The first defined benefit pension plan to be offered in the United States (US) is attributed to American Express Company (NYSE: AXP) in 1875. Pensions didn't really gain much traction until the US Federal Government began to offer defined benefit plans to federal workers in 1920. The real growth of defined benefit plans occurred during and shortly after World War II (OTCPK:WWII). To attract new workers during WWII and to compensate for the wage freeze enacted during the war, private companies began to offer both defined benefit pensions and healthcare coverage to their workers, both of which were exempt from taxes. The use of pensions grew through the '50s and '60s, flattened out in the '70s, and began to decline in the '80s. Today, less than 10% of the current private workforce in the US is covered by a defined benefit pension plan. The percentage of younger private workers in the US covered by a pension is even lower.
The younger workforce of today absolutely must save and invest for their future retirement. Social Security payments alone simply won't provide a secure and comfortable retirement. This article presents the case for investing in a company-sponsored 401(k) plan, Individual Retirement Account, or other tax-advantaged retirement savings program. Participation in a retirement savings program is clearly the best single investment of your lifetime.
Pensions Are Following The Dodo
The Dodo bird disappeared as a species in 1681. It is commonly thought that the primary cause of extinction was the result of Dutch sailors discovering a taste for the easy-to-catch flightless bird. But, like most things, it wasn't quite that simple. While a number of Dodos did end up on a dinner plate, just as responsible for the Dodo's demise were the pigs, dogs, and rats that the Dutch sailors brought to the Dodo's habitat. All three found the Dodo's eggs to be easy meals, and pigs wrecked havoc on the Dodo's environment.
Defined benefit pensions don't have a lot in common with the Dodo bird other than the fact that their demise is complicated and it appears that traditional pensions will also disappear, at least within private industry in the US. One could devote an entire article on the demise of the traditional pension, but I'll cover only enough to make the point that even the few workers today covered by a traditional defined benefit pension should not rely solely on this vehicle for their retirement.
Today, less than 10% of the current private workforce in the US is covered by a defined benefit pension plan. The chart below shows the percentage of the US private workforce covered by a defined benefit pension as of 2006. Over the last 10 years, and particularly during the period immediately after the 2009 financial crisis, the percentage continued to fall, and today sits at only 7%.
The chart above also shows the growth in defined contribution plans (401(k)) over the same period. Clearly, private industry in the US has shifted the responsibility for providing retirement income from the company to the employee.
The last bastion of the defined benefit pension plan today is in government service. Local, county, state, and federal employees have a much higher participation today in defined benefit pension plans. But, cracks are starting to form in the walls of this last bastion as well. In the bankruptcy proceedings for both Detroit, MI and Stockton, CA, the respective judges ruled that the pensions of current retirees as well as current employees could be frozen and/or cut as part of a Chapter 11 restructuring. New Jersey is not far behind Detroit and Stockton, and several states are looking at future pension liabilities they cannot possibly satisfy. Private industry backed out of defined benefit pensions when they became too expensive to maintain. Government services is several steps behind private industry because it is the taxpayer that is on the hook to make good on government pensions, and taxpayers are just starting to come to the realization that those pension liabilities are beyond what the taxpayer can support.
So, the bottom line of all this is the following. If you are retired or near retirement and you are covered by a well-funded pension supported by a healthy private company or government entity, you are probably going to do just fine in retirement. But, if you are under the age of 50 without a defined benefit pension plan, or your pension is on wobbly financial footing, you need to read the rest of this article. It could literally make the difference between scraping by in retirement or living out your golden years in financially secure comfort. For all the Generation Y and younger folks who are reading this - PAY ATTENTION!
The Best Investment Of Your Lifetime
Those of you who just read the last paragraph are probably wondering why I called out the Gen Y and younger folks in particular to pay attention to the balance of this article. The following chart is worth a thousand words in answering that question.
More than 50% of the population of 18-29 year old adults in the US have zero retirement savings, and more than one-quarter of the population of 30-44 year old adults have zero retirement savings. Let me repeat that for emphasis... ZERO RETIREMENT SAVINGS!
These age groups are least likely to have a traditional defined benefit pension plan through their employer. Without a pension and without retirement savings, the options for retirement income get pretty thin. One plan would be to work until you drop dead, and the other would be to scrape by on Social Security alone. While Social Security will probably still be around when the Gen Y group starts to retire, there will likely be some changes between now and then. Social Security is an unfunded liability, thanks to our government having spent the trust fund monies and filled the empty fund with IOUs. Those IOUs will all be called in by 2035 based on the latest Congressional Budget Office estimate, and the system, without additional changes, will only be able to cover about 77% of the current benefits due after 2035. One or more of the following options will have to be enacted for Social Security to continue as it is today.
Social Security benefit levels will be reduced. Social Security benefits will be subject to higher taxes. The age at which these benefits can be collected will be raised. The maximum earnings level for Social Security taxes will be raised. The Social Security tax (percentage) will be raised.
I'm guessing that at least two or three of the options above will be enacted sometime before 2035 to effectively spread the pain around and not have any one option be too painful. My point is that by the time Gen Y retires, the Social Security system will very likely have gone through some significant changes because it has to. Rather than rely on a Social Security system that is very likely going to look different than the one we have today, if you start now you can ensure a comfortable and secure retirement regardless of the changes to come.
From the first chart above, roughly 65% of private industry employees have available to them a 401(k) plan from their employer. For those employees that do not have access to a 401(k) plan through their employer, an individual retirement account (IRA) is an alternate option for building retirement savings. The US tax code allows those who are self-employed to set up their own retirement plans in the form of Simplified Employee Pensions, Simple IRA, or one's own 401(k) plan. These self-employed plans are not difficult to set up, so there really is no credible excuse for not participating in some type of retirement savings plan. When you really look at the numbers, the benefits of participation are staggering. As an example, let us take Joe Smart, a 25-year-old employee, married, filing jointly, making $75,000 per year, and with 42 years before his full retirement age of 67. For this example, I will assume that Joe contributes 8% to maximize the company contribution, that Joe gets a 7% investment return (before inflation), and lives in a time of 2% inflation and 3% wage growth. Further, Joe's employer offers a 401(k) where the employer matches up to 50% of the employee's contribution, capped at 4%. Today, this type of 401(k) plan would be considered a little better than the average plan, but Joe works for a Fortune 500 company with good benefits. Assuming that Joe stays with the plan until retirement, what would his retirement savings look like in 42 years?
Joe Smart, at the end of his 42-year career, would have over $1.4 million in retirement savings in today's dollars. I'll repeat the important part. Over $1.4 million in today's dollars. Even if Joe's employer were not so generous and contributed nothing to his 401(k) plan, Joe would still have nearly $1 million in retirement savings in today's dollars. That is truly impressive. What is even more impressive is his total investment return over those 42 years.
Because Joe's contributions to his 401(k) are in pre-tax dollars, his after-tax contributions over those 42 years are only $235,790, assuming his marginal tax rate is 25%. Joe's total return over the 42 years is a whopping 512%, or 9.63% per year, on his after-tax contribution.
To summarize this example: Joe contributes an after-tax amount of $235,790 over 42 years, his employer contributes $157,193 of tax-free money, Joe invests all the contributions into a conservative mutual fund that returns on average 7% (5% after inflation), and he retires at 67 years with a retirement fund of $1,442,388. WOW! Some folks will read this and point out that the $1,442,388 is in pre-tax dollars, and so, the after-tax value is less. Yes, it is true the after-tax value of Joe's retirement fund may be lower, but at retirement, he will likely be in a lower tax bracket than when the contributions were made. Today, the marginal rate up to $18,550 in taxable income is 10%, and up to $75,300 its 15%. The bottom line is that Joe is still way ahead at retirement.
Obviously, this is an idealized example, and everyone's personal circumstances are different. There are dozens of free calculators on the web you can use to simulate your particular circumstances and the market conditions you wish to model. I used one on BankRate.com. It is also the case that not everyone has access to a 401(k). As mentioned earlier in the article, there are retirement plans other than 401(k)s that are available to W-2 employees as well as to the self-employed and consultants. There are different limits and qualifications for each type of plan (IRA, SEP, Simple-IRA, Individual 401(k), etc.), and some are better suited to W-2 employees, while others are geared more toward the self-employed. There is a wealth of information on the web for each type of plan, and it's generally easy to read and understand.
What Are The Right Investments For Retirement?
Companies that sponsor 401(k) plans generally have a suite of available stock and bond mutual funds from which to choose. My personal approach with my retirement investments has always been conservative, and is more so today given I'm getting close to 65. I view retirement funds as my core or base that I will rely on if all my other investments go south, so I'm pretty careful how I invest those retirement funds. I also have a strong preference and familiarity with The Vanguard Group Funds. If I were starting today, I'd be looking at the following Vanguard funds.
- Vanguard Dividend Growth Fund Inv (NYSE: VDIGX) - A well-diversified, slow, and steady growth through investments in dividend-paying stocks.
- Vanguard Health Care Fund Inv (NYSE: VGHCX) - Healthcare stocks should perform well for the next couple of decades following the Boomer retirements. Supporting article here.
- Vanguard Energy Fund Inv (NYSE: VGENX) - The oil & gas industry stocks will recover along with the price of crude and natural gas. While renewables and EVs will eventually take a non-trivial market share from fossil energy sources, we are a long way from that day, and the Vanguard Energy Fund will rebalance its holdings along the way.
- Vanguard Windsor II Fund Inv (NYSE: VWNFX) - A well-diversified, large-cap fund.
- Vanguard Global Equity Fund Inv (NYSE: VHGEX) - With the global economy in the dumper, and US stocks hitting new highs, a strong contrarian approach would be to invest in markets outside of the US.
If your employer does not offer Vanguard's suite of funds as options, most large mutual fund companies (Fidelity, Franklin-Templeton, T. Rowe Price (NASDAQ:TROW), etc.) have similar offerings.
If you go the IRA or self-employed retirement plan route, the investment options are even broader. Self-directed IRAs allow investment in individual stocks, bonds, commodities, etc. While the alternatives are all available, I'll offer again that I believe the prudent approach with retirement funds is to go with conservative investments.
Private industry pensions covering current employees are almost already non-existent today. Public pensions, while still in use, are showing cracks in their foundations. Many public pension plans suffer from underfunding. Social Security is probably solid through 2035, but there will have to be some changes for the system to remain viable after 2035. Everyone who has access to a 401(k) at work or qualifies to make IRA or self-employed retirement plan contributions should be doing so. Even if the changes to the Social Security system are minor, you cannot retire comfortably on Social Security alone. Participating in an employer-sponsored 401(k) plan, IRA, or other retirement plan is the best investment of your lifetime, and you can make that investment today.
Disclosure: I am/we are long VGHCX, VDIGX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.