Alan Haft

The One-Minute Pension Manager

Most CPAs I know do a fantastic job of motivating clients to make tax deductible contributions into a retirement plan. But where are these contributions leading to?

September 20, 2010
by Alan Haft

Giving clients an idea as to where their efforts are headed not only provides a valuable service, but also educates them about how important making every possible contributions is, especially during these tough times when many people are struggling to make any type of contribution at all.

After all, understanding where your clients’ contributions are headed is especially important given that with rare exception, these days all of us are basically our very own pension managers.

But it wasn’t always this way …

A Long Time Ago in a Galaxy Far Away

A long time ago in a galaxy far, far away, there existed this wonderful thing called “pensions.” What used to take place in this world was that people typically worked for large corporations for a long time. And during those years, the companies they worked for contributed the equivalent of 15 percent of each worker’s paycheck into a pension fund. Doing so would ultimately provide their workers with an annual retirement income usually equal to 70 percent of their income during their working years.

As such, things turned out pretty good for these workers but there existed one key problem: true, the workers had monthly retirement pension checks for life but they also had little in savings to supplement it. Recognizing this, back in the late ’70s, Congress passed a law that allowed workers the ability to save a little money in a side fund forretirement and get a tax deduction as an incentive to do it. The side funds — as most of us know it today — are vehicles such as 401(k)s.

Slowly, but surely, corporations started to realize these side funds could essentially replace their costly and risky pensions. As they shifted the vehicle of retirement away from pensions to 401(k)s, the corporations no longer had to put money away, they didn’t have to manage it and they certainly didn’t have to incur expenses of doing it.

As a result, little by little most pensions of this seemingly far away world faded away and what we’re now left with today are 401(k)s that were never supposed to replace pensions but intended to supplement them.

Perhaps most troublesome is the fact that most people have been left with the responsibility of being their very own pension managers, which for most is quite an arduous task given many already have full-time jobs and families to support.

With that, you’ll do a great service to your clients to at least give them a basic idea as to where their contribution efforts are headed. After all, by reading this article, all it will take is just a mere minute to help them out.

But before we get to that one minute, it’s important to understand the framework behind it.

The Road to Retirement

Let’s first start by taking a look at an example of someone who is busy contributing money into a retirement plan:

  • A 45-year-old earning around $90,000 per year contributes $10,000 each year into a tax-deductible government-sponsored retirement plan such as a 401(k).
  • S/he consistently earns a seven percent return each year without any loss.
  • His or her account costs the average fee of 1.5 percent per year and
  • S/he retires at the cliché age of 65.

Running the math, she can expect to end up with somewhere around $350,000 in their 401(k). Now retired, they then ask themselves the question that pension managers of the past used to spend years pondering and calculating, something to the effect of: What’s the most amount of lifetime income can I get from this account without running out of money?

To answer their question it’s important to first understand what The Withdrawal Rate is. The Withdrawal Rate is a time-tested, fundamental financial planning concept that basically answers their question, and the answer is four percent of their account value.

Some might understandably ask: Why only four percent? What if they’re earning more than that?

Sure, on any given year, earnings could exceed this amount, but what about market years such as 2008 when most of mankind lost around 40 percent? The four percent benchmark provides a cash cushion for the bad years and also takes into account the cost of investing and other important elements as well.

So, going back to the example above in which the individual was accustomed to earning $90,000 per year, an ancient pension of the past would have provided them with $63,000 of annual retirement income but in the framework of a 401(k), they can now expect to receive before tax income of $15,000 per year with adjustments for inflation along the way.

Not great, and certainly nothing to write home about, but what else can we expect from a vehicle that was only designed to supplement a pension, not replace it?

The One-Minute Pension Manager

Now that you hopefully have a little understanding as to the framework behind one’s efforts, here’s where I can provide a bit of a shortcut, something I call The One Minute Pension Manager.

Using the average return of seven percent less fees of a typical retirement account at one and a half percent, all one has to do in order to provide a client with an understanding of how much before-tax income they can expect to receive at retirement is to merely know two key things:

  • How much your client is contributing per year and
  • How many years do they have until retirement

Using the concepts outlined in the example above, when knowing these answers, you don’t need to break out the HP 12-C to do the calculations. All you need to do is simply remember the following set of numbers:

1, 1.5, 2, 3

Just apply the contribution amount and years to retirement to one of the numbers above and you’ll end up with a rough idea as to how much income your client can expect to receive:

Years to Retirement Expected Income
15 1x the annual contribution
20 1.5x
25 2x
30 3x
If there’s a company match, simply increase the income above by the percentage of the match itself.

Memorizing the set of numbers above, you can bypass my long winded calculations and narrative. All you have to do is take the years until retirement (using my example, 20) and apply the contribution amount ($10,000) to the respective factor above (1.5x) and you’ll end up with a rough estimate as to how much before-tax income your client can expect to receive at retirement ($15,000).

Of course, this assumes various projections and estimates that will certainly change the outcome (such as consistently making seven percent every year), but in my experience, being the One-Minute Pension Manager has been a valuable tool in helping motivate clients to truly understand just how important making any contribution to any retirement plan is.

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Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller, You Can Never Be Too Rich, and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical and for example only.

* For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage servicesas well ascommissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.