
A single premium immediate annuity (SPIA) allows you to make a one-time payment in return for a guaranteed income for the rest of your life.
In most cases the income is fixed, meaning you receive the exact same amount every single year. This has both benefits and drawbacks, as Phil Walker, CFP® of Walker Wealth Advisors explains.
“In essence, you are shifting volatility – to the downside and the upside – to an insurance company, which can provide significant peace of mind to new retirees,” Walker says. “However, over time your purchasing power can significantly decrease because of inflation.”
Walker also warns that SPIAs might not be appropriate if you either need or value flexiblity, since you can’t access the money once you’ve purchased the annuity, beyond the fixed income it provides. So if, for example, you need extra money for long-term care expenses for you, your spouse, or an aging parent, a SPIA may not be able to provide it.
Life expectancy is another factor to consider before purchasing a SPIA. If you purchase the annuity today and die tomorrow, you’ll have paid a lot of money for little to no benefit.
“If life expectancy is especially short, you wouldn’t want to purchase a SPIA because it would result in a windfall to the insurance company rather than a legacy to your heirs,” Walker explains. “If life expectancy is especially long, you probably shouldn’t purchase a SPIA because it doesn’t offer protection against inflation.”
To sum it up, a single premium immediate annuity can be a great way to give yourself a guaranteed income, but it comes at the cost of decreased flexibility and decreased purchasing power over time.
2. Liability Driven Investing/Dedicated Portfolio
Dave Grant, CFP® of Retirement Matters helps clients build what are called dedicated portfolios that mimic the investment portfolio of traditional pensions.
“If you look at a traditional pension,” Grant says, “it is made up of two components: short-term, bond-like investments to meet cash flow needs and long-term equity-like investments which will grow over time and replenish the short-term investments as they’re used.”
“In building your own pension, the same approach can be taken by using individual bonds to match your short-term cash flow needs. For example, if you need $40,000 each year, you can build a bond ladder that produces $40,000 each year as the bonds mature. The ladder lasts for 5-7 years, and the rest of the portfolio is 100% invested in the stock market and is used to replenish the bond ladder at it’s used.”
Grant says that this approach can be very precise in generating consistent cash flow and can insulate you from the interest rate risk you’d be exposed to in bond mutual funds.
But it requires a significant amount of money to implement, given that you need to both construct a sizable portfolio of individual bonds and have enough extra money in the stock market to replenish those bonds over time. Walker also warns that buying individual bonds can be expensive, and that you still need to be careful about diversifying so that you aren’t too reliant on any individual bond.
In other words, it’s a complicated strategy that can be difficult to implement. “It takes an educated and disciplined approach to carry it out,” Grant says. “But if done right, it can be very successful.”
3. Conventional Balanced Portfolio
You don’t have to get fancy to keep your retirement income reasonably safe. Sometimes a conventionally balanced portfolio of stocks and bonds is the way to go.
“My personal preference is for the balanced portfolio approach,” Walker says, “as it provides more diversity and flexibility than the alternatives.”
In some ways, a conventional portfolio rebalanced on a regular basis functions much like a dedicated portfolio, but with less precision:
- The bond portion of the portfolio provides downside risk and makes sure that there’s money available to withdraw, even during a stock market crash.
- The stock portion of the portfolio provides long-term growth and is there to replenish the bond portion when it gets low (through rebalancing).
You may have to deal with more ups and downs than the other approaches, but again they come with their own risks. And if your portfolio is truly balanced, both the peaks and valleys will be smaller than one that’s 100% invested in the stock market.
Mix and Match
Of course, none of these approaches is all or nothing. In some cases, the right approach might be to use some of each.
Grant explains that an annuity can be “particularly useful for those who have other assets besides what would be in the annuity, transferring some of the risk and portfolio maintenance over to someone else.”
Walker agrees. “If someone has a significant portfolio,” he says, “it may be possible to purchase a SPIA to provide a steady income base and fund a balanced portfolio that will offer the potential for growth and fund future increases in income.”
It all comes down to your personal retirement income needs and your appetite for risk. But when the strategies above are used right, you can create your own pension payment that gives you the stability you’re looking for with the flexibility to adapt to life’s ever-changing circumstances.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money,