On Retirement

Time to replace the three-legged-stool myth

A multilevel pyramid is a better analogy for retirement income

May 26, 2013 @ 4:00 pm

By Mary Beth Franklin

It is time to retire the three-legged stool — the well-worn analogy for retirement security.

Face it: With disappearing pensions and inadequate personal savings, the remaining — wobbly — leg of Social Security makes retirement income look more like a pogo stick for many Americans.

A more apt analogy for today's version of retirement income security may be a multilayered pyramid.

I didn't come up with the new idea. The Investment Company Institute, the trade association for the mutual fund industry, did in its thoughtful white paper “The Success of the U.S. Retirement System” — a document that the defenders of the industry should have read before being skewered on the recent PBS “Frontline” program on the failings of the 401(k) system.

I think the pyramid is an appropriate image for this new era, when Americans will have to tap a variety of income sources to finance their many years, or even decades, in retirement.

The pyramid consists of five components: Social Security, homeownership, employer-sponsored retirement plans, individual retirement accounts and other assets. (If I were creating this from scratch, I would throw in part-time employment, too.)

At the base of the retirement pyramid is Social Security, which covers households across all levels of earnings. Although Social Security is the primary retirement resource for workers with low lifetime earnings, it still represents a sizable portion of income for middle- and even upper-income retirees, particularly when they are strategic about how and when they claim benefits.

HOMEOWNERSHIP

For some retirees, homeownership represents the second-most-important resource. Home equity can bolster retirement security in several different ways, including selling a home and adding the proceeds to a nest egg, tapping equity through a line of credit or reverse mortgage, or simply paying off the mortgage and living in the home, thereby reducing the amount of income needed to cover expenses during retirement.

Employer-sponsored retirement plans — both traditional defined-benefit pensions and contributory 401(k) plans — and IRAs provide a supplement to Social Security benefits for most retiree households, regardless of income or wealth.

In 2010, about 80% of near-retiree households had accrued benefits in retirement plans, according to the ICI report.

In fact, 94% of near-retiree households with income of $55,000 or more reported owning assets in retirement accounts. For many higher-income households, retirement plans and IRAs are more valuable than either their Social Security benefits or the equity in their homes.

Finally, at the top of the pyramid are other assets that a household may own, including bank and brokerage accounts, investment properties and second homes. Assets at the top of the pyramid tend to be owned by those at the top of the income heap.

For most Americans, Social Security benefits will serve as the broad base of their retirement income. The key is to teach them how to make the most of it.

The first step is to convince workers that their decisions about when to retire and when to begin collecting Social Security benefits are separate and don't necessarily have to occur at the same time.

I had a long discussion with Chris Jones recently. He is the executive vice president and chief investment officer of Financial Engines Inc., the largest independent registered investment adviser in America and the top managed-account provider for employer plans.

The company recently said that it is expanding its services to include management of IRAs.

Along with its Income+ program, the first retirement income solution designed specifically for 401(k) plans, Financial Engines is focusing on how to stretch the retirement resources of Americans of modest means. With an average account balance of just $75,000, the typical Financial Engines client isn't likely to attract the attention of many financial advisers, but advisers could benefit from the company's income strategy.

One tactic is to encourage retirees to draw down a portion of their retirement savings initially as a way of deferring Social Security benefits until they are worth more later.

In one example, Financial Engines research showed how a newly retired married couple, where the wife is 62 and the husband is 66, could boost their potential lifetime Social Security income by more than $130,000 by exercising some creative claiming strategies.

SPOUSAL BENEFITS

In the illustration, Jane claims reduced Social Security benefits at 62. At 66, her husband, Dan, files a restricted claim for spousal benefits only, collecting half of her benefit at her full retirement age (not half of her reduced benefit).

In the meantime, his retirement benefit earns delayed-retirement credits worth 8% per year between 66 and 70. At 70, Dan switches to his own benefit, locking in the maximum retirement amount as well as the maximum survivor benefit should he die first.

The challenge is to convince retirees that it is OK to spend their retirement funds first as a way to leverage a bigger Social Security payout later, Mr. Jones said.

“Figuring out how to maximize Social Security benefits is the biggest part of the retirement income puzzle,” he said, adding the 8% delayed-retirement credits are “a smoking-hot deal right now compared to anything you can find in the market.”

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