The Three-Legged Retirement Stool

 In Planning Insights

The metaphor of thinking about retirement as a three-legged stool was very popular with the post WW II generation. Each leg of the stool represented a component to funding retirement and it was necessary to have all three components to have a successful retirement. The thinking was that if even one of the components was weak or missing, the retiree would fall off the stool and have a much lower chance at a successful retirement.

The three legs of the stool are social security, pensions and personal savings.

Social Security should never be thought of as something that will completely support an individual in retirement. It was not created to do so. It was created only to help supplement retirees’ income. Benefits are calculated based on wage history and number of years of employment. If you did not work outside the home, but were married for ten years or longer then you could qualify for a spousal benefit. In the days of “file and suspend,” there were several different claiming strategies that could be analyzed to maximize benefits. Many of those strategies are no longer available and no one knows what the future will hold for social security. In 1945, there were 42 workers to support every beneficiary. By 2030, there will be only 2 workers to support each beneficiary. Certainly younger workers will wait longer before collecting benefits and will probably be collecting less. With a projected decrease in social security benefits, more weight is shifted to the other two legs of the stool.

At one time, pensions were the norm and represented another source of income for a large percentage of retirees. In 1983, 60% of employees of Fortune 500 companies were covered by pension plans. Today, fewer than 12% of new employees are offered any type of defined benefit pension plan. Companies realized that they could shift the burden of the uncertainty of the future to employees and also completely sever their relationship with retiring employees if they switched from defined benefit plans to defined contribution plans. In these plans, employees save for retirement with their own pretax dollars. With pensions becoming mostly a thing of the past, even more weight has been shifted to savings, the third leg of the stool.

Personal savings will now represent the most significant leg of the stool for retirees. These savings include saving in company sponsored plans such as 401(k) or 403(b) plans. Since these plans are being funded with participants’ money rather than the company’s, they fall under personal savings rather than the pension leg. However, many people falsely believe that if they maximize their 401(k) contributions, they will have enough for retirement when combined with what little they will get from social security. If they do not take the time to map out a realistic expectation of retirement, they will be very disappointed. A well thought out and properly maintained financial plan will help savers understand that it takes more than maxing out a 401(k) to have a successful retirement. We recommend:

  • Always max out any company retirement plans as this is funded with pretax dollars and employers will often offer a match (free money!) up to 6%.
  • If you are eligible to fund other retirement vehicles, such as a Roth IRA, take advantage of that as the savings in the Roth IRA are post-tax that will grow tax free and have no required minimum distribution(RMD.)
  • Whenever you get a raise, pay yourself first in the form of forced savings. These funds will be used to set up an emergency fund first, and will then build the basis for taxable investment accounts.
  • Build a model to understand retirement savings needs and update that model frequently. Life happens with mortgages, children, emergencies, etc., and it is very easy to forget the goal of retirement. A plan will help prioritize needs over wants or wishes, and help lessen impulse spending. It will also help you understand when the best time will be to claim social security in order to maximize your benefits.
  • Do not rely on the equity in your home for retirement. Many people believe that they will downsize and put some equity into their portfolios for retirement only to find that many of the downsized properties are more expensive than they believed and actually price themselves out of markets. Home equity should be saved for absolute emergencies or moving to the next phase of their life.

Given that two of the three legs of the “retirement stool” are diminishing, it is important to think of ways to help prop up the stool. Part time employment in retirement is becoming more and more popular. Many retirees find the shift to full retirement difficult, and part time work can be rewarding and helps supplement other income streams. Annuities do provide guaranteed income, but very few people understand the full cost of that guaranteed income. Work with a professional who will help your money grow for your future and help keep your retirement on track.

To shore up the retirement stool, have a plan in place and update it at least every 18 months to ensure that when you rely on that stool for retirement, none of the legs collapse beneath you.