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Author: BruceCM Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76237  
Subject: Re: Pensions Date: 3/16/2011 2:01 PM
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I do not write pension plans for a living, but I understand their basics reasonably well. So let me off you the following...

...I was a little surprised, however, to learn that all state employees are required to participate in the Wisconsin Retirement System...

Yes, Government defined benefit plans may not only require your participation, but require that you contribute to it. This is theoretically possible in private pensions, but extremely rare.

Some random thoughts: pension contributions are taxable, which surprised me. But then again distributions are not taxed at the end

Are you sure about thi? I have NEVER heard of govt employee mandated pension (defined benefit plan) contributions to be after tax. This can happen electively in a defined contribution plan....but I can't imagine why the employer would require non-elective employee contributions to be after tax...and I can't imagine ERISA (dept of Labor) would allow it.

...Another feature that is really unfortunate is that if you separate from state employee -- at any time -- you are only entitled to roll over your personal contributions of 5.8%. ...

Nope...can't be done. ERISA has very strict vesting laws on employer contributions. What you've described was the pre 1974 ERISA cutesie game unscrupulous employers would play on unsuspecting employees, where all plan contributions would not vest until retirement age...and then the employer would fire them the year before this...which as you've described it is what could happen with this pension plan.

What you may mean is that if you leave the employer within a certain time period (up to 5 years under current rules), you would lose all employer contributions. This is a 5 year cliff vest...but your employer could also use a 3 to 7 year graded vesting schedule.

I just ran some quick numbers, and basically this pension will result in potentially $100,000 less for retirement, forecasting 20 years of life after retiring at 66. Kind of crazy, at least to me. The pension system gives a percentage of the salary from your last three years of service, for the life of the annuitant. I used my starting salary (certain to go up, hopefully, sometime in the next 35 years), and was pretty surprised to see that investing the same amount of money with moderate returns of 5% per year would yield over $100,000 more. That's quite a difference!

You sound like you might be a 'numbers' kind of guy, so let me show you how to do this calculation.

You only give part of your plan's formula....which is usually something like the average of the top 3 earning years, times the number of years of service times some percent...usually 1 to 2%. Lets say your current salary is $75,000 and you expect this to grow by an average of 2%/yr, so in 35 years at your plan's retirement age, your final (highest) 3 would be (144,167 + 147,050 + 149,192)/3 = 147,070. So using my made-up formula your future benefit in 35 years at, presumably, your plan's full retirement age of 66 would be
147,070 X 35 X .02 = $102,949

So now the question is how much must be collected into a 'pot' to be able to fund this level pension (I assume its not inflation adjusted) over your retirement years. Assuming your life expectancy at retirement is 25 years (20 - 25 is average) and the average annual rate of investment return is 5.5%, then the 'pot' would have to be $1,456,903.

Now the question is, how much needs to saved over the next 35 years to reach this.

If you grow annual savings rate by an estimated inflation rate of 2%, and you could average an annual investment return of 5.5%, my calculator tells me you'd need to save $11,296 your first year, increasing this each year by 2%, so the second year's savings amount would be $11,522 and so on.

But there is one problem. The way most pensions are funded is by using what's called the 'accrued benefit' method, which is not a level method, but a small amount at the start that gets very large in later working years. This is the main reason that so many pensions are underfunded today. It's because the average years of service in the pensions plans and the average age of the worker is much greater than it was 30 years ago. But what this means is that in the early years, very little is set asided to meet your future pension needs. You've got to wait until your later years. So, for example, if you leave/quit/laid off in, say, 10 years, your accrued benefit, using my above numbers, will be $17,926 year....but you'd have to wait about 25 years to get it, which, at an average annual estimated inflation rate of 3%, would only be worth, in today's buying power, about $8,562 and if the plan offers a 'cash-out' option, which will represent the present value of the future capital required to fund your accrued (in this case $17,926 annual) benefit, this cash value would only be about $66,524, a number you could reach with personal savings, growing at 2% per year, by saving 3,536 the first year. This is one of the primary reasons DBPs are not very popular with the young.

BruceM
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