Chapter 3
New Retirement Paradigm

In this chapter we look at how retirement has changed, and why it will be different from our parents’ and grandparents’ retirements.

Throughout this book, I emphasize that money is energy and that we all have our own psychology about money. You have learned what elements contribute to your attitudes about money as well as how your financial behavior is impacted. Most of us realize that we will have various financial challenges as we approach retirement. We need to think about how to design a plan that supports each individual—a plan that evolves as our needs and desires change.

Perhaps Eric Hoffer, an American philosopher who was awarded the Presidential Medal of Freedom in February 1983, said it best: In a time of drastic change, it is the learners who inherit the future. The learned find themselves equipped to live in a world that no longer exists.”

The Coming Crisis in Retirement Planning

We are entering a new paradigm. The retirement of our parents is no longer the reality of what our own retirement will look like. And the rules of the game from prior decades are no longer relevant. According to Robert C. Merton, a Nobel Prize–Winner in Economic Sciences, there is a coming crisis in retirement planning. Merton says, “Our approach to saving is all wrong: We need to think about monthly income, not net worth.”1

Merton is correct in stating that the traditional approach to saving is misguided. The challenge—and the goal—is to design a custom savings plan that will help us generate enough annual cash flow—or income—to cover our expenses. The total cash flow needs to be an aggregation of Social Security benefits, possible pension income and personal savings and broken down into monthly income to become a stronger planning tool for us.

So, if we are trying to abide by the old rules, some of us might fall short of our retirement goals. We need to realistically look at money the way it should be looked at in this 21st century—not through the lens of the past, but using the most effective strategies of today.

The question should not be at what age do you want to retire, but at what income.

Why Is Retirement So Different Today?

While there are many reasons that retirement looks very different today than it once did, I want to focus on three reasons: (1) life expectancy, (2) disappearing pensions, and (3) the uncertain future of Social Security.

Life Expectancy

This realization should come as no surprise: Due to advances in medical care and better diets and exercise, we are living longer. In 1970, we could be expected to live to be about 74 years old. In contrast, in 2012, life expectancy was up to nearly 80 years old.2 While six years doesn’t seem like a long time, it means that the money we were setting aside for our retirement has to last six more years. If we think we can live on $5,000 per month in retirement, then that means we have to save an additional $360,000 in order to avoid having our money run out.

Disappearing Pensions

Once a primary underpinning of a comfortable retirement, pensions are fading away at a rapid pace. A pension provides a regular payment during a person’s retirement; the payment comes from an investment fund to which that person or their employer contributed during their working life.

The dynamics of pensions are very powerful. When an employee has a pension at a corporation, the corporation is using its own money to fund, in essence, an income stream that the employee can’t outlive. What is so remarkable about that is not only is the company providing the actual dollar amount in the form of a contribution to a big pot, but the corporation is also responsible for the management of those dollars. They own the risk. You’ll get a monthly income stream that you can’t outlive. The size of your payout is simply a function of a basic formula that factors in how long you worked, how much you earned and your life expectancy.

A pension becomes a very expensive plan for a corporation to provide their employees. Not only is it more costly to invest more in the pension because people are living longer but also because the markets are much more volatile than they have been in prior decades. The percentage of workers in the private sector whose only retirement account is a defined benefit pension plan is now 10 percent, down from 60 percent in the early 1980s.3

The 401(k), which is named after a section of the Internal Revenue Code, was developed by accident in the Revenue Act of 1978. The goal of the Revenue Act of 1978 was to limit corporate executives’ access to the perks of cash-deferred retirement plans. In 1980, thanks to the pioneering work of Ted Benna, a benefits consultant who created the first employer-based retirement savings program 30 years ago, companies began interpreting the law to create 401(k) plans that would allow full-time employees to fund their retirement with pretax dollars, often with employers making matching contributions. By 1984, the 401(k) had become the primary retirement vehicle for Americans.

With a 401(k), you are using your own money and are responsible for choosing how to allocate. Put simply, in a 401(k), “you own the risk.” If you don’t manage it appropriately, it might not last you through retirement. Given the shift from pensions to 401(k)s, it’s increasingly incumbent upon the individual to take control of their retirement planning.

The Uncertain Future of Social Security

A third factor leading to the shift in the retirement landscape is Social Security.

First, let’s talk a bit about Social Security.

The Social Security Act of 1935 was drafted during President Franklin D. Roosevelt’s first term and was passed by Congress as part of the New Deal. At the time, the average life expectancy was 62 and, in order to begin collecting Social Security, you had to be 65. This essentially meant that most people were not expected to live to collect money from the system into which they had paid. In addition, in 1935, for every person collecting Social Security benefits, there were 40 people paying into the system. For much of its history, Social Security was strictly a pay-as-you-go system, with current tax receipts funding current benefits.

In 1983, under President Ronald Reagan, Congress decided to raise the payroll taxes to build up a reserve for the coming onslaught of baby-boomer retirees. The increased payroll taxes were then invested in special nontradable Treasury bonds, with interest credited to the system. Another way of saying this is that the U.S. Government began to legally use the Social Security reserve dollars to fund its own spending. Today, the Social Security reserve system is full of government IOUs—special nontraded Treasury bonds. As interest rates eventually begin to rise, the cost to service those IOUs will go up, creating more of a financial obligation for the U.S. government.

The System Is Running Out of Energy

Social Security trustees project that the reserves for the retirement and disability trust funds could tap out by 2033, due to the increased number of baby boomers becoming eligible for benefits and the longer life expectancies of those who are collecting benefits. Absent a bailout from general revenues, insolvency could result in across-the-board Social Security benefit cuts of about 23 percent. The average 70-year-old today is probably not expecting to see the day that Social Security becomes insolvent. But if actual insolvency comes sooner, rather than by 2033, that is just what may happen.4 The fact is that it will need to be addressed at some point, but is not likely to be resolved soon.

Let’s be clear about the future of Social Security: there is a crisis looming. The ratio of working people to retired people in America is only increasing; as of 2010, there were only 2.9 people contributing to the Social Security pot for every 1 person collecting. Comparing this to the 40:1 ratio that existed in 1935 when Social Security was created.

At some point, Congress will have to address these issues and make some difficult adjustments. Unfortunately, the decision to make the needed adjustments to Social Security is something no politician wants to face. One of the most important goals of politicians is to get re-elected and the largest segment of registered voters tends to be those currently receiving Social Security.5 Therefore, politicians will most likely kick the can down the road for as long as they can afford to do so.

In 2013, the cochairs of President Obama’s Fiscal Responsibility Commission, Alan Simpson and Erskine Bowles, recommended three main changes to Social Security. The suggestions were to (1) increase the taxable maximum on income to 90 percent of all income. This solution was projected to raise $238 billion over the next decade. (2) Recommend a different measure of inflation to slow cost-of-living adjustments. (3) Raise the retirement age to 68 in 2050 and 69 in 2075. In the short term, it means that people who were “banking” on collecting benefits at 65 might have to work longer. But by pushing out the retirement age, there may not be a cap on the wages that people pay into Social Security. At some point, we should recognize that these three changes will come to light in some shape or form, and the tax rates may need to go up to fund that as well.

Did you know that 24 percent of the federal budget, or $823 billion, was paid out for Social Security? This amount provided monthly retirement benefits averaging $1,294 to 37.9 million retired workers as of December 2013. Social Security also provided benefits to 2.9 million spouses and children of retired workers, 6.2 million surviving children and spouses of deceased workers, and 11 million disabled workers and their eligible dependents during the same time period.6

People will need more personal assets to make up for the lack of pension income and possibly reduced Social Security benefits. People have more financial challenges than ever before. They have less pension income, are living longer, and are concerned about the insolvency issues with Social Security being underfunded.

What’s Ahead?

In future chapters, we’ll discuss how you can appropriately plan and make up for that deficit. From vision to execution, we explore what it will take for you to become financially independent.

Let’s also keep in mind what Merton said about our approach to saving. He is right—ever since pensions have been replaced by 401(k)s the conversation about retirement has shifted to account values. The conversation should still be about income replacement, and how much income can be generated by the dollar amount invested.

Notes

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