Retirement funding can be a challenge, but there are steps that can be taken to reduce the negative impact of these challenges.

Retirement funding challenges and what we can do about them Optimism, however, should not be an escape from the reality of what we should do to secure the financial future of ourselves and our family. It is perfectly fine to say the glass is half-full as long as that is followed by the quest to find out what needs to be done so that the glass does not break.

The financial realities the aging baby-boomers face are very different from that of the previous generations.  The followings are few of the most important factors that make the financial security of this generation more challenging. After describing each one, I will describe what we can do to reduce the negative impacts of these challenges.

Outsourcing of jobs Globalization has caused the outsourcing of many well-paid jobs to other countries.  This trend will continue for a long time until the standard of living of the labor force of less developed countries approach that of the United States. The speed of the loss of the loss of jobs is higher than the one experienced in the previous outsourcing waves that targeted manufacturing jobs.  This is because unlike manufacturing jobs, no major capital expenditure is needed for today’s well paying jobs to be transferred abroad.  A low-cost computer, a phone and internet access is all the equipment needed for many of these jobs.  This means that displaced workers have very little time to adjust to the new paradigm.  Even someone who is able to quickly get trained in another field will have a difficult time maintaining the same income.  The resulting drop in the inflation-adjusted income of the baby-boomer is happening around the peak time of their income-producing years (45 to 55 years old).  This further complicates their retirement planning.

Actual rate of inflation experienced The second financial challenge is the rate of inflation experienced by most Americans, especially those living in high-cost regions like the Bay Area.

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by the urban consumers for a market basket of consumer goods and services.  The index lumps all the geographic areas together, so it could underestimate the actual inflation for someone living in the Bay Area. Also, it is based on a basket of goods and services that may not adequately represent the basket used by many consumers. It is also important to remember that the government has a vested interest in reporting a low CPI since billions of dollars of social security benefits are annually adjusted upward according to the CPI.

It is also important to understand that some of the expense categories such as food, energy and health care which have very little elasticity of demand (consumer cannot reduce its demand even when the prices go up) have consistently had price increases higher than CPI.

Reduction in corporate defined benefit retirement plans The replacement of the defined benefit retirement plans with the defined contribution plans (such as 401K) is a major disadvantage the retirees of the future will face. In defined benefit plans, the benefits the employee receives for life upon retirement are predetermined and fixed. With defined contribution plans, the only thing that is defined is the contributions. This transfers the investment risk from the employer to the employee.

It is crucial to recognize that even if one has adequate funds for retirement, if the investment returns during a long retirement period is lower than the actual rate of inflation the retiree experiences, there is real danger the retire will run out of funds.

Reduction in Social Security and Medicare benefits Social Security and Medicare benefits are the government sponsored versions of the defined benefit plans just discussed. With the huge budget deficits the country faces, it is likely that the future retirees will receive the same level of benefits as today.

Increase in life expectancy With the current rate of advancements being made in the medical field, it is likely that future retirees will live longer, thus need larger retirement funds.

The financial world we live in is very complex.  Sometimes it may not be clear that an action has to be taken to improve or protect you and your family financially.  Other times you might be able to make the right decision on your own, or with the help of an unbiased and competent financial professional, if you were aware of all the facts affecting your options.

Now that I have explained what challenges lie ahead, let us explore what the future retiree can do in facing these challenges.

Financial Literacy The first and most important recommendation is a genuine commitment to increase your financial literacy.  Financial literacy would make you feel better equipped to handle any financial challenges you may face.  This is true even if you are confident that you have the best financial advisor in the world.

Financial Review Next you need to identify in detail the specific weaknesses of your financial situation, as well as how to protect its strengths. It is important to have a realistic view of how much you need to retire so that you can plan your retirement age accordingly. Alternatively it could be said that it is important to have a realistic view of your monthly retirement budget given that you would like to retire at certain age. Either way, the biggest mistakes to avoid is make a highly optimistic estimate of your investment return, and having a high annual withdrawal rate. Be aware that it is not just the average return that matter, but the sequence of returns matters a lot too. If the investment return at the beginning of your retirement period is low or worst if it is negative, and high toward the end, you will have much higher chance of running out of money than if it was the other way around (high return at the beginning and low towards the end). This is true even if the average annual returns of the two scenarios are the same. One way to reduce the negative impact of unfavorable sequence of return is to have sufficient cash or near cash (investment grade short-term fixed income) investments to be used in times of low returns.

One of the most important considerations especially for couples in their sixties is determining when to file for collecting social security benefits. Social security benefits should be viewed as an extremely rare and valuable asset because it has no investment risk (other than cut in benefits due to budget deficits), no inflation risk and no longevity risk. It also has no investment management fee.

Sometime the file-and-suspend strategy might be the best one. A spouse is entitled to her own social security benefit or up to 50% of her spousal benefit (whichever is greater) assuming the other spouse has reached his full retirement age. With this strategy, both spouses file for benefits. Then the higher income spouse will suspend his benefit by filing SSA-521, Request for Withdrawal of Application. He will file again for his benefit when he is 70 (to maximize his benefit). The lower income spouse will receive up to 50% of the higher income spouse without waiting for the higher income spouse to turn seventy. If the lower income spouse is at least 62, but less than her full retirement age, the percentage would be lower than 50%, but the strategy still applies. Maximizing the higher income earner’s benefit can be a valid strategy even if the higher income earner has a short life expectancy. This is true because the strategy will increase the survivor benefit (100% of the deceased spouse or 100% of the survivor’s spouse benefit whichever is larger) for the lower income spouse.

Even if you feel confident in your ability to sort out the financial issues related to your retirement, it may be wise to get a second opinion from an independent (no affiliation with any financial institutions), Certified Financial Planner.

Always be aware of the potential conflict of interest when receiving financial guidance. As an example, if you have investment assets in a brokerage account, it is highly unlikely that the broker or the brokerage house publications will recommend that you take the money out of the account they are holding (thus reducing their revenue) to speed up your mortgage payment.