Why Your Pension Eligibility Date May Not Be Your Retirement Date
In my experience as a law enforcement officer, I’ve noticed that many in the profession seem to be counting down the days until they can retire. I frequently hear officers refer to the day their pension kicks in as their retirement date. Believe me, I get it. Serving as a law enforcement officer is hard work, mentally, physically and emotionally. Most of us reach a point in our careers when we are ready for a break. And we are lucky to have the benefit of guaranteed monthly payments for the rest of our lives through our pensions, which is a rare benefit these days.
However, as I’ve learned from working with the talented wealth managers at Creative Planning, including my co-author, Bob Harris, retiring comfortably takes more planning than simply walking off the job the day your pension payments kick in. Before you start counting down the days until you retire, consider the following.
Pension plans have risks
When we refer to a pension plan, we’re talking about a defined benefit plan, which is an employer-sponsored plan that pays a monthly benefit at retirement. The benefit amount varies based on factors such as length of employment and salary history. In contrast to a defined contribution plan (401(k), 403(b), 457, etc.), the employer, not the employee, is responsible for managing investments and risk within the plan.
While defined benefit plans typically offer much more in the way of guaranteed long-term security than defined contribution plans, they are not without risk. These risks may include:
- Not enough income to cover expenses – The number one risk is that your pension benefit may not be enough to cover your monthly expenses. The benefits provided by each plan vary, so let’s consider a simple example.
Say your pension provides 50 percent of your salary based on the average amount you were paid over your last three years of service. If your average salary over the three years was $100,000, you would be eligible for $50,000 annually. Is this enough to live on? Possibly, depending on your age and lifestyle when you retire.
However, many police officers retire in their 50s. Will your mortgage be paid off by then? Will your children be out of the house and out of college? Will your medical expenses be covered? At this age, many police officers still have significant financial obligations that 50 percent of their monthly salary simply won’t cover.
- Inflation – Most defined benefit plan benefits are not adjusted for inflation. That means the monthly benefit you receive will have less purchasing power tomorrow than it does today. Referring to the example above in which you are hypothetically eligible to receive $50,000 a year when you retire, after 20 years with no cost-of-living adjustments, this same $50,000 will only have $30,514 in purchasing power (assuming moderate inflation of 2.5 percent over the next 20 years).1
- Underfunded pensions – There’s a lot of talk these days of underfunded state and local pensions. And given recent and political pressure, it is possible that pension funds will fail to provide their promised benefits in the future. While this is a worst-case scenario, it’s important to keep it in mind throughout your career and to make other plans for income in retirement.
What you can do
Your pension remains a valuable benefit that will likely account for much of your retirement savings, but it’s wise to have other sources of income. Saving in a variety of retirement accounts can help ensure a secure retirement. Options may include:
- 457(b) plan – This is a defined contribution plan typically offered to state and local government employees. Regardless of whether or not your employer offers a matching contribution (which is an added bonus), these plans still offer significant tax benefits.
With a traditional 457 plan, you can contribute from your paycheck using pre-tax dollars. This reduces your taxable income in the current year and allows those contributions to grow tax deferred until retirement. You then pay taxes at your ordinary income rate when you withdraw the funds in retirement. On the other hand, contributions to a Roth 457 are made after taxes, but can be withdrawn tax-free at retirement.
An additional benefit of a 457 plan is that there is no early withdrawal penalty for receiving funds before you reach age 59 ½ as there is with a 401(k) plan. This is a valuable benefit, as many police officers retire early.
- IRA – Similar to 457(b) plan contributions, you can choose to contribute to a traditional IRA using pre-tax dollars or to a Roth IRA using after-tax dollars. In 2021, the combined annual contribution limit for traditional and Roth IRAs is $6,000 for those under age 50, and $7,000 for those age 50 and older. Roth IRA contribution limits are gradually phased out for higher income earners.
In summary, while pensions remain a valuable retirement benefit for police officers, you should not base your retirement date on pension eligibility alone. There are many factors that go into determining your ideal retirement date, including your pension benefits, Social Security, other retirement savings, current financial situation, lifestyle expectations and long-term goals.
Are you ready to start planning for your retirement? Law Enforcement Financial Freedom can help. We are a specialty practice of Creative Planning that focuses on helping police officers achieve financial independence. Each of our teams includes an attorney, a CPA and a Certified Financial PlannerTM practitioner. Regardless of your specific situation, we are available to help you create a retirement plan that meets your long-term needs and goals. If you’d like help planning for your retirement, or for any other financial matter, please schedule a call.