5.1 Retirement
Objectives
+ Appreciate the goal of retirement within the Life-Cycle model
+ Understand the roles of personal savings, pensions and Social Security in financing retirement
+ Investigate the Social Security dilemma
Lecture: Saving for Retirement
The majority of Americans rank “saving for retirement” as their number one financial worry, according to Gallop polls. But still, the most common “investment” any individual makes is saving for retirement. The Life-Cycle model of personal finance recognizes that retirement is a period of dis-saving, when wage and salary income is generally lower than spending, and often zero. The income needed in retirement comes from work, pensions, Social Security, and income from savings and investment accounts. It can come from the sale of assets, but rarely does it come from loans (although reverse mortgages are available.)
The problem with retirement is that no-one knows how long it will be. A person can choose when to retire, but rarely does a person choose when to die. The uncertain length of the retirement phase of the life cycle makes planning so much more difficult, and encourages people to over-save for retirement, and under-spend during those retirement years. Fortunately, whether intended or not, any value remaining after death can be transferred to those remaining: children and other family members, the church, or the University. (Even though probate makes it less than simple to disperse assets after death.)
The goal for retirement investment is to have sufficient funds at retirement time, whether as a stock of assets, or a stream of income from those assets (or some combination of both,) to pay for the annual expenditures each year of retirement. Fidelity says you need 8x your last salary, while a Time article offers multipliers ranging from 11x to 18x.
Added to the uncertainty of the length of retirement is the uncertainty of events while retired. Many events are anticipated and for these you can plan, but some are completely unexpected, and these place a considerable strain on the retirement budget. For example, a retired couple or single person can expect regular living expenses including maintenance, birthdays, family holidays, graduations and regular health related costs. However, many expenses, especially health related, can be unexpected and sometimes very large. Even with health insurance, retired people face great uncertainty regarding expenditure levels at particular times.
There are a number of ways of saving for retirement:
1. Through employer pension plan (data regarding how many, and how much, is hard to find!) Tax advantages are often present. Most people save for retirement this way.
2. “Own-savings” through 401(k) – private, or 403(b) – public, non-profit plans. These plans are only available through employers, but the contributions come from employees or individuals, and may be matched by employers, but that is not a requirement. Tax advantages are often present.
3. IRAs – Individual Retirement Accounts through which people save for retirement with after-tax income. Even if a person has access to options (1) and (2) above, they may wish to invest specifically for retirement. Although an IRA has restrictions and limitations, it is tax-advantaged, just like employer plans and employer-sponsored alternatives. Roth IRAs (see below) on the other hand have quite distinct tax advantages, and disadvantages compared to the traditional IRA.
4. Individual savings and investments that are not subject to special tax treatment. A person can save through investment for retirement with after-tax income not spent specifically for retirement. Generally this is not common because of the special tax treatment of investments for retirement. Why would someone invest $1000 for retirement in one account, when an equivalent account can be designated “investing for retirement” and be taxed at a lower rate?
5. Social Security. See below.
Aside: the basics of retirement plans
It is relatively easy to understand any, and every, retirement plan with the following “basic math:”
Future benefits = past contributions (times) some rule
All retirement plans take contributions at some pre-retirement period, usually associated with working, and then pay benefits during retirement. The level of benefits is determined by some rule. These rules vary considerably between private and public plans, and types of plan.
There are two basic types of plan: defined benefit and defined contribution. Plans also divide into “pay-as-you-go” and fully funded. Many defined benefit plans are pay-as-you-go, the most well-known being the Social Security system.
Defined benefit plans base benefits on a formula, usually to do with years of service (even if that simply defines eligibility) and an average of the last few years salary. (For example here’s a link to how Social Security benefits are calculated.) Although eligibility comes from contributing, and contributions are based on salary, the level of benefits are often only loosely tied to contributions: it’s possible for an individual to get more out of a plan in benefits than was put in as contributions. In contrast defined contribution retirement plans base benefits on contributions directly. All contributions from the individual and any matching contributions from the employer are invested by the plan in the name of the employee. At retirement the employee is eligible to start withdrawing benefits from the account which is by then contributions plus accumulated interest and other earnings.
Most older retirement plans like Social Security are pay-as-you-go plans (and many public worker and union plans are the same.) Current contributions are used to pay current benefits (in an -inter-generational transfer.) So long as contributions in period t are sufficient to cover benefits paid in period t, the plan can continue ad infinitum. Problems arise when an imbalance between contributions and benefits occurs. As these plans look ahead, they can estimate both future contributions and future benefits. If the present discounted value of future contributions is less than the present discounted value of future benefits (and these are difficult to estimate as they depend on the health of retirees and the costs of health care in the future) the fund is said to have unfunded liabilities. Unfunded liabilities has become a serious problem for government plans and university, hospital and other large or public organizations with defined benefit plans. As plans deal with funding those future liabilities they must increase contributions, or lower benefits, neither of which are desirable choices.
A defined contribution plan cannot, by definition, have unfunded liabilities. Most defined contribution plans are fully-funded. Contributions by employees plus any contributions by employers are invested in the name of the employee, and provide benefits when that employee retires based on the level of contributions and the performance of the fund. In this way all future benefits are fully funded by contributions. Such plans can take advantage of aggressive investment strategies by fund managers to grow the investments and fund high levels of benefits. Unfortunately the opposite is also possible: poor management or tough economic times can limit fund growth, or even erode future benefits.
Part II – IRAs
Individual Retirement Accounts (IRAs) are available to augment employer pensions and Social Security. Contributions to traditional IRAs are untaxed until distributed as benefits, whereas contributions to Roth IRAs are made with after-tax dollars. These are the two main types of IRAs although there are others. Although there are limits on contribution levels and many restrictions on withdrawals before a certain age, and even after a certain age, the advantage of an IRA is control over the investment portfolio, and ownership of all contributions.
Roth IRAs (the Roth IRA was introduced in 1997 by the Taxpayer Relief Act of 1997) have become popular because they offer tax-exempt retirement savings rather than tax-deferred savings with a traditional IRA. A simple word difference, but potentially a big financial difference. Generally the decision to save through a traditional or a Roth IRA depends on the current tax rate, the tax rate anticipated in the future during retirement, and the time retirement. Consider the example comparison of two IRAs in the table below.
| Event | Trad. IRA | Roth IRA |
| Earn | 1,000 | 1,000 |
| IRA contrib | -100 | 0 |
| Tax (30%) | -270 | -300 |
| Net | 630 | 700 |
| IRA contrib | 0 | -100 |
| Spend Now | 630 | 600 |
| Invest (2x) | +200 | +200 |
| Retire | … | … |
| Tax (20%) | -40 | 0 |
| Spend Retire | 160 | 200 |
A person earns $1000 in the current period with a tax rate of 30%. Contributions to a traditional IRA are pre-tax, so only $900 of earnings are taxed for a net after-tax earnings of $630 including the IRA contribution. If a Roth IRA is chosen, $300 in taxes is paid on full earnings, and after the $100 IRA contribution, net earnings are $600. The traditional IRA leaves the person with more after-tax spending money in the current period. Come time to retire, the IRA is now worth $200. Taxes are owed on the amount withdrawn from the traditional IRA at the tax rate applicable at the time, which could be lower than the earnings tax rate (the example assumes a tax rate of 20%.) Note that both the principal and interest are taxed in this case. After taxes the person has $160 to spend in retirement with the traditional IRA, compared to the full $200 with the Roth IRA. All withdrawals from Roth IRAs are tax-free. Taxes on the traditional IRA are deferred into the future, and earnings are also taxed. Because taxes on the principal were paid up-front, the Roth IRA attracts no further tax, and earnings are not taxed.
The Roth appears more attractive based on the example. The person who saves through the Roth IRA has $30 less in the current period, but $40 more in the retirement period. Whether the traditional or the Roth is “better” depends on personal preferences, in particular whether future consumption is more important than present consumption. It also depends on the relative tax rates: if future tax rates are significantly lower than current rates, the traditional IRA may even provide both more current, and more future, money to spend.
Part III – Social Security
The Social Security Administration (SSA) was formed as the Social Security Board by President Franklin Roosevelt in 1935 as part of his New Deal. The original intent was to provide social insurance following the Depression. (The history of the SSA makes for good reading.) Originally intended as a fully funded plan, reserves accumulated quickly which encouraged law-makers to expand coverage and increase benefits. It evolved into a pay-as-you-go system and changes over time have created a plan that has at times had large reserves, and at other times smaller reserves. Those reserves are expected to disappear around the middle of the 2030s.
America was a very different country in the ’30s when the SSA began. More people lived outside cities, more people were poor. The elderly were more likely to represent the “face of poverty.” The Great Depression had robbed many retired people of their savings, and social insurance emerged as a solution to old-age poverty. It provided a “safety net” for people in need. Over time SS has become an entitlement program–once a person contributes for enough quarters (40 in total) and reaches a certain age (it varies by birth year) benefits are paid regardless of ability to support their retirement from other sources. It is no longer a safety net against poverty in retirement as much as a forced retirement savings program with uncertainty regarding the level of benefits in the future.
The reason the SSA system is in financial trouble is primarily demographic. When the baby boom generation was working they made large contributions into the system (contributions are a function of the number of people working and their earnings, both of which were high for the baby boomers.) The excess contributions grew the reserves to billions of dollars. (Law requires that these reserves–the Social Security Trust Fund–be invested in government debt.) Demographically the baby boom was followed by a baby bust (too many people in the 60s having fun, but not babies!) As the baby boomers retire they are eligible for benefits that are comparable with their contributions, but their contributions have already been spent in the pay-as-you-go system. Benefits for retired baby boomers must be paid for by contributions of employed baby busters. Cost of living adjustments (COLA) and increases in benefit levels from the legislature mean that high levels of benefits have been promised to baby boomers. The Social Security Trust Fund is being used (raided) to fund the shortfall between current level of contributions and promised benefits. Eventually it will run out, and current levels of benefits can not be sustained at current contribution levels.
One solution to save Social Security is to increase contributions or lower benefits. Raising contribution rates would place a severe burden on those currently employed, while lowering benefits would be seen as failing to keep promises. An alternative is to privatize social security, an idea once proposed by President George W. Bush, but which was, and remains, highly controversial. The privatization debate has attracted many famous and influential economists on both sides.
A comprehensive presentation of many of the issues is available on this Wikipedia page: Social Security debate.
The Quiz is available on the Learn website.
Additional Resources/links
1. US Govt Dept of Labor retirement planning website:
http://www.dol.gov/ebsa/publications/nearretirement.Html
2. Comparison of traditional and Roth IRAs and 401(k) plans:
http://en.wikipedia.org/wiki/Comparison_of_401(k)_and_IRA_accounts
3. Investopedia’s article on under-funded pension plans:
http://www.investopedia.com/articles/analyst/03/050803.asp
4. One real problem with retirement, especially these days, is living too long, and running out of retirement funds. Check out this novel new (old) idea that pools the risks of living too long. http://www.thinkadvisor.com/2015/06/29/milevskys-bold-plan-to-reinvent-retirement-income?eNL=55929fbd160ba0161d2add96&utm_source=TA_RetirementReport&utm_medium=EMC-Email_editorial&utm_campaign=&_LID=137393525&page_all=1
Homework
Write up to a one page, typed (single spacing is fine) essay on the following topic:
Estimate your retirement needs–age at retirement, ending salary, expected retirement, additional sources of income, annual financial needs, bequest desires. You can use an online retirement calculator is you want. Report your calculations and how you feel about the results.
Discussion
Discuss the following:
Read the Time article: “How much do you need to retire?“
Discuss ways in which we, as a nation, can increase our ability to pay for retirement. Is it an individual responsibility or a collective one? What happens to those who don’t or can’t save enough for retirement?
Philip Ganderton 