Turns out that the shift from benefits to contributions has caught the unaware and unobservant off guard.
Long ago families lived near each other and took care of each other. With industrialization across the globe families began to move to industrialized centers (which became cities) and family care began to shift towards people needing to care for themselves. Society (globally) kicked in and benefits set up to take care of old age issues like heath and retirement. However, such shifts take time and those caught early in the problems got left behind … a trend that always happens and is catching those retiring today because recognizing the second shift, discussed next, was also slow.
Now, funding those benefits is becoming a problem because the size of the population of those who need the benefits has grown. Benefits become harder, and may eventually impossible, if the population size of those on benefits exceeds the population size of those funding those benefits. Contributions need to come from somewhere and that somewhere is money from those still working. This form of funding retirement is called defined benefits (DB).
Thus, society (globally) shifted where support for one’s needs comes from the individual’s savings. We know this form of funding retirement as defined contributions (DC). So, pensions have changed because of funding pressures to keep them intact able to provide retirement income up to and including the last person to die; which in the modern era may be longer than the company providing the pension stays in existence. Government pensions are also underfunded.
With the short history of how we got to how retirement is funded behind us – the need to save for one’s retirement is clearly having to come from one’s own savings efforts. What do the young need to understand about money nowadays? The answer is summarized well in “3 Things Young Adults Need to Know About Building Wealth.”
- Understand Net Worth
- Recognize Your Biggest Asset
- Create an Investment Plan
All three of these are crucially interrelated in my opinion.
Net Worth – What you own … minus what you owe. Net worth is simply a frame or snapshot where one stands now financially. One also needs to realize where they want to be in the future. Then takes steps to get you from here to there. Without knowing your destination – anywhere will be; but all but one destination won’t be where you want to be! Human capital is also part of net worth as well as the source of your net worth. Human capital is the ability to generate earnings from your labor. It is where owning and owing originate. Also realize that the human capital is not just money – it also includes the value of the time and effort of raising kids.
Your Biggest Asset – Human capital, or the sum of your earnings over your lifetime, represent your Standard of Individual Living (SOIL) (individual means yours, not that of others). The short history lesson above is meant to explain why saving a portion of your earnings is important – because eventually those earnings will end. And then how do you support your SOIL? Answer: as you age, the value of your human capital goes down because the sum of your labor over your remaining years declines. Example: at 30 years old you’re earning $75,000 a year. To age 65, or 35 years, your human capital would total $75,000 x 35 = $2,625,000. Now at age 55 with 10 years remaining, $75,000 x 10 = $750,000. If you don’t save any of that, how do you support living at $75,000 a year after age 65? Continuing to work if health allows. Or, from your savings (and what Social Security may look like then too). Use your own current earnings and time line to see the value of your current human capital.
A hypothetical example using $500,000 at age 65 for 28 years suggests that it may provide a total of around $800,000 in total income and have a balance remaining to fund potential years after that as well*. In other words, the total you need to save as “financial capital” is not the sum of your human capital. Part may come from Social Security** and part from your financial capital.
Investment Plan – is what coordinates accumulating the financial capital you need to replace your human capital. Once human capital ends (you retire), you will need the financial capital to sustain your SOIL. Net worth is a nice number to know, but it doesn’t say how much you need – it simply is a barometer for what you have. Your investment plan must calculate ahead of time what your net worth needs to be in the future in order to sustain your SOIL that comes from your labor (human capital) today.
Moral of the story: Wealth is not rich. Wealth sustains one’s current SOIL. Rich is having more than that. Understanding the difference helps people understand that anyone may be wealthy if they can sustain the standard of living they’re comfortable with. This removes the need to try to compare yourself to others – because most of the others are driving off the cliff … so don’t follow them!
PS. Wealth Odyssey, explains these concepts and also brings risk management (insurance), estate planning, and other financial planning topics into context as to how they all relate to each other.
*Financial capital investment results depends on the returns the economy and market reflection of that economy and may vary over different time periods. The future is unknown and thus financial capital potential is also unknown. But … so is your human capital potential.
** Social Security only partially funds retirement for most workers, especially for higher incomes. Pay attention if the program changes and make changes to your overall plan savings accordingly.