Employee Education: Class 201 – “The Private Pension”

Summary:

Now that we know 401(k) lingo, history, and the general rule, we can wade a little deeper into the retirement waters.

Agenda:

Recent History
The Private Pension
When is Enough, Enough?
1. Income Gap
2. When is Enough, Enough? (today)
3. When is Enough, Enough? (retirement)
4. Needed Deferral %
Recap

1. Recent History

In decades past, companies promised their employees a continuation of their current paycheck when they retired via a company pension. This made the transition to a comfortable retirement of life and leisure as simple as could be. When an employee had earned their pension and reached the time in their life when they were ready to transition, the pension took over for the paycheck, and life went on. Simple, right?

Unfortunately, there were significant perils in this approach that have come to light over the past decades. So great were these perils that they have caused this model to crumble and, today, virtually cease altogether. The greatest peril in this approach was that someone else was in charge of your comfortable retirement and your pension was subject to their financial risks. If something went very wrong for the company, it could mean the end of your pension, and thus, the end of your comfortable retirement!

This terribly rude awakening has played out for far too many unfortunate people, and so, in time, companies and people looked for a new way to ensure that the dream of a comfortable retirement of life and leisure wasn’t at risk from the outside. Thus, the 401(k) came about.

2. The Private Pension

By this point, we know that the purpose of a 401(k) is to help you to continue to have a paycheck after you stop working so that you can enjoy a comfortable retirement of life and leisure. The 401(k) works with you to support you in retirement. To accomplish this, your 401(k) must evolve to become “The Private Pension” for you. In short, your 401(k) must transition from a pool of money to the continuation of your paycheck. This then, is how we truly answer the question from Class 101 – “How Much Should I Contribute to My 401(k)?”. We determine what we need to do to help build your Private Pension.

3. When is Enough, Enough?

Our ultimate goal here is to tell you how much you may need to defer into retirement savings like your 401(k) each year to be successful in addressing your retirement goal. In Class 101 – “How Much Should I Contribute to My 401(k)?” we said that the general rule is 10%.

Here then is where we really go under the hood for retirement and answer the most important question in retirement, “When is Enough, Enough?”.

In order to answer how much you need to be saving today, we first start from today, work into the future, and then come back to today to bring it full circle. Here’s a visualization of what is happening, and we will expand on it below:

A. Determine your Income Gap

That is to say, how much of your annual income is up to you to replace when you retire. To determine this, we take your annual income and subtract any guaranteed sources of income like Social Security or Pensions you have to determine our baseline. This is further modified by asking if you will spend About the Same, 100% of your annual income, or Less, 85%, in retirement. This then determines your Income Gap.It’s also important to note here that we are keeping everything in this step in today’s dollars. Meaning, we are not inflating anything for the future age at which you retire. That will come later.

B. Calculate When is Enough, Enough? (today)

Meaning, based on your Income Gap, how much would it take in savings for you to enjoy a normal[1] retirement today. We do this by applying the Withdrawal Principal. The Withdrawal Principal states that for a pool of money, such as your Private Pension, to last a normal retirement, studies have shown that you should tap approximately 4-5% of the total pool per year and lessen the risk of depleting your retirement savings.[2] Thus we need a pool of money large enough that your paycheck, less any pensions or Social Security you may receive, is only 4-5% of it. Put into practical terms, we use your annual income as a baseline, seeing as most people are good at spending the money they make today, and we then divide your annual income by 4% and again by 5%. Since that math is more difficult, an easier way to do it is to take your annual income and multiply it by 20 and again by 25, as this is the division we just discussed.The result of this is the savings you’d need for a normal retirement today, or When is Enough, Enough? (today).

C. Determine When is Enough, Enough? (retirement)

By inflating When is Enough, Enough? (today). Our assumption for inflation is 3%, as historically, this is about where core inflation has been. We’ll inflate When is Enough, Enough? (today) a number of times equal to the difference between your Retirement Age and your Current Age -1.This then is the answer to our first big question, “When is Enough, Enough?”! Not so bad so far, right? We’re not done yet though, so hang in there, as our final step is to take this information and bring it back to today so that you know what to do to achieve this goal.

D. Calculate Needed Deferral %.

Now that we know When is Enough, Enough (retirement), we can perform some tricky math and determine what constant % of your annual income you need to save each year to work towards your newfound retirement goal. This step is easier seen than explained, so, to make things as easy as can be, we created our most powerful tool yet, the Retirement Calculator. Give this resource a try now! Check out the Retirement Calculator for yourself and get started on your goals for your personal retirement!

4. Recap

In summary, the best answer to the question of When is Enough, Enough? is the answer you derive yourself! While the general rule discussed in Class 101 – “How Much Should I Contribute to My 401(k)?” suggest 10% as the guideline for pursuing your retirement goal, make use of our Retirement Calculator to help determine the exact number for your retirement goal!

Sources:

[1] Normal being defined as 30 years pursuant to mortality information from annuity tables by the Society of Actuaries.
[2] Fidelity Viewpoints, January 2013, “A key to a lasting retirement portfolio”, https://www.fidelity.com/viewpoints/key-to-lasting-retirement.

Tracking #1-212833 & 1-098244