Last week we discussed the changes in the way our younger generations are going to retire, based on the changeover from Defined Benefit Plans (traditional pensions) to Defined Contribution Plans, including 401(k) Plans, 403(b) Plans, IRAs, etc. The changeover was voluntary, for the most part, but the implications were not (and aren’t) clearly understood by most people. Employers reduced their long-term risk, and employees assumed that risk, although too few recognize that fact.
What should the retiring worker know, and when should he or she know it? Taking the second part first, knowing the rules and implications sooner will always beat knowing later. Knowledge is like money; more is better than less, and sooner is better than later. As to what we should all learn, it starts with a little history.
Nature abhors a vacuum, it is said. We had, and to a lesser degree still have, a vacuum of money management knowledge. When the transition to cash-based accounts began, there existed a shortage of money managers and education tools. Two primary groups rushed in to fill the void for the newly-wealthy retirees; the annuity industry and the brokerage industry. Both were eager to get their hands on this new pile of cash as people reached retirement age with a 401(k) or 403(b). Our industry, the Registered Investment Advisors, or RIAs, grew out of the brokerage industry, due to the conflicts of interest that were (correctly) perceived in the brokerage houses.
Make no mistake about the magnitude of the change in retirement planning. The days of receiving a pension payment for life are, for the most part, fading away. Today, the children of pensioners are extremely unlikely to have pensions for themselves. This is where trouble starts. We see it frequently in the perceptions among young people, who watch their parents live comfortably in retirement, and apparently without having a great deal of money. That is why we teach the concept of “equivalent net worth,” which is a term I coined several years ago to describe the pension generation.
The most common industry standard today is the 4% maximum annual withdrawal rate, which means that your “safe” income level is reached by only withdrawing no more than 4% of your nest egg annually. If you have $500,000 in a retirement account, that means limiting withdrawals to $20,000 income to stay reasonably safe. Therefore, a pensioner with a $20,000 annual pension stream has an equivalent net worth of $500,000, the amount of money required to produce an annual income of $20,000 using a 4% withdrawal rate. They may not actually have the money, but the effect is the same – a lifetime $20,000 income flow.
The problem comes when the pensioner dies, and there is no longer the equivalent pile of money. There is, quite literally, no money in the account, and upon the death of the pensioner, there is no cash flow, either. The children inherit nothing from the pension, including the parents’ lifestyle. Too many are left high and dry, as they didn’t understand the system that was keeping their parents in the style to which they had become accustomed. There is no “helping hand” for the next generation following the final pensioners.
The good news for the offspring of the 401(k) generation is that inheritance is now common. When there is an account, such as an IRA, that has been well-managed, with a reasonable rate of withdrawal over the years, there is generally money left that can be passed on to the next generation.
That does not absolve the next generation of personal financial responsibility! After all, parents have a tendency to spend a great deal of money in their final months, especially in medical costs. This is unlikely to change, and makes relying on an inheritance very dangerous. We always tell people that it is good to plan for an inheritance, but it is never good to plan on an inheritance. Too many things can go wrong, and when it is too late, it is too late.
Part of sound financial planning today is understanding that it is more likely that a person will not have a pension than to have even a small one. Only certain careers, including military and government service, and a shrinking handful of large companies, result in lifetime pensions, and even those are drying up, as risk-averse employers change over to Defined Contribution accounts. That means that the risk is being shifted to the workers, and they are far too often ill-equipped and under-informed as to the management of that risk.
The Certified Financial Planner© program developed out of the need for people to have trusted and knowledgeable financial advisors to guide them down life’s path, financially speaking. Always look for the fee-only and CFP© marks when considering an advisor. These will guarantee that your advisor is truly on your side, and that decisions will be made with your best interests at heart. While you are at it, listen to our radio show, read the blogs, and pay attention to what you read and hear around you. Naiveté is temporary, and can be vanquished by learning. Taking control of your own retirement will allow you to retire in a manner similar to your parents, but you will be likely to leave a better legacy.