FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 4.3: Your Retirement Plan
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
Every old person that I know agrees on one thing: Getting old sucks. Your physical health tends to decline, and it is difficult to do the things you’ve always done. Physical decline is different for every person, but the vast majority of us will one day find that we can no longer work. (Or as my father put it, “If I had known I would live this long, I would have taken better care of myself”). That’s how the idea of retirement got started in the first place—people got to the point where they couldn’t work anymore. I want you to look at it differently; I don’t want you to retire because you must, but because you have so much money that your money is making more than your salary. You chose a helping profession, and you’ve served faithfully for over 25 years. You’ve done your part as a salaried employee. Retirement is the time to be your own boss. You can keep helping if you want, but you can do it on your terms and you set the hours.
Everybody knows someone that is retired and living on a “fixed income.” For most people, that fixed income is Social Security. Think of social security as a national retirement plan. You will pay into it all of your working life, and your employer will put some in there in your name (unless you are self-employed, in which case you will be sickened to find out what you owe Social Security). The money comes out of your check like any other federal government tax. Social security seems to always be in the news, and none of the news is good. It pays too little, and the program is in big trouble because there isn’t enough money to pay out benefits. Some people think that Social Security will go away entirely in a few years. I think that retired folks are too important to Congress for that to happen. What is more likely is that social security taxes will go up, and benefits will flatten so that they don’t do a good job of keeping up with inflation.
When thinking about retirement, you have to estimate how much money you’ll need, and how much you are likely to get. The Social Security Administration has a website that allows you to check out how much you rake in if you retire at different ages. This gets complex because as life expectancies go up, the age at which you can retire goes up with it. The website takes all of that into account. I plugged in my name, rank, and social security number and used $40,000 to see what a career like that would net me. The results said that if I work at that salary until I’m 62 (the earliest I can retire), I’ll take home a whopping $1,331 a month. I’ll need a roommate and have to eat Alpo to make it on that. So much for early retirement at 62! If I wait until I’m 67 (“full retirement age”), I’ll take home $1,906 per month. That number is sobering. I could not maintain my current standard of living on that amount, and that isn’t even adjusted for inflation! What is the takeaway from this sad tale? You can’t depend on Social Security alone to retire in comfort with a decent standard of living and decent healthcare. You will need more—lots more!
Work Based Retirement Plans
Back in the day, all good companies and state jobs had a pension plan. You worked, you paid into the pension plan, and when you retired, you got a check until you died. The best companies had “widow’s benefits” where a surviving spouse would continue to get a check for life. Most companies realized that running these guaranteed pension plans was a huge expense and a huge risk. They got out of the business and started participating in what has come to be known as a 401(k) plan.
A 401(k) is an employer-sponsored retirement plan. If you work for a nonprofit institution (like a university) you may have a 403(b) plan; they are the same thing, just a different paragraph in the tax code. The idea is that the employer takes money out of your check, saves it for you in the plan, and when you retire you start taking your money out. Different plans work different ways, but the idea of all plans is to invest your money so it takes advantage of the magic of compounding. Most plans have several different options as to how to invest your money. Most all of them are bad. Some of them are downright terrible! You have to know what you are doing with your money before you start one of these if you don’t want to eat Alpo when you retire.
I don’t like 401(k) plans because the investment options available in most of them are simply not very good. Most of the time your best bet is to invest all of your 401(k) money into a low-cost fund that mimics the behavior of the S&P 500 stock market index. Companies don’t manage the 401(k) plans, they “sponsor” them. They bring in outside firms to actually run the plans. Your employer gets to pick that company for you; if you work for a large business or a big public agency, you may have a couple of options. The “Representatives” of the 401(k) plan managers will try to tell you all about risk aversion and age and capital preservation. These people are just reading off a card they got from the corporate office. Don’t listen to them. Safety means poverty when you listen to these folks. Within the limits of what your employer’s plan will allow, choose the options that give you the most control over what happens to your money.
So far, I make it sound like the 401(k) system is a bad idea. It has some awesome points that make up for the annoying lack of control that you have over your money. The first big advantage is that you don’t pay taxes on money that goes into your 401(k). That means a lower tax bill at the end of the year. It also means more dollars are actually invested because your “contributions” are made before taxes are taken out. This is a very strong incentive to invest in your 401(k).
The second big advantage is that many companies and agencies have what is known as a “match.” When your company does a “match” it means for every dollar you put in, they will put in a dollar. There is always a limit, expressed as a percentage of your salary. My retirement plan, for example, allows for a 10% match. That means if I am willing to contribute 10% of what I make to my retirement plan, then the university will match that 10%. It doesn’t take a genius to appreciate how awesome this is. Free money is always good (assuming that it’s legal and ethical–this is both!).
Looking at it another way, your investment made 100% interest instantly! It would take from 5 to 10 years to do that through actual investing.
You cannot afford NOT to contribute to your 401(k) up to your company’s match.
I don’t care if you are eating beans and rice 6 night a week; stuff every free dollar you can into your 401(k)! And it gets even better; you don’t have to pay taxes on the free money either. You do have to pay taxes on 401(k) withdrawals when you retire, but that will usually be at a lower rate because you will be in a higher tax bracket during your working years. Also consider the fact that if you follow my advice, you will be a millionaire and taxes won’t be such a big deal.
So the biggest benefit of the 401(k) is the match. If your company does a match, get the max amount of free money that you can. If your company doesn’t do a match, then don’t participate in the 401(k) if they give you the option to opt out. There is a much better option for saving your retirement money if you don’t get the match.
Individual Retirement Accounts
My biggest complaint about 401(k) programs is that you don’t get many options as to how your money is invested. You get really terrible bond and annuity options, and some less terrible mutual fund options. You can pay somebody to invest your IRA money, but you can also open an IRA account with a brokerage firm and keep the person who cares the most in charge of your money: you! If you are willing to invest some time in researching investment options and teaching yourself about the investment vehicles you plan to use, then you can make a lot more money doing it yourself.
You can avoid many pitfalls of “conservative” investing by doing it yourself. Investment advisors like to say that you need exposure to bonds your whole life, with the percentage of your portfolio in bonds increasing as you age. Most of the time, bonds suck and you shouldn’t be in them. The macroeconomics of bonds dictate that at certain periods in history, they are good investments. Currently, with the Fed holding interest rates around zero, bonds don’t keep up with inflation. This is “safety” in a sense. You will not lose your initial investment in federal bonds or bond funds based on them. You will also eat Alpo when you are old if you listen to these jokers. You need to make at least 10% (on average, there will be down years) on your money. Bonds almost never do that. Markets change and you can get that kind of return on a sure thing, then go for it! Most of the time, however, you will need to be in equities (stocks) to make your millionaire dreams come true. Being in bonds if you are under 30 years old is not conservative, it’s reckless.
One of the biggest scams perpetrated on the American working public is the “target-date” fund. The idea here is that your invested money is invested more conservatively as you age. Usually, this means that a bigger and bigger percentage of your money is moving into the bond market every year. By the time you get to retirement age, your nest egg is all safely invested in very low-risk bonds. What they don’t tell you is that you are paying a hefty fee, as a percentage of your holdings, to do this “managing” for you. They also don’t tell you that as you get older, you returns are getting smaller and smaller until your money is in a massive, collective cookie jar in New York rather than the one in your kitchen. If you have a million plus dollar fund, you will only use a small fraction of that each year. At that point, having 25% of your money in bonds sounds like a good safety margin, because you can access that money if the market turns sour for a few years.
Ask yourself a simple question: Do I have faith that over time the economy of the United States of America will grow? If you answered no, then bonds and annuities may be the investment vehicles for you. My sense of patriotism may cloud my long-range forecasting, but I believe that the United States will grow and prosper over the long haul. This doesn’t mean that there will not be bad years, just that there will be enough good years to make up for and surpass the bad ones. Putting your money in an annuity basically says that you trust one financial company more than you do the entire economy of the United States.
References and Further Reading
A big part of retirement planning is trying to figure out how long you will live. That is a depressing task, but one that factors in significantly when planning your retirement. The Social Security Administration has a website that will help you determine your life expectancy and estimate your retirement benefits. You can find these services and more at the following address: