Signs Point to Trouble for Workers Approaching Retirement

A recent study by the Employee Benefits Research Institute (EBRI) examined balances in 401k plans. In the EBRI study, when looking at participants in their fifties with long job tenure, 45% had balances of $100,000 or more. That means that that 55% had balances of less than $100,000. In fact, approximately 10% had a balance of $10,000 or less. In a world where most workers will have to rely on their 401k accumulations for income in retirement, the lack of a significant accumulation so late in the game poses a serious challenge.

For defined contribution plans like 401(k)s and 403(b)s, early contributions have a significant impact on later balances. Although compensation tends to be highest late in a person's career, the power of compound interest over time favors earlier contributions. Assume a 25 year old earns $40,000 a year and makes an annual contribution of 1% of pay, or $400. If he earns an investment return of 7.5% per year until age 65, that single contribution will grow to $7,218 by the time he reaches age 65. If he earns 5% pay increases, he will be making $135,454 at age 50. If he waits until age 50 to start, and makes the same 1% contribution, it will now be worth $1,355 a year, but at 7.5% return, it will only grow to $4,009 by age 65, just over half of the accumulated value of the age 25 contribution.

The Retirement Equation

Once you have missed the opportunity to save early in your career, you cannot reclaim it. So what can you do if you have reached age 50 with little in 401(k) /403(b) savings? Should you resign yourself to working for the rest of your life? Is retirement a hopeless goal? The first step is to examine the retirement equation.

The retirement equation is comprised of two equal components: 1) what it costs to maintain a standard of living; 2) the sources of income to support that standard of living.

You can reach equilibrium by either reducing the cost of your standard of living or raising the sources of income. It makes sense to look at each side independently.

Your Standard of Living in Retirement

How much do you need to live on after you have stopped working? The most common answer we hear is approximately 80%-90% of preretirement income. This calculation is based on data on consumption and an examination of the financial situation of various income categories. In general, you can expect to be relieved of expenses connected with your job and you will face lower tax bills (no FICA taxes, lower taxable income, and Social Security Benefits partially taxed). In addition, you will no longer budget for saving. On the other hand, prior to Medicare eligibility, you will have to pay for your healthcare from your pocket.

These general expectations provide a starting point – you will need less in retirement, but not significantly less. On the other hand, a broad brush approach ignores your particular situation, and does not consider whether you can do anything to change your personal expenditures.

Your particular circumstances will vary based on the following:

• Are you married or single?
• How much you are saving now?
• Do you have children and do you have college costs remaining?
• Do you own a home and is it paid off?
• Would you relocate in retirement?

Next, you should consider how flexible your expenditures are, by calculating the following:

• Do you know where you spend your money now?
• Do you have a budget?
• Have you figured out how many of your expenditures are discretionary?
• Are you willing to adjust your expenditures to allow for more saving?

Understanding and controlling your current expenditures is a powerful tool, and pays dividends in two ways. First, it increases the funds available for savings that will increase your resources to provide retirement income. Second, it reduces the income that needs to be supported by your retirement resources.

Sources of Income in Retirement

You will depend on some combination of the following for income in retirement:

• Accumulations from tax deferred plans (401k, 403b, IRAs, etc.)
• Annuities from defined benefit plans
• Personal savings
• Social Security
• Inheritance
• Sale of a business

In addition, your retirement may not mean the end of all remunerative work for you. You may continue to be employed for pay, in your current job (full-time or on a reduced schedule) or in another line of work. You may be employed by choice or by necessity. While you obviously will increase the odds of working by necessity if you have under-saved early in your career, "post-retirement" employment may be essential if you need to bridge an income/expenditure gap.

Although many employees still have defined benefit pensions that provide a guaranteed income stream, these plans are declining in importance. Many existing plans are frozen so that no further benefits are earned. The typical American will eventually be relying on accumulations in a defined contribution plan, supplemented by additional after-tax savings, to provide income in retirement.

One issue is the conversion of the money you have accumulated into a reliable income stream so that you do not outlive your income. Part of that dilemma is how to invest the accumulation during retirement. Some calculations have indicated that an annual withdrawal rate of 4%-5% can be supported, in conjunction with a balanced investment portfolio, without a high risk of outliving your assets.

Many people count on Social Security, despite well known problems associated with the program. There is a long-term imbalance between the expected benefit outflows and the taxes collected to support the benefits. In order to correct this imbalance, some combination of reductions in benefits and increases in taxes will probably be required. Nothing is certain, but reductions in benefits are likely to spare those already retired or close to retirement, although adjustments could be made to the indexing of benefits.

If you will soon be retiring, the estimates that you receive from Social Security present a good idea of the income you can expect. The Social Security website also provides calculators for more precise estimates. If you are farther away from retiring, your Social Security income will be harder to predict.