The ‘Three-Legged Stool’ of Retirement: Is it Still Relevant Today?May 25, 2023 May 26, 2023 /
The “three-legged stool” is a classic metaphor in retirement planning. It represents a well-balanced retirement plan based on three distinct income sources: Social Security, employer pension plans, and personal savings.
Each “leg” is intended to provide stability and security, ensuring that retirees can comfortably support their post-work lives. However, for those on their path to financial independence, there is a solution to the diminishing availability of the three-legged stool of retirement approach.
But how did this model come about, and does it still hold relevance in today’s changing financial landscape?
Understanding the ‘Three-Legged Stool’
Before we delve into the evolution and current viability of the three-legged stool model, it’s crucial to understand each leg’s purpose and importance.
The idea behind this model is to build a retirement strategy that balances three distinct income sources.
1. Social Security
The first leg of the stool, Social Security, was introduced in 1935. It is a federal program that provides a steady stream of income for retirees:
- Dependent on earnings history: The benefits you receive from Social Security are primarily determined by your earnings history. The Social Security Administration calculates your benefits based on your 35 highest-earning years.
- Age of benefits initiation: The age at which you start receiving benefits also influences the amount you receive. While you can begin taking Social Security benefits as early as age 62, doing so reduces the monthly benefit amount. Delaying benefits until full retirement age (typically between 66 and 67) or even later increases your monthly benefit.
2. Employer Pension/Retirement Plans
The second leg, employer pension or retirement plans, has historically been a crucial source of retirement income:
- Defined benefit plans: Traditional pensions, also known as defined benefit plans, provide a fixed, pre-established benefit for employees upon retirement. The benefit amount typically depends on factors like length of employment and salary history.
- Defined contribution plans: These plans, like the 401(k), involve the employee making regular contributions. The employer may also contribute, often matching the employee’s contributions up to a certain percentage. The future benefits depend on the contributions made and the performance of the investment options chosen.
3. Personal Savings/Investments
The third leg consists of personal savings and investments that individuals set aside for retirement:
- Individual Retirement Accounts (IRAs): These are tax-advantaged accounts designed specifically for retirement savings. There are different types of IRAs, including traditional IRAs, Roth IRAs, and more, each with unique tax benefits and rules.
- Other personal savings and investments: This can include savings accounts, stocks, bonds, mutual funds, real estate, and other investment vehicles. The idea is to create a diversified portfolio to spread risk and maximize potential returns.
Each leg of the three-legged stool plays a vital role in providing financial stability in retirement.
By combining Social Security, employer-sponsored retirement plans, and personal savings/investments, retirees aim to secure a comfortable and sustainable lifestyle post-retirement.
The Evolution of the ‘Three-Legged Stool’
The three-legged stool model emerged post-WWII, a time when defined benefit pensions were prevalent, Social Security was robust, and personal savings were encouraged.
This model rested on the premise that a balanced blend of these three sources could provide a reliable, steady income in retirement.
However, the retirement landscape has drastically changed over the decades.
Employer-sponsored pensions have been replaced by 401(k) plans and other defined contribution plans, transferring the investment risk from the employer to the employee.
And the future of Social Security is under constant debate, leading to increased uncertainty.
The Modern ‘Three-Legged Stool’: Is it Still Relevant?
The evolving retirement landscape has undoubtedly affected the stability of the traditional three-legged stool model.
As pensions become rarer and uncertainties surrounding Social Security persist, many question whether this model is still applicable.
However, while these changes pose challenges, the core tenets of the model—diversification and balance—remain crucial to retirement planning.
1. Shifts in Pension Availability
Historically, pensions played a significant role in providing financial security for retirees. However, this has shifted dramatically in recent years:
- According to the Bureau of Labor Statistics, only 14% of private-sector employers offered a defined benefit plan (traditional pension) to new hires in 2018, down from 38% in 1979.
- Additionally, in 2020, only 13% of private-sector workers participated in a defined benefit plan, compared to 38% in 1980.
These shifts indicate a trend towards defined contribution plans, like 401(k) plans, and away from traditional pensions.
2. Uncertainty Surrounding Social Security
The future of Social Security is a constant topic of debate, adding to the uncertainty:
- The Social Security Board of Trustees reported in 2023 that under the current law, trust fund reserves would become depleted in 2034. After depletion, continuing income to the funds would be sufficient to pay 79 percent of scheduled benefits.
- As of 2021, Social Security replaces about 40% of an average-wage worker’s income after retiring, and most financial advisors say retirees will need about 70% or more of pre-retirement earnings to live comfortably.
3. Adapting the Model to Modern Realities
Despite these challenges, the three-legged stool model can still be a valuable blueprint for retirement planning, provided it is adapted to today’s realities. Here’s how:
- Increase personal savings: With the dwindling presence of pensions and uncertainties around Social Security, personal savings and investments become more crucial than ever. This implies saving more assertively and exploring different investment avenues.
- Maximize employer-sponsored retirement plans: Make the most out of 401(k) plans or similar employer-sponsored retirement plans. Aim to contribute enough to qualify for any employer match, effectively leveraging ‘free money’.
- Consider alternative income sources: Look for alternative income sources in retirement, like rental income or part-time work. Diversification remains key to a stable retirement plan.
- Delay Social Security Benefits: If possible, consider delaying Social Security benefits until full retirement age or even later. This delay can significantly increase your monthly benefit.
While the traditional three-legged stool model has faced changes and challenges, its central premise remains relevant.
It’s crucial to adapt your retirement planning to reflect these changes and ensure a balanced and diversified retirement income.
Three-Legged Stool is Evolving with the DIY Pension
Without a pension, you might feel like your stool is missing a leg. One strategy to mitigate this is by saving more assertively to effectively create your own “DIY pension.”
This approach requires disciplined savings and strategic investments to build a sizable retirement nest egg.
One popular strategy popularized by those pursuing financial independence, is to adhere to the 4% withdrawal rate rule. This rule suggests that if you withdraw 4% of your retirement savings in the first year and adjust the amount annually for inflation, your savings should last for 30 years.
In essence, by following this rule, you can create a steady income stream, much like a traditional pension.
Stability is What Matters!
While the three-legged stool of retirement may look different today, its core principle remains the same: diversification. A well-rounded retirement plan should not rely on one source of income.
Even with the changing retirement landscape, by adjusting your strategy and saving diligently, you can still construct a sturdy, balanced “stool” to support your retirement years.
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