RETIREMENT: The Wobbly Three-Legged Stool - PLANNING FOR THE INEVITABLE - Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer

Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part III. PLANNING FOR THE INEVITABLE

Chapter 11. RETIREMENT: The Wobbly Three-Legged Stool

WHY do I need to read this chapter?

The most reliable retirement analogy—the three-legged stool—is still helpful, even if a bit wobbly. It describes your path to retirement through three primary sources of income after you stop working: a pension, Social Security, and your personal retirement savings.

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You need to know the role that each of these income sources plays—or doesn’t play—in your retirement planning. Are you working with a stable three-legged stool, or perhaps stilts, or a pogo stick?

Pensions

Corporate pensions—a stream of income pledged by the company for which you work—were once the strongest leg of the stool. Today, they are all but extinct. If you work for the federal government, a state, or a municipality, however, this leg of the stool may still exist.

If you have a pension, you likely have some options at your disposal. You may have the choice to accept your pension stream of income or receive a lump-sum distribution in its place. This is a challenging decision to make, and it must be based on several different factors. The largest factor is the financial solvency of the issuing entity. Most corporate pensions are underfunded, which means the company doesn’t have sufficient money set aside to deliver on the promises it has already made to pension holders. This is reason for concern.

Most corporate plans do have an extra layer of protection through the Pension Benefit Guarantee Corporation (PBGC), a quasi-governmental pension insurance program of sorts. The only problem is that the PBGC doesn’t always guarantee the entirety of the corporate pension pledges it underwrites. And the PBGC itself is also underfunded.

Most state pensions are also underfunded, but many are buoyed by their promisor’s position as a taxing entity. Regarding fear of default, federal pensions are still the gold standard. They have an advantage. Unlike companies and states, they don’t have to balance the budget—and they print the money. But in each pension scenario, it is important that you research and consider the implications of underfunding. This is especially true if you have a decision to make between a single lump-sum distribution and the stream-of-income option.

Please don’t interpret my cautionary tone to suggest that you should necessarily take the lump sum over the income stream. A good pension is an incredibly valuable “asset,” and an excellent stabilizing leg of the stool. Indeed, a pension that would provide $30,000 of income per year for the last twenty-five years of your life would be worth the equivalent of $422,818 today, sitting in an account earning 5 percent per year. If your pension also has an inflation adjustment feature, it is all the more valuable.

If you have a strong pension, or you don’t have a lump-sum option with a questionable pension, you still have a number of choices to make. For example, pensions will typically offer benefit options, like “life only” and “life plus survivor,” and many variations on those themes. The basic idea is that you could take a stream of income that would last as long as your life alone, or if you are married, you may elect the option that would continue to support your spouse for the remainder of his or her days. As you might guess, since the probability of one of two people in a marriage living longer is higher than the odds of only one, the life-plus-survivor option is typically going to pay out less money per period. But if you have a spouse, and they would need all or some of the pension income in the case of your passing, it’s likely your best course of action would be to accept the smaller stream of income for both of your lifetimes.

Social Security

Each scenario needs to be reviewed individually, but having a third leg on your retirement stool, in the form of a pension, is a helpful and stabilizing force. Otherwise, your stool is just a pair of stilts. If so, your balancing act is hopefully grounded on one side with pledged income from Social Security.

Initially instituted in 1935 as a base level of income to keep retirees from falling into destitution, it could be argued that Social Security was never intended to be what it is today. And that’s a primary source of income for many retirees throughout their retirement. After all, in its inaugural year, the average life expectancy of a male was just under 60, and Social Security didn’t start paying until age 65.

This age of 65, denoted as Full Retirement Age (FRA), remained the norm for many years. Now, FRA is on a sliding scale. If you were born in 1937 or earlier, your FRA remains 65. But if you were born in 1960 or later, your FRA is 67. If you were born in between 1937 and 1960, your Full Retirement Age is somewhere between ages 65 and 67.1

Regardless of where your FRA lands, you may still begin receiving your Social Security benefit early—as soon as age 62—but at a discounted rate. The degree to which your benefit will be discounted is determined by your FRA. If you’re in the 67 crowd and begin benefits at 62, you would receive only 70 percent of your expected FRA benefit, and your benefit would be discounted forevermore.

And there’s another catch. The Social Security early retirement benefit is designed to work only for people who actually retire from a job that generates earned income. Any earned income you make over $15,720 (in 2015) begins to reduce your Social Security benefit, eventually eliminating it entirely. Therefore, it really only makes sense to take early Social Security if (1) you need the income, and (2) you don’t have earned income over $15,720.

Once you reach Full Retirement Age, you can make as much money as you want and not suffer from any reduction in your Social Security benefit, but that doesn’t mean it would be optimal to do so. This is because you can also delay the receipt of your benefit until as late as age 70. And why would you want to do that? If you can wait to take the benefit, the reward is a meaningful one for at least three reasons:

1. Every year you wait to take Social Security past age 62 offers an “investment rate of return” equivalent to earning 7 to 8 percent—guaranteed by the federal government. Would you accept a guaranteed rate of return on an investment at 7 percent? I would. This benefit continues to rise until you reach age 70, the latest point at which you can begin receiving your Social Security benefit.

2. Every year you continue to work further adds to your overall Social Security benefit, especially if you are finishing your career with a relatively higher income.

3. The benefits from the first two points are compounded by the fact that Social Security retirement benefits have a built-in cost of living adjustment. Yes, the government decides what it is, and no, it doesn’t always reflect reality. It is, however, far better than a stream of income with no cost of living increase.

The bottom line? If you are retiring early and need the money—or you have good reason to believe your life expectancy is shorter than average—by all means, take it as needed. If, however, you’re financially stable enough to wait to take Social Security, wait. Let it build. This “longevity insurance” will be a valuable tool in helping ensure that you don’t run out of money in retirement.

And please don’t leave any money on the table. There are many lesser-known Social Security provisions of which you might take advantage, most notably, the spousal benefit. This benefit allows lesser-earning spouses to receive whichever is greater—their retirement benefit or up to 50 percent of their partner’s. That’s right. Even a spouse who has never earned an income and never paid into the Social Security system is eligible to receive up to 50 percent of their spouse’s benefit, even while their spouse receives 100 percent of their own benefit. The spousal benefit is only one of many provisions that might surprise you.

But take care; while the spousal benefit is only one of many provisions that might surprise you, we must also expect Social Security provisions to shift and change with the political winds. Two arcane strategies rising in popularity—“file and suspend” and “restricted application”—were recently killed by an act of Congress. Nonetheless, it is estimated that $10 billion in eligible Social Security benefits are left on the table every year. Don’t let it be yours.

It is estimated that $10 billion in eligible Social Security benefits2 are left on the table every year. Don’t let it be yours.

Younger generations question whether or not they can count on Social Security at all. They believe that, like most pension plans, Social Security is underfunded. It is true that Social Security, after years of congressional raiding of the Social Security surplus, is now headed toward a deficit. However, I believe the “Social-Security-won’t-be-here-for-me” fear is unwarranted. After all, the entity that doles out the benefits is the same entity that prints the money.

I acknowledge that this reality is not necessarily a comforting one, especially since the government magic show that creates money also has the unwelcome consequence of lessening the value of our dollars. But the United States is highly unlikely to default on its biggest financial obligation to its own citizens, if only for the reason that self-preservation wins every time in politics.

I do believe that younger generations can expect to see the value of their Social Security benefits reduced. In addition to the devaluation of the United States dollar, we should expect to see benefits means tested, resulting in potentially reduced benefits for higher-income retirees. It is also likely that we’ll see the Full Retirement Age, already increased to 67, continue to rise higher.

The net effect is that younger generations are dealing less with a three-legged stool, or even stilts, in retirement. More and more they’re left with a pogo stick. This makes them largely reliant on the third and final leg of the stool, Personal Savings, its own Pandora’s box. Let’s take a look inside.

Personal Savings

401(k), 403(b), 457, TSA, TSP, SEP, Simple, IRA, Roth. This is a not-quite-exhaustive list of different buckets into which retirement savers can shelter money for their future. It’s written in code—IRS code, that is.

You see, retirement accounts—such as Individual Retirement Accounts (IRAs)—aren’t investments, per se, but instead, investment receptacles, or buckets. Each bucket has a unique set of rules established by the Internal Revenue Service. These rules dictate how taxes are handled on money coming in and out. Various investments—stocks, bonds, mutual funds, cash, CDs—can be held inside the buckets, and the tax rules established for each bucket trumps whatever tax rules are associated with the individual investments.

Let’s segregate the retirement buckets for now as Individual Retirement Accounts (IRAs) and employer-sponsored retirement plans:

IRAsTraditional versus Roth

IRAs were created in 1974 to give American workers an opportunity—and an incentive—to save for retirement. In 2015, workers are able to save up to $5,500 per year, plus an additional “catch-up” allotment of $1,000 for savers 50 and older.

If you meet certain requirements,3 contributions to a Traditional IRA are tax deductible. Growth inside the accounts is tax deferred. What is the price to be paid for this tax privilege? Well, it comes in a few forms—early illiquidity, forced taxes, and higher taxes on the back end.

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The illiquidity—or the lack of accessibility to your money—is an understandable feature. The government is giving you a tax break today to incentivize you to save for the future. So, if you touch the money before age 59.5 (with precious few exceptions), in addition to being taxed, you’ll also pay a 10 percent early withdrawal penalty. The combination of federal, state, and local income taxes and the penalty can often halve your savings, making early distributions prohibitive. Compounding the prohibitive nature of early withdrawal penalties is that IRAs offer a level of creditor protection in most states, so if you’re a visible member of the community or in trouble with creditors, your retirement accounts might be the only “safe” asset.

So, you can’t take it out until after age 59.5, but you must take it out after age 70.5. It’s called your Required Minimum Distribution, and whether or not you need the money, it’s gotta come out. The penalty for not doing so is 50 percent of the required distribution! You didn’t think the government would give you a tax deduction and indefinite tax deferral, did you? And don’t think you can get out of it by dying before age 70.5 either. Your kids will have to pay the taxes, at what is likely a higher tax bracket than yours in retirement.

Additionally, when you take distributions, everything that comes out of the account is treated as ordinary income and will be taxed accordingly. This is disadvantageous if you own stocks and stock mutual funds—the primary growth vehicle for most retirement savers—because equities held for more than one year offer their own long-term capital gain tax privilege. Yes, the tax deduction on the front end is still worth it, but if you have the luxury of non-IRA investment savings, it may serve you well to overweight your equity holdings in taxable investment accounts that complement the equity tax privileges or a Roth IRA.

Speaking of the Roth, this little gem was brought to us by a senator of the same name who hails from a state known for its tax privilege, Delaware, in the Taxpayer Relief Act of 1997. From a tax perspective, the Roth IRA is the inverse of the Traditional IRA. There is no tax break on the front end, but distributions are tax free. Forever.

“I’m sorry, could you please say that in my good ear?”

Yes, it’s true. And while your heirs would be forced to take Required Minimum Distributions (RMDs), they don’t pay taxes on them either, making the Roth IRA the best gift you can give an heir. Meanwhile, neither you, the original saver, nor your spouse are required to make RMDs during your lifetime. Only use the money if you want or need it.

If it sounds like I’m biased in favor of the Roth IRA, it’s because I am. There’s an ongoing battle in the financial realm pitting the Roth IRA against its older cousin, the Traditional IRA. Most of the debate, however, is rendered irrelevant in my opinion because it doesn’t consider the most important factor. The IRA debate as it stands is almost entirely about predicting taxes. As we’ve discussed, Traditional IRAs are taxed at the back end while Roth IRAs are taxed at the front end.

As the predominant logic goes, if you expect to be in a higher tax bracket in retirement than you are in today, contribute to a Roth IRA. If, instead, you are likely to be in a lower tax bracket in retirement, contribute to a Traditional IRA. By this math, if your tax bracket never changes, there’s virtually no difference between the two investment options. But, like many personal finance one-liners and rules of thumb, this one falls woefully short of giving you the whole story.

Please consider this question: Which is more valuable—a dollar in a Roth IRA or a dollar in a Traditional IRA?

As long as you’re expected to pay taxes, the answer to this question is always the dollar in the Roth. This is because the Roth allows you (and your heirs) tax-free growth and distributions free from taxes. The dollar in the Traditional IRA, on the other hand, is subject to taxation whenever you (or your heirs) remove it. So, if you’re in a 25 percent tax bracket, your Traditional IRA dollar is actually worth only 75 cents. The higher your tax bracket, the less your Traditional dollar is worth.

In order for the Traditional-is-better logic to work, we must assume you’d take the extra cash on hand, which is an outgrowth of your tax deduction specifically associated with your Traditional IRA contribution, and invest it for your future retirement. If you make a $5,000 contribution to a Traditional IRA and you’re in a 25 percent tax bracket, your deduction should be worth $1,250. In order for the Traditional to benefit you more than a Roth, you must not only be in a lower tax bracket in retirement, but you also must save that additional $1,250 for retirement at the time of your IRA contribution.

But what do most people do with their tax refund? Spend it!

What if you use your refund as a down payment on a car or for a vacation? The Traditional edge is eliminated. What if you didn’t receive a refund at all? Unless you write a check to invest the amount you should have received as a deduction for your Traditional IRA contribution after Uncle Sam gives it back, the Roth wins.

One of the great frustrations in financial planning is that most of the planning is based on the assumption of things we can’t actually control or change. These include annual income, inflation, market returns, and of course, taxes. So, you can contribute to a Traditional IRA, calculate the proportionate tax deduction, and invest that in a taxable account dedicated to retirement—every year—and hope the $17 trillion national debt somehow doesn’t lead to tax increases. Or, you can take control of one of those factors and prepay your taxes using a Roth IRA, allowing you to ride off into the tax-free sunset.

Like so much of personal finance, the Roth/Traditional debate appears on the surface to be about numbers, but it’s more about behavior. Again, personal finance is more personal than it is finance.

Employer Plans

As important as IRAs are for retirement savers, the majority of retirement saving today is done in employer-sponsored plans, the most visible of which is the 401(k). 403(b)s are the equivalent for nonprofits, and the Thrift Savings Plan (TSP) is the federal government’s version of a 401(k).

The 401(k) plans have three primary components: an employee contribution, an employer match, and the potential for profit sharing, but the only one that is guaranteed is the first.

Employees may contribute up to $17,500 in 2015, plus an additional $5,500 for savers age 50 or older. Most 401(k) contributions are delineated as a percentage of your salary, and this is also how the employer match is handled. For example, you might save 10 percent of your salary, and the company matches 3 percent, for a total of 13 percent. Another common articulation of this match is “50 percent up to 6 percent.” This, too, would be a 3 percent match, but it requires the employee to contribute more in order to receive the full match.

The match is “free money,” a guaranteed rate of return on your investment simply for contributing. Do not leave free money on the table!

I repeat:

DO

NOT

LEAVE

FREE

MONEY

ON

THE

TABLE.

The final way to get money into your 401(k) comes in the form of profit sharing. This occurs when your company elects to share a portion of its profit with its employees. Please make sure to say thank you. This is behavior we’d like to encourage!

Until the mid-2000s, there were only traditional 401(k) plans. But now Roth 401(k) options are becoming more the norm. Here’s how they work:

If your plan offers both a regular and Roth 401(k) option, you are making a choice between having your contributions made on a pre-tax basis—similar to a Traditional IRA and similarly taxed on the back end—or after-tax in a Roth contribution, right inside of your 401(k). Now you’d have two different buckets inside of your 401(k), but any employer match or profit sharing will go only into the traditional bucket.

How to decide whether or not to contribute to the Roth bucket, and if so, how much? First, if you are just getting started in your career and in a low tax bracket, going with the Roth is an easier decision to make than if you’re in a higher tax bracket and counting on the traditional 401(k) contribution to reduce your taxable income. But, if you’re in that higher tax bracket, it’s also possible you make too much money to contribute to a regular Roth IRA because of the income caps.4 In that case you may well want to take advantage of the Roth 401(k) opportunity. If you’re stuck between the two, employ the wisdom of Solomon and split your contribution down the middle.

I’m thankful for the incentives the government has created to encourage us to save for retirement, and I hope you’ll take full advantage of them. Remember, also, that these opportunities send an implicit message: “We—the government—want to help you take care of yourself because we can’t or won’t.”

As the sun sets on pensions and Social Security’s security is questioned, personal retirement saving is becoming an increasingly important leg of the stool. Having a wobbly retirement stool also begs the question, should we consider a fourth leg to stabilize it?

If you’re self-employed or a small business owner …

you actually have some additional retirement saving options at your disposal. Your decisions will be driven by the amount you’re able to save. If you’re not able to save more than $5,500, it’s likely best to put what you can into a Traditional or Roth IRA. If you can save about $12,500, the Simple IRA may be your best bet. Or, if you’re able to save between $12,500 and up to $53,000, consider the SEP IRA or individual 401(k). Each of these has its own rules and tax ramifications and should be reviewed with your CPA and financial advisor before jumping in.

Annuities—a Fourth Leg?

“There are no bad investment products, just bad uses for them.” This is marketing balderdash whipped up by someone promoting the sale of bad products. While there are certainly inappropriate uses for good products, there are also investment products that need never have been created. When combined with ignorance or self-deception, they can have disastrous results.

While every major branch of the financial services industry—banks, brokerage firms, and insurance companies—are or have been the proprietors of bad instruments, there’s little question that “annuities,” a product subheading under the insurance umbrella, have attracted the most criticism. They’ve even earned the anonymous tagline, “Annuities are not bought, they’re sold,” and while I admit that the tagline was likely written in an effort to market an annuity alternative, it rings a great deal truer than the “no bad products” quote.

Annuities are often promoted as a fourth leg of the retirement planning stool—or at least as an alternative leg—but do they hold up?

Types of Annuities

Since the word annuity has generic applications outside of the investment universe, for the purposes of this book, an annuity is an investment product created by an insurance company. There are four primary varieties of annuity common in the marketplace: immediate annuities, fixed annuities, variable annuities, and equity indexed (or just simply indexed) annuities.

An immediate annuity is a product in which you trade a lump sum of money for a stream of income from an insurance company. A fixed annuity has characteristics similar to those of a certificate of deposit (CD) with a bank, although the terms are typically longer. A variable annuity has characteristics similar to those of a mutual fund or mutual fund portfolio. An indexed annuity is, in reality, a fixed annuity advertising gains indexed to the upside of equity markets without the downside. If your too-good-to-be-true bells are going off, it’s for good reason.

Annuity Pros

Please don’t mistake my skepticism as blind condemnation of all annuity products. Annuities come with benefits that often cannot be duplicated in any other investment. Immediate annuities are, in my opinion, the most useful of the suite. For many people who will not be retiring with a meaningful stream of pension income, immediate annuities offer that potential. Because they are returning both interest and principal, the distributions are likely to be higher than anyone could justify taking from a balanced portfolio of investments. They can, in the right circumstances, be a valid replacement for the pension leg of the stool.

Another similar annuity product, the deferred income annuity, also may serve a valuable purpose—longevity insurance. For retirees concerned that they might outlive their money, deferred income annuities require a deposit today but don’t begin paying until years in the future. If you’re planning (with good reason) to be around to have your birthday celebrated on a Smucker’s jar, it’s possible that a deferred income annuity could offer some sleep-at-night peace.

Fixed annuities allow an investor to lock in rates of return comparable to CDs, but likely for longer terms. If—when—interest rates rise from abnormally low rates to abnormally high rates, it could be a wise time to allocate some fixed income exposure to a fixed annuity. And unlike a CD, where interest is paid out and taxed annually, the interest or gains earned in annuities are deferred until distributions are taken.

Many annuities promise some level of principal protection. Even in certain variable products, a portion of your principal or even future income may be guaranteed by the issuing company. Not losing money is generally a good thing.

Regarding advantages of equity indexed annuities, uh … well, whoever sells you the policy will likely be going on a nice vacation soon. The commissions on these products range into double-digit percentages. Additionally, you could suspend disbelief and allow yourself to think you’re getting the upside of the market without any downside. Ignorance can be blissful, if only momentarily.

Annuity Cons

Unfortunately for each of the pros, there are significant cons. At this time, prevailing interest rates (and correspondingly the rates used to calculate immediate annuity payouts) are so low that to commit funds could expose you to a meaningful amount of inflation risk. So even if you’re predisposed to lock in a more secure income stream with an immediate annuity, consider waiting until rates normalize. The same could be said for most fixed annuities.

The tax deferral of annuities is worth something, but there’s a price—or prices, really—to be paid. All of your gains will be taxed at your ordinary income tax rate. Especially if you’re investing in a variable annuity with equity exposure, you’re trading the tax privilege of capital gains for a rate—deferred or not—that could be twice as much.

Another negative tax implication is the loss of a “step-up” in cost basis to your heirs. Capital assets—like stocks and real estate, for example—that were purchased at a low cost are afforded a step-up in their cost basis upon your death. If you had sold those assets during life, you’d have paid capital gains tax. If you gave them to your heirs while you were alive, your heirs would inherit your cost basis. But if you wait to pass them to heirs until after your death, they will receive a step-up in their basis to the cost of the holding on your date of death, giving them an opportunity to sell those assets tax free.

Annuities with significant appreciation, however, receive no such benefit. In fact, not only will your heirs inherit your cost basis, they’ll be paying tax at their ordinary income rate and may be forced to distribute the policy and take that gain in short order, resulting in a tax time bomb for those you hope to bless with an inheritance.

Simple Definitions

· Cost basis—The amount you paid for an asset, plus any investments you’ve made in improvements.

· Capital gains (and losses)—The difference between your selling price and your cost basis. If you sell for more than your cost basis, it’s a gain; if less, it’s a loss.

· Step-up (in cost basis)—Typically refers to a selection of the largest United States companies, best represented by the S&P 500 Index.

· Capital asset—“For the most part, everything you own and use for personal purposes, pleasure, or investment,” surprisingly simply put by the IRS.

· Asset class—A collection of investments with similar characteristics; could be as broad as “stocks” and “bonds” or as specific as “Japanese small cap value.”5

More Cons?

While the guarantees in some annuities are comforting, even if they’re only made by the company (not the federal government), you may end up paying dearly for them. Many annuities offer a cafeteria plan of shiny options, but each comes with a cost. The insurance on your investments is not free.

My least favorite feature of annuities, however, is the illiquidity. First, you must be 59.5 years of age to withdraw the gains from an annuity and avoid paying tax on the gains as well as a 10 percent early withdrawal penalty. Second, because actuaries need time to make assumptions work and insurance companies need time to recoup the larger-than-average commissions to agents, most annuities tie your hands with a surrender charge. That can be a meaningful reduction in your payout, which usually descends over five, seven, or even up to fifteen years.

Finally, because you’re paying for tax deferral by taking a tax hit upon distribution, many investors are understandably afraid to take the money out. This is true because annuities are taxed on a LIFO basis—last-in-first-out—which means that the gains (100 percent taxable) are distributed before the tax-free principal, unless you convert the product into an immediate annuity.

If you decide to purchase an annuity for any of their applicable uses, I recommend hunting for a low- or no-commission product with little to no surrender charge. This will help eliminate a couple of the most unfavorable qualities of these products. But even then, there still may be more cons than pros.

Unfortunately, the annuity sales process is notorious for capitalizing on fear and greed. This is a strategy used too often by every branch of the financial services industry, especially in the world of retirement planning. But any time you get a whiff of these decaying emotions—anytime someone is pressuring you to buy something with an urgent plea—that’s a good indication that you should walk away.

Wisdom is never in a rush, and no financial product can buy you Enough.

Simple Money Retirement Plan Summary

1. Corporate pensions, once the strongest leg of the retirement three-legged stool, are all but extinct. The value of a financially solvent pension supported by a strong entity is high, but all of your options should be carefully considered.

2. Social Security, the second leg of the stool, was never intended to be our primary source of retirement income, but projections suggest it will become even less beneficial for workers many years from retirement. As long as you’re healthy and able to continue working, waiting to take the Social Security retirement benefit will increase its advantages.

3. The third leg of the retirement planning stool is personal savings—Individual Retirement Accounts and company-sponsored retirement plans, like 401(k)s. The weakening of the first two legs of the stool put a lot of pressure on the third leg. Take advantage of “maxing out” your 401(k) and, in most cases, a Roth IRA.

4. Annuities are oversold, but that doesn’t mean they should be ignored entirely. Immediate annuities—and especially deferred income annuities—may help stabilize a wobbly retirement stool.