By FPA member Jean S. H. Schwarz, MBA, CFP®
Last Updated: November 8, 2010
Income security in retirement was once illustrated as a stool supported by three legs. These legs were: Social Security income, employer pension plans and personal savings. However, the unpleasant truth for many people nearing retirement is that two of the three legs are too small to help balance the weight of the stool — leaving retirement security wobbling only on one leg — Social Security income. As the percentage of the population reaching Social Security retirement age will continue to increase over the next 25 years, the future stability of this program is also becoming more uncertain. In a newer version of the retirement stool, a fourth leg has been added — called work. If you want to secure a comfortable retirement future, then it is important to understand how each leg of your retirement stool will be built.
Social security was never designed to be the only source of income for retired workers — rather, the benefits were structured to replace approximately 40 percent of an average worker's pre-retirement pay. Workers who have earned the maximum Social Security wage base can expect Social Security benefits to replace approximately 28 percent of their pre-retirement income (In 2010, the maximum wage base is $106,800). Assuming your goal is to replace approximately 80 percent of your pre-retirement income, under the current system, you would need to fund 40 percent to 52 percent of your retirement income from other sources. For those who earn significantly more than the maximum Social Security wage base, the amount needed from other sources would be even higher. In a July 2010 report titled, "Social Security Policy Options," the Congressional Budget Office projects that under current law, the Social Security trust fund will be exhausted by 2039 and that beginning in 2040, the payable benefits could be as much as 20 percent lower than the scheduled benefits.
Learn more by visiting FPA’s Social Security Predictor, a web tool that allows you to compute your benefits based on your age and current projections for the future funding of the system.
Employer Retirement Plans
Unless you work for a state or the federal government, chances are that you are not covered by a defined benefit pension plan which promises to replace some portion of your wages when you retire. Today, most workers are covered by 401(k) plans or other types of defined contribution plans. Many workers neglect to participate in their retirement plans, or if they do participate, they fail to make sufficient contributions to benefit from employer provided matching funds. Many of the workers who do participate have difficulty making appropriate investment elections and thereby jeopardize the future growth potential of their accounts. Finally, and perhaps most damaging, a significant number of workers take early withdrawals from their retirement plans.
In order to strengthen this leg of your retirement stool, strive to make the maximum contributions allowable each year. Diversify your investments to include an appropriate mix of current income and future growth in your portfolio. Avoid taking early withdrawals — not only do these withdrawals make it more difficult for you to reach your retirement goal, they also come at the cost of current income taxes and a 10 percent penalty if you are younger than 59 ½.
Personal Savings — How Much Should You Save?
If you have been maximizing your retirement plan contributions since you first started working, you may be well on your way to achieving your retirement goal. However, you should also consider saving additional amounts in an investment account. To determine if your overall savings rate is on target to meet your retirement objectives, some planners suggest you compare the amount of your accumulated balances to your current salary. In your mid-thirties, the total should be almost twice your annual income. In your mid-forties, the balance should be three to four times your annual income. Some planners suggest that by the time you are age 65, you will need to have accumulated 16-20 times your annual wages. While this benchmark provides a useful guideline for most middle to upper income earners, there are several key factors that could impact the adequacy of your personal savings. You can get a more precise evaluation of your own situation by working with a personal financial planner to review how variations in investment returns, annual savings and inflation could impact your future financial independence.
The Fourth Leg: Work
Increasingly, middle and upper income Americans are reaching the age of 65 without adequate personal savings or employer pensions. Because Social Security income does not provide enough income to maintain the lifestyle to which they have become accustomed, many people are delaying retirement or returning to work after retirement to help support their expenses. If, after reviewing your own situation, it appears that work past the age of 65 is in your future, take steps now to be prepared. Take classes to enhance your existing job skills or to learn new skills. Keep in touch with your professional network to improve your chance of finding a new job if your current circumstances change. Focus on maintaining a healthy lifestyle to reduce the risk that illness or injury will cause you to leave the workplace before you are ready.
The aim of personal financial planning is to help individuals achieve personal life goals — and ultimately financial independence. Take the time now to review how the legs of your retirement stool are shaping-up. Will your retirement security depend entirely on Social Security? Will you have three strong legs? Or, do you need to add the fourth leg? A personal financial planner can show you how to make adjustments which will strengthen your financial future.
FPA Member Jeanie Schwarz, MBA, CFP®, is a financial planner in McLean, Virginia.