What is the funding status of your "personal pension"?

For retirees in the “Greatest Generation,” employer-provided pensions were common, but structural changes in the American economy since 1980 have dramatically reduced traditional defined benefit pensions for private sector workers. Instead, the burden has shifted to most private sector workers to fund their own retirements.

In this new landscape, to have income for life after retirement, intended to replace part or all of your employment income (a “personal pension”), you’ll have to build your own asset base (whether through taxable investment accounts, or tax-deferred options like 401k accounts or IRAs).

The cash flow you want to have each and every year of your retirement is a promise you’re making to yourself, and you want those promises to be fully funded. How much will that cost? And, perhaps even more importantly, how can you know if the funding you owe yourself is on track?

There are several questions to keep in mind as you consider personal pension funding levels: longevity, target annual income, risk tolerance, and projected investment returns. At Yellow Cardinal, we built an illustration to explore these considerations.

The chart below summarizes the results:¹

The illustration is cautious about longevity, and assumes retirement will last until age 100. In reality, according to the Social Security Administration, 50-year-old males have a 99% chance of not living past 100 (for 50-year-old females, it’s about a 98% chance).²

Projected investment returns will vary over time, but at present, a 5.4% pre-tax return (net of inflation and net of fees) for global equities seems at least directionally reasonable.³

It’s your personal pension, so you have to decide on your own target annual income. (This example supposes you’re aiming for an inflation-adjusted $100,000 per year. If you want a larger or smaller personal pension, adjust the required funding levels at each age proportionally.) The underlying math isn’t too difficult, and details are available below for calculating funding for a single year in retirement.⁴

As the chart above does, it’s easy to sum each present value calculation to determine the cost to fund every year of your personal pension, and determine your retirement funding liability at any particular age before retirement. Then, by comparing that funding requirement to your current level of retirement savings, you can determine the extent your retirement is underfunded (or, a better problem to have, the extent it’s overfunded).

For instance, if our 50-year-old test subject has retirement assets of about $700,000, he’s on track to reach his personal retirement goal. Assets above that level might suggest an earlier retirement is possible, while assets below that level suggest increased savings (and/or a delayed retirement) are advisable.

By thinking about retirement saving as funding your personal pension, we see some familiar financial planning concepts in new ways:

• Early retirement is expensive, because you’re adding years to the front of your retirement period, not the back. Assuming a consistent return as illustrated over time (and noting that of course that actual returns are unlikely to be consistent), the net present value of the liability for funding an extra year for your personal pension in your 60s will naturally be larger than an extra year in your 90s.
• At age 22, the liability to pay yourself an annual $100,000 personal pension starting at age 67 has a net present value of about $160,000. Very few workers enter the workforce with that level of retirement savings, so in their 20s and 30s they try to “catch up” to target funding levels.
• The size of the personal pension liability grows each year by the projected net investment returns of 5.4%. So, the sooner one creates a pool of retirement savings, the more likely it is that each year’s personal pension funding requirements may be met through investment returns, rather than annual savings from current income.
• Funding your personal pension with less risky assets may reduce future returns, increasing the required funding amount.
• A family that could send a child to an expensive (e.g., private) college, but instead sends them to a lower cost option like an in-state public university and invests the difference for their child could use the funds to help “launch” their child into the workforce with additional savings that could be set aside to fund a personal pension right out of the gate.⁵
• By age 67, $17.13 of assets is needed to fund $1 of annual retirement income through age 100. While that’s certainly substantial, it’s less than the $25 of assets per $1 of income suggested by conventional wisdom for secure retirement funding.⁶
• Clients sometimes feel intimidated by funding calculators, because the results usually suggest the client is behind. It’s daunting to try to save towards a single “ginormous” number, but it can feel more manageable to view funding for one’s personal pension one year of retirement at a time.

Financing retirement is challenging. By seeing the project for what it is – funding your personal pension – you avoid making it harder than it needs to be.

1 The values reported on the chart are in current (not future) dollars. Calculations reflected in the chart are based on contributions at the beginning of each year, projected inflation of 2.4%, a retirement age of 67, and pre-tax real (e.g., post-inflation, post-fees) investment returns to an aggressive-growth-focused portfolio of 5.4%.

2 See, e.g., Social Security Period Life Table, 2020. Available at https://www.ssa.gov/oact/STATS/table4c6.html.

3 Past performance is not indicative of future results. The information provided herein is for illustrative purposes and should not be considered investment advice and is not designed to address your investment objectives, financial situation or particular needs. The information is as of the date referenced herein and is subject to change at any time based on market, economic or other conditions.

4 The present value (PV) of the future cost to fund each year of your retirement is the target income (or future value, FV) for that year, divided by (1 plus the projected return (r) on your retirement savings), compounded by the number of years (n) between now and the future year of retirement. In equation form, that’s PV = FV / ((1+r)^(n)). For instance, funding the first year of retirement from age 67 to 68 with $100,000 of annual income requires almost $41,000: $100,000 / ((1.054^(67-50)).

5 Although funding not required for the high-cost college could be earmarked for retirement instead, gift tax considerations may need to be addressed. Options include making a series of “annual exclusion” gifts during the child’s young adulthood, or a single larger “taxable” gift that may use a relatively modest portion of the lifetime gift tax exclusion amounts of the child’s parents. For specific guidance on U.S Federal gift tax rules, you should consult with a qualified tax professional or estate planning attorney.

6 The ratio of $25 of assets for every $1 drawn in annual income reflects the well-known “4% Rule” for safe withdrawal rates. First advanced by William Bengen and confirmed by the Trinity Study, but subject to continuing debate, the “4% Rule” has become a foundational financial planning “back of the envelope” assumption for safe withdrawal rates. See, e.g, W.P. Bengen, “Determining withdrawal rates using historical data” J. Financial Planning (Oct. 1994), p. 171-180, available at https://kyestates.com/wp-content/uploads/2015/02/Bengen1.pdf and P. L Cooley, C. M. Hubbard, and D.T. Walz, “Retirement savings: choosing a withdrawal rate that is sustainable” AAII Journal (Feb. 1998), p. 16-21, available at https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf.

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The information presented in the material is general in nature and should not be considered investment advice, is not designed to address your investment objectives, financial situation or particular needs. Information is gathered from sources deemed reliable but its accuracy or completeness is not guaranteed. The opinions expressed herein may not come to pass, are as of the date of publication and are subject to change based on market, economic or other conditions.