The Three Legged Stool of Retirement Planning

by Mike

The Three Legged Stool Is Looking Pretty Beat Up These Days

My first real job out of college was in the benefits department of a large retirement services company.  The first thing I did was spend an entire week in new-hire training, where we learned all about the different types of plans we administered.  And I still remember one of the first things we discussed was the three legged stool of retirement planning.

The three legged stool is an old image that was meant to demonstrate the different sources of income a retiree could rely on. As the image below suggests, the 3 legs represent Social Security, company pensions, and personal savings.

Do you see a problem with this picture?  Let’s take a look at each leg and see where we stand…

retirement planning

Company Pensions

The days of spending 40 years working for the same company and then retiring to collect your gold watch and pension have pretty much gone the way of the dinosaurs.  Traditional company pensions that promised a defined benefit are all but extinct, replaced by 401k plans in which the onus for savings is placed firmly on the employee.  In other words, people who previously had their retirement taken care of for them now need to learn how to save money for themselves. (Read more about defined benefit vs defined contribution plans).

Now 401k plans are a great way to save money and they offer some tax advantages, but they require participants to contribute their own money instead of strictly company money.  Plus, the average participant receives little education on how to maximize their earnings so they end up making a variety of 401k mistakes which cripple their earning power.  So when you step back and look at that first leg it looks like it was broken in half and then repaired with some 401k glue.  Will it hold?

Social Security

I’m sure you’ve heard one of the many warnings that Social Security is on the road to insolvency and benefits will have to be drastically cut.  Many young workers worry there won’t be anything left by the time they retire.

I can’t see the future but I also can’t imagine the government allowing Social Security to go completely belly up.   They may cut benefits or tax us more to pay for them, but I believe there will be something.  Unfortunately there’s no way to know what it will be, so it’s hard to really rely on that second leg.

Personal Savings

Before the recession, US savings rates were hovering around 1 to 2 percent.  Those numbers have since increased to around 6 to 8 percent, but that’s still not enough.

How much should you save?  That is a tough question to answer.  The general rule of thumb is 10%, but that’s just a guideline.  JD Roth thinks you should save 20%.  Dave Ramsey says 15%.  You have to look at your own financial situation to determine what is best for you.  But especially considering the weakness of the first two legs of the three legged stool, it is absolutely vital that you save as much of your income as you can.

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{ 2 comments… read them below or add one }

Ravi Gupta

Very interesting. I’ve never seen social security as a viable income source, nor have I ever counted anything besides my own savings. I guess with my first real job I’ll be adding a second leg (TSP), a Thrift Savings Plan. One leg that I’m currently working on would be a side business or making money off the internet. It will not just be one big pool but (hopefully) a steady source of income.

-Ravi Gupta
Ravi Gupta´s last [type] ..Ethics and Investing Part II



The 3-legged stool can now be – Roth IRA, 401(k), and Investments :-)


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