Let’s think about retirement funding. Assume that at some time in your life you would like to a have a steady stream of income without working every day. Most people envision this happening sometime in their sixties. It doesn’t happen by accident.
For U.S. citizens, a core part of this is the national pension plan, Social Security. The amount of money we receive from Social Security is based on our best forty quarters of work. If we did not pay into Social Security for at least forty quarters, zeros will be averaged in, which will substantially lower our benefits. For me, I paid in the maximum amount from 1985 through 1995. That means my Social Security is paid up, no matter how much I made the other years.
An important determining factor of the amount of Social Security we receive is how old we are when we begin drawing from the Social Security fund. We can start any time after age 62, but the monthly amount increases for each month we wait until age 70. Some people will tell us to start as soon as possible so we get the largest number of checks over our lifetime. Others will say to wait as long as possible to increase the size of our monthly checks when they do begin. Unless we know the precise month we are going to die, these are impossible projections to make.
The Social Security system was not intended to be a person’s only income. Most of us will need an additional source of income if we want to do more than merely survive. My mother worked for Southwestern Bell, part of AT&T, for over forty years. The company provided a lifetime pension based on her salary at retirement and life-long health benefits as well. These benefits were a primary reason she worked there. The company also knew this was the best way to retain employees over a long period of time.
These types of pension plans, called defined benefit plans, are virtually non-existent in today’s world. Most of us now have to take retirement planning into our own hands. Many companies help with programs such as 401(k)s. These defined contribution programs are completely different than the old defined benefit plans. Defined benefit means you know how much you are going to get, but they have no cash value. You can’t cash them in for a large lump sum. Defined contribution means it is our money and we can put in any amount we want into a variety of financial instruments. It is still ours. What we get back depends on what we put in. Taking it out too soon can be very costly.
When I was 25 years old, I went to a seminar about a new program called Individual Retirement Accounts or IRAs, which allowed individuals to put money in an account and deduct the amount from our gross income for income tax purposes. It would then grow tax free until we took it out, presumably at retirement age. It would be taxed as ordinary income when withdrawn. The idea of money growing tax free for forty years was amazing. Compound interest has been called the “Eighth Wonder of the World” because of the incredible compounding effect.
We put in $500 into a Mutual Fund Account that first year and put money into an IRA every year after that we had income. That one thing has made all the difference in our financial lives and has given us the flexibility to make decisions based on our hopes and dreams through the years rather than limiting our lives to what our Social Security alone would be able to provide.
The best time to start saving for retirement, of course, is when we receive our first paycheck from our first job. The second best time is today. Maybe a later discussion should be about the importance of paying ourselves first.
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