Paul Winkler: And welcome, this is “The Investor Coaching Show,” and you know what we talk about around here. I mean, the name gives it away. What do you think, Michael?
Michael Sharpnack: I think so. We’re not hiding here.
PW: Well, it’s not just investing. There’s financial planning too because, well after a while, if you just talk only about investing, it can get old.
So we have other things. We’re not just one-trick ponies, so we’re going to talk about everything.
Retirement planning, and planning for that future point in time when hopefully money’s working for you, rather than you working for money. Because let’s just face it. That’s fun.
Okay, so Michael Sharpnack is from up in the Goodlettsville office, and I’m bringing him on because he likes to read a lot as well, and I know you’ve been into some research, and we got to talking in the office this week, and I said, “Hey, have any good ideas?”
And he went, “As matter of fact, Paul, I have been doing some reading.”
And he told me a couple of things, and I thought, “You know what? That would be a really, really good topic,” so I figured I’d drag you in here and talk about, among many things, first of all, pensions, 401(k)s. Just in general, there is really good information—interesting stuff—out there.
How Pensions Are Funded
Just to start off the conversation, you had said something regarding Kentucky, wasn’t it? Regarding the pension system up there, and some interesting things going on.
What on earth is going on in Kentucky, and why should anybody, except for people in Kentucky, maybe care?
MS: So I was writing a blog for the website on pensions and doing a bunch of research on it, and basically I came across some research that didn’t make it in the blog talking about funding of pensions and how well the pension is funded.
And a pension is funded by the employer, so it takes the burden off the employee to actually do the funding themselves. The opposite of a 401(k), really, in that sense, where the—
PW: Yeah, so we go back 40, 50 years, that’s pretty much what everybody had prior to the 401(k) coming about. They had pensions.
The employer put the money in, and they took care of them while they worked for them, and then they took care of them after they retired and had to fund it so a certain level of income was going to come out at the end.
And you have actuaries who tell you how much money you have to put away based on expected returns to have a certain sum of money in the future when retirement starts to fund a certain amount of income until the person is likely to have left the planet and passed away and no longer need to pay the income anymore. So a pretty complex set of calculations to determine that.
So underfunding is, in essence, when they didn’t put enough money away to hit the bogie or hit the number that they had to hit to give these people the income that they promised them for the rest of their lives.
That’s a scary proposition for the employee.
MS: Absolutely. And the trickiest part of pensions being underfunded are states and local governments, and we can get into that, but private pensions are covered by the PBGC (Pension Benefit Guaranty Corporation).
PW: Mm-hmm.
MS: So if you work for a private employer and they underfund, the PBGC can take over the pension and guarantee benefits up to a certain limit.
PW: Hence, that has happened many times when people have been working, and I’ve had this—let’s hit this real quick for a second because this is something I’ve had people actually bring up to me: “Paul, I got this pension, and I don’t know. My company’s not doing so well, and I’m a little bit worried.”
And in this case they had a private pension, private company, and I would say, “Well, you have an insurance program backing this, in essence, that all these employers have to contribute to in order to make sure they can meet their obligations, and as long as you don’t have a $100,000-a-year pension, you’ll have limits, and you can actually look up what those limits are that you’re insured to.”
But for most people, a vast majority of people, because they don’t have pensions that large, you’d be fine even if the company went under because it’s separate from the company itself, and it’s insured.
MS: Yeah, they cover up to, depending on a couple factors, but $67,000 per year they will cover, depending on when the plan closed and what age you started the pension.
PW: It didn’t seem like it was that long ago. I remember it was $40,000—I had somebody that was at that level—and this was back, that makes sense, because that was back about 20 years ago, and that’s what happened.
This guy came in, and he worked for this huge company, and said, “I’m thinking about retiring. They’re giving us offers for early retirement.” And probably the company had seen the writing on the wall that things weren’t going so well.
And he said, “My friends, they’re going to continue on.”
And I said, “Well, good luck to your friends. So what are you going to do?”
And he said, “If you think it’s okay, I think I’m going to retire.”
And he ended up doing that. Came back a year later, the company did go under, and his friends were sunk, because their pensions were $100,000, and the limit was $40,000 at that point in time.
MS: Ouch.
PW: But $67,000, I seem to remember seeing something that was in that range right now, which would make complete sense based on inflation.
Pensions on a State and Local Level
So that’s the insurance level, and when you’re talking about the municipality, you said there’s a difference there.
MS: So municipalities, local governments, and state governments are not covered by the PBGC. So when they’re underfunded, it becomes a little trickier of how that can actually be taken care of.
So states and local governments are a little bit different. For instance, cities can file bankruptcy. So if their pension gets underfunded, it goes under. Detroit filed bankruptcy not too long ago now, so they went under.
And the pension is going to be toward the top of the list of the claimants against the city, but people are probably not going to get their full pensions, and they’re probably going to get some lump sum amount that’s a reduced amount of what they would’ve gotten. They will be paid off because the city filed bankruptcy.
PW: And then you go, “Well, why would a city file bankruptcy?”
Well, their tax base dries up, people leave, and companies leave a city.
And it’s one of the reasons I’ve often talked about that I’m not crazy about using municipal bonds in an investment portfolio because if their funding dries up, they can’t meet their obligations. So that makes a lot of sense.
And for people working for these governments, what else do they do? And I’m sure you’re going to get into that.
MS: Absolutely. And I wanted to hit on Kentucky, where that comes in. As a state they can’t file bankruptcy. Legally, states are not allowed to file bankruptcy.
So this brings it back to the piece of research that I found while I was looking into pensions. Kentucky’s pension is 16% funded.
PW: 16%, 1, 6.
MS: 1, 6. 16% funded, lowest in the nation.
PW: Wow, that’s amazing.
MS: It’s amazing that they let it get that far.
PW: So what do you do there? And they’ve got a state income tax.
MS: So the talk is, honestly, it’s not sure exactly what they’re going to do right now. The governor of Kentucky is actually pushing against the law that prohibits states from filing bankruptcy.
He wants to file bankruptcy as a state, which is scary. That opens a whole other can of worms there.
PW: Wow. What do you do?
I remember Art Laffer and Rex Sinquefield. I used to go hear them speak wherever they were speaking, and that was one of the things they did: research on every state in the union. It was fascinating.
And they looked at not only states, but they looked at municipalities and local governments, and they found every single time that they tried to raise the tax rates, then their economic growth actually went backward.
So you can’t come in and just say, “Hey, let’s just throw in an income tax,” because people respond to that, and then they leave. That puts them in quite a pickle.
MS: It really does. The only two options really are, one, they just can’t pay the pension and benefits are reduced, and there’s about 500,000 people either on the pension or subject to receive benefits, so that would be just a huge crippling blow to many people.
The other option would be the federal government steps in and bails them out.
PW: And we’ve heard that with California, people saying California would love for the federal government … and that’s a big political nightmare because you have one side that might be likely to do it, and the other side is like, “Heck, no.” Wow.
MS: So it’ll be interesting to follow that and see what actually ends up happening. On a side note related to that, it’s interesting that the governors and legislators have a separate pension, believe it or not, that is 114% funded.
PW: Oh, that’s convenient.
MS: Convenient how that works.
PW: Well, it’s, “Maybe we’ll just go and transfer it,” but there’s not enough money there to make any difference. I mean, when you’re looking at the number of people being insured—wow, that is a real challenge.
MS: 26 billion in debts, the pension.
Make Sure You Save in Addition to a Pension
PW: So a takeaway from this for anybody thinking about these issues, and particularly if you’re working for a government like this: make sure.
Because I’m going to tell you … my father was covered under a federal pension. He was covered under a state pension as well, being in the military, and one of the things that he always did … it was interesting, I was like, “Dad, you save a lot of money.”
“Paul, you’re not getting Converse sneakers. It’s all there is to it because they’re too expensive.”
“Well, why?”
Now I look back and I understand what dad was doing. He was saying, “We’re just not going to go waste money,” because he didn’t want to depend or bet on anybody coming through with a promise.
So he saved a significant amount of money outside of the pensions that if everything went to heck in a handbasket, my parents would’ve been okay.
And I think that’s a good lesson for younger people, especially, and that’s probably where you’re going.
MS: Absolutely. I mean, this affects teachers. It’s a big one that affects police officers, firemen, workers that are under state pensions or local pensions.
And I find a lot of people, especially younger people, may think they’re covered under their pension, so they’re not thinking about how a pension works.
PW: Or have to save money.
MS: They think, “I don’t have to save money.”
A lot of pensions, especially now, if you’re entering into the workforce in the past 10 years or so, your pension is going to be what they call a hybrid type of pension, where you have a reduced pension from what it was previously, under what they might call a legacy plan, but now you have a 401(k) option alongside of it, or 403(b), depending on the type of plan.
So you have the option to save for yourself with your own money, but—
PW: So typically how did the old legacy plans work? Explain to people how the old legacy plans used to work.
MS: So a legacy plan would work with basically, the employer’s going to contribute to the pension on your behalf, and it’s going to be usually in the neighborhood of 5–7% of salary.
And you’re going to work for a number of years, and basically they’re going to have a formula that’s going to determine how your benefit is paid out in retirement.
So it might pay out at age 62 or 65, you might have the option, and the formula is going to factor in years of service. It’s going to have an accrual factor, they call it, so it might be 1%, and then it’s going to factor in your salary somehow, usually the final three years of compensation or average five highest.
PW: Five years, or whatever, sure.
MS: Exactly.
PW: Unlike Social Security, by the way, folks, then it’s 35 years.
MS: Yes.
PW: A lot of people get them confused. They think Social Security is five years, or whatever, but no, it’s much longer. They use your entire work history, or most of it.
And then the pensions, they’re going to be using your final five, so that can be a problem for somebody … let’s say you go part-time just before you retire for the last three years or something like that. You could be really shooting yourself in the foot when it comes to your pension.
MS: Exactly, it’s really important to know how your benefit works because that affects when you should retire or what type of option you should take. It’s really important to understand the inner workings of the pension.
That’s basically how the legacy pension worked, and the goal of that was to cover your retirement.
PW: And you have to watch out, making sure that when you look at your pension to be very, very conscious whether there’s a cost-of-living increase built into the pension, or whether there’s not.
A lot of private employers, no COLA, no cost-of-living increase, so therefore you take somebody that’s living off $50,000 today.
Well, it may take, and it may seem like it’s ridiculous, but you may need to have $300,000 in the future to live on what $50,000 pays just wonderfully right now.
And if you’ve got a pension that’s paying that same amount, you could be going broke little by little because of that silent tax called inflation. So be very, very conscious of that aspect of it. Now that’s the legacy pension.
Now if you go into the hybrid pension, they’re saying, “We’re going to reduce it. We’re not going to be replacing 80% of your salary,” or whatever the number is, however their formula works, and it varies based on the employer. In essence what happens there?
MS: So they’re going to significantly reduce the pension, maybe close to half or more of what it would’ve been if you were under the legacy plan.
But then they’re going to introduce some sort of 401(k), 403(b), 457 type of option where you’re able to then contribute your own money and save for yourself and invest for yourself. So the goal, then, is that under both you have a small pension, along with your own savings, you’re going to be able to make it in retirement, along with Social Security, and all of that.
So it puts an increased burden on the ability of the employee to know—
PW: The employee becomes a pension manager.
MS: Yeah.
Make Sure You Have Plenty of Options in Retirement
PW: Because you have to know something about investing, and most people don’t have a clue about investing.
So what they’ll do is they’ll do target date funds, and in that particular case, I’ll say, the investment managers don’t seem to have a clue when they put those things together. The employee has to become a student of it.
So maybe instead of a 70% pension—70% of your income being covered—it might be 35% in this example, and then the other 35% is made up by you and Social Security, of course. So those two things, they end up being in concert together to help you make sure.
Now I thought it was interesting that you threw out a number really quickly, and I thought it was a good one to remind people of.
Because you said they put 5–7% of a person’s salary away in order to cover the pension and make sure the money’s going to be there.
Think about it this way, folks, when you’re trying to figure out how much money to put away for your own retirement, typically you’ll hear us say that you start at 10% or so.
Because remember, 5%–7% is just covering a small portion of your income in retirement, so you’ll often hear us say, and as you get older it might even be higher than 10% of income that you put aside, and that’s because you end up with the money that you set aside, and then the growth on that money, as far as the expected return, will make up the difference as to what else you need in retirement. So those two things combine together.
Because people often ask, “How much should I say for retirement?” That gives you an idea: what were the employers doing? And they were putting aside just shy of 10%.
But then remember that number is just shy of 10% because a lot of them don’t have the cost-of-living increases. You should be planning for that cost-of-living increase.
So that’s why when you often hear me say 10%—and I like to move up … if you can get to the point where you’re saving 15%, 20% of income—it just gives you more options.
It’s like that old doctor who says, “You know what? I spent my whole life chasing money, and I got to retirement, and I realized money isn’t as important as I thought, but it is important for one really, really good reason. It gives you choices, and it gives you options later on, and that’s the reason that we save for the future.”
But recognize this is how pensions work. This is something that’s important.
Make sure that, especially, well not only if you’re working for a company that’s only doing one of these smaller pensions, the hybrid approach, where they’re expecting you to get involved, don’t necessarily think somebody’s going to take care of you forever from cradle to grave.
We’re increasingly living in a society that says you have to take care of yourself and be responsible for yourself, and that is especially true when it comes to retirement planning.
And I find a lot of people just put their head in a hole and just hope they’re going to be okay.
That’s not the way success usually works. It usually takes some proactive effort on the part of the person who desires success.
So I hope this motivates you a little bit to get involved regarding these issues.
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.
