How To Plan For Your Social Security Or Pension Being Cut

Last November American Airlines filed for bankruptcy protection. Many of American's employees are in a defined-benefit pension plan, which means American Airlines promised them a certain amount of money each year in retirement, regardless of what the markets do. But promises such as this are fleeting, as can be seen by the infighting going on now between employees of the airline and executives.

Many now agree that some employees of American Airlines will not receive their full retirement benefits. It has yet to be determined how much their pensions might be cut.

Then there is Eastman Kodak Co., which just recently filed for bankruptcy protection. Their pension plan currently covers over 63,000 retirees. It is all but assured that benefits to some of these people will be cut.

So just how much of an impact does a cut in pension benefits have on a person's retirement plan? What if social security benefits are reduced as well?

To determine just how a couple in retirement might be affected by cuts in their pension, social security, or both, I ran some scenarios in our retirement planning application. I modeled a plan using a couple that has just retired at age 65. They currently have a combined $30,000 in social security payments per year as well as $15,000 in pension payments. They plan on spending $40,000 per year in retirement. Given this, they will run out of money when they are 120 years old, which pretty much means they should not ever run out of money.

Now let's look at what happens when their pension payments are cut in increments of 5%.

% Change in Pension Payments	Age of First Shortfall in Retirement
0%	120
-5%	119
-10%	118
-15%	117
-20%	116

It's not the end of the world for this couple if their pension payments are cut, but a 20% drop would slice 4 years off of their funds in their retirement years.

What about Social Security? It's becoming more and more likely that social security benefits will be reduced in the future of the social security fund runs out. I've written at length on this topic before here. At the very least, social security will likely become "means-tested" where those who are deemed well off enough will have their benefits cut. Let's see what happens if this couple has their social security benefits reduced.

% Change in Social Security Payments	Age of First Shortfall in Retirement
0%	120
-5%	117
-10%	115
-15%	113
-20%	111

Things start looking quite a bit worse when social security payments are cut. If benefits are reduced by 20%, they would see 9 years lopped off of their funding in retirement.

What about a combination of the two?

% Change in Pension & Social Security Payments	Age of First Shortfall in Retirement
0%	120
-5%	116
-10%	112
-15%	108
-20%	104

It's quite a bit uglier when both pension payments and social security are cut at one time as 16 years are cut from this couple's retirement funding.

So what can one do to prepare for such a situation? It is best to assume that not all of the social security benefits promised will be there. To be safe, those who are under age 50 should assume they will see at least 15% of their benefits cut. Those who are expecting a defined-benefit pension payment each year should also be wary.

In terms of preparing for such cuts, I have always recommended saving more money today, cutting expenses while in retirement, and investing in low-debt dividend paying stocks with a history of consistent dividend growth, such as Johnson & Johnson (JNJ), Procter & Gamble (PNG), Exxon (XOM), Coca-Cola (KO), and Merck (MRK). Investing in solid dividend payers will provide a more consistent income stream during retirement and will make retirees less reliant on social security and pension payments.

Disclosure: I am long JNJ, PG, XOM, KO.