In my grandfather’s generation, most middle class Americans with good jobs could count on working for a single company for thirty or forty years and then retiring at the end with nice little pensions. Those who had managed their money well and paid off their mortgages could often count on their pensions to provide a reasonably comfortable existence for the rest of their lives.
Unfortunately for workers, companies (and now some government agencies) have come to realize that funding traditional pensions (sometimes also called “defined benefit retirement plans”) is expensive and can create big liabilities when the plans are not properly managed. The net result has been a big shift towards “defined contribution” plans such as the now common and well-known 401K. With a 401K plan, a company can shift the burden of planning for the future from themselves to their employees.
So – here’s the question…can we create our own pensions, using 401K plans and other tools available to us, with characteristics similar to the pensions of our grandfather’s generation? If we could, here’s a short list of the features we would want them to have:
- Manageable contribution levels during our working years
- Generate a reasonable income in retirement
- Have a high probability of delivering the expected income
Is it possible to actually have all of those features, though? I believe that the answer is a resounding “yes”, but not without a little bit of work. Here’s what we need to do:
- Get all of our money working hard for us
- Choose the right investment options
- Diversify our investment portfolio appropriately
And here’s how to do it:
Step 1: Identify any old 401K plans (accounts with previous employers) and roll them into a self-directed IRA at any number of third-party IRA Custodians permitting alternative investments.
Step 2: Educate ourselves on the many alternative investment options with the potential to outperform traditional investment choices. Get comfortable with a particular category (for example, oil and gas master limited partnerships or real estate) and distribute our self-directed money into a carefully chosen mix of funds. Be sure to understand the fee structures, risk profiles, and return potentials of each.
Step 3: Review the investment elections in our current 401K accounts using any number of web-based tools available and re-allocate our investment choices to get the best chance of solid long-term performance. Also be sure that we are maximizing any contributions that are company-matched.
Step 4: Review investment elections for all of our cash investments, and re-allocate as noted above.
Step 5: Review our entire investment portfolio (self-directed IRA, 401K, and cash) – looking for too much overlap in any one area. Categories that can be considered different enough to provide some degree of diversification are domestic stocks, international stocks, government bonds, oil & gas, real estate, and annuities. Re-allocate choices appropriately.
A few more items to keep in mind during our portfolio review:
- Alternative investments can have better risk/return profiles than traditional investments, simply because you are competing with a smaller pool of potential investors.
- Idle cash (in any account) isn’t doing anything for us, except losing a little more value every day. Find good investments and put your money to work!
- Investing in just one category, or even two categories, provides very little protection from diversification. It’s best to have money in three or more “low-correlation” categories.
If we all were to do each of these steps, we have the potential to create our own private pensions with solid long-term performance, reasonable cash flow in retirement, and a good chance of actually being there when we need it.