The following is adapted from Keep It Simple, Make It Big.
Imagine trying to sit on a two-legged stool. You would need impeccable balance, and even then, there’s a good chance you’d end up sprawled on the ground. Take one of those legs away, and it becomes even more challenging.
For the stool to be stable, it needs at least three legs.
Saving for retirement is similar. Having just one or two sources of income is typically not enough. To make sure you have enough money in retirement, you need more legs—more sources of income—for stability.
Traditionally, the three legs of the retirement stool are Social Security, employer-sponsored pensions, and defined-contribution plans.
Leg #1: Social Security
Social Security is an important leg of your retirement stool. It is a government-sponsored defined-benefit pension. As long as you have paid into the Social Security system for forty quarters, or ten years, or are attached to someone who has, you can qualify for these benefits.
Although Social Security is sponsored by the government, it’s paid for by workers who pay taxes on wages during their lifetimes. The 2020 tax rates are 12.4 percent on income up to $137,700, half of which is paid for directly by the employee and the other half paid directly by the employer.
Benefits are calculated as a percentage of your average annual wage over a thirty-five-year period, with a cap on how much can be paid out. The average benefit paid in 2020 is $1,503 a month. The maximum at full retirement age is $3,011 a month. The 2020 maximum benefit is $3,790 per month for a person who waits until 70 to collect.
The program is designed to replace 40 percent of the average worker’s wage prior to full retirement age. It replaces much less for high earners. At the peak earning of $137,700, it replaces 26 percent at full retirement age.
The question to ask: Can you live on 40 percent of your average wage? If you are a six-figure earner, can you live on 25 percent or even less?
Probably not, which is why you need additional legs for your stool.
Leg #2: Employer-Sponsored Pensions
Employer-sponsored pensions have traditionally been the second leg of retirement’s three-legged stool. The style has evolved over the years. Today pensions take three prevalent forms: defined-benefit, cash-balance, and defined-contribution.
The traditional pension is a defined-benefit pension. Defined-benefit pensions, with a few exceptions, are solely the responsibility of the employer. Employers contribute money to a pool that must pay out a defined-benefit, typically a monthly payment, to an employee once they retire. The monthly payments can range from a few hundred dollars to $18,750, depending on the plan. An employee’s payments are based on salary level and the years of work for the company.
Cash-balance pension plans have become popular in corporate America. As life expectancy has increased, traditional defined-benefit pensions—which require companies to accumulate enough money to fund a stream of payments over an entire lifetime—have become a costly burden for many employers. Many have converted to cash-balance plans.
Like traditional pensions, the contributions and the investments are the responsibility of the employers. But unlike pensions, employees are shown an account balance to which they are entitled, not a stream of payments based on an earnings-and-tenure formula. Employers will typically contribute a set percent of an employee’s salary to the investment pool.
The third type of pension—defined-contribution plans—is unique enough that it represents a separate leg of the stool.
Leg #3: Defined-Contribution Plans—401(k), 403(b), and 457 Plans
Defined-contribution pensions shift the responsibility for retirement funding and investing from the employer to the employee. The most common of these is a 401(k).
Unlike traditional pensions that guarantee a benefit, defined-contribution pensions guarantee a level of contribution, and even that is optional for the employer and subject to change at short notice.
What is guaranteed, provided one’s employer offers a plan, is the right for an employee to defer a portion of their income, tax free, up to a government set limit.
Some companies, but not all, offer after-tax and Roth options too. These allow employees to contribute after-tax dollars to the plan as well. In the case of the Roth option, both contributions and earnings can be withdrawn tax free at retirement provided the account was open for five years and the employee met age requirements.
The employee is responsible for making investment choices from those provided by the plan. Some plans do arrange for employees to secure advice for an additional fee. The amount of money an employee ultimately has at retirement is determined by the amount of contributions and the investment gains, or losses, on those contributions.
Alternate Legs
Combined, Social Security, a traditional pension or cash-balance pension, and a defined-contribution plan make a sturdy retirement stool.
However, for an increasing number of people, the second leg is not available. Only one in five Americans who work in the private sector have a defined-benefit pension, and the proportion has been dropping for years.
Fortunately, you are not limited to only these three legs. Many people rely on inheritance, family, charities, or part-time work during retirement to further supplement their income. Although these are valid income streams, you do not have complete control over them.
For this reason, to strengthen your retirement stool, you should also build personal savings. Individuals can save and invest in a variety of instruments including bank accounts, mutual fund and brokerage accounts, Individual Retirement Accounts (IRAs), Roth IRAs, and variable and fixed annuities.
By working to build a sturdy retirement stool now, you can ensure your last decades are more comfortable.
For more advice on retirement savings, you can find Keep It Simple, Make It Big on Amazon.
Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.
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