Why retirement looks different compared to your grandparents' generation
Saving for retirement has changed within the past few generations. Certified financial planner Matt McCoy breaks down the three parts to saving for retirement and what to do next.
Thirty years ago, retirement income followed the three-pronged approach we are all familiar with: 1) Pension income from your employer; 2) Social Security benefits; and 3) income from your investment portfolio – mainly interest income from bond holdings.
In other words, income replacement was mostly achieved with the “guaranteed” payments from a pension and Social Security, leaving a smaller portion to be withdrawn from the investment portfolio. So how does your retirement picture compare to that of your grandparents or possibly even your parents? Let’s compare each income source in turn.
- Pension income - While some of you may be fortunate enough to participate in an active defined benefit (pension) plan through your employer, the majority of workers have access to only a defined contribution plan (401(k), 403(b), or similar). The shift away from defined benefit plans toward defined contribution plans has placed more responsibility in the hands of the plan participants regarding contribution amounts and investment selection. Whereas a pension plan would provide a clear picture of income replacement, participants are now left to their own devices to save enough and invest prudently in order to reach the desired level of income replacement needed. And this does not consider the shift in the cost healthcare coverage for retirees from the employer to the retiree – especially those who retire prior to age 65.
- Social Security benefits – Each of us have our own opinions regarding the current and future status of the Social Security system, but we’ll leave the debate for a future discussion. The fact is the ratio of workers paying into the system per retiree collecting benefits has fallen substantially since the program’s inception. Many experts expect this trend to continue, which leads to one simple conclusion — something has to give. Whether that “something” comes in the form of reduced benefits or complete overhaul of the system, it certainly means that you should plan with caution.
- Investment income – While investment income includes interest (coupon) payments and dividends, the focus here is on the interest portion. The old rule of thumb states that investment portfolios should become more conservative as retirement approaches; meaning a greater percentage invested in fixed income. Consider someone who retired 30 years ago and repositioned their portfolio more conservatively as mentioned above. Assuming that they repositioned their investment portfolio coincidentally with their retirement date, they were able to purchase a 30-year Treasury bond with a yield of somewhere in the neighborhood of 11 percent (at the time of this writing, the 30-year yield was just north of three percent). And that was a “risk free” security. Add in corporate bonds with credit risk and their yield would be even higher. What has this scenario looked like over the past 30 years? Recall the general rule regarding interest rates and bond prices: as interest rates fall, bond prices rise and vice versa. This retiree was able to lock in their interest income at a rate of roughly 11 percent and also watch their principal increase as interest rates fell. Now they would only receive the face value of the bond at maturity, but would have had plenty of opportunities to realize capital gains prior to maturity.
What does all of this mean for your retirement? First of all, you are not doomed. You just have a bit of work and planning to do. Let’s first consider the investment income portion as it relates to interest income. Based upon what we discussed above, should you expect the same outcome? Well, I think given the current level of interest rates it is pretty safe to say no – at least if you are anywhere close to retirement. This means that your investment income will likely need to consist of more than simply owning bonds. In fact, there has been recent research that recommends a rising allocation to equities in retirement rather than bonds. You may have to consider your total return – income and capital gains – and get comfortable with spending some of your principal.
Social Security benefits have been a hot button issue for some time, however the dominating factor these days is regarding the future status of benefits. Will you collect the amount estimated on your statement when you file for benefits? I’m not sure anyone knows the answer to that question – I sure don’t. What I do know is that you should plan cautiously and conservatively. This means that you should do your homework – or hire a knowledgeable professional who understands the Social Security system. What happens if you plan for a secure retirement withoutconsidering Social Security benefits? Obviously you are out the money you paid into the system if you receive no benefits, but you won’t have to go back to work unwillingly.
Realizing that this is not your grandparents’ retirement is a good first step. It may look much different and pose more challenges, but it is not impossible. Have realistic expectations regarding Social Security benefits and invest for total return. With some careful thought, dedication, and some professional help, you can put yourself in a great position to reach financial security.