Explaining the 3-Legged Stool of Retirement

The three-legged stool of retirement was a previously popular model for retirement that refers to a worker’s three sources of income during their golden years: Social Security, employee pensions, and personal savings, such as in a 401(k). Each of the legs is important on its own, and together they create a multi-faceted but unified plan for long-term financial saving and investing.

The three-legged stool model has declined in popularity over the past several decades. This is largely because employee pensions are disappearing, but also because the future payout rates of the Social Security program are not totally known. This means personal savings might be more important now than ever before.

The Three Legs of the Three-Legged Stool

The three-legged stool approach to retirement incorporates multiple sources of retirement income, including personal savings, pensions, and Social Security benefits. Here’s an overview of each of the different legs in the model.

Personal Savings

Personal savings refers to money an individual has saved on their own for use in retirement. This could be money held and invested in a brokerage account or in an account designed for retirement, like a 401(k) or a traditional or Roth IRA.

Some retirement accounts are offered through an employer, such as a 401(k), 403(b), or Thrift Savings Plan. Generally, contributions are taken from an employee’s paycheck and deposited into the account. Workplace retirement plans may have the added benefit of an employer match program. This means that when an employee contributes to their account, their employer may match contributions fully or partially up to a certain amount.

Workplace retirement plans might have investment options such as target date funds or mutual funds.

Individuals might set up an account on their own, such as an IRA. Self-employed individuals might want to consider a SEP IRA or Solo 401(k).

Some investors may also choose to consider an online brokerage account. While this type of account doesn’t offer the tax advantages of an IRA or 401(k), it does give an individual another potential way to invest for retirement.

Pensions

Pensions (also known as defined benefit plans) are retirement programs in which the employer saves, invests, and disburses money on behalf of their employees.

In retirement, employees would generally receive a monthly check. How much of a pension they would receive generally depends on how long they worked for the company, their position, and other variables.

However, pension plans are typically more common for workers in the public sector than they are in the private sector. For example, teachers, firefighters, and other government workers may have pension plans.

But even employees with pension plans can choose to put money toward their personal savings for retirement.

Social Security

Social Security is designed to be retirement income for workers who pay into the program each year through their FICA taxes. Both the employee and the employer pay into Social Security.

Social Security benefits can generally start being paid out when an individual is between the ages of 62 and 70. However, individuals have a full retirement age, depending on what year they were born. For every month they claim their Social Security benefit before full retirement age, their benefit will be reduced. For every month after full retirement age that they claim their benefit up to age 70, the benefit will be increased.

It’s important to be aware that there is the chance that Social Security may become underfunded in the future, which might lead to reduced benefits, lower inflation adjustments, or higher taxes down the road.

In other words, an individual may not want to rely on Social Security as their only source of retirement income. And Social Security benefits alone might not be enough regardless. While some expenses like commuting costs no longer apply in retirement, new expenses may keep a person’s lifestyle costs fairly similar to what they are now.

Recommended: 4-Step Guide to Retirement Planning

Getting Ready for Retirement

The three-legged stool of retirement may no longer be applicable for as many individuals as it once was. However, there are still ways for people to save for their golden years, including:

•   Taking advantage of an employer match. If an individual has a workplace retirement plan, their company may offer an employer match, which means the employer also contributes to the plan, typically up to a certain amount. For example, if an individual contributes 6% of their pre-tax salary to their 401(k), their employer might contribute 3% up to a certain amount.

•   Diversifying. Next, investors may want to consider having multiple investment account types. This may diversify income streams and potentially help to hedge against market downturns, though loss is always a risk with investments.

•   Checking in. It can also benefit investors to regularly check in on their retirement accounts and make adjustments if needed, which might help to ensure their savings and investments align with their goals. A retirement calculator may help them determine whether they’re saving enough.

The Takeaway

Saving and investing for retirement typically requires a multi-pronged approach, and it’s important to stay organized and on top of all of the moving pieces. While the pieces may be separate, ideally, they should work together with the purpose of helping individuals reach their retirement goals.

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FAQ

Is the three-legged stool of retirement still accurate today?

For most workers, the three-legged stool of retirement no longer applies. Pension plans, which are one of the legs of the stool, have disappeared from many workplaces in the private sector and have been replaced with defined contribution plans like 401(k)s. Additionally, the Social Security System, a second leg, may be under strain. That means more workers may need to rely more heavily on personal savings (the third leg) for retirement.

What happens if one leg of the retirement stool is missing?

If one leg of the retirement stool is missing, the stool may become wobbly. For example, in the case of the three-legged stool for retirement, one of the legs is pension plans, which are no longer as widely offered to workers in the private sector as they once were. For a number of individuals that leg may be gone. That means they might need to rely more heavily on personal savings, including 401(k)s and other retirement plans.

Can the three-legged stool of retirement have more than three legs?

It is possible that the three-legged stool of retirement could have more than three legs. For example, a fourth leg of the stool might be part-time employment in retirement to bring in extra income. Additionally, selling a home and downsizing to a smaller place might free up money in retirement (and may also save on taxes and insurance costs), which could potentially be thought of as a fourth leg of the stool of retirement.

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