Believe it or not, we are not heading in the right direction when we look at retirement planning issues. I’m not talking about the markets here. In fact, the markets should not do so bad in the upcoming years (I’m an optimist by nature!). But Government pension plans as well as many other companies’ pension plans will let you down big time. In a few years, we will be hearing a lot of “we are sorry, but…” stories like “we are sorry, but you can’t retire today with a full pension”.
Why Government & Other Pensions Will Reneg on Their Promises
From 2003 to 2007, there was some kind of stock market party going on. The economy was booming so hard that the USA had hit its full employment capacity. Virtually, unemployment couldn’t have been lower than that. The Canadian economy was literally fueled by oil sands and everybody was eyeing the day that the barrel would hit $200. From Jan 2003 to Dec 2007, the S&P 500 jumped by 69%:
Those hyper periods on a stock market are always very dangerous for pensions. You would think that companies would benefit from such market booms. Well they did… but not the way you wish they would!
Technically, companies would continue to make their payments to their defined pension plans to ensure their employees enjoy a solid retirement. During a market boost, companies should be ahead of their plan and show a solvability ratio over 100%. But companies are greedy animals. They look at their actuarial calculations and noticed they were in advance in their pension plan contributions. What’s the best thing to do in such a situation? You guessed it right: they slowed down on the contributions. Instead of contributing to the pot, they let the market returns compensate for their contributions. There wasn’t any problem since their pension plan solvability ratio was more than healthy.
After 2008, several companies saw that same ratio head under water. To this date, roughly 75% of pension plans are still underfinanced. The thing is that over the past 5 years, the stock market is showing a 0% return. While inflation and actuarial returns were calculated, most pension plans are falling behind as they are still showing a value similar to those prior to 2008.
Government pensions are not clearly reported but you can guess that if companies have a hard time generating investment returns, it’s no different for the Government. If they don’t let you down on your pension, this will mean that they will finance your monthly payments through more debt. Here again, this is not a sustainable solution.
It’s Already Starting
What was the main reason why GM almost disappeared in 2008? There was definitely a problem in their branding but the world’s largest auto constructor didn’t fail because of bad cars. It failed because their retired employees were more numerous than their actual employees! How can you compete efficiently when more than 50% of the staff you are paying is not even working??
Over the past few years, we have seen several companies go from a defined pension plan to a defined contribution pension plan. Here’s the major difference between the two plans:
Defined pension plan: Both employees and employers contribute to the pension. Your pension amount is already known in advance. It is usually a simple calculation based on a percentage of your salary multiplied by the number of years worked. If there is not enough money in the pot to pay your pension, it’s up to the employer to cover the difference.
Defined contribution pension plan: Both employees and employers contribute to the pension. Contributions are put together to be invested. There is no way of knowing your pension amount at retirement as it solely depends on the investment return your pension account will generate. Therefore, if you hit a few bad years on the stock market, you might end-up working a few more years to build a bigger pension.
There is no question that defined contribution pension plans are a huge relief for employers as they know in advance how much the plan will cost (their bi-weekly contribution on your pay stub). If you don’t have enough to retire at the age of 65, it won’t be their problem anymore. In addition to that, this situation gives them more power over their older employees.
Aging Is Not On Your Side
An aging population comes with two majors problems when we look at retirement.
#1 People are living older and older. This means that if you stop working at the age of 65 and you live until 85 or 90, you will definitely not have enough money saved aside. You will work for roughly 35 years and try to live on your savings for 20 to 25 years. It is mathematically very hard to make this work.
#2 There are less and less people working to pay for pensions. At the moment, the 65+ population is growing at a 2.1% rate while the rest of the population is growing by a 0.8% rate. This clearly shows you that each year, there are more retired individuals counting on less employees to pay for their pensions. Do you really think that Governments can support this situation forever?
In both France and Canada, the official age of retirement to get your pension was moved from 65 to 67. I won’t be surprised to see it moved to 70 in ten years or so. The reason is simple: people are living too old these days. When the government pensions were set, people used to retire at 65 and die within 10 years. Now, they want to retire at 60 and will live until 90. This creates a huge gap in the actuarial calculations!
Inflation Is a Sneaky Enemy
The concept of inflation combined with an aging population can create disastrous situations. 50 years ago, the concept of inflation during retirement wasn’t that important. Most people would not live more than 10 years as retirees so the cost of life wasn’t increasing by that much. But now, imagine if you live 30 years as a retiree? If you need $30,000 per year at retirement, you will need $62,927 per year 30 years later to cover the same expenses! This is only at a 2.5% inflation rate!
The problem is that most defined pension plans are not covered or only half covered for inflation. This means that if you retire today with $30,000, your pension won’t be indexed to follow the increasing cost of living. At one point, you will have some problem paying for your lifestyle and will have to cut down on travel, nice restaurants or your new car…
If The Money Is Not In the Pension Plans, Where Is It?
Ahhh, that is the question! If nobody will pay of your retirement, who will pay? The money is actually in your pocket! Sorry to tell you this, but chances are that if you don’t put up your own savings, you won’t be able to aim for a comfy retirement.
By saving more money and investing it by yourself, you will become the master of your retirement. I don’t know about you but I would rather handle all the variables when it comes down to planning my retirement. This is why I’ve started my own retirement account even though I’m in a defined pension plan. I count Government and employer pensions as plan B but I want to make sure I have enough on my own to retire by my own means.
How You Can Build Your Own Pension Plan
There are several retirement accounts that can be used to create your own pension plan. In the USA, I think the Roth IRA is the best one since it gives more flexibility. In Canada, the RRSP and the TFSA are two types of accounts that can help you build some nice savings for retirement.
Then, a simple excel spread sheet can make it easy to know how much you will get at retirement. I like to keep things simple so I only take my amount of savings and use a 5% investment return (including dividend yield 😉 ).
For example, if you save $10,000 per year for 30 years at 5%, you will have $664K. Then, if you want to withdraw money for 25 years and maintain that 5% return, you can withdraw roughly 47K per year. These are very basic calculations but they give you an idea of how much you need to retire. You can also use a lower investment return such as 3% to factor for inflation.
Tactical Asset Allocation
The most important part of your retirement plan is your asset allocation. Depending on your risk tolerance and retirement needs, this will fluctuate from one individual to another. Personally, I’m better off with a 100% stock portfolio with a few “safe picks” such as KO or JNJ. I don’t expect them to grow like crazy in the upcoming years but I expect them to pay a nice and healthy dividend. These are like my bonds.
Using a bond fund or ETFs could be a very good idea if you don’t want to manage this part of your portfolio. I would personally prefer a bond fund because managers can play on bond spreads while ETFs don’t do that. With a very low interest rate environment, you will get more from capital gains generated by bond spreads than interest rates.
If you want to learn more about asset allocation, I suggest you read my first free eBook on Dividend Investing. I provide tools to find your risk tolerance and help you understand the power of asset allocation.
Make It Happens With Dividend Growth
If you haven’t read this piece, I strongly suggest you read The Power of Dividend Growth. The reason why I decided to use dividend investing to plan my retirement is the fact that dividend growth will compensate for inflation.
The key is to select companies that will increase their dividend by more than 2.5% each year. Therefore, your dividend payouts will follow the rate of inflation. At retirement, the ideal scenario would be to live off your dividends. For example, if you need $40,000 per year to live, at a 4% dividend yield, your portfolio should worth $1M. If you can achieve that, you will be able to live off your dividends for the rest of your life without having to use any capital.
The $40,000 dividend will increase by more than 2.5% and will always cover inflation. Therefore, a $1M portfolio would be the perfect scenario for someone who wants to retire without any worries. If I take my previous example where I save $10K for 30 years, a $664K portfolio would generate $26,560 per year. You will definitely earn a few bucks from a Government pension even if it won’t be the jackpot. However, it is very feasible to reach $35K by combining your dividends and government pension. As you can see, there is no magic here. However, it requires a lot of discipline to save money towards retirement… To be honest, I’ll have to put more savings aside as I’m 31 and I’m not saving 10K per year at the moment… This is definitely something I need to take control of!
Are you planning to set up your own retirement plan or are you leaving that to your government and employer?