Examining retirement in a changing environment


Retirement is a time when you leave your active working life. It is a time when one plans to do the things they never had the time to do, while spending more quality time with friends and family. There used to be a belief that if you worked hard and made an average amount of money annually, retirement would come naturally. You would then be able to live a lifestyle similar to the one you were able to live while working. However, this may no longer be true. Retirement is something that cannot be put into the background, but rather should be on your mind when you start your first job on your career path. It takes planning and initiative to make sure you will have the funds to support a lifestyle similar to the one you were able to live while working. People are living longer, pensions are becoming obsolete, and Social Security is running a deficit. The times have changed and people need to begin to adapt.

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There are many retirement accounts that can be taken into consideration while planning for retirement, the first of these being Social Security. The first form of Social Security, although limited, was to implement "social insurance" during the Great Depression of the 1930's. This was because poverty rates among senior citizens exceeded 50% (SSA.gov). President Roosevelt signed the Social Security act on August 14, 1935. It was an attempt to limit the hardships of American life which included old age, poverty, and unemployment.

Workers can start collecting Social Security when they turn 62 years old. However this is considered the "early retirement age" and they will not be able to receive their full benefits. The age you can retire while receiving full benefits depends on your year of birth, and ranges currently from 65-67 years old (Appendix C). Starting your benefits at age 62 will result in an approximate 20-30 percent reduction in benefits depending on your date of birth. If you were born in 1937 or earlier retiring at age 62 will decrease your benefits by 20%, if born between 1943-1954 your benefits will decrease by 25%, if born in 1960 or later your benefits will decrease by 30% (Appendix C). These are permanently reduced and will not go up as you reach your full retirement age, unless you return to work or pay back what you have already borrowed. You can also delay your retirement which will increase the benefits until you reach the age of 70. The rate will increase each month and the increase depends on your date of birth. After reaching 70 the benefit amount will stop increasing.

Social Security benefits are based on your lifetime earnings. Your actual earnings are adjusted to account for changes in average wages since the year the earnings were received. There is also a cap placed on the maximum earnings contributed to your Social Security, this cap is based on a year by year basis (Appendix D). Social Security calculates your average indexed monthly earnings during the 35 years in which you earned the most. There is a formula applied to these earnings and you arrive at your basic benefit (Appendix E). This is how much you would receive at your full retirement age 65 or older, depending on your date of birth. Social Security retirement benefits are not intended to be your only source of income when you retire, as the benefits generally average about 40 percent of your former wages (SSA.gov). Savings and other retirement accounts are expected to make up the rest of your sources of income when deciding to retire.

There are many different accounts to look into when starting to save for your retirement. These include 401 (k)'s, Traditional IRA's, Roth IRA's, SEP IRA's, Keoghs, 457's, Employee Stock Ownership Plans (ESOPs), and Defined Benefit Plans. There are many similarities with these accounts, but small differences can have a major affect on your overall retirement plan. It may seem like a daunting task to pick which account or accounts you would like to open, but a little research into the accounts, and how they act will go a long way towards a successful retirement plan. Paying attention to what is going on with your retirement accounts, whether you are looking at returns, fees, or asset allocations will also be in your best interest. Ignoring the accounts until you are close to your retirement age will leave susceptibility to surprises. The last thing needed is a surprise in the amount of money you have set aside for your retirement.

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The first of these retirement accounts is a 401(k). 401(k)'s are typically employer sponsored plans and allow employees to contribute a certain amount of their earnings to be set away in their account. The IRS limits the annual amount to $16,500, although they do not limit the monthly contribution (IRS.gov). 401(k) plans can allow additional catch-up contributions in the amount of $5,500 for employees aged 50 and over. One of the benefits with type of retirement account is that the contributions are taken out before your earnings are taxed, making it a tax deferred account. Another great benefit to this account is that the employer may set out a match amount. Although this is not required many employers will match a certain portion of your contribution to increase participation rates, so you are being paid by your company for your inclusion in their 401(k). Once the money is collected it is then sent to a third party administrator who invests in money market securities, bonds, mutual funds, etc. The employee determines the proportions in the types of investments. A drawback for this plan is if you decide to take out money before you are 59.5 years old you will have to pay the tax on it and the IRS will fine you 10% on the amount that was withdrawn.

A Traditional IRA is another popular retirement account. You are able to put $5,000 a year towards your IRA. There is a catch up phase if you are above the age of 50 and you will be able to contribute $1,000 more a year, bringing you to a total of $6,000. Money you put in a traditional IRA is generally tax-deductible no matter how high your adjusted gross income might be, unless you're an active participant in a qualified employer plan such as a 401(k), 403(b) or 457. If that is the case then there are limits that are set. The money is partially tax deductable if your adjusted gross income is in the range of $56,000 and $66,000 and not tax deductible if above $66,000. Like the 401(k) plan if you decide to make a withdrawal before the age of 59.5 you will have to pay the tax and the 10% fine charged by the IRS.

Also in the IRA family is the Roth IRA. It contrasts with the Traditional IRA as contributions are not tax deductable. Withdrawals from the account are tax free if you meet the proper qualifications. The qualifications to meet the tax free deductions are the account must have been opened for at least five years for principal withdrawals and the owner's age must be at least 59.5. Also the earnings and appreciation are tax free. To participate in a Roth IRA your modified adjusted gross income must be less than $166,000 annually for individuals who are married and file a joint tax return. $100,000 annually for individuals who are married, lived with their spouse at anytime during the year, and file a separate tax return. $114,000 annually for individuals who file as single, head of household, or married filing separately and did not live with his or her spouse at any time during the year. There are fewer restrictions on the withdrawal of the money from a Roth IRA because you have already paid the taxes upfront. For example you do not need to start withdrawing money by a set age like you would in a Traditional IRA, which forces you to make withdrawals by the age of 70.5. A Roth IRA can be advantageous if you are predicting overall taxes to increase, or your personal tax bracket to increase over the course of your savings. This is because you are paying the current tax rate when you put the money in the account and not paying the tax rate as you take the money out. The same is true for the opposite situation; if you believe the overall tax rates will decrease, or you personal tax bracket will decrease then it would not be a good idea to choose a Roth IRA because you will not receive the tax advantage.

There is also a SEP IRA. This is a retirement plan designed to benefit self employed individuals and small business owners. Sole proprietorships, S and C corporations, partnerships and LLCs also qualify. The contribution limit is $49,000. The contributions are tax deductable and investments earnings are tax deferred. This is a simplified plan which makes the administrative costs lower than other complex plan options. Other advantageous to business owners are there are no complex forms to fill out and no annual reports that need to be filed with the IRS.

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Keoughs are a tax deferred pension plan available to self-employed individuals or unincorporated businesses. A Keogh plan can be set up as either a defined-benefit or defined-contribution plan, although most plans are defined contribution. Contributions are generally tax deductible up to 25% of annual income with a limit of $47,000. Keogh plan types include money-purchase plans, defined-benefit plans and profit-sharing plans. Keogh plans can invest in the same set of securities as 401(k)s and IRAs, including stocks, bonds, certificates of deposit and annuities.

A different type of retirement plan is an Employee Stock Ownership Plan (ESOP). In this situation the company gives employees shares of their companies stock. In this case the company feels that the workers will try to improve the company because they are tied in with the company through this plan. Essentially if the company does well their plan will do well. This is seen as a positive situation as the employees are not charged any transaction costs so they are able to build up a large amount of shares over the course of their career. Also the companies contributions are tax deferred to a certain point so they also benefit. The deductibility of contributions to an ESOP becomes even more attractive when they choose to use a leveraged ESOP. Under this arrangement, an ESOP takes out a cash loan from a bank or other lender, with the borrowed funds being paid to the sponsoring employer in exchange for employer securities. Since contributions to a tax-qualified employee benefit plan are tax deductible, the employer may deduct contributions to the ESOP which are used to repay the interest and principal on the loan. This makes the ESOP an attractive form of debt financing for the employer from a cash flow perspective.

There is also a Defined Benefit Plan. This is a plan where you receive a specific amount each month when you retire. This number is figured out by a formula that takes into affect salary, tenure of service and age. This is a nice plan because there are not too many surprises when it comes to the amount that you will receive each month. The liability of the pension lies with the employer who is responsible for making the decisions. Employer contributions to a defined benefit pension plan are based on a formula that calculates the investments needed to meet the defined benefit. These contributions are determined by taking into consideration the employee's life expectancy and normal retirement age, possible changes to interest rates, annual retirement benefit amount, and the potential for employee turnover.

For many of the retirement accounts they leave it up for the investor to either choose the allocation of their funds or they funds themselves. Some of the choices will be common stock, bonds, commodities, mutual funds, exchange traded funds, and real assets. The choice of these investments depends on your time horizon to retirement and your risk tolerance. In general if you are 10 or more years from retirement you should be leaning towards more of the growth side of the spectrum and be invested in mostly common stock or mutual funds. Once you get closer and closer to your retirement age you need to begin relocating your plan assets into more income based investments like bonds and cash. There should never be a complete allocation in either direction as you need to be diversified to hedge risk. Also when your retirement year is greater than 10 years away it is important to realize that it is a long term investment, and you should not to be too worried about the short term highs and lows.

Taking a look back on the average returns on these different types of investments can also be beneficial. If you look at the average return of the S&P 500 from 1960-2010 there is an annualized return of 11% (YahooFinance). This lets you know that over the long run if you invested your money into stocks you would have an average annual return of 11%. Of course this is based on the overall average return of the whole stock market, and with risky securities like stocks, there is a good sized deviation from this average. When you look at the average annual return of mutual funds, it is estimated at a 9% annual return since their existence (Vangaurd). The average annual return on U.S. Treasury Bonds is 4.9%, U.S. Treasury Bills 4.3%, and Gold 1.4% (Dow.com). When you look at these results you may wonder why everyone does not just invest in Stocks and Mutual Funds because of their higher annualized returns. The key fact that needs to be considered is the amount of risk tolerance. The overall return may seem nice but there is more risk involved and the returns can deviate from the average. With securities such as bonds there is not as much deviation and risk involved in the investment. As stated earlier when you are early in your retirement saving process and have over 10 years until you will need that retirement money it would be beneficiary to invest in riskier securities, to be able to capture some of those larger gains. Although when you are closer to your retirement age it is better to stay on the low risk side because you do not want to get caught on a bad year or two where the returns deviate in a negative way from the average returns.

For younger generations like Generation Y Social Security no longer is something that one can count on when planning for retirement. No standard definition for Generation Y exists, but analysts generally classify anyone born from the 1980's to 2000 as members. For the first time in nearly 30 years, the system will pay out more benefits than it receives in payroll taxes both this year and next, the government officials who oversee Social Security have stated. Social Security cash flows will likely head back into the black in a few years once the economy recovers, but starting in 2015 it looks to stay in the red for the long haul, which was stated by the trustees in their annual report. With a current 9.5% unemployment, fewer Americans are paying taxes into the system and nearly 73% of Social Security filers are taking a percentage of their benefits as early as age 62, instead of waiting until the full retirement age (CNNMoney). The trustees report also stated that the Social Security trust fund will be tapped out by 2037. This has a major impact on retirement savings as you will no longer have Social Security as a guaranteed source of income once retired.

Looking at some key components it is easy to see why one might be unsure of the future of Social Security. Life expectancy is increasing faster than expected, in 1940, a 65-year-old man could expect to live another 12 years, today it's 15 years, and by 2040 it is estimated to be 17 years. The fertility rate is falling faster than expected also, from 3.6 children for a typical woman of child-bearing age in 1960, down to just 2 today and a projected 1.9 by 2020. The rate to replace the existing population is 2.1, so the rate is already below and expected to decrease. The elderly portion of the population is expected to rise from 12 percent today to 20 percent by 2050, which will cause an increase in the number of retirees from 34 million to 80 million. Social Security is a pay-as-you-go system, with each generation of workers paying the benefits of current retirees. This works fine as long as the working population grows faster than the retired population, but now that the trend has reversed, the system is simply unsustainable (National Center for Policy Analysis).

Not only does Generation Y have to worry about Social Security being there when they retire, but it also is predicted to be the first generation that incomes will not surpass their parents. The average salary has fallen 19% for 25-34 year olds compared to 35 years ago (MSNMoney). With all of these issues compiling there must be strategies to combat the problems. Generation Y has to be focused on saving more, and has to invest using their heads. One factor that some see as a future problem is the investing techniques of Generation Y. Many feel that Generation Y is too conservative when it comes to investment choices. This may be the fault of the economic turmoil that they have had to live through. So not only will this generation have to save more, they may not be getting the type of return that they should be getting with a more aggressive long term approach.

The first answer to this conundrum is pretty simple. Generation Y needs to save more money to be able to retire and maintain the lifestyle they lived while working. Then the question is how much more will they have to save? The issue now becomes more complicated. There needs to be an evaluation of how much needs to be saved with full Social Security benefits and with no Social Security benefits. At this time we are not sure of the future of Social Security so all the possibilities will have to be taken into consideration. There are also other ways to avoid some of the issues that Generation Y will have to face. One of those is when starting your career you calculate your total benefits and not be so focused on the salary. It is just as important to make sure there are retirement plan matches or pensions. This generation needs to invest using their heads, whether taking the time to look for companies that have strong track records in overcoming adversity or using the vast amount of technology and information that is at our fingertips.

Before there can be an in depth analysis of the amount that needs to be saved some assumptions need to be made. One assumption is the percentage of your income that you will receive when you retire that will let you live a similar lifestyle to the one you were living while you were working. There also needs to be an assumption on the average yearly income. An evaluation on the average life expectancy based on the year you were born to see how long you will need to support yourself once retired will also be beneficial. The average return on your retirement savings and the inflation rate will have to be forecasted also.

It is estimated that you need 70-80% of your pre-retirement income to live a similar lifestyle to the one you were able to live while working (MoneyCentral.MSN). If we look at the average median income in the past two years we arrive at $50,125 (Appendix B). If we take 70-80% of this average median we arrive at $35,088-$40,100. This is the annual amount of income that you would need to bring in if you wanted to live a similar lifestyle once retired. It is a monthly amount of $2,924-$3,342. The life expectancy is based on the year you were born (Appendix F). This is an important piece of information because you will need to have an estimate of the amount of years that you will have to support yourself once retired. This number is just an estimate as there are many other factors besides your age that will affect your life expectancy. The average annual return on retirement savings is estimated to be 9% (MSNmoney). To get an average inflation rate we can look at the past 50 years and take the average of those and that will be the expected inflation (Appendix A). We get an average inflation rate of 4.07%. This is what the actual savings will have to be adjusted by to take into affect the inflation rate.

Let's look at a 22 year old who just graduated from College and is starting on their professional career. For simplicity we will assume that they start with a salary of $50,000 dollars a year and only increases with the inflation rate. We want to calculate how much this person will need to save monthly and their total lump sum to be able to support a lifestyle similar to the one lived while working. Using the assumptions we made, and the life expectancy table we can come up with an estimated answer. First of all this person would retire at the age of 67 years old and is expected to live until the age of 84. That gives us 17 years of expected retirement. Also we have to adjust the earnings to inflation which was estimated at 4.07%. We also have to assume that 75% of their previous income will provide them with a similar lifestyle to the one lived while working. Lastly we will have to assume that they would be able to get a 9% annual return on their retirement accounts.

When all of this is taken into consideration we arrive at $105 dollars a month, and a lump sum of $1,077,902 (Appendix B). This number is with Social Security Benefits. When we calculate the totals without Social Security Benefits we arrive at $242 a month, and a lump sum of $2,494,613 (Appendix G). It is very evident that Social Security has a huge factor in the amount that needs to be saved as it more than doubled without Social Security. Also these numbers were assuming that you began saving right when you entered the workforce at age 22. This is typically not the case as many wait awhile before taking their retirement income serious. Taking this into consideration lets apply the same scenario for this person but have them wait until they are at the age of 30 to start saving for retirement.

The starting salary adjusted for inflation would be $68,800 if we start at the base of $50,000 as we did with the previous example. The monthly contribution to maintain 75% of your income with Social Security would rise to $266 a month and a lump sum of $1,287,378 (Appendix H). The monthly contribution without Social Security to maintain 75% of you income would rise to $516 a month, and a lump sum of $2,494,693 (Appendix I). It is evident from this data that waiting until you are 30 years old causes major increases in the amount that needs to be put away each month.

There are some possible solutions to this Social Security issue. Some of these possible solutions include raising payroll taxes, lowering of the benefits, rising the retirement age or privatize part of the system and let individuals invest in stocks, bonds, and mutual funds in order to attain higher rates of return on their payroll taxes. Making any change to this system causes issues because there are so many people already receiving these benefits. All of these possible solutions would stir up other issues as well. Nobody wants to have their taxes raised, there benefits decreased, their retirement age increased. When it comes to privatizing Social Security it is a double edged sword, in the way that it puts risk in Social Security in seeking greater benefits. There is a possibility that there could be a negative return and make Social Security in a worse position than it already is.