Retirement Troika: For those 77 million “Baby Boomers”, either entering or facing the prospects of retirement, understanding the three main pillars that create the foundation for retirement is an important consideration for successful retirement planning.
The Three Pillars: In our opinion, those pillars consist of Medicare, Social Security and Retirement Plans. Each of these pillars is complex in its own right.
Building the Foundation for Retirement: Our simple undertaking is an attempt to make each pillar more understandable through rudimentary illustrations. We have provided such illustrations of the first two pillars, Medicare and Social Security, in reports entitled “Managing the Medicare Maze” and “Managing the Social Security Maze”. To this we add our final installment of the trilogy: “Managing the Retirement Plan Maze”.
Why Understanding Retirement Plans is Important
1. Private Retirement Burden Shifting: With the rapid shift from private defined benefit retirement plans to defined contribution plans, the investment onus to generate sufficient retirement income now falls on the retirement beneficiary and not on the plan sponsor.
2. Evolution of State Public Employees’ Pension Plans: While the overwhelming majority of statewide retirement plans are defined benefits plans, there have been a number of states that have departed from this model (reference). Nebraska did so in 1967. In 2005, Alaska replaced its defined benefits plans for public employees and teachers with a defined contribution effective July, 1, 2006. Indiana’s public retirement model has a hybrid system of defined benefits and defined contributions. This is likely a trend that will continue to evolve under the pressure of state budget deficits.
3. Insufficient Retirement Savings: Workers have been left on their own to plan for their retirement, yet they don’t have a clue regarding their retirement savings needs. The 2% to 3% of income that workers are contributing to their defined contribution plans will be insufficient at retirement. Only 10% of the workers contribute the amount needed to achieve the typical employer’s 6% to 8% maximum match. Depending on when you start saving for retirement you’ll have to save up to 15% to 40% annually of your wages and pray for higher investment returns.
4. Inexperienced Investors: Workers typically aren’t interested nor are they qualified to select the appropriate investments to generate retirement income. Most of the workers who are automatically enrolled in their employer’s retirement plans are provided a Qualified Default Portfolio Investment Alternatives, one of the acceptable choices the federal government has approved. I would speculate that few change from the default portfolio.
Check Your Retirement Plan(s): You should annually check your retirement plan(s) to review your investment allocations and do some arithmetic regarding the income that will be generated by the time you retire.
Secondly, if you and your spouse are currently covered by an employer's retirement plan, you should contact the plan's provider for details regarding its particulars as it may impact the amount of deductions you receive for contributions on a personal IRA.
Investment Recommendations: Each retirement situation is unique and deserves individual focus. Given the confluence of economic and political factors, we believe retirement portfolios should have a portion of their investments in dividend growth stocks. Approximately 50% of the return on equities from 1900 to 2010, according to Forbes, comes from dividends.
We continue to recommend the S&P Dividend Aristocrats. These are a subset of the S&P 500 that have raised their dividend every year or the last 25 years in order to qualify. These stocks on average yield almost 3% which is better than the 2% one can receive on 10 year Treasury bonds. (A list can be found at our website along with related data under the “Research” menu, under the green banner, under the tab “Dividend Aristocrats” free of charge or just “Google” “Dividend Aristocrats".)
Also there are several ETFs that invest in dividend paying stocks. Two of the most notable are SPDR S&P Dividends (SDY) which invests in the S&P Dividend Aristocrats Index, or the iShares Dow Jones Select Dividend Index (DVY). Each is a low fee alternative for a “one stop” diversified portfolio of dividend paying stocks.
Retirement Plan Illustrations (Below): While there are many different configurations in terms of illustrating the various relationships among retirement plans, we have created three super categories: Employer Sponsored Retirement Plans, Self-Employment Sponsored Retirement Plans and Personal Retirement Plans. While there is considerable overlapping of certain types of plans among the super categories, we have illustrated the plans as they would most naturally be employed.
Similar Principal: Most of these retirement plans operate on a similar basis of deferring income taxes on contributions (or salary reductions), tax-free build-up of value within these accounts, and taxation of distribution on withdrawals from the plan at ordinary income rates.
Exceptions Abound: There are many exceptions to this fundamental rule, the most obvious being the Roth IRA, which taxes contributions and whose distributions are tax-free upon withdrawal, but to highlight each would be counterproductive in providing a conceptual illustration.
Due Care: While due care was taken in the construction of the following chart, its accuracy cannot be guaranteed. We recommend you consult with a specialist in retirement plans prior to establishing or changing your current plan.
(Click to enlarge)
