In past generations, a worker would find employment with a company and then spend his or her entire career with that firm.  In addition to a regular paycheck, money was put into a tax-sheltered pension plan and professional portfolio managers invested that cash in stocks, bonds, mutual funds, real estate, and other assets.  Eligible employees were given guarantees of income for several decades after retirement, or in some cases for life, which were funded by the dividends, interest, and rents produced by the pension investments.


This setup allowed blue collar workers, especially, who didn't understand money to focus on their primary skill and leave the professionals to think about how the check would show up in the mail.  In a lot of ways, this division of labor made sense.  The guy building cars focused on making great cars, and the pension fund managers had to figure out how to make sure his check cleared when they mailed it to him.  That way, the employee didn't spend his every waking moment worrying about fluctuations in the Dow Jones Industrial Average or trying to find good blue chip stocks that produce decade after decade of profitable growth.

With the rise of the 401(k) plan, companies breathed a sigh of relief and began giving employees cash today instead of the promise of future checks during retirement.  This could have been a great thing - in fact, for people who understand the investing process, it often is advantageous - but for a subset of average workers, it has turned into an unmitigated disaster.

 Unable to treat the stock market as anything other than a casino, they sell when stocks are cheap and buy when people are irrationally euphoric.  They incur trading expenses and overpay by picking mutual funds with high expense ratios.  

That means if you want a pension plan of your own, you are going to have to create a portfolio that replicates the goal of a pension plan - namely, creating passive income that you can live upon during your golden years.

Steps An Individual Investor Could Take To Establish a Pension

There are two phases to creating your own de facto pension.  These are:

• The Accumulation Phase: During this phase, your job is to amass money in the most tax-efficient way possible so that you have a giant pile of capital.

• The Distribution Phase: During this phase, your job is to invest that money in a way that it provides the safest maximum income possible, allowing you to collect a stream of checks to use to pay your bills, put gas in the car, cover hospital expenses, keep your pantry stocked, and your home warm in the winter.  

Let's look at each of these phases individually.

The Accumulation Phase of Establishing a Pension

During your career, you need to put aside as much cash as you can afford into tax shelters such as the four types of IRAs available to most American workers.  These not only allow you to save money, they let you accumulate wealth without sending any of it to the IRS in the form of taxes for years, in some cases even decades, as long as you follow the rules.

For example, if you and your spouse are successful self-employed business owners with few or no employees, you might be eligible to put up to $100,000 per year into a special type of account called a Simplified Employee Pension Individual Requirement Account, also known as as SEP-IRA for short.  Not only will you save tens of thousands of dollars from the tax deduction, but the money in the account will grow without any capital gains taxes, dividend taxes, interest taxes, or other taxes until you make withdrawals during retirement.

Likewise, a Roth IRA allows you to save thousands of dollars per year and, although you don't receive a tax deduction, under current rules, you will never have to pay a penny in taxes on any of your profits.  That means if you are fortunate enough to find the next Microsoft or Wal-Mart, it's all yours, tax-free.  The Roth IRA remains the single best way for the vast majority of Americans to amass significant amounts of wealth during the accumulation phase of their careers. 

Academic research shows that over long periods of time, the best asset class, hands down, is common stocks.  Though they can fluctuate by 50% or more per year, stocks represent ownership in businesses.  Most good businesses have a sort of built-in protection against inflation because management can raise prices, whereas a bond has no such buffer.  I've done case studies of blue chip stocks including Procter & Gamble, Colgate-Palmolive, Coca-Cola, Clorox, and Nestle on my personal blog that will help you understand how this is possible.

The Distribution Phase of Your Pension

As you get closer to your distribution phase, many financial advisors recommend switching to assets that are geared to produce consistent and steady streams of passive income.  These can include municipal bonds, dividend stocks, master limited partnerships, and REITs or direct real estate.  You could look at a passive income asset allocation model.

In some cases, it might be better to consider a single premium immediate annuity, which is a product you buy from an insurance company.  You give the insurance company money, which it gets to keep forever.  In exchange, it pays you an agreed upon amount every month, for the rest of your life.  You cannot outlive your money and you no longer have to think of ways to invest your cash.  You just sit back and wait for a check to show up in the mail.  The downside?  You can't leave an annuity to your children, grandchildren, or charity.  That is the trade-off.

By way of example, as of October 29th, 2012, a 65 year old woman living in New Jersey who had saved $500,000 during her career could use that money to buy an annuity from the Berkshire Hathaway Group that would pay her $2,406 every month for the rest of her life.  If she dies after the first month, insurance company will make a profit of $497,594.  On the other hand, if she lives to be 105 years old, it will have to pay her $1,154,880 over all those years.  The main appeal of replicating a pension check through the use of this type of annuity is the peace of mind it brings.

An alternative to a single premium immediate annuity would be a charitable remainder trust, which has many of the same benefits but results in your money going to a worthy cause upon your death.