Perspective Matters
October is Retirement Security Awareness month. For most of our lifetimes the image of a three legged stool has been used when thinking about planning for one's own financial security. The three legs of the stool have been Social Security, a company pension, and savings. The legs of that stool have evolved and changed over the years and the individual savings portion needs to be bigger for more Americans than it has in the last 150 years. First, I will provide some history, and then discuss actions you can take now to help improve your long term financial security.
For centuries, governments have provided some sort of lifetime income for certain soldiers and public service employees. For example, the Civil Service Retirement System (CSRS) came into being in 1920 and provided retirement benefits to most US Federal government workers and officials for 15 years before the Social Security system was formed.
In the mid-19th century Otto von Bismarck and William the First of Germany advocated the idea that governments should provide some sort of social insurance safety net for workers to cover unemployment, disability and retirement. Use the links below to read more about Germany’s social insurance program, adopted in 1889, and other interesting facts about the history of the US Social Security system. Included are some “myth-busters” as well as answers to common questions.
Social Security was never intended to provide retired workers with years of relaxation in warmer climes. It was intended to solve the widespread problem of extreme poverty in the elderly, and it has been hugely successful. Over the decades since it was passed, there is one critical statistic that has affected the math underpinning the system. It is a change that highlights the successes of the 20th century, which were beyond what most people could imagine.
It is not as simple as basic life expectancy at birth. Infant and child mortality rates have improved exponentially in the last 90 years. In creating the Social Security system, Congress looked at data related to men expected to turn 65 in 1940 (so born in 1875.) Penicillin wouldn’t even be used for the first time until 1941 * and there were no vaccines for diseases such as polio, measles, and diphtheria. In 1900, more than 30% of all deaths in the US were children less than 5 years old! ** In 1935, less than 55% of the boys born in 1875 were expected to survive from age 21 to age 65. *** As it turned out, medical advances would mean that more than 70% of the boys born in 1925 would go on to survive from 21 to 65, increasing by more than 50% the number of people the Social Security system would support.
(Note – these are not the actual numbers, and the process is simplified here to illustrate the important concept – the higher your income while working, the less income Social Security will replace when you retire.)
If your average income over 40 years of working is $3000 a month, your income from Social Security at Full Retirement Age might be $2000.
In this example, Social Security is calculated like this:
90% on the first $1000, 70% on the next $1000 and 40% on everything above $2000, up to a maximum benefit of $2500 a month.
So, somebody with $3000 a month of average income over 40 years would have their income from Social Security at Full Retirement calculated like this:
[(90% * $1000) + (70% * $1000) + (40% * $1000)] = $2000
That's 2/3 of what you were earning while you were working.
Using this same formula, if your average income over 40 years is $4000 a month your income from Social Security at Full Retirement Age might be $2400:
[(90% * $1000) + (70% * $1000) + (40% * $2000)] = $2400
That's 60% of what you were earning while you were working.
Again, using this same formula, if your average income over 40 years is $5000 a month then your benefit is $2500:
[(90% * $1000) + (70% * $1000) + (40% * $3000)] = $2800 BUT that's over the maximum of $2500 so your benefit is capped at $2500 a month.
That’s 50% of what you were earning while you were working.
The second leg of the Retirement Income stool has always been a pension. Pensions are a form of a Defined Benefit plan; workers knew what income they would have if they retired after meeting clearly defined criteria, such as working for a certain number of years and achieving a particular age. Many municipal workers and teachers still have pensions like this.
A typical formula might mean that a city worker who retired at age 65 with 30 years of service might get a pension equal to 60% of their salary.
Pensions for company employees began to spread in the early part of the 20th century and became very popular after 1921 when companies began to get tax deductions for contributions they made to employee pensions. They experienced another surge in popularity during World War II when wage controls meant companies could not compete for workers by offering higher salaries but fringe benefits such as health insurance and pensions were exempt from wage controls. It became commonplace to shift the focus from wages to fringe benefits and most Americans were soon found themselves eligible for a pension.
The pension system began to show weakness in the 1960s. The actual number of people living to 65 and collecting a pension was much larger than the original calculations imagined. When some well-known companies went bankrupt and employees lost their pensions, legislation was passed to protect employee’s pensions, including creating the Pension Benefit Guaranty Corporation. In 1978 Congress passed legislation designed to make it more difficult for companies to have profit sharing plans in place that gave tax advantages to the companies and were primarily for the benefit of their executives and not the rank-and-file employees.
An unintended consequence of the 1978 legislation led to a 1981 IRS regulation that essentially created 401(k) Defined Contribution plans. Employers could now legally let employees defer a portion of their compensation, and both the employer and employee could receive immediate tax benefits. By the end of 1982, nearly half of all large US employers offered 401(k) plans to workers. ****
Over the next several years there were several more pieces of legislation that led to the growth of the Defined Contribution plan and ultimately the demise of the Defined Benefit plan. This transition shifted ultimately most of the responsibility and risk associated with generating a lifetime of income payments after retirement from the employer to the employee. Replacing Defined Benefit Plans with Defined Contribution Plans is the main reason that the three-legged stool of Retirement Income for most Americans depends disproportionately on a what you save while you are working.
So, what should you do?
First, develop the habit of saving something from every paycheck.
Below are two charts showing the benefits of saving early. The first, courtesy of Ned Davis Research, compares the results at age 65 (under certain assumptions) of either 1) saving $2000 each year from age 19 to 26 or 2) saving $2000 each year from age 27 to age 65.
The second chart, courtesy of J.P. Morgan Asset Management, incorporates not only when you start, but also compares the results of saving different amounts and earning different returns. The focus is the power of compounding, and how much of the Ending Portfolio amount is what your money earned (vs. what you saved.)
Second, find out if your employer offers a retirement savings plan, like a 401(k), 401(b) or SIMPLE, and whether or not they offer any “matching contribution.”
Often, if you agree to defer up to 6% of your salary into one of these plans, your employer will contribute additional money. Keep in mind these plans are designed to be for the long term, and there may be rules about how long you must be employed to keep their contribution (become vested,) and there may be penalties for withdrawing money before you are 59 ½. Educate yourself on the company website, find more information here and consider speaking to a CFP® professional to learn more about the best way to use your employer-provided retirement plan as part of your financial plan.
Third, know your targets; how much of your income should you be saving based on your age and income and how much you should have in savings if you want to maintain your lifestyle once you retire.
Below are several charts, courtesy of J.P. Morgan Asset Management, that you can use as reference points. Don’t panic if you don’t seem to be on track; wherever you are, you can take more control of your financial future. If you are not saving anything, start by reviewing your budget to see how much you could start saving immediately with minimal changes to your day-to-day life. Maybe that means deferring 1% or 2% of your salary or opening a savings account and putting $100 from every paycheck into it. Consult a CFP® professional who will help you review your financial situation in detail, including what’s available to you in employer sponsored retirement savings plans. A CFP® professional will help you develop and implement a plan specific to you, and help you understand the financial trade-offs specific to your situation.
Don’t focus on what you haven’t done before, focus on what you can and will do in the future. The decisions you make today can have a significant impact on your long-term financial security, and the sooner you start saving, the better.
Please read the assumptions carefully, and keep in mind that these charts are for informational purposes only and are not meant to be investment advice specific to any individual.
Please read the assumptions carefully, and keep in mind that these charts are for informational purposes only and are not meant to be investment advice specific to any individual.
Please read the assumptions carefully, and keep in mind that these charts are for informational purposes only and are not meant to be investment advice specific to any individual.
Please read the assumptions carefully, and keep in mind that these charts are for informational purposes only and are not meant to be investment advice specific to any individual.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.