Today's post was contributed by our friend Dirk Cotton, an expert in retirement finance, and the author of the blog "The Retirement Cafe"
My first job out of college, with a degree in computer science, was with staid General Electric's Information Systems Division. I was promptly taken under the wing of a few GE lifers whose first advice was this: “Never change employers. Stick with GE for your entire career and they will pay for an excellent pension for your retirement.”
At the ripe old age of 21, retirement wasn't on my radar. I stuck with GE for three whole years. Since the 1980's, defined benefit pension plans have all but evaporated, replaced by defined contribution plans like 401(k)'s. That's retirement planner-speak for the burden of funding retirement being shifted from your employer, like GE, to you and me.
Whereas the 1975-vintage GE retirement plan guaranteed eventual retirement benefits, new plans define how much you can contribute to the plan with tax advantages and your eventual retirement income depends on how well you invest those contributions. Defined benefit "pension" plans like GE's are nearly extinct, as you can see from the following graph published by the Employee Benefit Research Institute (EBRI).
The terms "defined benefit plan" and "defined contribution plan" can be confusing. A defined benefit plan, sometimes referred to as a pension, says, "Work for us for 30 years and we will pay for your retirement. Let us worry about where the money comes from to pay for it." A defined contribution plan, like an IRA or 401(k), says, "You can save for retirement and we will give you a tax break on those savings. You can use this money to help pay for retirement and the amount available to do that when you retire depends on your personal investment results."
401(k) plans were created during the Reagan administration and quickly began to replace defined benefit pensions. While it is tempting to imagine conspiracies at play to transfer the risk of retirement funding from corporations to employees, it appears that defined contribution plans were a random development that just happened to meet the interests of large companies that wanted to shed the burden of their employee pension plans. Pension plans weren't perfect, either – some became “mobbed up” and others simply made promises they couldn't keep. Several failed.
The notion that we are in a retirement-funding crisis is well documented. John Bogle, the storied founder and retired CEO of Vanguard Investments has referred to our retirement system as a “train wreck” waiting to happen. Labor economist, Teresa Ghilarducci, has testified many times before Congress on the nature of what she refers to as “Our Ridiculous Approach to Retirement.”
As Ghilarducci explains, we need to save 20 times our annual income (in some cases more) in financial assets to fund retirement. Retirement researcher, Wade Pfau, finds that in some cases employees will need to save upwards of 20% of their income throughout their career. These are staggering numbers for families trying to pay the mortgage and put a couple of kids through college. The results are seen in EBRI's Retirement Readiness Rating™ that "finds that nearly one-half (47.2 percent) of the oldest cohort (Early Baby Boomers) are simulated to be 'at risk' of not having sufficient retirement resources to pay for 'basic' retirement expenditures and uninsured health care costs."
Families need to earn enough over a 35-year career not only to support themselves for those three and a half decades, but also to help fund perhaps three more decades in retirement. Most Americans will receive Social Security benefits, but they are meant to replace only about 30% of pre-retirement income.
The “train wreck” we face is the result primarily of four trends. First, life expectancy at birth has increased from 47.3 years in 1900 to 68 years in 1950 to 78.2 years in 2009. Because we essentially pay for retirement by the year (a three-year retirement is far cheaper than a 30-year retirement, right?), these extra years of life for the typical retiree dramatically increase the overall cost.
A second contributor has been the stagnation of middle class incomes over the past 30 years. At the same time we shifted the enormous burden of personally saving enough money to fund retirement from corporations to individuals, after-inflation incomes for all but the highest-paid of the middle class flat-lined, as shown in this chart from the Economic Policy Institute.
(Note: Some economists question this income stagnation. I'll let you do your own research and make your own assessment, but I am personally convinced that it is all too real.)
A third contributor to the train wreck is medical cost inflation. Medical services are, as you might expect, disproportionately used by the elderly and represent a substantial risk to retirement finances. As I mentioned above, retirees are living longer and people who live longer consume more medical services than those who don't. The following chart from Business Insider shows both the stagnation of income for many in the middle class alongside the tremendous increase in medical costs since 1980.
A final contributor to the train wreck of retirement finance has been under-saving by Baby Boomers. (Before you complain about Boomers, note that studies like the EBRI's Retirement Readiness Rating™ referenced above indicate that Gen X'ers and subsequent cohorts are in even worse shape.) In addition to stagnant incomes and a huge savings burden, we Boomers didn't recognize the importance of the sea-change from company-provided pensions to 401(k) plans quickly enough. Those few of us who did save enough didn't do so because we foresaw the retirement funding problem. We saved in 401(k) plans because we had high incomes and the plans offered substantial tax savings.
Most Boomers, in my experience, reached age 60 with very little idea how their retirements would be funded, except for some vague notion that they had earned Social Security benefits.
Corporations stopped pooling retirement risk for us and left us to handle it on our own. This put a tremendous savings burden on the middle class. Costs went up dramatically while incomes remained flat, so there wasn't much left to save. We enjoyed longer lifespans so retirement costs even more. Most of us had no idea this was transpiring.
This explains the roots of the retirement finance “train wreck”, or “Our Ridiculous Approach to Retirement”, but it doesn't explain the challenge of retirement planning. In essence, we have about thirty or so years of career that must not only pay for those thirty years of supporting a family but also generate enough additional wealth to fund perhaps thirty or more years of retirement.
Fortunately, we don't have to generate that entire retirement income while we are working because we can invest our retirement savings and hopefully watch them grow, taking advantage of the time value of money. A dollar earned today and invested might be worth $7 or $8 in thirty years. (Of course, halfway through our careers we have only 15 years of job earnings remaining, so a dollar saved then is worth only $2.80, and right before we retire a dollar saved is worth about a dollar.) If our investments are successful both while we are contributing to our 401(k) plans and after we retire, we can generate a lot of the income from earnings. We need only save an adequate nest egg.
Unfortunately, that's far easier said than done.
Dirk Cotton is a retired executive of a Fortune 500 technology company. Since retiring in 2005, he has researched and published papers on retirement finance, spoken at retirement industry conferences and events, and regularly posted on retirement finance issues at his blog, The Retirement Cafe. He is currently a Thought Leader at APViewpoint, Advisor Perspectives' online community of investment advisors and financial planners. He provides retirement planning advice as a fee-only financial planner.