Pension Strategies for FIRE
How does a pension fit into your retirement plan?
A. Your only source of income
B. Your main source of income as retirement accounts are exhausted
C. An important supplement to retirement accounts
D. A nice risk mitigator but otherwise mostly extra
Option A cannot be the answer if retiring early. Barring a few exceptions, you can’t start collecting until your early 50s to mid 60s, and you’ll want to avoid the lowest age ranges to apply for retirement; otherwise, your pension will be too low to have much effect.
Option B is a possibility, especially for people late to the financial game. But planning to be reliant on income rather than assets means you are always waiting for the next paycheck. In essence, you are choosing to retire paycheck-to-paycheck, and your lifestyle will be constrained and difficult to upgrade. Pensions only adjust for inflation once retired.
Option C is likely the most common answer. The pension and Social Security will work together like an annuity that will always cover your baseline expenses. Even if you spent every last dollar you saved, you would just default to Option B. However, using a 3% to 4% withdrawal rate, you can keep your retirement accounts intact and growing over time, allowing moderate lifestyle inflation over time if desired.
Option D is the traditional, aggressive FIRE accumulation strategy and requires extra saving compared to Option C. With enough money in invested assets, you would be perfectly fine even if your pension and Social Security completely vanished. The pension is a nice bonus but mainly serves as an additional security blanket during market downturns, like holding a few years of living expenses in a bond tent. The guaranteed income means that a 4% withdrawal rate is quite safe. Despite conservative FIRE advice to lower your withdrawal rate as low as 3%, if your bridge is only from age 45 to 62, for example, you are looking at a 17 year bridge, not a 30-year risk horizon. Still, be smart about your withdrawal rate when the market is down.
Pension Formulas and Why They’re a Carrot on a Stick
(I use the 2% at 62 CalPERS plan for California public employees in this example.)
The standard pension formula is:
Service Credit x Benefit Factor x Final Compensation
For CalPERS, Benefit Factor is the age you start collecting. It’s NOT the age you stop working. That means early retirement is completely doable without ruining your pension. Since you are entirely in control of when to pull the retirement trigger, you can decide based on your circumstances to wait anywhere from age 52 to 67 to set a 1.0x to 2.5x multiplier. What really matters during your working years is your Service Credit and Final Compensation. Let’s assume going forward that you apply for retirement at age 62, with the 2.0x multiplier.
Note: Having any long gap between separating from servie and applying for the pension is called a Vested Deferred Retirement, and yes, you often forfeit employer-subsidized retiree health insurance. However, with ACA subsidies, geoarbitrage, and other tactics, that’s not often a dealbreaker.
This is where people lock themselves into a lifelong game of maximizing Service Credit and Final Compensation that’s designed to keep you working. But it’s an illusion.
For Service Credit, it’s simple. Every year you work increases the number by one. The number increases incrementally throughout the year and for CalPERS, you only need to work 1,720 hours a year for full credit. So naturally, you will want to work longer to earn a higher percent of your Final Compensation. If I retire at 62, work 20 years, and my final wage is $80,000 per year, I will earn 40% (20 times 2.0%) of that as a pension. That equals $32,000. Not bad. Most lifestyles won’t be fully supported by that amount, but it covers a sizeable chunk.
For Final Compensation, it’s natural to want to climb to the top of your merit step ladder. Depending on the employer, that’s likely either a 5 or 10 year process. There is also usually an annual wage increase and of course promotions and applying to higher paying positions. I say go as far as you can to increase this number.
The problem occurs when people read the pension chart and see that the number keeps going up every year. Waiting on more year means another merit step, another general wage increase, another year of service credit. However, this continues for 40 years. If you got your first job on the pension plan at age 25, you would have to work until age 65 to max out service credit. With promotions every five years, you will continue being reset on the merit step ladder. And general wage increases will never stop. If you’re looking at retiring early, where’s the cutoff?
Finding Your Personal Cutoff
If you want to retire early, you have to establish a hard boundary.
The cutoff is simple. It is the day when your investment portfolio can support your lifestyle expenses, not the day your pension does.
Treat the pension like an insurance policy to protect against running out of money. Don’t rely on it as a replacement for active and aggressive wealth accumulation. With Option C, you can still blend the pension in to calculate a lower FI number, but never let the pension chart dictate the timeline of your life.