Until about the 1980s, the pension, or defined benefit plan, “was a very, very successful program for people,” said Phil Maffei, head of corporate retirement solutions at insurance company TIAA. “You would get a portion of your income delivered as income for life when you retired.”
What happened to pensions?
Pensions can be expensive and risky for companies. Companies fund pensions and decide how to invest and grow them to keep them fully funded. It’s also tricky to predict how much an employer will need to meet their retirees’ pension obligations, especially with people living longer.
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Pensions also siphon away money that companies otherwise could use for investments that enhance the bottom line.
Most of the record 4.1 million boomers turning 65 each year from 2024-2027 don’t have pensions, according to Jason Fichtner, chief economist of the Bipartisan Policy Center. The next-oldest generation, called Generation X, may be even worse off. They saved much less and were “the first generation to rely on 401k plans instead of pensions and the next in line to retire,” said Deb Boyden, Head of U.S. Defined Contribution at Schroders, in a statement last December.
In January, online Medicare learning resource center MedicareFAQ surveyed 569 retirees, and 59% said they’re concerned about their finances in retirement. Recent research from Fidelity Investments shows that while young people have recovered their 401(k) losses from 2022’s market volatility, older adults haven’t.
Also “the 401(k) plan was really designed to accumulate assets,” Maffei said. “It never was designed to provide income.” What we need to do now is figure out how to turn that money into a lifetime stream of income, he said.
What went wrong with the defined contribution plan, or 401(k)?
The jump to 40-year high inflation exposed the fragility of 401(k)s. People struggling to afford everyday necessities dipped into their nest eggs or reduced their contributions. Aggressive interest rate hikes further strained household finances, and financial market turbulence deflated 401(k) balances, igniting a wave of retirement worries.
What is an annuity?
An annuity is a contract you buy from an insurance company that can guarantee you an income. Some allow regular payouts until you die or for a fixed number of years.
How much you would receive varies, based on several factors, including age, how much you pay for the annuity, the insurance company, and the interest rates at the time the annuity was bought. Generally, annuities are popular when interest rates are rising or high because you can lock in a higher return. And they’re usually offered when someone’s near retirement, said Tina Wilson, chief product officer at retirement plan provider Empower.
Will pensions return?
Maybe, but in different clothes.
When the United Auto Workers (UAW) union walked out last summer at the big three automakers, one of its demands was a return to pensions. Ford Chief Financial Officer John Lawler called pensions a “plan of the past,” and offered instead beefed-up 401(k) company matches.
What UAW finally received was an annuity option in their defined contribution plan. It essentially allows them to create their own personal pension by converting some of their 401(k) money into an annuity.
- Most pensions, unlike Social Security payments, don’t offer a cost-of-living adjustment that keeps pace with the current inflation rate.
- State and local government pensions typically offer up to a 2% or 3% adjustment a year. Private-sector employers that still provide pensions, however, typically don’t offer a COLA at all.
- There may be a tension between enhancing a pension’s adjustment and maintaining the plan’s longer-term financial health.
State and local pensions
The current dynamic is especially acute for former employees of state and local government, such as retired public school teachers, firefighters and police officers.
Nearly 11.5 million people were getting income from a state and local pension in 2020, according to the U.S. Census Bureau.
State and local governments tend to use pensions instead of 401(k)-type plans as their primary retirement plan for workers.
Tensions
Some states throttled back the generosity of their pension COLAs after the Great Recession, Aubry said.
Prior to 2021, inflation had been low for years and pension COLAs had largely kept pace; some were even higher than inflation.
Just one state pension — a plan for police officers and firefighters in Washington state — is keeping pace with the current inflation rate, according to a National Association of State Retirement Administrators report published in June. Its adjustments are fully indexed to the Consumer Price Index, a key inflation gauge. The plan (Washington LEOFF Plan 1) is available only to workers hired before Oct. 1, 1977.
The current inflation trajectory exposes a central tension: While retirees may be falling behind in the short term, offering a more generous adjustment (especially one that’s permanent and automatic) can be expensive. A modest COLA might benefit retirees in the long run by maintaining better financial health of a pension — perhaps offering more reassurance to retirees that the plan will be able to pay the promised benefits.
“It’s no good to have a promise for $1 million if they can’t pay it,” Aubry said. “You want a promise that can be kept.”
Fully indexing state and local pensions to a national inflation rate may be challenging since state finances are more closely tied to the local economy, he said.
- The balance in retirement savings accounts like IRAs and 401(k)s can get hit by inflation if the money isn’t invested in assets that will at least match the inflation rate.
- If you have a pension, it may or may not adjust for inflation but it’s debatable whether the increases have been sufficient.
- Social Security benefits are adjusted for inflation every year.
- Inflation has a direct impact on the revenue, savings, and spending of all consumers, including retirees.
- Interest, dividends, and rental income all tend to move with inflation. Check occasionally to make sure you’re still getting a good deal.
- Put cash to work. Conservative investments will get you a better return that a regular savings account.
- Retirees can diversify their revenue streams, allocate their savings wisely, and make mindful spending choices to protect against rising costs.
Retiree Sources of Income
You probably anticipate having more than one source of income during retirement. The mix could include Social Security income, savings, investment income, and pay for part-time work. Not all sources of income are the same in terms of their vulnerability to inflation.
Retirement Plans and Inflation
The only remedy to inflation in retirement is to save early and often if you can.
Saving early means contributing to your 401(k) or to an IRA right from the start of your working career to take full advantage of the magic of compound interest.
Saving often means taking full advantage of the annual maximums for tax-advantaged retirement plans.
Wages, Salaries, or Self-Employment Income
Many retirees choose to pick up a part-time job or a side gig. One-quarter of all retirees generate this type of income.1
Broadly speaking, there is no mandated cost of living adjustment for salaries or wages. Companies set policies on their own and decide what, if any, adjustments to make.
Housing Costs
Among the big decisions retirees face is whether to sell their home and enjoy the flexibility of becoming renters again, downsize, or stay in place.
Should retirees decide to rent, they must be mindful of escalating rent costs. Average asking prices for rentals soared by as much as 18% nationwide after the COVID-19 pandemic. Notably, the warm-weather cities favored by many retirees were among the worst hit. By the end of 2023, the price increases were leveling off, at least for the short-term.
- Reduce housing costs. Trading in a large home for a smaller one reduces the monthly outflow for property taxes, utilities, homeowners insurance, and maintenance. Retirees worried about future inflation may want to steer clear of renting.
- Add inflation-correlated investments to your portfolio. Some investments do better when inflation is high. Consider rebalancing your portfolio to include inflation-proof stocks or higher-interest bonds.
- Diversify income streams. Some income streams increase due to inflation; others go stagnant. Consider moving away from fixed-income sources of income and into sources of income that adjust with inflation.
- Calculate your retirement needs as early as possible. By saving early in your working career and factoring inflation into what you will need, you’ll be better prepared to leave the workplace behind.
What Should I Do With My Money During Inflation?
This question is best posed to a financial advisor who will review your specific situation.
Many will suggest considering Treasury Inflation-Protected Securities or short-term bonds. Some may recommend real estate investment trusts tied to short-term leases. Others may suggest alternative assets that have a positive correlation to inflation, such as gold or commodi
The Bottom Line
Inflation can be a retirement killer, but it doesn’t have to be if you take the time to develop a plan for beating it. Creating a realistic retirement budget, adjusting asset allocations, and being ready to adjust your revenue streams can all help to soften the blow.
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