Do You Have Enough Legs?

I saw right away he was going to tip over.

The maintenance guy was changing the light bulb outside our office entrance. His first mistake was using a chair to reach the lamp. I knew that chair had a loose leg on it. His second mistake was putting the chair on uneven ground.

I told him "You don’t have a leg to stand on" and I asked if he wanted some help as I walked in. "No, I’m good to go, thanks."

I heard the crash as I entered the coffee shop.

Every moron knows you need at least three legs or you will tip over. Four is better.

Financial Planners talk about three legs to your retirement planning. The legs are social security benefits, pensions and tax deferred plan assets, and savings. These are the typical sources of income most of us use in planning for our retirement.

But there is a problem.

Don’t Count On These Two

Some of these legs are unsteady and are becoming less and less dependable.

The Social Security System is a pay-as-you-go system, with the government using general tax revenues as needed to fund social security payments. Baby boomers are about to start collecting benefits en masse in a year or so. This means the federal government will have to raise taxes, increase our already bloated deficit, or cut social security payments. My guess is the government will do all three.

Social Security benefit payments are limited in amount. The maximum monthly payment is $2,185, or $26,220 a year. Many of us have earned much lower benefit amounts. So, social security benefits payments may be inadequate to support you in retirement. Social Security may not provide much “security”.

Clearly, this leg of our retirement is unsteady and may become undependable. The outlook for current workers to receive the benefits promised is poor.

The next leg is employer sponsored pension plans and tax advantaged private plans, such as IRAs and 401K plans. There are two types of plans, defined benefit plans and defined contribution plans.

These two types are completely different and the differences are important.

A defined contribution plan permits the beneficiary, you, to make contributions. 401K plans are sponsored by your employer and many employers make an annual contribution into your account, called a “match”. The assets that accumulate in these plans are yours and remain with you whether you stay with your employer or not. In the case of an IRA, you make contributions, you manage the account, and the assets you accumulate are available to pay the benefits you determine.

A defined contribution plan is described a “WYSIWYG”, or What You See Is What You Get. This is not true with defined benefit plans.

In a defined benefit plan, the plan sponsor, your employer, promises you a benefit of a certain amount at a certain time. The assets that accumulate to pay the promised benefits are in a Trust and remain in the sponsor’s control. The assets do not belong to the workers.

There are many circumstances where the promised benefits will not be paid. For example, if the employer declares bankruptcy, the assets and benefit promises are transferred to a government guaranty entity, the Pension Benefit guaranty Corporation (PBGC). The PBGC is obligated to pay you only the maximum benefit permitted under its charter, which in many cases is about one third of the employer’s promised benefit.

If the accrual under the defined benefit plan stops, your benefit payment drops drastically. The accrual stops when you take a job with another employer or when the plan sponsor terminates or “freezes” the plan.

At their peak in 1984 there were 112,000 defined benefit plans. Now there are 28,800. According to the Pension Benefit Guaranty Corporation, the government entity that insures benefits, 101,000 employer defined benefit plans were terminated from 1986 to 2004.

This understates the situation. More and more corporations are “freezing” their plans. IBM, Motorola, Sears, NCR and the most recent, Verizon, have “frozen” a defined benefit plan in the last several years.

Here is a simplified example of how this freeze works:

Let’s assume you work for your employer for 20 years. Normal retirement is after 40 years of service. The employer freezes the plan at the end of 20 years of service.

The following schedule shows the annual benefit amounts you will receive when you retire in another 20 years:

"Freezing" a plan drastically reduces your benefit amount at retirement and is almost the same as terminating the plan.

In 2007 Watson Wyatt, an employee benefit consulting firm, surveyed the Fortune 1000 about actions taken in the last five years regarding defined benefit plans. Here are the results:

The trend in this schedule is inescapable. Defined benefit plans will continue to diminish. This leg, defined benefit plans, is also looking awfully shaky for today’s workers.

Our Strongest Leg

In contrast, defined contribution plans are growing. The assets in these plans now exceed $4.0 trillion, greatly exceeding the $2.3 trillion in assets held in defined benefit plans. When we add the $4.1 trillion assets in IRAs (Individual Retirement Accounts) the retirement assets in accounts we control is over 50% of the total in all retirement assets of $15.9 trillion.

These are the plans you and I contribute to, and in some cases, our employer contributes as well. These are the plans you and I manage and control. The assets in these plans go with us when we change jobs.

If you don’t have one of these types of plans you should start.

How Are We Doing?

The following schedule is from a 2008 survey done by the Employee Benefit Research Institute (www.erbi.org) of workers about their savings for retirement.

Total Savings and Investment

Planning for retirement and asset accumulation, as you can see, is age dependant. Nearly 7 out of 10 young people, aged 25 to 34, have saved less than $25,000. This is what we should expect as they are just getting started in their careers. But this is not enough money to buy a new car much less pay for your retirement. Young workers need to consistently and regularly add to their “nest egg”.

The startling part is 43% of America’s workers, age 55 or over, have saved less than $50,000, and the big part of this group (32%) has saved less than $25,000.

The good news is nearly one third of us have savings of $100,000 or more. And as we age, many of us save more. Nearly half of workers aged 55 and over have saved $100,000 or more.

The same survey also shows how workers expect to pay for their retirement and how retirees are paying for their retirement.

Sources of Income In Retirement

This is a startling chart. As you can see, there are dramatic differences between how retirees are paying for their retirement and how workers expect to pay for theirs. Right now retirees are funding 62% of retirement with two legs that will be shaky and unreliable for today’s workers, social security and defined benefit plans.

Workers don’t expect company sponsored defined benefit plans (13%) and social security (14%) to help very much. They shouldn’t. They have a remarkably clear understanding that they are responsible for accumulating enough assets to enjoy their retirement.

Workers understand they are on their own. And they expect to pay 52% of their retirement with assets they have accumulated and managed. They understand they must build their own legs and they have started.

But both workers and existing retirees can add another leg that is often not given enough consideration. If you are a worker you can continue working into your retired years, and if you are a current retiree, you can go back to work. Eleven percent of workers expect to keep working.

I believe this is an important leg. Workers have accumulated vast experience and knowledge during their work years. This powerful resource is lost if workers just retire. You may not want to or be able to continue the work you have done, but there are many other work activities that can benefit from your knowledge and experience.

We Are On Our Own

There are dramatic changes underway in the way America pays for its retirement. The traditional sources relied upon for the last fifty years, social security and defined benefit plans are going away. We can not rely on these for the next fifty years.

The responsibility for paying for your retirement is slowly shifting to each of us. This brings into sharp focus the need for America’s workforce to carefully grow their retirement assets. The process is already well underway and will continue.

We think Panhandle Portfolios can help. Our sole purpose is to help individual investors safely grow their wealth. We build and manage high yield, concentrated portfolios that generate much more income than the stock market.

Our portfolios may add value to your portfolio objectives and help you grow your retirement wealth. To read about how we can help you, click HERE.

Live long and prosper,

Mike Williams, CFA

(back to portfolio commentary)