Sources Of Income In Retirement

Where are you going to find income in retirement?

Well, retirement income is usually thought of as a three-legged stool; any less than three legs and you're in trouble. The legs are Social Security, your company pension, and your savings. Wait a minute; you don't have a company pension? Many people don't these days, since defined benefit plans are going the way of the dodo, but instead you may have a defined contribution plan like a 401k or 403b. Your savings are your US savings bonds, your brokerage account, or maybe your baseball card collection. Together they are your financial resources that you will tap in retirement. Let's take a quick look at each one.

First: Social Security.

Social Security will replace part of your earned income. How much it will replace depends on how long you paid into the system, how much you paid in, and the age at which you retired. Today's mid-range earner can expect Social Security to replace 41.2% of her earning power; the number for a low wage earner is 55.5%; and for a maximum wage earner is 27.3%. We can expect the benefit from Social Security to slowly reduce over time; indeed, current legislation will reduce these numbers by up to one quarter by 2030 as the retirement age increases, Medicare Part B premiums increase and more of the benefits are subject to tax. There's a good chance further decreases in benefits will have to be made because of the crisis in funding the Social Security, Medicare and Medicaid programs. We have a separate article on this topic.

The second leg of the stool is employment related plans - either defined benefit pension plans or defined contribution plans.

Defined Benefit Pension Plans

Receiving a pension year in, year out sounds great, but only about one in five of us is in such a plan. Even for those lucky few, there are four reasons why the benefit might not be as large as they hope. These are:

(1) The statements sent to participants make the future benefits look large because they are stated in future dollars, not today's dollars. Dollars in the future will be worth less due to inflation,

(2) The plans are back-end loaded - the biggest increases come in the last few years prior to retirement. If you don't make it to the end, the pension may not amount to much,

(3) Your pension payment will not increase to counter the effects of inflation. Over time, its value will erode. At a three percent inflation rate, the real value of an un-indexed pension that you start receiving at age 60 will be cut in half by age 85. If inflation were 10% it would be cut in half by age 70!

(4) Many pension plans are severely under-funded. If yours has to be bailed out by the government, you may not receive the full amount.

Defined Contribution Plans

Defined contribution plans allow you to save on a tax-deferred basis, perhaps with your employer kicking in some matching percentage. These are more popular with employers because the investment risk is shifted from the employer to the employee. That is, if the market is bad and there's not enough money in a defined benefit pension plan, the employer has to come up with the money. But in a 401k or IRA plan, when a bad market reduces the account value of the employee, it is the employee's problem, not the employer. Again there are four concerns with this kind of retirement plan:

(1) You may be overvaluing the account balance by forgetting that the funds will be taxed upon withdrawal. Next time you look at the statement, imagine Uncle Sam standing behind you, looking over your shoulder and calculating how much he is going to receive.  

(2) The plan may have excessive transaction costs, fees, loads, commissions and other implicit taxes that DC plan administrators and investment managers impose on plan assets,

(3) Most employees are not professional investors, and buy high or sell low so they receive poor returns on their money. And too many 401k participants are still too heavily invested in their own company stock.

(4) The taxable withdrawals will probably trigger taxation of your Social Security benefits.

You can hear more about tax-deferred accounts in a separate article.

The third leg of the stool is your ‘After-tax’ savings.

These are any savings you were able to make from your net income. You will have to pay tax each year on any capital gains, but at a lower rate than on regular income. The mainstream thinking is that you should put as much as possible into the tax-deferred accounts. However, for most people, this leaves little left over for the apparently low-priority after-tax savings. The money from these accounts is important because it can be used to fine tune your taxable income to try and keep you in a lower tax bracket. It plays an important role in retirement income planning, and the lack of after-tax money reduces flexibility. At Bay Area Planners, we want to see you take full advantage of any employer matching funds in your 401k, but then we emphasize after-tax savings, for the flexibility, and because we are not convinced you will actually be in a lower tax bracket after retirement if you only have tax-deferred savings.

Some other stools are designed with four legs. What else might comprise the additional leg?

Other financial resources available to you in retirement might include wages, for example from part time employment or self-employment, or the equity in your home, from reverse mortgages or downsizing the house.

The next article in this series is 'Maximizing income by minimizing taxes.'

If you would like to hear more about our thinking related to the different types of savings accounts and how to avoid taxes, call (408) 725-7135 or click here.

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