From 1946 to 1964, 78 million new Americans were born. It was a population explosion, and this generation came to be known as the baby boomers. The boomers' hard work fueled the rapid expansion of the U.S. economy over the last 40 years. Now this generation is beginning to reach retirement age. In 2006, the first set of baby boomers reached age 60, with 4 million baby boomers set to turn 60 each year after that for the next 18 years.
This huge population explosion changed the way we've come to think about retirement. Many of the safety nets that were in place for previous generations disappeared as the boomers neared retirement. A new income-generating strategy was needed, one that was very different from that of the boomers' parents. In this article, we'll review some of the reasons that retirement planing has shifted focus and discuss one possible solution. (For more on the changing face of retirement, read The Generation Gap.)
Boomers are Likely to Live Longer
Improvements in healthcare and lifestyle mean baby boomers who reach 60 in 2007 can expect to live an average of another 22.5 years. In some cases, retirement could last four decades or more. This longer life expectancy means retirement income must last longer than for any previous generation. With the increase in cost of living, boomers and those that come after them will likely need to save more than any previous generation to finance retirement. Compounding this situation is inflation, which has averaged about 3% per year in recent years and shows no sign of slowing down. What you could buy for $100 in 2004 costs $109 in 2007. (To keep inflation from whittling away at your savings, read Curbing The Effects Of Inflation.)
Lifestyle Changes May Mean More Expenses
Gone are the days when retirees were satisfied with just "getting by" in retirement. Now, boomers see retirement as an opportunity to pursue hobbies and live lifestyles that they put on hold because of work, or simply because they were cautious about depleting their nest eggs. For many, retirement is the time to buy trendy gadgets, take trips to favorite destinations and generally enjoy the fruits of their labor.
Boomers also want a more active lifestyle in retirement than previous generations. More travel, golf, tennis and volunteerism will mark the retirement activities of the boomer generation. More activity means more spending. And for many, buying that luxury car is an indulgence that can no longer be put on hold. This change in lifestyle will undoubtedly cost more than the low-key pre-retirement boomer lifestyle.
The High Cost of Health Care
A longer life expectancy also means increasing healthcare costs. Medicare premiums continue to increase each year as do the costs of private insurance. Employers are limiting their offerings of health insurance benefits for retirees. In the past, companies would provide health insurance for retirees and their families; now most larger employers are minimizing contributions to retiree healthcare insurance, or eliminating the benefit altogether. As boomers transition to retirement, many will be forced to finance their own healthcare. And with these rising costs, a lifetime of savings could be wiped out with one serious illness unless preventative measures are put in place.
Removing the Safety Net
In the past, the two primary sources of retirement were defined-benefit (DB) pension plans and Social Security. However, the number of defined benefit plans has been declining because many employers terminate the plans early. Also, few new employers adopt these plans. According to the Employee Benefit Research Institute, from 1992 to 2001, the number of family heads participating in DB plans declined from 59.3% to only 38.4%. Meanwhile, over this same period, the number of family heads participating in defined contribution (DC) plans, such as 401(k) plans, increased from 57.8% to 78.7%. (To learn more about the loss of DB plans, see The Demise Of The Defined Benefit Plan.)
So, what does this mean? While DB plans are intended to provide guaranteed income for life, DC plans are intended to build wealth for retirement, with no guaranteed source of retirement income. Thus, boomers (and their advisors) must learn how to convert savings into income that will last through retirement. The good news is boomers have contributed more to IRAs and Roth IRAs than all other generations combined. While these accounts are also intended to provide savings and wealth accumulation, they can be converted into income along with DC balances. (To learn more about Roth conversion, see Did Your Roth IRA Conversion Pass Or Fail?.)
The other source of income, Social Security, currently replaces only about 42% of income, which is substantially lower than the 70-80% replacement rate that many financial planners believe is required to avoid a drop in standard of living during retirement. The ever increasing drain on this pay-as-you-go system has created the real possibility that future Social Security benefits will replace an even smaller fraction of pre-retirement wages than they do today. Frighteningly, experts project that social security funds will be exhausted by 2040.
The New Retirement Problem: Converting Savings into Income
In the past, financial advisors and baby boomers focused their efforts on wealth accumulation. The vexing problem with living off of your savings is that no previous generation has ever had to perform this feat. Previous generations had income from pensions and Social Security throughout the retirement years - any savings were considered a bonus. They didn't have to "live on their savings" alone, so there's really no past model to learn from when it comes to converting savings to income.
The question then becomes, how much of your savings should you spend each year? If you spend too much, you may find yourself living on Social Security benefits, which won't buy very much of anything. Alternatively, if you spend too conservatively, you could deprive yourself of the lifestyle you worked for. Unfortunately, the financial experts we've relied on for so long have been trained in ways to build savings and not on the best means to access them. Therefore, converting your accumulated savings into income that you will not outlive is a challenge that you and your financial advisor will need to face together.
Create Your Own Personal Pension
To address the challenge of ensuring your income lasts throughout retirement, you may need to consider converting your savings into a reliable, guaranteed, steady income. In essence, you must replace the former company-sponsored pension with a "personal pension". The solution is finding a lifetime income vehicle with a guarantee that it will at least keep up with cost of living and inflation. But how do you create this personal pension? (To get started, see Personal Pensions: Repackaging The Annuity.)
First, find an advisor who is educated in income planning. There are new and improved asset models that help you to create your personal pension. Learning what they are and whether they'd work for you will depend on the following factors:
- Your life expectancy
- Anticipated healthcare and long-term care costs
- Cost of living and inflation
- Taxes you will owe
- The types of assets you own
- Your lifestyle (Get started by reading Asset Allocation Strategies.)
Change is brewing in retirement and income planning for the baby boomer generation due to unique factors such as a longer life expectancy and more savings than any other generation to date coupled with the need for new sources of guaranteed income.
How boomers and their advisors adapt to these changes in developing personal pensions will determine the type and quality of the boomers' retirement and, quite possibly, for the generations afterward.
For tips on converting savings to retirement income, check out Stretch Your Retirement Budget and Insure Your Retirement Income.