How to Retire with Enough Money

Think for a moment about the last ad you saw for a mutual fund. Did it feature a fit, salt-and-pepper-haired couple in their 60s on a terrace or a boat watching the sun set? These ads aren't selling you a mutual fund, they're selling you an ideal life. “Invest with us,” these advertisements say, “and this is what your future will look like.”

The future that many Americans see for themselves is a little different. I know, because many kinds of people write to me at my website. And they're afraid.

“I didn't work while my kids were young,” one 59-year-old woman told me, “and after my divorce I didn't have a job for more than five years. My second husband has a pension from the city, but I don't know if it is enough. I told him we have to do something.”

She's not alone in feeling this way. A lot of people realize they're in trouble. These worries can put a lot of strain on relationships. Another person wrote to me, “My wife is 64.5 and I'm 67.5. We're both retired and have a home that's paid for. We both get Social Security and have a fair amount in savings. After 41.5 years of marriage, we've learned how to discuss money and still remain reasonably calm and unemotional. I keep thinking we're rich, she's ready to go pick up soda bottles, and I suspect the reality is somewhere in between. Our two children don't need anything from us except continuing love and acceptance. My reason for writing is that I feel it's time to smell the roses, and I'd rather not fit that in while also collecting soda bottles to cash in.”

Clearly, there's a lot of anxiety out there. And a lot of people are trying to take action. They're vowing to give up going out to lunch, they're reading investment advice, and they're turning to individual, boots-on-the-ground measures to rescue their retirement plans. But what many people don't realize is this: We had help getting into the current mess. And we need help getting out.

How'd that happen? I'm glad you asked.

The traditional pension used to be the dominant model in America. Why is this significant? Because a traditional pension is a defined-benefit plan, one that guarantees a fixed amount to the retiree. Here's how it works: The employee has a mandatory deduction taken from his paycheck throughout his working life, supplemented by contributions from his employer (although in some companies, the employer alone funds the pension). The money is held in a fund and invested by a professional. Then, after retirement—and this is the key point—the employee is guaranteed a fixed-sum benefit for the rest of his life. The company has an obligation to send that monthly check no matter how the pension fund's investments perform. You can see why the choice of a financial professional to oversee the pension fund is a key hiring decision! If the pension plan's funds are poorly handled, the company will have to dip into other sources of money, such as profits, to pay off its obligations.

(A word about terminology here: The plan I've just described is what I usually call a traditional pension. But because the term is going to come up so often, I'm just going to use the word pension—so when you see it, that's what I mean.)

From the 1960s to the mid-1990s, about 75 percent of full-time American workers were covered by a pension, and it was a model that worked well for them. It gave people a guaranteed income after they stopped working. Equally important, during their careers, it allowed them to concentrate on what they did best—from building airplane engines to selling overcoats—without having to be amateur money managers in their evening and weekend hours. Finally, a not-insignificant benefit of the pension—and Social Security, as well—was that it gave retired people a reliable income, so they were able to keep spending and stimulating the economy. This was part of what made the American economy more stable in the middle of the twentieth century than it is now.

That was how retirement generally worked until the late 1970s, when an accountant noticed a provision in the tax code, implemented at the request of a large company, that allowed highly paid executives to take a tax break on deferred income. The accountant began promoting this tax provision to other companies, and the Internal Revenue Service allowed it, but only if employers allowed everyone working for the company into the plan. The idea caught on, and a new kind of retirement account was born, named for the loophole's place in the tax code—subsection 401(k).

What's important about this short history lesson is this: The 401(k) was originally supplementary in nature, a way for highly compensated executives to get a tax break on money set aside for retirement. This humbly named plan was never meant to be a replacement for traditional pensions. If it had been, it wouldn't have been given the dull name 401(k). It would have been called the Great American Pension Plan.

However, employers found the 401(k) plan to be cheaper than traditional plans. It was explained to the average employee this way: The 401(k) would give the employee freedom to invest retirement savings (or not invest—it isn't a mandatory program) as he or she chose (although the 401(k) managers and the possible investment vehicles would be the choice of the employer; employees have no say in these things), plus money put into a 401(k) account wouldn't be taxed until it was withdrawn at retirement age. Even better, often there would be matching funds from the company: 50 cents on the dollar (usually) on the 3 to 6 percent of pay that employees were allowed to contribute. That's free money! You can't beat free money!

The problem? Whereas a pension is a defined-benefit plan, a 401(k) is a defined-contribution plan. And a defined-contribution plan depends entirely on how much money an employee can afford to contribute—and remember, contributing is entirely voluntary—as well as the employer's match. How much is contributed, plus how well it is invested, determines how much money a 401(k) plan participant has after retirement. There is no fixed amount for the benefit, no guaranteed monthly check that keeps coming for the rest of one's life. When the money in the plan is gone, it's gone.

There are some inarguably nice perks to the 401(k) plan. But the employer's contribution to an employee's 401(k) is voluntary, and not all employers make one; others contribute very little. Of course, the larger problem is when employees themselves don't put any money into a 401(k). Young people earning less, and perhaps saving for a house or to start a family, might look at their paychecks and be unable to see how they could afford to put money into a 401(k). Of course, if they don't contribute at all, they get no tax break and no employer match. (And worse, no money is set aside toward retirement, a drawback that will come home to roost sooner than they think.) And the tax breaks that make these plans so attractive? They work out much better for higher earners, who can comfortably set aside the maximum contribution, thereby getting a bigger tax break and the largest possible employer match. Eighty percent of retirement account tax breaks go to the wealthiest 20 percent of taxpayers.

The move to 401(k) plans shifted most risk from the company to the worker, who now found himself the manager of a pension fund for one. Employees didn't ask for this change; neither did unions. The shift to 401(k) plans was spearheaded by big business, which was more than happy to relinquish responsibility for sending its retirees a fixed pension check every month. The tax break and the employer match were the spoonful of sugar that eased this bad medicine down the throats of the regular employees, for whom the 401(k) was a poor substitute for a defined-benefit plan.

Along with the 401(k), the Individual Retirement Account (IRA) rose to prominence during this time. IRAs provided a similar service to those who didn't have a 401(k) through their work, or who were leaving or changing jobs (but most 401(k) money ends up in these less-regulated Individual Retirement Accounts—see box).

If 401(k) plans offered a dangerous amount of responsibility and freedom to the individual worker, they at least limited choices in investments to the families of mutual stock and bond funds offered by the employer. But IRAs are really the Wild West, with the individual able to choose virtually any investment he or she wants. Want to be 100 percent in airline stocks? No problem!

Thus began what I like to call the do-it-yourself (or DIY) era of retirement planning. The DIY system works only if average people save voluntarily—sometimes at very high levels—and are savvy enough to find low-risk investments with low management fees. It requires people to keep their heads and not withdraw money during financial downturns or during personal or family emergencies. Thus, the theory goes, they'll retire having saved enough money to last the rest of their lives, regardless of how long that is or of the health problems they have in their final years.

To put it mildly, this hasn't happened. What would you expect if we were all asked to cut our own hair, install our own toilets, and do our own electrical wiring? A few of us would succeed at one of the three. But there'd be an awful lot of bowl haircuts, flooded bathrooms, and smoldering houses out there.

However, although 401(k) plans have problems, not having one is worse. So, if you have a 401(k), contribute the maximum amount and take steps to protect your money—I'll show you how.