Monday, March 26, 2012

Retirement in the 21st Century


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I'm always amazed by the number of articles that I read that discuss the impending Social Security crisis and the retirement savings crisis in the country. As the baby boomer generation starts getting into the older ages and is unable to retire, the country will have an unemployment spike involving older individuals and will have a huge public policy problem to determine how to take care of all of the would-be retirees who have either no savings or vastly insufficient savings to sustain them for the later years.

Ultimately one of the major challenges (or opportunities) is that the world has shifted to the defined contribution model for retirement (IRA, 401k, etc), but the mentality of the average individual remains the defined benefit (also known as pension). People still believe that someone, whether it is the government or a company, will cover their retirement years for them. This isn't the case... social security has all but failed fiscally, companies are restructuring and eliminating pensions, and even the state and federal government is asking people to voluntarily reduce their pension benefit. Ultimately, people are being asked to take responsibility for their own financial care and feeding.

This creates a problem for the average individual because it requires an investment of time and effort into developing strong financial literacy. Additionally, effort needs to be taken by people to understand how different financial instruments (stocks, bonds, derivatives, etc.) and how the economy as a whole works. It also doesn't help that the average financial adviser/planner subscribes to a fundamentally flawed view that retirees need to use savings in place of income in the retirement/post retirement years.

This last statement probably surprises a lot of people... "Why would he say that?"

Let's take a step back and think about the basic concepts of assets, liabilities, revenues, and expenses... or really more fundamentally stocks and flows. I'll cover assets, liabilities, revenues, and expenses in a lot more detail in future posts.

From a financial standpoint a stock is a store of value, such as cash under the mattress, in a savings account or IRA, or in a hard asset like a home. The fair market value of a portfolio can also be considered a stock. Liabilities such as credit cards, mortgages, car loans, etc. can also be considered stocks, but these stocks work against you. For the majority of people, there is a combination of both and the average American has a negative net worth from a personal financial standpoint.

Financial flows are represented by income and expenditures, these can be income from working, dividends, bond coupons, etc. Some common expenditures are debt service payments (mortgage, car loans, and credit cards, etc.) and regular bills (car insurance, health insurance, utilities, food, taxes, etc). Naturally, any surplus of income is added to an existing stock, such as the cash pile under the mattress. Any surplus in expenses reduces an existing stock or increases a negative stock (such as a credit card or other loan). Flows ultimately determine what is financially possible.

I will focus on income because it is the main determinant in purchasing power and the quality of retirement living. Income is either active (working) or passive (from direct or indirect investment). Direct investment means owning a business and investing in the tangible (machinery, etc) and intangible (customer databases, patents, trademarks) assets of the business. Indirect investment comes from owning a financial instrument or investing in a business that is not directly managed or overseen (via a board of directors seat).

So back to the retirement question, why is the strategy sold by financial/retirement advisers fundamentally flawed?

The average retirement adviser recommends substituting income through the sale of assets during retirement. This could be the partial liquidation of a stock/bond portfolio or could be something like a reverse mortgage on a home. This poses a problem because once the stock is gone, there is nothing left to use. Ultimately that same asset could be used to generate an income (use a home for rental income, reinvest in more bonds, reinvest dividends, etc.), but the main problem exists that the income generated from these assets is insufficient to support the average individual during retirement.

Ultimately, when the asset is sold, no further income can be generated from it.

The secret to comfortably retiring in the 21st century is going to be the successful creation of passive income sources and the active management of personal finances. This also requires a fundamental mind shift to think about things the way an accountant or an investment fund manager would.

I'll use this as an anchor for other posts in the series, so bookmark this page or follow my blog for the latest and greatest.

Retirement in the 21st Century

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