Three-Legged Retirement Stool Wobbly for the Wealthy

February 09, 2011

By John Rafferty
Feb. 9, 2011 – I will soon turn 47. Despite feeling somewhat professionally inadequate, considering Presidents Kennedy and Clinton were my age or younger at their respective inaugurations, thoughts of my future retirement (and even my own mortality) are creeping up. You see, my father – funny guy that he is - reminded me that I am more than halfway to age 90. To quote Shakespeare, “How sharper than a serpent’s tooth it is to have a wisecracking father insensitive to the aging anxieties of his adult son.”

As a result, I decided to read my annual statement of benefits sent by the Social Security Administration to me and millions of other wage earners. I’d only given this document a cursory glance in years past, so I took a close look this year. I was particularly interested in the estimate of retirement benefits that were due me at full retirement age, which for me is age 67.

Having maxed out my Social Security contributions for a number of years, (earning in excess of the maximum taxable wage base) and thus being entitled to a fairly high level of future benefits, I was underwhelmed at how high those benefits can go. In particular, what struck me is how small the estimate of benefits was relative to my current household income. While my wife and I are certainly not independently wealthy, we are by the liberal definitions of wealth part of the demographic considered affluent. Not a terribly exclusive club these days, but fodder for conversation about retirement readiness at the very least. The movie As Good as it Gets came to mind, as it was clear to me that no matter how much I earn during my career, there is a pretty finite limit to what one can receive from Social Security.

In fact, this whole Social Security examination exercise got me thinking about the classic three-legged retirement stool, since Social Security is one of those legs. Specifically, I was curious as to whether it and the other two legs of the stool – traditional pension plans and personal savings such as qualified plans and IRAs – were adequate for higher income earners.

Taking that theme of As Good as It Gets, let’s take a look at how the three-legged stool functions in the context of a high-income earner making $250,000 a year and up. We’ll start with the first leg, Social Security.

Social Security

The fact is, if you were to retire today at full retirement age (which is now 66), $2,346 of income per month is as good as it gets in terms of what you’ll receive from Social Security. That equates to $28,152 of inflation-adjusted income per year for a single earner. To qualify for this level of income from Social Security, you need to have earnings that exceed the annual taxable wage base, which in 2009 and 2010 was $106,800. Multiply this by 1.5 if you are married and have a spouse who either didn’t work or whose Social Security benefit would otherwise be worth less than half of yours. In that case, total income from Social Security would be $42,228.

While those income numbers might seem modest, you might be surprised at the amount of lump sum you’d need to come up with to generate the same amount of income on your own. Because if you wanted to create $28,152 of inflation-adjusted, guaranteed lifetime income for a 66-year-old male just like Social Security pays, it would cost you $520,000 today if you were to purchase a single premium immediate annuity from an insurance company. That $520,000 lump sum is essentially the present value of what Social Security will provide to high-income earners in retirement. Add a non-working spouse to the mix, and to replicate the $42,228 of income of inflation-adjusted lifetime income that Social Security would provide that 66-year-old earner and spouse, it would cost you just shy of a million bucks ($986,000) to purchase a private annuity.

Think about it – if you were earning upwards of $250,000 a year and were about to retire, the best you can expect out of Social Security today is less than 20 percent of your pre-retirement income, even if you are married and your spouse gets a benefit equal to 50 percent of yours.

For high-income earners who have already discounted Social Security as a significant source of income, consider what it takes to recreate that income in terms of the lump sum required to purchase it. It’s a larger lump sum than most would otherwise think.


Continuing our theme of As Good as it Gets, let’s look at the 401(k), the second leg of the classic three-legged retirement stool. In existence since 1981, there are now close to 500,000 plans in place, with a total participant count of 50 million, totaling $2.6 trillion in assets, according to (BlackRock, Sungard to Deliver New Support for Lifetime Income within Defined Contribution Plans).

In 1987, deferral limits were put in place for defined contribution plans, and today in 2010, $16,500 is the maximum you can defer into a 401(k) plan, regardless of your income. If you are over age 50, add $5,500 for catch-up contributions. So if you make $250,000 or more, and are at least 50 years old, As Good As it Gets with respect to 401(k) deferrals is $22,000 a year, or less than 10 percent of a $250,000 annual income.

It’s hard to argue that saving less than 10 percent of one’s income each year will be adequate to the task of amassing enough wealth to generate adequate income in retirement. In fact, for high-income earners, they’ll likely need several million dollars in investment assets at retirement in order to create six-figure incomes on their own. Every million dollars of investable assets produces between $40,000 and $70,000 a year in income, depending upon what products and methods are chosen to create that income.


Now let’s move on to the third and final leg of the retirement income stool, pensions. Let’s not assume that they have completely disappeared, as many still do have pension plans. The challenge has more to do with how long today’s high-powered movers and shakers stay at jobs to maximize the value of their defined benefit plans.

To explore this, let’s compare and contrast Steady Eddy and Restless Roy. Eddy worked for the same firm – let’s call it Stuffed Shirt Corporation – for 40 years. The firm’s pension benefit formula is pretty standard. It credits 1.5 percent per year of service, and multiplies this figure by the final average salary in the last three years of service. Assuming Eddy’s final average salary was $250,000, his annual pension payment would be $150,000 per year, representing a healthy 60 percent of his pre-retirement income.

Now let’s look at what Restless Roy’s pension benefit looks like, assuming he had the exact income pattern as Eddy and the same pension formulas. The only difference between Roy and Eddy is that Roy worked for two firms in his 40-year career, spending exactly 20 years at each firm. His first 20 years at Widget Manufacturing ended with a final average salary of $125,000, which earned Roy a pension benefit of $37,500 a year using the same formula as used for Eddy. Roy’s last 20 working years were spent at Stuffed Shirt Corporation and ended with a final average salary of $250,000, netting him a pension benefit of $75,000. His combined benefit from both firms is $112,500, or 25 percent less than the pension earned by Eddy.

Keep in mind that even our Roy scenario is relatively rosy when you consider that the average tenure of U.S. private sector workers in 2006 was 3.9 years, according to the Employee Benefits Research Institute, while many defined benefit plans require five years of service to qualify for benefits.

Clearly, the classic three-legged retirement stool is a good starting point for most middle-income workers looking to build their future retirement income streams. But for the affluent earning $250,000 a year and more, additional retirement accumulation and income products are necessary. This is where the annuity industry can shine, with products like indexed annuities and deferred income annuities. Offering tax advantaged accumulation and income (if nonqualified), virtually no contribution limits, and guarantees, indexed annuities and deferred income annuities can help today’s affluent pre-retirees reinforce that third leg of the stool.

John Rafferty is vice president of marketing at American General Life Companies, American General Life is the marketing name for the insurance companies and affiliates comprising the domestic life operations of American International Group, Inc. American General Life Companies insurers offer a broad spectrum of life insurance, fixed annuities, accident and health products and worksite benefits to serve the financial and estate planning needs of customers throughout the United States.

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