3 Big Risks When You Are Retiring With a Pension

A pension can be an incredible benefit if you are lucky enough to have one. Pensions help with income, predictability, and peace of mind in retirement. While they provide stability, there are three hidden pension risks that can quietly erode your financial security. If overlooked, these risks could mean the difference between a surplus and running out of money too soon. 

The good news is that none of these challenges is insurmountable. With the right type of planning, they can be anticipated and managed. 

Pension Risk #1: Inflation

Inflation is one of the most common and underestimated pension risks. 

Some people do have inflation protection built into their pension, often called a cost-of-living adjustment, or COLA. But not everyone does, and even when it exists, not all COLAs work the same way.

• If you are in the private sector, chances are your pension does not include any cost-of-living adjustment. That means your income stays flat while your expenses rise.
• If you are in the public sector, you should read the fine print carefully. Many public pensions offer a simple-interest COLA, and some provide increases only on an ad hoc basis.

With a simple interest COLA, the increase is applied only to the original benefit amount. For example, if your pension benefit is $100,000 per year and the COLA is 2 percent, your income increases by $2,000 each year, based on that original amount. With a compounded COLA, your benefit increases as a percentage of the previous year’s benefit.

This matters because inflation itself compounds. When inflation is 3 percent, prices increase based on last year’s prices, not the prices from decades ago.

What Inflation Looks Like in a Real Plan

Let’s look at what happens when a pension does not have a cost-of-living adjustment. For example, a person’s desired living expenses are about $140,000 per year, plus healthcare costs that increase at an even higher rate. Their basic living expenses rise at about 2.5 percent per year.

Their pension pays $65,000 per year, which comes out to about $59,000 after taxes, and it stays exactly the same every year in retirement. Over time, expenses increase, but pension income does not.

So what happens? Portfolio withdrawals have to increase year after year to cover the gap. That slowly eats away at the investment portfolio. Eventually, Social Security kicks in and increases over time, but we have also seen long periods when Social Security did not increase at all.

In this scenario, the individual has about $2.5 million in a taxable investment account. With inflation modeled at 2.5 percent, they still end their plan with a surplus. They are okay.

But what happens if inflation is higher?

If we increase their basic living expense inflation to 3.5 percent, their pension still stays flat. Social Security does not keep pace. Portfolio withdrawals rise significantly. Instead of ending with nearly a million dollars left over, they now end with nearly a million-dollar shortfall. Inflation alone completely changes the outcome of the plan.

SEE ALSO: How to Reduce Required Minimum Distributions (RMDs) and Taxes

Pension Risk #2: Gap Years

Gap years are early retirement years before pension and Social Security income begins. During these years, you have to take an elevated amount of withdrawals out of your portfolio in order to meet your living expenses.

In this example, instead of retiring at age 62 when the pension begins, the individual retires at age 59.

Immediately, portfolio withdrawals jump during the first few years to cover all expenses. Eventually, the pension starts at 62. Later, Social Security begins as well. For this scenario, we assume inflation is 2.5 percent.

Even so, the plan now ends with a shortfall. The main reason is those early years of heavy withdrawals before a reliable income begins. When you combine gap years with a pension that does not have a cost-of-living adjustment, the risk compounds.

Pension Risk #3: Survivor Benefit Decisions

The next pension risk is the survifor benefit. When you get the paperwork from your employer, you’ll see a few different options: 

• Single-life annuity
• 50% survivor benefit
• 100% joint survivor benefit

A single-life annuity is going to be the higher benefit now, but there are some things to consider. There are situations where choosing a single-life annuity makes sense, but there are also many cases where protecting the surviving spouse should be the priority.

Tip: We have a Guide to Pension Annuity Options that you can download for free. 

In our original example, the pension used a 100 percent survivor benefit. Now, let’s change the pension survivor benefit to 50 percent. Separately, when one spouse passes away, Social Security declines because only the higher of the two benefits continues. In this example, total household income falls from about $120,000 per year to about $90,000. Second, the pension drops because of the 50 percent survivor benefit. In this case, pension income falls from about $63,000 to $32,000.

In this scenario, John is the pensioner and lives to age 90, while Sarah lives to 95. That already means Sarah has spent several years living on a reduced income. Now consider what happens if the pensioner passes away much earlier. If John dies at age 80 and Sarah lives until 95, Sarah must spend nearly twenty years with both a lower Social Security income and a reduced pension benefit.

The financial plan takes a hit, and the shortfall becomes much larger. Any one of these pension risks on its own might not derail a retirement plan. But when multiple risks occur together, inflation, gap years, and a reduced survivor benefit, the damage compounds. An early death combined with the wrong survivor election can significantly reduce long-term financial security.

Why Savings Still Matter

Pensions provide stability and predictability that many retirees no longer have. But as these examples show, they are not enough on their own.

Inflation changes. Retirement timing changes. People pass away earlier or later than expected. Healthcare costs rise. Survivor income needs vary. Savings provide flexibility. They allow you to absorb inflation, fund gap years, support a surviving spouse, and adjust when life does not follow the original plan. Without savings, pension limitations become permanent. With savings, those risks become manageable.

SEE ALSO: The 6 RMD Mistakes Wealthy Retirees Can’t Afford to Make

What Should Your Next Steps Be?

Pensions can be an incredible benefit. They offer consistency and peace of mind that few people have today. But they also come with real risks that must be planned for.

The good news is that none of these pension risks are impossible to overcome. With proper financial planning, adjusting your withdrawal strategy, building in buffers, and coordinating your pension with other income sources, you can keep your plan on track and sleep better at night.

Want Help Planning Around Your Pension?

If you have a pension or will soon need to choose benefit options, thoughtful planning can make a meaningful difference. A financial advisor in Atlanta is here to help. At Pace’s Ferry Wealth Advisors, we help clients understand their pension choices, plan for inflation and income gaps, and coordinate pensions with investments and Social Security.

If you would like to review your situation or discuss your options, consider scheduling a conversation with our team.

Schedule a consultation with Pace’s Ferry Wealth Advisors or learn more about our retirement planning service. 

Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”). This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.