Much like Bobby Fisher learned how to master the game of Chess by starting with the endgame, a single king vs. a pawn and a king; when it comes to personal finance, taking a look at the endgame is the difference between knowing how to play the game and mastering it. When it comes to personal finance, the collective likes to call the endgame ‘retirement’, and guess what?! Turns out retirement is deeply misunderstood.
The current state of retirement-health in the US is pitiful at best. According to the Economic Policy Institute (EPI) the average American family has only $95,776 in total retirement savings. But this number doesn’t even begin to scratch the surface of the iceberg. 1 out of every 3 people over the age of 55 don’t have any retirement savings, and, 1 out of every 3 Americans has no retirement savings at all. That’s over 135 million people without any form of retirement in place. This picture gets even worse when considering Millennials (18-35), who, in some fairly conservative estimates, show that 42% do not have any retirement savings whatsoever.
Before diving into the specifics, lets take a moment to review the broad concept: what is retirement?
1. The action or fact of leaving one's job and ceasing to work.
2. The period of one's life after retiring from work.
3. The action or fact of ceasing to play a sport competitively.
- Oxford English Dictionary
Retirement simply means not having to work for money. Retirement means you either saved your whole life and are now living off of that pile of savings (investments, 401K’s, IRA’s, Pensions, cash, etc.), or, it means you have enough productive assets, which produce cashflow to support your lifestyle. These are your 2 endgame options. Simple.
Let’s for a moment assume you went for option #1: worked your whole life until you’re in your 60’s (or a later age), you put money aside into your employers’ plans, you’ve invested in equities through your 401K and IRA accounts, and/or you’ve got a pension, you have some cash in savings, etc. In this instance most folks will outlive their ‘savings’, because their withdrawal rate will outpace their meager rate of return (less fees).
Here's the thing about retirement so many people miss, having a healthy, or productive looking retirement fund/portfolio, is actually doable, if the withdrawal rate is sustainable over a long period of time. Below is a graph that demonstrates what a baseline portfolio can look like at different annual withdrawal rates assuming a 7% annual average growth rate.
$500K Portfolio - Withdrawal Rate Scenarios (4% - 10%)
This is what your retirement portfolio can look like! For example, if at the age of 20 you were to invest a one time amount of $10,000, by the time you were 80 you’d have well over $500K. Due to compound-interest of 7% annual average returns on a $500K portfolio, and 4% annual withdrawal rate (starting with $20,000/year at retirement at 65) the investment-portfolio stabilizes and continues to grow through time at roughly 3% annually. If this were the case for everyone, retirement may actually be a pleasant experience for most Americans. This math is supported by the Trinity Study.
However, most people fail to 1. Save up/allocate $500K by the time they are ready to retire. Problem#1. And, most people fail to 2. withdraw only $20K/year in retirement, for most people this isn’t enough to cover their expenses (Essential, Excess, or Actualized). However, if one can either severally contract their spending (which is what most elderly ‘retired’ people do), or generate enough consistent monthly cashflow to support their spending, then when can effectively retire at any age.
Generally speaking, the average American thinks there aren't too many choices when it comes to retirement; and they are right!
In reality, there aren’t many option, there are only 4. These are the 4 main retirement options:
Owen Assets, as many valuable ones as possible (preferably productive): Real Estate, Stocks, Commodities, Businesses/Companies, Markets/Indexes, Bonds, Art, etc. = Wealth.
Family Support/ Inheritance = Luck
Not having any or little savings/investments = Bottom 1/3
The 401(k) and/or IRA programs = What people think retirement plan is, but is not.
The first two options are great if you are lucky, or savvy, or an entrepreneur/investor; unfortunately the average American doesn't have access to a bunch of assets or a well-off family to support him or her. Pretty much we are looking at about a third of the population with little or no savings to support them during retirement, or over half the population with all their retirement savings in a 401(k) and/or IRA combination.
The 401(k) wasn’t designed to be a primary retirement instrument for the masses, it was designed to get average people back into the stock market. The issue with this instrument being people’s primary retirement plan is that most 401(k) companies simply say something along the lines of "give us your money and you will be pleasantly surprised when you are 65 and open your retirement check." The reality is that in most cases anywhere from 50% up to 70% of what your investments generates is scammed out of your pocket. If you have a 401(k), and/or an IRA/ROTH IRA, the chance of you getting cheated out of your retirement savings is likely.
*More on this below, but first historical context is needed.
A Brief History of Retirement
1881: in Europe, Otto von Bismarck, the conservative minister president of Prussia, presented a radical idea to the Reichstag: government-run financial support for older members of society.
mid-1800s: In the United States, certain municipal employees—firefighters, cops, teachers, mostly in big cities—started receiving public pensions.
1875: the American Express Company started offering private pensions.
1920s: a variety of American industries, from railroads to oil to banking, were promising their workers some sort of support for their later years.
1920s: Manufacturing companies were the last to adopt the new retirement plans. The Internal Revenue Act of 1921 helped to spur growth, by exempting contributions made to employee pensions from federal corporate income tax.
1935: Social Security Act was passed in the US, the official retirement age was 65. Life expectancy for American men was around 58 at the time.
1939: Great Depression Ends (October 29, 1929 – 1939)
WWII: September 1, 1939 – September 2, 1945
1940s: Labor unions became interested in pension plans and pushed to increase the benefits offered.
1950s: nearly 10 million Americans, or about 25 percent of the private sector workforce, had a pension.
Americans start to live longer: due to advances in medicine, technology, and economy.
1960: life expectancy in America was almost 70 years. About half of the private sector workforce had a pension.
Pensions were the primary means of retirement in America. Massive collective piles of savings which were invested in a variety of market vehicles and govt. projects/bonds = defined benefits plans.
1970s-1980s: America begins shifting from defined benefits plan to defined contribution plans: 401(k) plans, 403(b) plans, 457 plans, and Thrift Savings Plans.
1974: The Employee Retirement Income Security Act of 1974, ERISA - made pension plans more secure by establishing legal participation, accountability, disclosure requirements, guidelines for vesting, etc. — ERISA stands out as one of the few laws passed in US history that fundamentally changed the nature of retirement, and retirement administration in the US since it effectively created a regulatory framework around employer-sponsored retirement plans.
1978: the Revenue Act of 1978, created the 401(k).
1980s-1990s: The 401(k)s and other defined contribution options quickly surpassed the defined benefit pension as the plan of choice for large private sector companies, due to cost.
1990: 401(k) plans held more than $384 billion in assets, with 19 million active participants.
1996: Assets in 401(k) plans exceeded $1 trillion, with more than 30 million active participants.
1997: The Taxpayer Relief Act of 1997, which created the Roth IRA.
2001: The Economic Growth and Tax Relief Reconciliation Act resulted in several changes to the 401(k). In general, the law increased the amount that individuals and companies could contribute to the accounts. Additionally, it allowed participants over the age of 50 to make “catch-up” contributions. In 2017, the contribution limit is $18,000 and the max catch-up contribution is $6,000.
2006: The Pension Protection Act made it easier for companies to enroll their employees automatically in 401(k) plans. Some companies even automatically increased their employee’s contributions by 1% a year to encourage saving.
Today: 401(k) plans hold more than $4.8 trillion in assets. And pensions, in the private sector, are increasingly rare.
Today: the Social Security Administration estimates that there are 38 million retired people in the United States alone.
The 401 (k) & Defined Contribution Options
Let's put the concept of 401(k)/IRA retirement into historical context for a minute. The original retirement fund was the pension plan where all of the members of the said company would contribute a portion of their pay check to the fund and it would be collectively invested on the employees’ behalf. As the population demographic of 65+ grew to record highs, corporations recognized the increasing cost of their pension plans, thus many pension plans across the US were dissolved over time, and new ones weren't created. The burdens of saving towards retirement were placed on the individual employee instead.
As corporate profits began to rise across the country, so did the gap between executive and ordinary worker pay. Naturally, most executives wanted to invest some of their extra income for the future while simultaneously hedging towards future tax rates (i.e. income taxed upon withdrawal of funds vs. taxed upon deposit of funds). The 401k (1978) and the IRA (1974) were initially designed to service such a need. As the deposits continued to pour in from various bank and company run 401(k) plans, mutual funds quickly recognized the opportunity to manage such enormous funds. The IRA was initially geared more towards a mass base, the 401(k) was used primarily by the higher ranking executives of said big companies to put some more of their excess money invested-away for the future (i.e. they were stashing excess cash in tax beneficial savings/investment instruments in order to have it protected from taxation). Both the IRA and the 401(k) were heavily marketed by banks, insurance companies, and boutique brokers, and the market for retirement was wide open for the taking (and some would argue, it still is today).
Fast forward to today, the 401(k) is now the go-to financial instrument for millions of Americans’ Retirement, yet very few take the time to fully understand how it works, how to use is, and how to incorporate it as part of a larger investment plan for their retirement years.
The 401(k) & IRA, are simple saving/investing instruments. Here’s how they work:
The employer should let his employee set his or her contribution amounts from his or her pay check (with a limit).
Ideally every dollar put in to the 401(k) by the employee should be matched by the employer.
The employer aggregates everyones' contributions and invests it on the employee's behalf.
It is the employer's fiduciary responsibility to invest the employ's money to safeguard and maximize the investment as best they can.
Often employers contract this work out to third party business, many of which are called mutual funds.
The employer literally transfers money from the employees to the investors, who can essentially do what ever they want with it.
Contributions can be made both before and after payroll taxes are applied (electing a ROTH option will control this variable).
Tax payments can be deferred into the future, so no payment on income is made now.
Reduces your current taxable income.
Puts off paying taxes until employee is retired, assuming that he or she will likely be at a lower income bracket then. Twisted thinking?
ROTH 401(k) acts as the opposite of taxes terms. The income invested in a ROTH 401(k) is taxed upon deposit, and will be tax free come withdrawal time.
The limits on a 401(k) plan:
The limits on an IRA plan:
How is the 401(k)/IRA scamming retirees?
Fees. 90% of all 401(k) plans in the US are managed by Mutual Funds. A Mutual Fund is a company that actively manages and invests your money. Nearly 90% of mutual funds do NOT beat the market, so in most cases you are better off taking a portion of your pay check and investing it yourself in a low cost index fund tied to the market. In addition, there are "fees and commissions," the little dirty secret of the 401(k) industry; over the life of a 401(k) it is commonplace to see 70% of profits go to the “active managers,” while the investor, you, are left with only 30% of the profits at the end of the investment period, also known as your retirement savings. This is the "pleasant surprise" check that the employee receives when he or she retires. Not too pleasant once understanding the calculus.
The 401(k), is a retirement investment instrument, it can actually be useful for folks who use it as part of a larger investment-strategy. It is fundamentally flawed to view the 401(k) and/or the IRA as the entire package deal for your retirement savings as this use comes with major consequences. If one were to use the 401(k)/IRA as part of their asset allocation strategy in protecting against taxation, then it would only represent a portion of his or her portfolio and hence would prevent the risks of relying completely on the 401(k)/IRA.
Keep in mind that not all 401(k) plans are "evil" and that there are actually a few good ones out there, but not many. You must do the research if you are going to entrust others with your retirement savings and planning.
Furthermore, there are many possibilities of what a healthy retirement strategy can look like, so it is crucial to plan accordingly and be in control. Next steps for taking control of your retirement:
Read the FPF framework - understand the concepts of financial control and financial freedom.
Read and understand concept of investment.
Learn as much as you can about the topic of retirement. If you are in need a starting point, read this article: http://www.investopedia.com/articles/personal-finance/011216/average-retirement-savings-age-2016.asp
After you're all caught up: Select your investment strategy and asset allocation plan. Take your time here at the core of your decision-making. Apply Risk Management Principles.
Select a broker, be in control. This is critical (Lowest Fees & % possible).
Run your pro forma reports before you sign anything. Project 10, 20, 40, 80 years into the future.
Review all documents carefully. Use your lawyer if possible.
Action! Invest your money. And keep diversifying over time. Your retirement savings is not an investment worth gambling with, so stay conservative.
All in all, know where your money is going, operate from a position of financial control, and invest well over time.
Your retirement is not something to be messed around with. Do not go blindly with the herd. Use the 401(k) plans, IRA’s strategically, NOT as your sole/primary retirement savings/investments. Do your homework! Know where your money is going, and don't be afraid to start thinking about this now. Take action, stay informed, and take control of your future.
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