Sunday, January 4, 2015

This Blog's Not For You!

There is a generational schism in this country today - those with defined-benefit pension and the new 401(k) generation.

I recently received an e-mail from a retired teacher.   Teachers are the last of the "defined benefit pension" class of Americans, and many of them are making, well, pretty hefty amounts of money, both in terms of salary and retirement.

Yea, I know, you've heard about "underpaid teachers" and what saints they all are, your whole life.   But over the last 20-30 years, that has changed, in a number of parts of the country, many teachers - and school administrators - are taking home six-figure salaries, either by themselves (e.g., in New York State) or as a husband-and-wife couple.  In case you were late for class, that is an awfully large amount of money - about three times the national median, and twice the national average for household income.

And as retirees, they can take home 70-75% of that - or even more (if they choose to work longer) which means a defined benefit pension well into the six figures for the rest of their lives which can be a long time, if you started teaching at age 25 and retired at age 55.   And usually there are cost-of-living increases with these pensions as well.   So they never have to worry about running out of money or inflation eating away at their retirement.

(And now you understand why there was such a brouhaha in Wisconsin over collective bargaining for public service employee's unions.  The unions are still doing a good job of selling many Americans on the "underpaid teacher" myth - but in many parts of the country, school teachers are making more than Doctors and Lawyers - and other public service employees are not far behind!  This in turn is driving up property taxes to the point where some cities are going bankrupt).

For teachers with defined-benefit pensions, this blog might not be so useful.   Why is this?   Well, I am part of the 401(k) generation, and as such, we have to save up money for retirement which at first seems like a good deal.   However, you realize, particularly as retirement approaches, that having a pile of money is often not as attractive as having  a guaranteed income stream in retirement.

To begin with, we don't know how long we will live - so the 401(k) retiree has to worry, constantly, whether his money will outlive him.   If you spend a dollar today, well, that means you might not have that dollar ten years from now, when you need it.   Every spending decision becomes agony.

For the pensioner, so long as their monthly expenses are less than their monthly income, all is well.

For the 401(k) retiree, having debt makes no sense - you have to service that debt with income, and that means taking more money out of your 401(k), which in turn puts you in a higher tax bracket.

For the pensioner, with a six-figure retirement salary, debt is not as bad, as they can deduct home mortgage interest and thus reduce their tax burden.

In other words, what works well for the 401(k) retiree often doesn't work as well for the pensioner, and vice-versa.

And the funny thing is, a 401(k) retiree and a pensioner can have wildly different financial scenarios, and yet lead roughly the same lifestyle.

For example, consider this contrast between a Pensioner and a 401(k) retiree.

Pensioner and his wife are retired school administrators, taking in a whopping $148,000 a year in pension.   In order to generate an equivalent amount of income, they would have to have saved up $3,000,000 in savings.   Pensioner doesn't consider himself a millionaire, but is one, three times over.  However, in terms of actual savings, he has only $50,000 in the bank - which is less than the vaunted "six-months salary" that most financial advisers advise.  On the other hand, as a retiree with a pension, what does he need cash for.

Pensioner has a mortgage, a home improvement loan, and a car loan, with monthly payments totaling a whopping $4123 a month (!!!).  This leaves them "only" $8277 a month to spend on mad money.

The 401(k) retiree has "only" a million in savings - but has no debts whatsoever, including a home that is paid-for.   Thus, his monthly debt-service is, well, zero.   With Social Security (which our Pensioner does not get) and using the 5% rule on a million in savings, he has a retirement income of "only" $76,000 a year.   This equates to about $6300 a month to spend.

Pensioner, however, has a huge tax bill to pay - in the 25% bracket and perhaps above.   So he needs every deduction he can find to bring that bill down.   Sadly, since he is looking at the tail-end of a mortgage, his deductions will dwindle during retirement (all together now, "awwww!")

The 401(k) retiree, however, is only taxed on the amount he chooses to take out of his 401(k) every year that is until age 70-1/2, when you are forced to take out a certain amount (which really isn't an issue, as the amount is less than most people take out anyway).   So the 401(k) retiree might end up paying little or nothing in taxes.

The net result is, they may end up with similar levels of lifestyle.   The big difference is, of course, that the Pensioner has no worries about "running out of money" during his lifetime, unless, of course, his pension is from a private corporation that goes bust (or is bought by Mitt Romney).

Of course, the Pensioner would be way out ahead if he were debt-free - another $5000 a month to spend on world cruises or whatever.  Having no debt is better than having a deduction.   But with a defined-benefit pension of his size, the amount of debt he has is "manageable" and not a threat to his livelihood.

He does, of course have a government pension which is fairly secure.  Even for towns and cities facing bankruptcy, the significant loss of a portion of a pension is not likely.   Detroit pensioners are looking at cuts of 5-10% of their pensions, which is an amount anyone should be able to swallow.   Others in the private sector have lost more than half, in some instances, due to malfeasance on the part of their employers.  Like I said, the Pensioner is a dying breed.   In 10-20 years, I suspect that starting school teachers will be getting 401(k) type programs, leaving pensions only to Presidents and Congressmen.

For the 401(k) generation, the rules have all changed and they are completely different.   In order for our 401(k) retiree to "afford" the debt load of Pensioner, he would need at least $3M in the bank to generate the income needed to service the debts and maintain the same lifestyle.   This in turn would place him in a higher tax bracket, negating the tax advantages of the 401(k).   Moreover, he would now be taking a risk that his portfolio would not sag or drop (as it did in 2009) and his house would not drop in value to less than the mortgage amount (as they did in 2009).   As a retiree, such events can be catastrophic.

As a 401(k) retiree, you are far better off having no debt and thus have no need for a huge income and thus pay a lot less in taxes.

And that is who this blog is directed towards.    If you are fabulously wealthy (like our pensioner friend, who oddly enough doesn't think of himself as "rich") then maybe cutting costs and reducing debt isn't as important as it is to those of us who have to live on our savings.

But then again, one does hear, time and time again, about people who claim to be going broke, even on incomes of $150,000 a year or more.   It all comes down to spending versus income.   And perhaps, in that regard, this blog might be of some use.