My last two articles titled, “What Happened to the Three-Legged Stool?” and “Leveraging Both Financial Powers” address pre-retirees and the plight they face in preparing for retirement in our changing financial world. This article continues that theme.
Seniors often express concerns to me regarding their children being unprepared for retirement. Some seniors are blessed to have children experiencing significant career success and assume they are prepared, but in reality they are woefully unprepared. In short, unless one has a defined benefit pension plan common in the public sector today, then he or she is likely unaware of the plight that awaits them when deciding to hang up their spurs. This is true even if one has aggressively contributed to a defined contribution plan or IRA. The absence of actuarial science, as noted in my last article, is the elephant in the room.
To better understand this problem, let’s discuss traditional retirement planning and the pitfalls of such approaches faced by those entering retirement today, especially those working in the private sector. Most understand the importance of saving for tomorrow. Accordingly, most save in three buckets or categories. The first category is short-term savings. This would comprise liquid checking, savings and money market accounts. These resources are set aside for emergencies, opportunities or security.
The next two categories comprise long-term savings. The first is qualified savings and the later is non-qualified savings. Qualified savings relates to deposits being made to 401k, 403b, IRA’s, SEP’s, etc…
Contributions to these qualified plans are often made on a pre-tax basis and carry with them a variety of rules depending on the instrument. The qualified accounts might be related to an employer defined contribution plan, or for a self-employed person a stand alone IRA or SEP. No matter the tool, specific rules govern how money transfers in and out of such plans.
The second category of long-term savings is considered non-qualified savings. These are largely after-tax accounts or ventures, meaning the contributions to these accounts were started with after-tax dollars. These could be brokerage accounts with investments in cash, CD’s, REIT’s, stocks, bonds or mutual funds. They could also include real estate, growth or deferred annuities, and/or ownership in a private business venture.
Now that we understand traditional long-term savings, let me ask a simple question. “What is the underlying premise or purpose for all long-term savings?” Or rephrased differently, “Why does one give up current enjoyment of his or her income to save?”
I have asked hundreds of people this question and the answer is typically, “for retirement” or “for the future” or “so someday I can stop working!” While all of these answers are understandable they are not entirely correct. Shouldn’t the answer really be to generate an income stream in retirement? At some point, doesn’t one have to convert his or her savings to an income stream to replace their working income? Of course!
With this being true, doesn’t it makes sense that one should understand how retirement income streams work so savings can be directed today in strategies that can provide the highest possible income at retire? In other words, how retirement income streams work economically define how to allocate our savings today. The sooner we get on the right path the greater positive impact we can have on the results.
I would strongly suggest that most pre-retirees and advisors haven’t a clue how retirement income streams work and yet this is the central most critical issue of retirement planning. Assets are accumulated for tomorrow, but most lack an understanding of how to efficiently convert those retirement assets into a guaranteed retirement income stream putting themselves or clients at risk of running out of money!
Have I got your attention?
To help you better understand this concept, imagine you are a hiker planning a lengthy expedition to a high mountain peak. What is the hiking objective? Most amateurs say, “To get to the top.” However, isn’t the objective to get back down safely? Hiking up and down a mountain can be analogous to the topics of pre and post retirement. On the way up the mountain we are in the accumulation phase setting away assets for retirement. On the way down we are in the distribution phase where we convert or distribute those assets in the form of retirement income streams.
Like accomplished hikers, effective retirement planners see this up and down experience as one continuous journey. Expert hikers make sure they pack for the decent as well as the accent. The same is true when laying out an effective retirement plan. There are two rates that make up every person’s retirement journey and they are equally important. One is the accumulation rate and the other is the distribution rate.
Understanding how retirement income streams work defines how to pack your bag in pre-retirement. Packing your bag early and correctly in pre-retirement can translate into potentially doubling one’s retirement income and position it on a guaranteed basis. The concept of beginning with the end in mind is illustrative here. More on this process in my next article!