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While most workers would welcome the opportunity to earn better returns on their contribution to the retirement system, defined-contribution accounts would expose workers to a substantial hazard that their pensions would be too small to finance a comfortable retirement. When we consider the effects of inflation on the value of annuities after workers retire, the financial market risks associated with individual accounts seem even bigger. Details of the calculations. I have made calculations of the pensions that workers could expect under an individual account plan using information about annual stock market performance, interest rates, and inflation dating back to I start with the assumption that workers enter the workforce at age 22 and work for 40 years until reaching their 62nd birthdays.
I assume that the age profile of earnings in a given year matches the age profile of earnings for American men in as reported by the Census Bureau using tabulations from the March Current Population Survey. Optimistically, I assume that workers incur no expenses buying, selling, trading, or holding stocks. Even the most efficient funds impose charges equivalent to 0.
When workers reach their 62nd birthdays they use their stock accumulations to purchase a single-life annuity for males. Joint survivor annuities for a worker and spouse would be about one-fifth lower. To earn a secure return on its investments, the annuity company is assumed to invest in long-term U.
The nominal interest rate on these bonds is shown in Chart 2. These assumptions are all unrealistic. My assumptions therefore yield an overly optimistic estimate of the pension that each worker would receive. Chart 3 shows the replacement rate for workers retiring at the end of successive years from through The hypothetical experiences of 88 workers are reflected in this table. The average replacement rate was For workers retiring after the replacement rate averaged Chart 4 shows the real internal rate of return on the contributions made by the 88 workers.
This return is measured at age 62, when the worker retires. The average rate of return was 6. Workers fortunate enough to retire when financial markets are strong obtain big pensions; workers with the misfortune to retire when markets are weak can be left with little to retire on. The biggest pension shown in Chart 3 is more than 5 times larger than the smallest one.
Even in the period since the start of the Kennedy Administration, the experiences of retiring workers would have differed widely. The biggest pension was 2. Social Security pensions have been far more predictable and have varied within a much narrower range.
For that reason, traditional Social Security provides a much more solid basis for retirement planning and a much more reliable foundation for a publicly mandated basic pension. Workers typically cannot buy annuities that are indexed to the price level, as Social Security pensions are indexed. For workers who retired before World War II, prices did not always rise; in some periods, they fell. A worker receiving a level annuity receives a windfall when prices decline.
The value of his annuity rises. But rising prices rather than falling prices have been the norm since the end of the Great Depression. On average, inflation has reduced the rate of return workers would actually have obtained on their individual-account pensions. Chart 6 shows the trend in rates of return on worker contributions, when the rate of return is calculated at the age of death of workers rather than at age 62, when they first begin collecting pensions.
Notice that the average realized rate of return is 1. This simply reflects the fact that, on average, workers would have received real annuities that are less in value than was anticipated when they first began their retirements.
The debate about reforming Social Security should not rest on exaggerated claims about the potential gains workers can obtain from a shift to privately managed individual retirement accounts. Social Security provides workers with crucial protections against financial market risks.
It is worth remembering that when the system was established in , many industrial and trade union pension plans had collapsed as a result of the stock market crash and the Great Depression, leaving workers with no dependable source of income in old age.
The private savings of many households was wiped out as well. Given these circumstances, most voters thought a public pension plan, backed by the taxing power of the federal government, was preferable to sole reliance on individual retirement plans. Financial market fluctuations continue to make private retirement incomes uncertain.
The existence of these kinds of risk means that there is a continuing and crucial role for traditional Social Security, even in the case of workers who earn middle-class wages throughout their careers. Risks and returns of individual accounts Many critics of Social Security want to scale back the present defined-benefit plan and replace it partially or fully with a privately managed system of individual defined-contribution pension accounts.
Advocates of individual accounts claim three big advantages from establishing individual accounts: It can lift the rate of return workers earn on their retirement contributions. It can boost national saving and future economic growth. It has practical political advantages in comparison with reforms in existing public programs that rely on higher payroll taxes or a bigger accumulation of public pension reserves.
But first, start by learning the five steps everyone should take, no matter what their age, to build a solid retirement plan. Your current age and expected retirement age create the initial groundwork of an effective retirement strategy. Though there will be volatility , stocks have historically outperformed other securities, such as bonds, over long time periods.
Additionally, you need returns that outpace inflation so you can maintain your purchasing power during retirement. It starts out small, but given enough time, can turn into a mighty oak tree. You might not think saving a few bucks here and there in your 20s means much, but the power of compounding will make it worth much more by the time you need it.
In general, the older you are, the more your portfolio should be focused on income and the preservation of capital. You will also have less concern about inflation. A year-old who is planning on retiring next year does not have the same issues about a rise in the cost of living as a much younger professional who has just entered the workforce. You should break up your retirement plan into multiple components. You should also be rebalancing your portfolio over time as your time horizon changes.
Having realistic expectations about post-retirement spending habits will help you define the required size of a retirement portfolio. Such an assumption is often proved to be unrealistic, especially if the mortgage has not been paid off or if unforeseen medical expenses occur. Retirees also sometimes spend their first years splurging on travel or other bucket-list goals.
People are living longer and want to thrive in retirement. Retirees need more income for a longer time, so they will need to save and invest accordingly. As, by definition, retirees are no longer at work for eight or more hours a day, they have more time to travel, go sightseeing, shop, and engage in other expensive activities. Accurate retirement spending goals help in the planning process as more spending in the future requires additional savings today. Having an accurate estimate of what your expenses will be in retirement is so important because it will affect how much you withdraw each year and how you invest your account.
The average life span of individuals is increasing. Those outlays have to be factored into the overall retirement plan. Remember to update your plan once a year to make sure you are keeping on track with your savings. Once the expected time horizons and spending requirements are determined, the after-tax real rate of return must be calculated to assess the feasibility of the portfolio producing the needed income.
As you age, this return threshold goes down, as low-risk retirement portfolios are largely composed of low-yielding fixed-income securities. A primary advantage of planning for retirement at an early age is that the portfolio can be grown to safeguard a realistic rate of return. Depending on the type of retirement account you hold, investment returns are typically taxed. Therefore, the actual rate of return must be calculated on an after-tax basis.
However, determining your tax status when you begin to withdraw funds is a crucial component of the retirement-planning process. How much risk are you willing to take to meet your objectives? You need to make sure that you are comfortable with the risks being taken in your portfolio and know what is necessary and what is a luxury. This is something that should be seriously talked about not only with your financial advisor but also with your family members. Israelsen, Ph.
When the various mutual funds in your portfolio have a bad year, add more money to them. Portfolios are similar. Refuse to give in to panic. Estate planning is another key step in a well-rounded retirement plan , and each aspect requires the expertise of different professionals, such as lawyers and accountants, in that specific field.
Life insurance is also an important part of an estate plan and the retirement-planning process. Having both a proper estate plan and life insurance coverage ensures that your assets are distributed in a manner of your choosing and that your loved ones will not experience financial hardship following your death. Tax planning is another crucial part of the estate-planning process. If an individual wishes to leave assets to family members or a charity, the tax implications of either gifting the benefits or passing them through the estate process must be compared.
A common retirement-plan investment approach is based on producing returns that meet yearly inflation-adjusted living expenses while preserving the value of the portfolio. The portfolio is then transferred to the beneficiaries of the deceased. You should consult a tax advisor to determine the correct plan for the individual.
Early on, matters such as powers of attorney and wills are necessary. Once you start a family, a trust may be something that becomes an important component of your financial plan. Hebner, founder and president, Index Fund Advisors, Inc. The burden of retirement planning is falling on individuals now more than ever.
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