Have you ever heard of the “3 legged stool” retirement theory? With as much personal finance reading as I’ve done over the past almost 2 years, I thought I had heard it all but somehow this one escaped me until just last weekend.
I was working at my part-time job when a co-worker started asking me about investing and retirement saving options. Why these people ask me about personal finance I’ll never know because I certainly haven’t told them about my pseudo-anonymous online blogging career about personal finance, but I digress. After sharing with her my limited knowledge of investing, as my main personal finance interests are debt payoff and entrepreneurship, I was surprised when a customer chimed in from across the store and asked if I had ever heard of the 3 Legged Stool theory of retirement investing.
Since I hadn’t heard of it myself, I decided to do some research on it and share that with you today.
What is the 3 Legged Stool Theory?
According to About.com:
The 3 legged stool is a metaphor for how the post-World War II generation looked at planning for retirement. The three legs represent an employer pension, employee savings, and Social Security. You need each one to build a strong retirement foundation. Without one, the stool would not function.
This metaphor is often attributed to Franklin D. Roosevelt, who created the Social Security program.
Does the 3 Legged Stool Still Exist?
Personally, I don’t think relying on the 3 legged stool for all of your retirement savings needs is a good idea anymore. The social security leg of the stool is much shorter than what it was when this theory was first invented in the mid-1900s and in fact some people believe that Social Security will be entirely non-existent by the time that millennials begin to retire many years from now. This leaves you with, at best, a 2.5 legged stool.
Then when you look at the employer pension leg of the stool, you’ll notice that employer pensions have pretty much gone by the way-side in the past 20-25 years. These days employers choose to offer a defined contribution plan rather than a defined benefit plan, making your employer 401(k) essentially a part of the third leg that is employee savings. Sure, some employers still contribute to employee 401(k)s, but for the most part this account is employee-funded.
Now you have one long leg and 2 short legs on your stool and you’ll be lucky if you can balance on it at all when it comes time for retirement.
Today’s 4 Legged Stool Theory
In light of these changes, a new theory has emerged in the past few years: the 4 legged stool. This theory means that you will take part of the long leg of the 3 legged stool, personal savings, and invest it in a passive income producing asset, like real estate. Thus you now have a stool with 4 legs: employer pension, employee savings, Social Security, and passive income investments.
With this new theory in mind, do you have a plan in place to build your 4 legged stool?
Photo courtesy of: Crimthann Fid-Nemed