The Three Legged Stool of Retirement

I just got off the phone with one of my uncles.  I’m Italian, I have lots of uncles.  This is an Uncle I haven’t discussed in this blog.  He’s an ex government employee, who upon retiring from a local government agency with full benefits, he then moved on and got his second job at a state government agency where he’s about to retire with a second pension.  His retirement income will be over six figures and he’s still worried about how he’s going to be able to afford healthcare for his wife after he retires, but that’s the subject for another blog.  Today’s conversation is about the three legged stool of retirement.

We had a long discussion about the book i’m writing about professionals and the section related to retirement.  My uncle fell into the tail end of the sweet spot for the American professional.  He’s a late era baby boomer so he was a professional in the era of expected full benefits.  He was also a government employee so he skirted around the transitions the private sector made from pension plans to individual retirement accounts during the time period of his career.  What I thought was very interesting was that my uncle was well aware of the transition and he felt that government agencies at every level are about to make the same transition.  In his words, government always follows the private sector by 30 years.   So get ready state employees, if my uncle is right, you are about to have those pension plans pulled out from under you.  

The whole thing got me thinking about retirement.  This blog, the book effort, and my thoughts are all about the collision between the professional world and life.  There is no clearer demarcation point between work and life than benefits and retirement is one of the big three, and maybe the scariest because it’s so easy to not think about until it’s too late.  It’s also one of the areas with the most dramatic change over the last century.  

As I continue to work on the book, I keep thinking about how i’m going to bring all of the different pieces together.  I think i’ve come to the conclusion that with retirement, for it to be successful, at least as it’s been sold to the population, It must be looked at as a three legged stool.  Otherwise, if you pull a leg out, then the stool doesn’t work.  The three legs are Social Security, Defined Benefit (pension plans) , and Defined Contribution (401K, 403B, etc..).  I’ll save the story of how each came to be for the book, and for the record each has a very interesting history.  Now there are tons of articles about planning your retirement and the current status of retirement in America and I don’t want to repeat them.  I’m going to try for something different here.  This post is about how each relates to the life and plans of the modern professional and how each has a unique role to play in a good retirement.  I’m going to do this like a school lesson, and put together a matrix.  

Before we get to defined contribution, or defined benefit, let’s define the most important thing.  The goal of retirement.  For the purposes of this post, the ideal retirement plan will is one where the professional receives a regular payment (annuity) that 1) is guaranteed, 2)meets the financial needs of the retiree insomuch as it maintains their lifestyle and 3) maintains pace with inflation.  

Defined Contribution:  401K/403B.   

To overly simplify the history of these defined contribution retirement plans, they came about because shortly after they became legal, organizations realized they can use them to shift the risk and cost of the retirement plans onto the worker.  The companies also got the benefit of completely severing all ties with the employee when the employee left the company vs. maintaining a connection via  the company pension plan.   

Non-unionized (i.e. Professional Individual Contributors or white collar) employees were among the first to get switched over. On the face of it, it sounds like a good deal.  It’s not a one size fits all solution and professionals are intelligent enough to comprehend the different options.  If you don’t mind risk invest in the high growth option.  If you are risk averse, choose a bond fund.  It doesn’t matter what you choose, over time it will grow.  Also, if you want to be an upwardly mobile professional, that means jumping from company to company to take advantage of opportunities.  With the Individual Retirement Account, you can take your 401K money with you as you bounce around in your career.  

How do the numbers work out on this?  Yes, I know numbers are very boring so i’m going to keep them to a minimum, but we do need to look at some numbers, if just to make a point.  Let’s say an employe makes $50K a year which is very close to the median income in America.  They put in 5% and the employer puts in 3%.  Realistically this won’t start until the employee is in their 30’s.  Depending on compound interest between 3.5% & 7% the employe will retire with $250,000 to $500,000 in their retirement account.  If you were to buy an annuity with that money it equals $1000 to $2000 a month in income assuming cost of living adjustment as part of you plan, i.e. the monthly check goes up 3% a year.  Now I know all those numbers are hard to follow.  Heck, they are hard to follow for me and I figured it out and wrote it down.  

The key thing to keep in mind is if you do everything you are supposed to do,  your income will be equivalent to $1K to $2K a month from your 401K.   Yes, this is basic math, and yes, I didn’t get into the complexities of  inflation and the changes in your wages as you work throughout your career.  That’s not the point, the point is that no matter how you massage the numbers, the defined contribution plans available today simply will not cover all your expenses unless you are putting an unusually high amount of your income aside and you maintain that throughout your entire life.   Unfortunately life happens, recessions, kids, mortgages, borrowing against your 401K for emergencies, periods without employment, vesting issues, halted employer match because of bad quarters or years, etc..   consistent long term investment into a retirement plan is the ideal, not the reality for today’s professional.  

Even if you were successful in putting together a big chunk of change.  There is another challenge, one that I don’t see discussed in the media but I hear about quite often. When there is a blob of money sitting there, professionals who have managed that money themselves their entire life tend to be loath to give up control.  The theory behind the 401K is that the employee saves and saves and the company contributes.  Together they build up a big nest egg and then when the employee retires they can purchase an annuity.  The annuity is guaranteed with shared risk, just like the pension.  Except it’s much more painful to pay $500,000 for something all at once than it is to pay for it over time.  Don’t believe me? How many new vehicles would be sold if everyone had to pay cash for their $40,000 SUV with the butt massagers built into the captain’s chair.  Sorry, Jr, no fold down video screen for you.    It’s especially galling to pay that $500,000 into an annuity where if they die the day after the papers are signed the money is gone. So professionals tend to keep that money set aside, or draw down on it themselves. Without the sharing of risk via an annuity, then there is no way for those who die early to subsidize the fortunate who live extended lives.  Bottom line, the money always runs out early for those who live long into retirement, something that’s happening more and more.    

So the 401K is all bad, right?  Well no, there is one benefit it has above all plans.. This is the thing that makes it stand out as a necessary leg in our three legged stool.  Let’s say you are abnormally successful throughout your life when it comes to your self discipline and income.  If you put in the max allowable under the law, you are looking at an income of between $4500 and $9000 a month which gets adjusted up every year for inflation.  The true benefit of the 401K is that if you are especially successful in life you will see that benefit in your retirement.  It’s the only type of retirement besides a mass of cash savings that works like this.  It’s sort of like a huge retirement award for being a strong achiever in life.  It’s the ultimate screw you to the fool who never saves a penny and believes that you can beat the system by charging up a bunch of credit cards and going bankrupt every 10 years.  Using the matrix, the first row looks like this:

Program	Type	Negative	Benefit
Defined Contribution (401K)	Only Individual Risk / Individual Reward	Difficult to convert to annuity (emotionally) Life may get in way of regular savings.	Higher productivity in life = higher benefits in retirement

 

Social Security:

The option is the most politically charged but I don’t really care about the politics or the potential changes to the system, at least not for this article.  For those of you reading this who have never paid attention to your social security retirement benefits, your option is to retire at 62, 67 (considered full retirement), or 70.  An average income will generate benefits of approximately: $1,300, $1,800.00, or $2,250 at the aforementioned respective ages.  The obvious takeaway is no matter what happens, SSI simply doesn’t pay enough for a decent retirement.  Sounds familiar, doesn’t it?

For what it’s worth, it was never intended to.  It was simply designed to keep the surviving elderly from being poverty stricken and homeless while also having the stealth benefit of being a jobs creation tool for a massive population of younger workers who were unemployed.  Social Security is an entitlement, more specifically it’s a retirement safety net.  This is why it’s a negative investment, because it’s not actually an investment, it’s an insurance policy.  Insurance costs money, don’t believe me, go to a chamber of commerce event and ask your local state farm rep for a quote.  (I am pretty sure there is a federal law that requires an insurance agent to be at any chamber of commerce networking meeting because there always is one in the group)

If you take all the hyperbole and emotions away from the currently political discord, the reality is that there is only three things that will happen to keep social security solvent.  Benefits will go down, age will go up, and taxes will go up.  (yes, I know there is discussion about privatizing part of it, but that’s not going to happen) No matter what ratio of the three happens, SSI will still continue to exist, albeit in a more limited form than currently.  Like the other legs of the retirement stool, there is a benefit to social security.  The positive takeaway for the professional is that you can count of SSI to be part of your retirement, just how much is is the question.  It’s simple redistribution and it’s heavily protected by the government.  The SSI check can’t be garnished by creditors.  You can’t sell you ‘equity’ in your social security ala a reverse mortgage or the financial disaster of trying to cash out an annuity.  The government doesn’t play like that.  

Even considering the benefit of its universal nature,  if we just raised taxes and kept everything exactly the same, SSI, like your average 401K is still not enough for a strong retirement by itself.   

Program	Type	Negative	Benefit
Defined Contribution (401K)	Individual Risk / Individual Reward	Difficult to convert to annuity (emotionally) Life may get in way of regular savings.	Higher productivity in life = higher benefits in retirement
Social Security	Redistribution	Negative ‘investment’ Not nearly enough to live off of comfortably.	Universal, no matter what happens to you in life.

At this point it’s easy to see why you have to look at retirement as a multi-leg stool.  Unless your super consistent throughout your life, amazingly disciplined, and lucky enough to avoid the pitfalls that life throws at you, neither solution will be ‘enough’.

So conventional accepted belief is that 401K and SSI together are enough, right?  Not so fast.  Your options here are the average post retirement income is going to be: $2300 to $3800

• $2300 (Low to average 401K annuity return $1,000 + SSI @ 62 = $2300)
• $3800  (Average to good 401K annuity return $2,000 + SSI @ 67 = $3800)

When you get to $3800/month we are starting to look at a halfway decent retirement IF life doesn’t get in the way, and IF your investment choices are good and IF your retirement doesn’t fall into a period of recession, and IF all you have to do in retirement is exist in a healthy state, and IF SSI benefits don’t track downward over time.  The list of risk is so long the whole thing is starting to sound kind of iffy to me. (insert groan here)

Even in the best case scenario your income is right about where it was before.  The greater reality that the nation is coming to understand is that life does happen.  For the great majority of people, the $2300 number is the more realistic expectation.   This is where the concept of the mandatory third leg comes from.  The two accepted paths right now are 401K and SSI.  We (the professional class) has to come up with a way to prop these two up.    The solution is our good old friend, the Defined Benefit (Pension) Plan.

Defined Benefit Plans (Pension Plans)

This is sort of the bridge between the two previously discussed plans.  It has elements of both.  

Using the numbers from above, and figuring in 30 years of service to a pension providing organization, the pension based ‘retirement’ will equal about $2275.00 a month.  Now, if you were to add the lower monthly payments of all three together you get  $4575.00 (Low to average 401K annuity return $1,000 + SSI @ 62 + Pension = $4575/month).   I think 60K is a good income for retirement, especially if you have down sized in home, got rid of your debts, and generally were in a mature financial place.    The best part is that this is a lowest case scenario.  

Even considering the numbers, the dollars really aren’t why i’m saying that a pension plan is absolutely necessary.  I say it because the pension fits in between the other two retirement tools.  It’s a tool that is unique in that it includes elements of both.  Like the 401K, the more you make, the more your pension will be, i.e. effectiveness in your career is rewarded.  Also like the 401K the pension plans tend to have a foundation in investments so less chance it will shrink over time.     Like SSI, it’s safe, stable, includes mandatory participation, and is government insured.   

Going back to our matrix

Program	Type	Negative	Benefit
Defined Contribution (401K)	Individual Risk / Individual Reward	Difficult to convert to annuity (emotionally) Life may get in way of regular savings.	Higher productivity in life = higher benefits in retirement
Defined Benefit (Pension)	Shared Risk with working group	Lots of restrictions Limited / zero growth	Nearly as stable as SSI. Nearly impossible to screw up on a personal level.
Social Security	Redistribution	Negative ‘investment’	Universal, no matter what happens to you in life.

In summary on the pension plan part of this article… Will you be buying a second beachfront house with your pension plan? Probably not.  Use your 401K money for that.  But will it complete the picture for a nice retirement?  Heck yeah!  

In writing this article I didn’t include a mass of personal wealth as one of your options.  Yes, we would all like to have stock options in a hot tech start up and millions in mutual funds above our retirement plans, but the reality is that won’t happen for the vast majority of people.  As an example, no matter how good my book is, I doubt it’s going to sell 500,000 copies.

Bringing it all together.  The three legs of the stool are all about risk.  Visually, you know what part of your body you will fall on  if you try and sit on a stool with only two legs.  The big challenge for professionals is that the third leg is disappearing.. And there really isn’t anything to take it’s place.. This is why we have a massive retirement crisis.  It’s up to us to be savvy about making up for that shortfall.  Maybe you give up the higher wage job and go find a low paid government job that includes the pension.  Maybe you just bump up your retirement savings to max out a 401K. Maybe you figure out how to get the time you need to take that side business and turn it into a really money spinner, or maybe you just sweet talk your Aunt Tilly into making you the only beneficiary of the family urinal cake fortune. The point is to be aware and to really evaluate our options.  

I believe this is one area where the average professionals lack of deeply specific knowledge and more generalized knowledge foundation is an asset.  We have to look at a lot of different options and figure out some answers.  We are uniquely qualified to do that as a class and I think we shall see some unique solutions to make up for this shortfall in the following decades.   

This post has gone on pretty long, but I think I made my argument well enough.   You need all three types of retirement solutions for a stable stool or you’re going to have some workarounds you will have to figure out.  So on that point I’m going to stop writing.  I could go on, but I have some other stuff I should do.  For instance I just realized I haven’t talked to Aunt Tilly in a while and it’s probably time for a call.