Wednesday, May 4, 2011

Part 3: The Two-Legged Stool: Where Will Your Retirement Income Come From?

Part 3: Tying Up a Few Loose Ends

In Parts 1 and 2, I discussed Social Security and personal savings, because they will be the two most common sources of income for most retirees.  They are not the only two sources, though, so let’s discuss some other possibilities.

Public Employee Retirement Plans

Most of us spend our entire career seeing “FICA” deductions on our pay stubs. Those are tax payments that qualify us for Social Security and Medicare benefits.  Many public employees, however, see deductions for  “Railroad Retirement”, “Teacher’s Retirement Plan”, or something similar on their pay stubs, instead.  They’re covered by a public employees retirement plan and not by Social Security. 
(If neither you nor your spouse were ever public employees, you may wish to skip this section.)
Back in the 1930’s when was Social Security was conceived, the federal government wasn’t sure it would be constitutional to tax municipalities and similar public entities, so they excluded them from Social Security and help set up separate retirement plans.  As a result, some teachers, railroad workers and other public employees are not covered by Social Security.  As I mentioned in Part 1, teachers in fourteen states currently do not participate in Social Security.  These are Alaska, California, Colorado, Connecticut, Illinois, Kentucky, Louisiana, Maine, Massachusetts, Minnesota, Missouri, Nevada, Ohio and Texas.
Of course, people can work as public employees for some of their career and in jobs that contribute to Social Security at other times, paying into more than one retirement plan over the years. Employees who are covered by a public retirement plan but have also paid into Social Security for at least 40 quarters may be eligible for benefits from both. 
Social Security benefits may, however, be reduced for those workers who held both types of employment by the Windfall Elimination Provision.  Likewise, people covered by a public pension and eligible for spousal or widow’s benefits under Social Security will have their benefits reduced by Government Pension Offset.  Both laws were intended to prevent “double-dipping” from both Social Security and a public pension.
Workers covered by a public pension plan should contact their plan provider to determine their expected benefits.  If they also paid FICA for 40 quarters for some part of their career they may be eligible for Social Security benefits, but they will also need to contact SSA or review the WEP on the Web to determine if Social Security benefits will be reduced.  Those who have a public pension and might also be entitled to spousal benefits under Social Security will need to check the Government Pension Offset to determine how much their Social Security benefits will be reduced.

Your Home

Many families have most of their wealth tied up in home equity.  Home equity is the amount of money you would have left over if you sold your house and paid off your mortgage.
Not surprisingly, homeowners planning retirement often ask if they can include their home equity as personal savings when they determine how much they can spend after retiring.  As you will recall from Part 2, a good estimate of annual spending available from personal savings is 4.46% of total savings on our retirement date.  But, does total savings include home equity?
The answer depends on what you plan to do with your home.  Retirees who plan to live in their home until they pass it on to their heirs cannot include that home equity amount in the personal savings total for purposes of estimating how much they can spend.  You can’t spend home equity until you convert it to cash and these retirees don’t plan to do that in their lifetime.
Those who plan to downsize their home in a few years and buy something less expensive or even rent a home can include some or all of home equity in the spending calculation because they will be converting that illiquid home equity into cash that they can spend in retirement.  They need only ensure that they have adequate liquid1 funding to cover their spending until they plan to sell the home. 
There are ways to turn home equity into cash without selling the home, like taking out a home equity loan or a reverse mortgage, but both methods have drawbacks. It’s harder to qualify for home equity loans after you retire and have limited income to qualify for them, they have relatively high interest rates, and they have to be paid back beginning immediately.  Your home is used as collateral and that increases the risk of losing it to foreclosure.
Reverse mortgages, or Home Equity Conversion Mortgages (HECMs) as HUD refers to them, work differently2. These are a special type of home loan that lets you convert a portion of the equity in your home into cash. Unlike traditional home equity loans or second mortgages, no repayment is required until the borrower and spouse no longer uses the home as their principal residence.
HECM’s are often criticized because they are difficult to understand and upfront fees can be expensive.
I am not recommending home equity loans or reverse mortgages, though they may be appropriate depending upon the retiree’s specific financial situation.  I am merely identifying them as potential sources of funding for retirement.
For planning purposes, it’s better to begin a retirement plan foregoing these alternatives and to simply decide if you want to spend the rest of your life in your home, as about 80% of elderly Americans say they do, or if you might prefer to sell it at some point and buy something less expensive, thereby freeing up some cash to spend.
Simply stated,

o      If you plan to live in your home for the rest of your life, you can’t count on your home equity to increase your retirement spending.  Don’t include home equity in personal savings.
o      If you plan to sell your home at some point and buy a less expensive one, you can count the cash that will be left over as personal savings and increase your annual spending by about 4.46% of that amount.
o      A reverse mortgage might allow you to spend some of the equity in your home and still live in it for the rest of your life.


I sometimes speak with clients about their retirement plans and they mention to me that they expect to inherit some money from their parents.  I recommend they be very cautious about including a presumed inheritance in their retirement plans.
There is, of course, no predicting when those inheritances might materialize. Some people live far longer than the average life expectancy for their age group and an inheritance delayed 15 or 20 years could devastate a retirement plan depending on it.
Most of us aren’t completely familiar with our parents’ financial situation.  We can’t know for sure how much wealth they might have to leave their heirs.  For many Americans, a large portion of their lifetime medical expenses will accumulate in their last year of life.  It is entirely possible that much of the wealth our parents intend to leave their heirs will be spent on health care in their final year or on long term care in their last several years.
I know a family that met with their matriarch’s executor only to learn that there simply wasn’t much left to inherit.  Unknown to most of the family, granny had co-signed a loan for one of the grandchildren a few years before her death.  The grandchild was unable to repay the loan and when she passed away, the executor was required to pay off that loan before any monies could be inherited by the family.  The payoff amount consumed most of her wealth. 
Despite the grandmother’s obvious wishes that her wealth be divided among her children and grandchildren upon her death, nearly all of her money went to the benefit of one grandchild and the other family members were left to divide up the paltry remains.  I assume grandma just didn’t understand that co-signing a loan could destroy her estate plans.
The point is that inheritances are at best unpredictable and shouldn’t be given a major role in retirement planning.  They are best considered a pleasant surprise and I wouldn’t count on them until the check is actually cashed.

A Second Career

The financial press is fond of recommending continued employment, either part or full time, as a means to address a shortfall of retirement savings or, more recently, to make up for stock market losses in the 2007 crash. 
They told you for years to invest your retirement savings in the stock market. After you did— and lost half of it— they now suggest you simply redefine retirement as a time to get another job.  It’s much more fulfilling than wasting your time on a trout stream somewhere. Besides, if you work longer, you’ll have more money to buy more stocks!
I have nothing against working for as long as you want, but I find the advice a bit disingenuous. How do you fund retirement?  Don’t stop working!
You also need to be aware that the SSA will reduce your Social Security benefits significantly if you are under full retirement age and keep working.
If you begin to receive Social Security benefits before full retirement age (66 if you were born between 1943 and 1954), continuing to work will reduce your Social Security benefits. If you were younger than full retirement age during all of 2011 and held a job or were self-employed, the SSA deducted $1 from your benefits for each $2 you earned above $14,160. If you worked and were full retirement age or older, you could keep all of your benefits, no matter how much you earned.
Continued employment at some level is a legitimate alternative to be considered, especially if you just enjoy your work or want to delay Social Security benefits to get a bigger check. 
Financing retirement by continuing to work, though, sounds a lot like not retiring to me.

The Key Points

Here are the key points to remember from Part 3:

  • Social Security and personal savings are not the only sources of retirement funding; they’re just the most common.
  • Some public employees (e.g., teachers, railroad workers, municipal employees) have separate retirement plans, don’t pay FICA, and aren’t eligible for Social Security benefits.  They need to determine expected benefits from those pensions by contacting the plan administrator.
  • Some public employees covered by a public retirement plan may also have paid FICA from other employment.  They may be eligible for both their own retirement plan benefits and Social Security benefits, but the latter may be reduced by the Windfall Elimination Provision federal law.
  • You can include home equity in your personal savings for purposes of estimating how much you can spend in retirement if you plan to sell your home and buy a less expensive one, or to rent a home If you plan to live in your home until you pass it on to your heirs, you cannot include it.
  • Don’t count on an inheritance until the check cashes. An inheritance can take many wrong turns between the best estate plan and the executor. 
  • Yes, you can fund retirement by working longer or taking a part-time job, but is that really retiring?

If You’re Playing Along at Home

If you are calculating retirement income for your own plan as we go along, you should review your calculations thus far. Data for the light blue rows can be copied from the table at the end of Part 2.
You can download a copy of this spreadsheet here.  Click File | Download As | Excel.
If you are eligible for both a public employee pension and Social Security, go to the Windfall Elimination Provision website and determine how much your Social Security benefits may be reduced.  Enter this reduction amount in row (f).
If you are pretty sure you will sell your home and buy a less expensive one after retiring, enter the surplus cash you expect in row (i).  Otherwise, enter zero in row (i).
If you included an expected inheritance in your personal savings (row h), I recommend you remove it from the total for now.
Copy entries for rows (a), (b), (c), (d) and (h) from the table in Part 2.


(a) Monthly benefits at earliest retirement age ____

(b) Monthly benefits at full retirement age ____

(c) Monthly benefits at age 70


(d) Company pension benefits


(e) Public employee pension benefits

(f) Reduction of benefits for public employees with pension and Social Security3


(g) Total annual Social Security/Pension benefits (add rows (b), (d) and (e) minus row (f) )


(h) Expected personal savings at retirement

(i) Surplus cash from downsizing current home4 or zero if you don’t plan to sell

(j) Spendable savings (add row (h) and row (i) )

(k) TIPs portfolio income. (Multiply row (j) x .0446)


(g) Total expected retirement income at full retirement age. (add rows (g) and (k) )

[1] Liquid assets are assets easily and inexpensively converted into cash, like stocks, bonds, CD’s and mutual funds.
[2] Additional information on reverse mortgages is available at American Bar Association and U.S. Department of Housing and Urban Development.
[3] Reductions due to Windfall Elimination Provision for employees covered by both Social Security and a public pension, or by Government Pension Offset for public employees with Social Security spousal benefits.
[4] (Market value of current home x 0.94) - (expected cost of new home).  0.94 accounts for 6% closing cost on sale of home.

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