Retirement

So far in our journey we have discussed all of life milestones, in the context of Human Capital. Something that is not only different to how the “new” cult of financial independence and retire early movement thinks, but also very practical for those that like a model more customized to each individuals needs. We think of retirement, predominantly, as a time in life when our working years are behind us and we can finally hang our hat and walk out the door.

It’s a time of celebration for many, for some, it’s a time of anguish and sadness. While others, despite careful planning and a big nest egg, they feel that they don’t have it in them to hang it all and walk away. Retirement, now more-so than ever, is becoming a ‘personal’ decision, rather than one which was dictated to us by the finance professors. In the context of Human Capital, retirement comes when you primary years of working based on your profession has allowed you to unlock all of your financial capital. Sometimes that could happen earlier, given the pace of change in technology and irrelevancy of skills, and sometimes it happens later for the growth-oriented evergreen individuals. Really though, Retirement in this context, starts when you begin to draw on your financial capital, instead of your human capital. When that shift happens, whether earlier or later in life, you have officially initiated a phase in life that will be very different than when you planned for all of your financial milestones.

This time of your life requires a need to create an income stream without relying on your human capital. During the Golden Years of the past few decades, many organizations worked with the employees to help them smooth out their retirement if they dedicated their life to it. What they offered was something called the “Defined Benefit Plan.” As per the defined benefit plan, you are entitled to receive a pension that will help you transition into retirement without worrying about investments or withdrawal rates.

The way a Defined Benefit Plan works, for example, is taking the years of service, let’s say 30 years, and taking your annual earnings towards the end of your career, let’s say $100,000, and then multiplying the years with the earnings and then multiplying it again with 2%. So $100,000x30x2% = $60,000 annual pension for the rest of your life. Wow! those were the days (are for some that are still on a defined benefit plan).

In those golden days, the greater the number of years of service, the greater your salary towards the end of your career, the greater your pension! Also, this pension is guaranteed never to decline and may even increase if there’s a cost-of-living inflation adjustment built into the plan. This type of a plan created the employee that your father and grandfather were. They loved their job, they got to work on time, they gave it their all, and they never though about job hopping or a $10,000 pay raise elsewhere. These organizations had really found a way to keep their retention low and build the skill levels of their internal talent to grow companies! They also allowed the transfer to a survivor in case of an untimely death or a longevity risk of living till 95-100! Good lord!

Sadly, many employers have been cutting down on this kind of a plan and replacing with something that is completely different. In order to save money and increase the shareholder’s value, organizations and municipal governments have been replacing the Defined Benefit plan with the Defined Contribution Plan. A Defined Contribution Plan is no different than a 401k or an RRSP, a tax-sheltered saving plan that an employee contributes too and the employers matches up to a certain number, usually 5% of the contribution. Pocket change, in my opinion!

More than likely if you work in the private sector in the United States, there’s only a 15% chance that you are covered by a Defined Benefit Plan. More than likely, if you do have a plan, for the 40% of other employers, it is a Defined Contribution Plan. In the Government sector, there’s a 74% chance that you have a Defined Benefit Plan. In Canada, there’s a higher percentage of Defined Benefit Plans out there because the Public sector accounts for 19.3% versus 6.3%, in the United States. This is the main factor that, on average, more Canadian are covered by a Defined Benefit Plan. The pension plans are dying faster in the United States than in Canada, but they are dying, nonetheless!

All of this means that the liability of your old age is falling from your employer or corporate balance sheet to your personal balance sheet. This could’ve been predicted with the rise of the shareholder’s value maximization that came into effect in the 80’s.

Behavioral financial research indicates that income from a defined plan with a stable, guaranteed, lifetime source of funding, creates happier retirees. As people age, the increasing mental decline and diseases like Alzheimer’s create a need for an autopilot of retirement income fund. Whereas, those with a tax-sheltered account, experience a decreasing rate of happiness and satisfaction.

Another interesting study showed that happiness was the highest among retirees with a Defined Benefit Pension plan, moderate if you had no pension plan, and the lowest, if you had a defined contribution plan. I feel that this is due to the increasing age and need for management of the funds and how it will play out in your much older years. Again, it shows that instead of it being a corporate liability, it has become a personal balance sheet liability with yet another financial decision to manage into your retirement. It’s very sad to see the rise of Defined Contribution Plan, in place of, a defined pension.

Initially though, the Defined Contribution Plans were created due to the demand from some employees who wanted more mobility in their careers and a need to manage their own finances. The savings for corporations from this changed, essentially, changed the paradigm for everyone where the responsibility became the employees altogether.

Once you enter retirement, those who have been following the Human Capital Value series, you transition from withdrawal from your Human Capital to your Financial Capital. If you made rational forward-looking decision, you should see a smooth transition without a drop in your living standard. If, however, you have not been following the smooth consumption throughout your life, you will see a drop or a gap in your standard of living. Often, these retires wake up to realize that they have to tighten their belt to survive.

One good news for the retirees, whether in smooth consumption model or superfluous lifestyle model that they followed while working, is that they can use some of their time as currency to reduce their costs of living. As they say time is money, in retirement, you can spend your time looking for cheaper deals, go to multiple stores to purchase an item for the cheapest price, you can walk to the superstore and other life hacks to replace using monetary currency for time currency. This finding was researched by the University of Chicago and the Federal Reserve Bank to explain the 30% drop that retirees tend to experience in their spending as they transition.

The other arguments by people is the inheritance that they expect to receive as the Baby Boomer retire across North America. According to BMO Retirement Institute, Canadian’s averaged $56,000 in inheritance, while Americans averaged $64,000 from inheritance. This is pocket change and definitely not worth celebrating.

If all of this has you down and your company doesn’t offer a Defined Benefit Plan, you can still shop in the market for plans that make sense. Instead of trying to figure out everything on your own, you have a choice of buying an Annuity Plan that helps with longevity, need for planning till a very old age, protects against longevity, and offers Spousal transfer in case of an untimely death. Also, if you plan rationally, keep Human Capital Value as the framework to make all lifelong financial decisions, saving and invest money, you can create your own personal pension plan that pays out a withdrawal of 3.5-4% that can easily sustain you against all risks. We will cover retirement strategies in another article, but know that despite the corporate belt tightening, you should still continue to invest and save in a smoothed consumption pattern.