All you never wanted to know about retirement
Did you know that April is Financial Literacy month? Yeah, me neither. I just found out a couple of weeks ago and decided that my second post for the month should be something related to financial literacy... so I decided to write about retirement.
Before I learned about the FIRE (financial independence, retire early) movement, I thought of retirement as simply 'that point in the future when you stop working'. And I didn't think much more beyond that. Maybe I pictured boring old people playing golf together or something. What do you think of when you hear the word retirement?**
Photo by Aaron Burden on Unsplash
When it comes to retirement and finances, there is so much jargon like 401k, IRA, Roth and Social Security that I thought I'd explain these terms with a narrative, sorta-factually-accurate version of the history of retirement. This is going be long, so brace yourselves. Here we go...
Once upon a time, there was no such thing as retirement. You worked and worked and worked until you died (I'm thinking farming days). Retirement wasn't much of a thing as life expectancy wasn't that high, so most people didn't live long enough to 'retire'. If you survived long enough to become unable to work due to illness or old age, then hopefully you had a family or community to take care of you.
But then the Industrial Revolution happened and instead of folks working on farms, they started working in factories or for companies. They started moving into cities, no longer living with extended families around them. And folks started living longer too. Some folks were getting older and holding onto those jobs that younger folks could be doing. This idea that older folks should maybe stop working was born.
But how are we going to get these old folks to stop working? Because if they stop working, then they stop making money and if they stop making money, how are they going to support themselves? No one's going to voluntarily choose to do this! Some companies enticed workers with something the military had been doing, which is to offer a pension plan - a plan to pay workers a fixed amount every month after they stopped working. Back in the mid-1900's, these pension plans got really popular. They had them in the military, for government jobs and some private sector companies offered them as well. The catch is that you had to work a long time at the same company to qualify for them and by the time you retired, you probably didn't live long enough to enjoy it for too many years. For example, a pension plan might kick in after the age of 60 but the average life expectancy didn't even pass 60 until around the 1940's.
Around the 30's and 40's, as life expectancy was creeping up and America went through the Great Depression, the idea of how to take care of the old, disabled or poor started to come up. People weren't living in these tight-knit farm communities anymore. People were surviving but unable to work and how, as a society were we going take care of them? And this was the birth of Social Security, a government run social insurance program to provide economic security to the old and disabled. Among its many facets, it provided an income for retired folks 65 or older (life expectancy at this time was 60, so you can do the math for how many people benefited from this). Similar to pensions, you didn't just get this benefit for free - you had to work for it. Folks who earned money would pay a tax (that's that 'social security tax' line in your paystub) and earn credits for Social Security. Then, when it was time to retire, you'd get a fixed amount of monthly income based on the number of credits you earned over your lifetime. (fun fact - this is why they invented social security numbers, because they needed an account number to keep track of these credits).
Pensions and social security sounded great in theory but in practice, they had problems. One major problem was that people kept living longer! It was one thing to offer a fixed amount of money, every month until someone passed away when a majority of your folks either weren't going to live long enough to qualify or weren't going to collect that money for too long. The second major problem was that the company or government was responsible for paying what they promised, regardless of financial market conditions or how long you lived. If you lived longer than they expected, they had to figure out how to come up with the extra money. It was nice for us folks - we didn't have to worry if the stock market was doing badly or if we hadn't saved enough. For this reason, some pensions started to fail and go under. Social Security has a similar problem where they are not collecting enough to cover their payments in the long-term. People are always wondering when the funds are going to run out - will Social Security be around when I retire?
This idea that you can retire and live as long as you want and someone else had to figure out how to fund it wasn't going to work. So things started to change. In the 70's, individual retirement accounts (IRAs) were born. They were introduced for folks who worked at companies that didn't offer a qualified retirement plan ('cause those folks needed to retire too). People could put their own money into an investment account and get tax benefits (remember those tax discounts?) if they did - this was the government's way to incentivize people to save for their own retirements.
IRAs didn't solve the problem of the companies with pension plans who were stuck holding the bag when retirees lived too long. That came in the form of a section of the Internal Revenue Code called 401(k), also introduced in the 70's. It was originally written to level the playing field for the working middle-class because rich executives were stashing away large bonuses, tax-deferred while ordinary employees didn't have access to the same benefits. The 401(k) rules stated that regular employees should be allowed to stash tax-deferred cash too and not only from bonuses but even from regular paychecks! When they passed this law they didn't think many people were going to use it. But companies figured out, thanks to a dude named Ted Benna, that they could still offer employees the benefit of a retirement plan - in the form of a 401k savings plan (where employees save their own money into a retirement account) while getting out of the responsibility of making sure there was enough money to last a retiree's lifetime. These companies would offer this new 401k plan and use what used to be pensions funds as 'matching contributions' for employees that took them up on the 401k offer. The IRS freaked out when this 401k thing got popular because they were suddenly losing out a lot of tax money from those tax discounts. They tried to undo it but it was too late.
Back in the 70's, they thought that retirement plans would always look like pensions. Today pensions are becoming rarer and most people take part in some type of IRA or 401k (or 403b if you work for a non-profit). The most recent change to this landscape involves a law from 1997 that introduced a new flavor of IRA called a Roth IRA. This new flavor gave a different tax benefit where you didn't get a tax discount to put money in the IRA, but you never had to pay any taxes when you took the money out. For folks who started saving early, this was a HUGE tax benefit because that money had a lot of time to grow (compound interest) in that account.
And here we are today. We've gone from having no provisions for retirement to company/gov't sponsored retirement to mostly self-sponsored retirement.
The most worrying thing is that when things shifted from someone-else-sponsored retirement to me-sponsored-retirement, they didn't really prepare us for managing our own retirement funds. When companies ran pensions, they hired professionals to figure out how much to save/withhold, how to invest it and how much they needed based on the life expectancy of the plan participants. Basically, it was part of someone's full-time job to manage that money to make sure there was enough for retirement. That burden has now fallen on each of us to figure out and manage. We need to figure out how much money to set aside, how to invest that money and how much we need in total to last us through retirement.
If managing your own retirement sounds really daunting, and you don't know where to start, let me share a few basic things:
- If you don't have a retirement account, open one now.
Unless you are filthy rich or expect to receive a huge inheritance, you probably need to worry about how to provide for yourself if/when you stop working. It's never too late to start saving for retirement because every little bit will help. If your employer offers a 401k plan, open an account. If they offer matching funds, take advantage of the free money! Yes, it involves you setting aside some of your own money, but you can argue that you should probably have been setting it aside anyway. If your job doesn't offer retirement plans, then go to an investment management company (like Vanguard or Fidelity) and open an regular (traditional) IRA or a Roth IRA. If you're not sure which one, google it. There are a TON of traditional vs Roth articles out there. If you're too scared to deal with investment accounts and 401k's, just put some money in a savings account. You won't get any tax benefits if you go that route, but something is better than nothing.
- What should I invest in? Try target date funds.
Most retirement accounts have target date mutual funds available in their array of investment choices. They usually sound something like this - 'Target Retirement 2040'. Those funds will figure out how to adjust their investment mix for someone planning to retire in that year. There are many reasons not to use target date funds but one reason to use them is that some professional is tailoring the investments for the purpose of retirement so you don't have to.
- How much do I need to save in total? Start with around 25 times your salary.
It pains me to write this bullet point because the amount you need to save for retirement totally depends on a number of factors, like what your living expenses will be in retirement and how long you think you'll live. There is no simple formula, but you gotta start somewhere and this is a good place to start. If you are curious where this number comes from you can google the '4 percent rule'. If this formula is too simple for you and you want more sophisticated and personalized modeling, Personal Capital has a retirement planner tool that runs simulations based on a number of inputs you provide.
** On a total side note, why do searches for retirement always bring up pictures of beaches? My image search yielded two things - beaches and elderly folks... or elderly folks on beaches. I absolutely do not think of beaches when I think of retirement, but I ended up using this photo because it appears that this is what a lot of other folks think.
