Retirement Planning: Three Sources of Retirement Income

The three-legged stool concept.

With the increase in the average life expectancy, we should give careful attention to the time-proven "three-legged stool" concept that identifies three major sources of retirement income: Social Security benefits, personal savings and employer-sponsored retirement plans. The three-legged stool concept holds that 15% to 25% of retirement income should come from Social Security, 0% to 60% from an employer-sponsored retirement plan or pension plan, and any gap between the two should be filled by private savings.

Social Security benefits. To receive a Social Security retirement benefit, you must generally have at least 10 years of earnings from which Social Security (FICA) taxes were deducted. You must also be at least 62 years old, but benefits begun at this age are permanently reduced by 20% to 25%. To receive a full retirement benefit, you must be of "normal retirement age," which increases from 65 to 67 for people born after 1937. You may also continue to work after Social Security benefits begin, but your benefit amount is reduced by $1 for each $2 of earnings more than $12,960 ($1080 per month in 2007) if you are under age 65. Your benefit is not reduced if you are more than age 65.

Employer-sponsored retirement plans or pension plans. Employer-sponsored retirement or pension plans serve as the second leg in the three-legged stool concept. Employer-sponsored retirement plans include two major categories: defined-contribution and defined-benefit plans. In a defined-contribution plan, the retirement benefit an employee receives depends upon the amount contributed. Contributions can come from either the employee, the employer or in some cases, both — which can grow over time depending on investment results. Defined-benefit plans differ significantly from defined-contribution plans in that the retirement benefit from a defined-benefit plan applies to all qualifying employees and is based on a predetermined formula, generally including factors such as income history and length of service.

Personal savings. The third leg of the three-legged stool concept is personal savings. One factor threatening the stability of the three-legged stool is that the national savings rate averaged 0.9% of after-tax income in September 2007 (according to the Federal Reserve Board). Even when this somewhat anemic rate of savings is added to Social Security benefits, the resulting retirement income will most likely be insufficient. And, if you begin to save for retirement too late in life, your retirement income is less likely to even reach 70% of your current income — and that is at the low end of the income range recommended by most financial planners.

If your Social Security retirement benefits and the pension benefits you receive from your employer do not equal the 70% to 80% you will need to retire, the difference must be made up with personal savings.