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Why Plan for Retirement

Back in the 1950s

But then Things Changed ...

Life in the 1990s

Taxable vs. Tax-Deferred Savings

Where do I go from here?


Back in the 1950s

Back in the good ole days when life was far simpler, we worked until about age 65 and lived until roughly age 70.  In the 50s, long-term retirement planning had a negative slant consisting mostly of putting your affairs in order.  For those who did live beyond their working years, the financial aspects of retirement were typically simple.  They often had little money set aside, relying instead on a predictable stream of income from a company pension plan or Social Security and sometimes from both.   The purchasing power of their income was not much affected by inflation because inflation was low (around 2 percent per year) and retirement generally lasted less than five years.

Note:  The dollar amounts displayed along the vertical axis have been adjusted to make the purchasing power comparable for this and the following two graphs.


But then Things Changed ...

Life expectancies started increasing and people started living into their 80s.  Annual inflation rates increased.  People started retiring before age 65.  They started becoming more active in their retirement and needed more money to support their lifestyles.  To protect the purchasing power of Social Security, starting in 1950, the Social Security benefit was indexed (adjusted annually for inflation).  This helped a little, but because pensions generally were not adjusted, inflation still remained a problem.


Life in the 1990s

Today's retirees can expect to live another 20-30 years.  With improvements in medical science, it may soon be even longer.  People's expectations about retirement lifestyle have also changed.  They are no longer interested in sitting on the front porch in their rockers watching the world go by.  They want to see the world.  Social Security and pension are no longer sufficient to meet their needs.  A longer life expectancy combined with a long-term inflation rate of 4-5  percent can have a significant effect on purchasing power.  This problem is further intensified by increasing post retirement medical and health costs.

The above graphs has been drawn in terms of purchasing power.  You can also think of it as being in Today's dollars because the dollar shown in any year has the same purchasing power that it has today.    Social Security benefits are shown as a constant amount because Social Security, being indexed for inflation, maintains its purchasing power.  The decline in the purchasing power of the pension and any additional purchasing power that you may wish to have to meet your spending goals will have to be provided from personal savings.  Savings become very important if you want to maintain your current standard of living during retirement.  The problem can become even more critical because people are tending to retire earlier, at 60 instead of 65.  Apart from requiring funding for a longer retirement period this may also reduce the pension and Social Security benefits.

In the future, savings may become even more important because many companies are terminating or radically revising their pension plans.  Also, many younger companies never established pension plans, opting instead for other types of plans.  In both cases companies are often setting up defined contribution plans, such as 401(k) plans, in which you have to save money in order to get a contribution from the company.


Taxable vs. Tax-Deferred Savings

It is much better to save in a tax-deferred plan such as a 401(k) plan or an IRA than to save outside such a plan.  If you save outside a tax-deferred plan, then you currently pay tax on the amount that you put aside, as part of the tax on your earnings.  You also pay tax on any investment income.  In a tax-deferred plan, tax is deferred on the part of your earnings that you put into the plan and on any investment income; you pay tax only on the money that you withdraw from the plan.  There are some restrictions on the money you invest in a tax-deferred plan.  Primarily, you can not withdraw the funds prior to age 59½.  If you do, there is a significant penalty.  Also, the amount of your income that you can annually save in a tax-deferred plan is restricted.

The following graphs are based on the assumption that starting at age 40 you save $9,240 a year.  This is the tax-deferred amount that you were allowed to save in a 401(k) plan in calendar 1994.  (The IRS indexes this amount annually for inflation.)  Assume that you also increase your annual savings to keep up with inflation and save the maximum amount permitted.  This means that in terms of Today's dollars you save $9,240 annually.  Let us further assume that your savings plan has an annual pre-tax return of 8 percent, and your marginal tax rate is 31 percent both before and after retirement.  Then at age 65, you retire and start withdrawing money from the plan.  You live until age 90.

If you save in a taxable savings plan, then as the following graph shows, in Today's dollars you can withdraw $8,743 annually until you die.

If, on the other hand you save in a tax-deferred savings plan, then as the following graph shows, in Today's dollars you can have $15,771 annually until you die.  This amount is net of taxes and is 80 percent more than what the taxable plan provided.  As you can see, you pay tax only as you withdraw funds from the plan.  In Today's dollars this allows you to invest $9,240 every year, instead of only $6,376 [= $9,240 x (1-0.31 tax rate)] annually in a taxable plan.  Also, you do not pay tax on the investment income until you start withdrawing the funds.

We have displayed the above graphs in Today's dollars, to prevent any confusion that may be caused by the effect of inflation.  But over time, in everyday life you will have to deal with a dollar whose purchasing power keeps shrinking due to inflation.  For example, if a cup of coffee costs $1 today, when you are age 40.  With a 4 percent annual inflation, the same cup of coffee will cost nearly $2.70 by the time you retire and more than $7 by the time you reach age 90, as the purchasing power of the dollar continues to shrink.

Now that you understand the difference between Today's dollars and Future dollars, the following graphs display the same information as the prior graph, except that all the values are in Future dollars.  This permits you to see how your annual savings and withdrawals will have to grow to keep up with inflation.  You would add $9,240 to your saving in 1994, while at age 64, in year 2018, you would add $23,685 to your savings.  Similarly, at age 65 you would withdraw a net amount of $40,425 ($15,771 in Today's dollars) which would gradually increase to $107,766 at age 90 to maintain the same purchasing power.

The following graph shows how your investment balance will build up over time if you save on a tax-deferred basis versus a taxable basis.  As you can see, on a tax-deferred basis you will become a millionaire.  Though, by then a million dollars would buy you less than what half a million dollars buy you today.

It would require nearly a 50% greater rate of return on a taxable investment to generate long-term results comparable to those in our tax-deferred savings example.  You must also get away from the age-old fallacy that you can save enough in the last five to seven years before retirement to meet your objectives.  If you delay starting to save till age 55, then you will only be able to afford $4,609 annually until you die.  Current regulations do not permit saving more than $9,240 annually, in Today's dollars, on a tax-deferred basis, for most of us.  But, even if you could increase your tax-deferred savings rate to $23,100 annually, so that in 10 years you would put aside the same amount of money as you would have previously in 25 years (at $9,240 per year), you could only afford to draw $11,520 annually.  This compares to the $15,771 that you could afford if you started saying at 40.  This is the effect of tax-deferred compounding.  So you should start saving as soon as possible.


Where do I go from here?

The Price Waterhouse Retirement Planning System will help you define a retirement spending goal and then guide you in developing a strategy for achieving that goal.  You will have to make most of the subjective decisions, such as when you plan to retire, how long you expect to live, etc., while the Retirement Planning System takes away all the computational burden.  It presents the results in such a way that it is easy for you to see the impact of your decisions.

Because of its ease of use, the system encourages you to alter every variable entry, life expectancy, annual savings, inflation, investment return, etc., and see what impact it has on the life-style that you may wish to maintain after retirement.  Only you can define what you want for retirement, but this system can help you pave the way to get there.