When the modern definition of retirement planning came of age in the United States there were two main accounts that were used to give Americans the opportunity to retire with income. These accounts were Social Security which was signed into law during Franklin Roosevelt’s administration in 1935 and a pension which has its roots as far back as 1776 and was originally designed for soldiers of the Military (http://www.ssa.gov/history/briefhistory3.html)
Since their inception, these plans have had many changes on the way to their modern-day forms. Both of these programs provide income to people who get older and/or become sick or disabled and lose the ability to create their own income via their own labor. A pool of money is created from contribution or taxation of many people to form a large amount of money that in theory will grow over time and then as the contributors begin to stop working full-time “retire” or become disabled, they can start to draw a monthly income to pay their bills and maintain a decent lifestyle.
There will come a time for almost all people where they will exit the full-time workforce and enter the non-working class or the part-time workforce. When this happens their income will usually dramatically decrease. So during their working lifetime, they will contribute (mandatory) to social security (most professions contribute but not all are required to contribute to social security) and many will contribute to a pension or now the much more popular 401k or IRA and other similar qualified accounts. There are other types of qualified accounts and the qualifications are governed by Uncle Sam. Many times the name of the account references the section of the IRS code that covers the rules and qualifications for these types of plans ex: 401k and the 403b.
Most of these accounts give the contributor the ability to set aside a certain amount of money annually into these qualified plans and offer tax-advantaged status. With traditional qualified plans, you put money inside of the account and can defer your tax on that contribution and any growth that account may or may not have until the money is withdrawn voluntarily or at mandatory ages. The newer Roth accounts don’t qualify for the tax deferral on the contribution but all growth of the account is tax-free for life and withdrawals are tax-free as well.
These qualified accounts have taken over as the main retirement vehicles for American workers and replaced a traditional pension. Companies have embraced these accounts and run away from traditional pensions. In doing so, they have shifted the risk of retirement from the company over to the employee. The Old Style Traditional PensionWhen I speak to people about retirement planning, many of them long for the old days of the pension plan. This type of plan is called a defined benefit program which simply means the pension fund and the employer guarantee the retiree a certain amount of income every month regardless of the pension.
The Old Style Traditional Pension
When I speak to people about retirement planning, many of them long for the old days of the pension plan. This type of plan is called a defined benefit program which simply means the pension fund and the employer guarantee the retiree a certain amount of income every month regardless of the pension funds performance over time. So it might look like this: Joe works for ABC Company, ABC union, or ABC municipality for 25 years and contributes from every check along with his employer into the pension fund. He is promised that when he retires he will be paid $3,000 per month every month for the rest of his life (and usually his spouse’s life but not always it will depend on options the plan administrator offer and what options you take) from the pension fund.
If the pension fund does not perform well in the market or other investments during those 25 years it does not affect Joe’s income because his benefit is guaranteed. This guarantee is only solid if the overall pension fund remains viable. One of the big financial stories a couple years ago was the municipal bankruptcy of Detroit where a portion of those pension payments are in jeopardy. (http://www.latimes.com/nation/la-na-detroit-bankruptcy-20140222,0,3941443.story#axzz2w34XwofH) If the funds don’t perform as projected then it is up to the plan sponsor to put in more of their money into the plan to keep it funded properly. When you hear the term underfunded pensions it usually does not mean that the proper money was not put in the account but rather the contributions did not grow as planned thus creating a shortfall in total pension funds to be able to pay retirees. Sounds good for the worker but they have some serious flaws such as:
1) Workers are usually not qualified to receive income until after many years of working for the same company, union or municipality. If they leave and go elsewhere that pension and the amount they contributed are generally not portable and transferable. A real downside for the modern “free agent economy”.
2) The worker’s ability to get the actual cash before retirement is very limited and impossible for some accounts. This will depend on the plan administrator and how the account was set up at inception. 3) The employee does not control the cash generating the income but rather the pension fund has all the control. So if you and your spouse pass away relatively early then the pension income stops and your estate receives no cash from the pension fund In 1981 the 401k and other qualified plans were born and even the man who is widely credited with their invention says they are failing most Americans. (http://www.marketplace.org/topics/sustainability/consumed/father-modern-401k-says-it-fails-many-americans) These plans are referred to defined contribution plans. In these
3) The employee does not control the cash generating the income but rather the pension fund has all the control. So if you and your spouse pass away relatively early then the pension income stops and your estate receives no cash from the pension fund.
In 1981 the 401k and other qualified plans were born and even the man who is widely credited with their invention says they are failing most Americans. (http://www.marketplace.org/topics/sustainability/consumed/father-modern-401k-says-it-fails-many-americans) These plans are referred to defined contribution plans. In these plans, the worker contributes to these accounts on a voluntary basis as does the employer also on a voluntary basis. The growth of these accounts are not guaranteed. The eventual incomes from those accounts are not guaranteed as they are with the traditional pension. So retirement income is totally in the hands of the account owner and how they allocate those funds. The income is very much dependant on how the stock market performs for most workers because the stock market is where the lion’s share of all the money in those funds is invested. So if you withdraw money as income and pay your required taxes (in the case of traditional accounts) the balance is left for you to spend to live your life. If your money remains in the market during retirement and the market goes bear then you must sell more shares of your investment to achieve your desired income.
Many people are familiar with dollar cost averaging during their working years but almost nobody is familiar with the dirty little secret of reverse dollar cost averaging. Reverse dollar cost averaging will cannibalize your retirement (click here for more information on both dollar cost averaging and reverse dollar cost averaging) and must be handled to have a successful retirement. One of the best ways to combat dollar cost averaging and set up your own stable income stream for life is to set up your own “private pension” by utilizing your old 401K or existing IRA.
This can be done by the proper rolling over of those accounts from risky market accounts to a properly designed annuity contract. As with any financial product, there are always upsides and downsides. Purchasing an annuity is no different. We will cover the benefits and pitfalls of annuities next week in part two of this article. For now, understand that there are 3 basic structures of annuities:
1) Fixed Annuities
2) Variable Annuities
3) Fixed Indexed Annuities
These 3 types of annuities have the same basic name but have wide variations of how they work. Then once you know how each work there are many different varieties and terms offered and by a wide range of providers. The fees will also vary based on product and provider.
One of the biggest benefits of many annuities is the ability to structure the contract for guaranteed lifelong income once purchased. Also, you can use qualified funds such as IRA’s and 401k’s to purchase the annuity and accomplish this via a tax-free rollover in most cases.
One of the biggest downsides of annuities is the non liquidity of the money beyond a certain percentage of the total account. Most annuity contracts come with steep penalties for early withdrawals beyond a certain amount (usually around 10%) of money withdrawn out of the account during a certain period of time.
Please read my next article when we will discuss in more depth how to successfully turn your IRA and 401k into a paycheck machine for life while at the same time avoiding the costly pitfalls.