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Chapter 12

Retirement Planning

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Chapter Goals

Recognize the importance of planning for retirement. Evaluate retirement savings structures. Weigh the advantages and disadvantages of pensions

as compared with personal savings vehicles. Summarize the retirement planning process. Identify and describe the risks that can affect

retirement planning. Contrast pre- and postretirement alternatives when

shortfalls in capital needs become apparent.

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Overview

The retirement planning process:– Familiarize yourself with retirement issues.– Develop goals.– Become knowledgeable about retirement structures.– Asses types of retirement assets and alternative structures.– Analyze retirement risks.– Decide on retirement investment policy.– Calculate retirement needs.– Finalize plan and implement.– Review and update.

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Familiarize Yourself with Retirement Issues

The concerns of retired people are assigned a relatively high priority by the working population and the government.

Per capita spending by the government on the elderly substantially exceeds that for the rest of the population.

The average age of retirement has declined from 67 in 1950 to 62 in 2000.

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Familiarize Yourself with Retirement Issues, cont.

1960 2000 1960 2000

40-44 95.4 92.1 45.3 78.745-49 94.5 90.1 47.4 79.150-54 92.0 86.8 45.9 74.155-59 87.7 77.1 49.7 61.260-64 77.8 54.8 29.4 40.165 and older 30.6 17.5 10.4 9.4

Labor participation rate ofpopulation 16 years and older 80.4 74.7 35.7 60.2

Labor force participation rate (percent)

Age Men Women

Source: Richard Johnson, “Why the ‘Average Age of Retirement’ is a Misleading Measureof Labor Supply,” Monthly Labor Review 124, no.12 (December 2001), 38-40.

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Familiarize Yourself with Retirement Issues, cont.

The quality of life of the elderly has risen absolutely and probably relative to the average worker.

The elderly are expected to rise from 15 percent of the population in 2000 to 20 percent in 2030.

This greater concentration of retired people is projected to create a shortfall in Social Security pension resources.

Medical costs are rising at a faster pace than overall inflation, which adversely affects the elderly on fixed cost pensions and government funding to assist in medical cost reimbursement.

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Develop Goals

What do you want retirement to look like? Will your overall living costs go up or down? When do you want it to happen?

Most wish to retire sooner than later. However, a significant number view retirement as something you do when you are unable to continue working.

In planning, many people select an early retirement or financial independence date that can provide them with the option of retirement at that time and also better accommodate a forced retirement due to health or company layoffs.

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Pensions

Retirement structures: Financial frameworks such as pensions, annuities, and Social Security that are established specifically for retirement.

Pensions: Savings structures into which money is deposited to generate income for retirees. Include both private and government pensions.

Private pensions: – Used to be largely limited to fixed monthly retirement sums set by

companies. – Sometimes heavily weighted toward highly compensated workers

and those who had worked for a company for many years.

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Pensions, cont.

Vesting: The point at which an employee is entitled to a stated amount of nonrevocable benefits from an employer.

The U.S. government has mandated that plans be nondiscriminatory by being open to all workers.

Maximum periods before full vesting were reduced sharply and generally are no more than six years.

The Employee Retirement Income Security Act requires that employers act as fiduciaries managing investment assets in the employee’s best interests.

The Pension Benefit Guarantee Corporation, guarantees pension assets or income when companies go bankrupt.

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Qualified Plans

Qualified plans: Pension structures that comply with established government regulations.

– They allow you to place pretax (untaxed) dollars into the plan.

– This allows you to place a greater sum in the plan, which results in higher earnings.

– All dividends and capital gains generated while in the pension plan are tax deferred as well.

– All amounts you withdraw are treated as taxable income and are taxed at ordinary income rates.

The qualified pension’s combination of pretax dollars deposited and tax-free compounding is what makes it such an appealing way of saving.

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Qualified Plans, cont.

Two principal types of qualified plans: Defined contribution plans: Place an amount of money in the

pension regularly. Often portable when you change jobs or retire.

Defined benefit plans: Provide a stated stream of income, often a level amount, throughout retirement.

The normal pension by a company or a union offering yearly income is a defined benefit plan.

Social Security can be considered one as well. It is the emphasis on end of working period time and/or salary

for calculating benefits in contrast to beginning of working period contributions that distinguishes defined benefit from defined contribution plans.

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Nonqualified Plans

Nonqualified plans: Pension plans that may be used for retirement but whose deposits are generally not eligible to receive a tax deduction.

While deposits are in the plan, investment income and capital gains are not taxed.

Withdrawals are taxed only on appreciation in asset values. The original amounts placed in the plan are not assessed by governmental authorities since they were taxed prior to their deposit.

The taxable portion of withdrawals is subject to ordinary income rates.

Two common examples are tax-deferred compensation and tax-deferred annuities.

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Tax-Deferred Compensation

Tax-deferred compensation: Monies that employees have earned that is not paid out by their employers until some future time.

In the interim the sums grow tax-deferred. The amounts may be paid out at a stated date, at

retirement, or over a period of years. Since tax-deferred compensation is an exception to

the nonqualified pensions after-tax rule, a requirement of these plans is that the employee be subject to risk; if the employer goes bankrupt, the employee becomes a general creditor of the company.

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Tax-Deferred Annuities

Tax-deferred annuities: Savings vehicles that allow for retirement or other purposes; after-tax deposits grow tax-free until monies are withdrawn.

Withdrawals are taxed only to the extent of income and gains on original deposits.

If not withdrawn by death, all gains over original cost are subject to tax at ordinary income rates.

Tax-deferred annuities can be separated into fixed and variable types.

– Fixed annuities: Provide an interest rate that is established by the issuer and often changes annually.

– Variable annuities: Offer a range of investment choices to be selected by the purchaser, often in stock and bond mutual funds.

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Tax-Deferred Annuities, cont.

Most annuities also have a redemption charge for liquidation or transfer prior to a fixed period of 5 to 10 years with a declining rate as the period the annuity is held increases.

Withdrawals of a fixed percentage annually are not subject to this redemption change.

Annuitizing converts a lump-sum asset accumulated into the payment of a fixed flow of income per year based on life expectancy.

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Tax-Deferred Annuities, cont.

Advantages of Annuity

Advantages of Competing Instrument

Explanation or Additional Information

Fixed Annuities Versus CD

Tax deferral Safety of U.S. government agency guarantee

Comparison of returns varies

Fixed Annuities Versus Taxable Bond

Tax deferral Lack of fluctuation in principal

Flexibility in shifting. Annuity has redemption charge for a number of years

Comparison of returns varies

Fixed Annuities Versus Municipal Bond

Higher pretax return

Tax-free return1 Highest return often depends on length of holding period; very long periods often favor annuities

Variable Annuities Versus Mutual Funds

Tax deferral Guaranteed death benefit

Favorable capital gains rates on equity fund, appreciation and dividends. Higher total expense ratios and a redemption charge for annuities. Limitation on investment choice for annuities.

Death benefit is guarantee of return of original principal or, in some cases, a higher interim amount. Most variable annuities have total charges of 0.75 percent to 2.0 percent.

1 If you buy muni in the state you reside in.

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Social Security

Social Security: – Principally provides monies to retirees and their spouses. – Extends benefits to surviving spouses and the family’s minor

children when a wage earner dies before retirement. – Gives benefits to those who are permanently disabled.

The Social Security system is a blend of two goals. – To provide retirement payments to individuals based on their

contributions. – To redistribute income so that all workers may retire at a minimum

standard of living. Advantages: Overhead costs at less than 1 percent of

payouts and its form of forced savings. Disadvantages: Discourages savings and work and

provides a low rate of return on investment.

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Social Security, cont.

Social Security is a mandatory system that is funded by a payroll tax on both employers and employees.

Each pays a tax of 6.2 percent on a maximum of $84,900 in 2002 and a Medicare tax of 1.45 percent with no maximum.

In order to be eligible to receive full retirement benefits you must have completed 40 quarters equivalent to 10 years of work.

Benefits are linked to the amount of contributions. Spouses receive the greater of their own work contribution or 50 percent of that of the sole or other wage earner. If the wage earner passes away first, the surviving spouse payout is raised to 100 percent.

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Social Security, cont.

Your date of birth determines the percentage you receive for earliest retirement at age 62.

It ranges from 70 percent to 80 percent, depending on the date you were born, and rises proportionately the longer you wait until retiring.

If you wait until after your normal retirement age to start taking payments, they will rise by 4.5 percent to 8 percent a year until you are age 70.

There is no incentive to delay payments beyond age 70.

In addition, no further payroll taxes are taken out of wages at age 70 and beyond.

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Social Security, cont.

Birth Year Year Worker Attains Age 62

Normal Retirement Age

1938 2000 65 + 2 months

1939 2001 65 + 4 months

1940 2002 65 + 6 months

1941 2003 65 + 8 months

1942 2004 65 + 10 months

1943…..

1954

2005……2016

66

1955 2017 66 + 2 months

1956 2018 66 + 4 months

1957 2019 66 + 6 months

1958 2020 66 + 8 months

1959 2021 66 + 10 months

1960 2022 67

1961 and thereafter 2023 and thereafter 67

Source: Tax Partners and Professionals of Ernst & Young LLP. The Ernst & Young Tax Guide. Hoboken, NJ: John Wiley & Sons, 2004.

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Social Security, cont.

Those who choose to work beyond their full entitlement date (age 65 and 4 months or older) are entitled to full Social Security benefits regardless of the amounts they earn.

Those who are eligible for payments but are younger than age 65 and 4 months are allowed to earn $11,640 in 2004 with a phase-out of benefits of $1 for every $2 earned above this amount.

Social Security payments for people earning more than certain threshold levels of income are subject to taxation on 50 percent or 85 percent of the cash received.

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Social Security, cont.

Factors to consider when choosing payout date:– Risk Tolerance – Investments: The lower the person’s risk

tolerance, the lower the investment return on the money taken at an earlier age. A low investment return favors a full payout date.

– Longevity: People in good health from families with longevity may want a full date while others might favor early Social Security. Payouts are not differentiated by sex. Women statistically live longer than men. Women should therefore be more likely to take a later payout.

– Desire for Current Funds: Those retirees having a preference for spending as much as possible today will favor an early retirement payout. Those with modest assets and a desire to retire early will also favor early payout.

– Tax Bracket: People in high marginal tax brackets that are likely to decline over time favor later Social Security payouts.

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Assess Types of Retirement Assets and Alternative Structures

Financial assets can be divided into pension and personal assets.

– Savings through qualified pension structures offer the benefit of pretax contributions and tax deferral.

– Savings in personal accounts are more liquid. When withdrawn through asset sales, personal account savings are taxed at favorable capital gains and dividend income rates .

– Annuities offer tax deferral and annuitization features and have withdrawals at ordinary income rates.

Human-related assets: Worth is typically derived from streams of income related to a person’s life span. Social Security and company pension payments from defined benefit plans are two such assets related to retirement.

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Assess Types of Retirement Assets and Alternative Structures, cont.

You have less control over human-related assets. – In the case of Social Security, the money is automatically

taken from your paycheck. – For company pensions, you are paid in yearly income

streams that you cannot sell nor can you otherwise control the payout.

Human-related retirement assets are typically nonmarketable.

As you approach retirement, your human-asset values decline sharply; and because Social Security and pension payments draw nearer, their discounted values become larger.

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Assess Types of Retirement Assets and Alternative Structures, cont.

Financial planners and Total Portfolio Management take into account human-related asset values.

Company pension and Social Security retirement income streams have significant benefits:

– Company pensions generally provide a predictable level annual payment not subject to market fluctuations.

– Social Security’s payout is adjusted for inflation and is at least partially tax exempt, with full exemption for those in lower income brackets.

Disadvantages of company pensions and Social Security payments are:

– The absence of an option to draw down the money earlier than the scheduled date of payment.

– The inability to transfer this asset to others at death.[

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Assess Types of Retirement Assets and Alternative Structures, cont.

Advantages Disadvantages Qualified Pension Plans

Pretax dollar contributions Tax deferral Modest administrative charges or

none Often the most attractive retirement

savings vehicle

Money generally cannot be withdrawn without penalty until age 59 ½

Withdrawals taxed at ordinary rates Overall limits on annual contribution Mandatory withdrawals must start at

age 70 ½ Annuities Tax deferral

No price fluctuation and guaranteed rate for fixed annuities

The option to annuitize No limits on annual contributions No mandatory withdrawals

Withdrawals taxed at ordinary rates Material overhead charges After-tax dollar contributions

Personal Savings Using Mutual Funds

Capital gains and dividends taxed at favorable rates1

Broad flexibility in shifting investment positions

Ability to select from the universe of choices

No limits on annual contributions No mandatory withdrawals

No overall tax shelter After-tax dollar contributions

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The Home

Thinking of the home as a retirement savings structure is complicated.

Advantages: – Tax deduction for mortgage interest and property taxes.– No taxation on the first $250,000 of gains per person or $500,000

per couple with any remainder taxed at favorable capital gains rates.

– A good inflation hedge.– Can be financed largely through debt.

Complications:– The home doesn’t provide cash flow unless part or all of it is rented

out– Many retired people prefer living in the same home for the rest of

their lives.

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The Home, cont.

Reverse mortgage: Provides borrowed funds based on the market value of the house and the age of the borrower. The debt is repaid from the proceeds of the home upon voluntary sale or upon the death of the borrower.

Even when the intention is to remain in it forever, the home has an embedded option: the alternative of selling. The greater the home’s value, the greater the option’s value.

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Investment and Withdrawal Risk

Investment Risk: The potential for below average returns. Declines are of particular relevance to retirees because of withdrawal risk.

Withdrawal risk: The chance of taking monies out to fund retirement when asset prices are depressed.

– When declines in assets happen at the beginning of retirement, they have a much greater effect than they might at the end of the retirement period.

– For those who are still working, the timing of negative investment returns makes little difference. Unless assets are withdrawn, the average compounded return over a period of years is the only item that matters.

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Inflation Risk

Inflation risk is a particular problem for retired people as salaries are often adjusted to take into account inflation, but the retired don’t have that job-related revenue buffer to offset increases in living costs. Annual inflation, 1914-2004:

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Longevity Risk

Longevity risk: The possibility of death occurring well before or after it is expected. In retirement, the financial risk is of living longer than the average person your age does.

The average male and female who retire at age 65 have 16 years and 19 years of projected retirement, respectively.

14 percent of males and 27 percent of females have a 25-year retirement and 10 percent of males and females have 27 years and 30 years of retirement, respectively.

Social Security extends until death as company defined-benefit pension plans typically do.

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Strengths and Weaknesses of Annuities

Strengths– You cannot outlive your annuity payments.– Annuities allow you to receive a fixed sum of money each year regardless

of market fluctuation. Weaknesses

– Annuity payments are usually not inflation adjusted. The flat payments tend to decline in purchasing power over time.

– Sometimes liberal assumptions favorable to them are used by companies on the length of life. In addition, the people attracted to annuities may be expected to live longer lives.

– Lack of liquidity once you annuitize, with no way to recover your lump sum or to speed up payment. Similarly, there is no sum to liquidate at death and leave for your heirs.

– A payout guarantee from a company which itself is subject to bankruptcy risk.

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Health Risk

Health risk: The possibility of large unreimbursable costs.

A great number of elderly people find that their medical costs more than double in retirement, even without a catastrophic illness.

Many medically related costs for the elderly are paid for under Medicare.

Medigap insurance, which can pay part or for some people all of the drug costs as well as certain supplemental medical payments are a way of meeting this risk.

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Health Risk, cont.

Long-term care costs can be high. The elderly may need partial or full assistance from another person either in a facility or in their own home at costs that can be sizeable.

Government assistance in this area tends to be limited in what is covered and the time period for coverage.

Those daunting costs sometimes compel people to enter a nursing home. For most, nursing homes are perceived as costly and not a desirable option.

Home health care designed to allow you to stay in your home when you have difficulty operating independently can also be very costly.

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Decide on Retirement Investment Policy

The retirement investment policy comprises types of assets and, in many cases, which investment structures they go into.

In many cases, the allocation for these assets will be similar to the overall longer-term asset allocation.

To sum: – Typically the most attractive place to save for retirement is a

qualified pension. – The principal exception can be the purchase of a home.– In order to realize the financial benefits of homeownership

for retirement planning, the home must be sold or borrowed against.

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Calculate Retirement Needs

Capital needs analysis is a way of establishing how much money we have to save to meet our goals.

Under the household approach, then, internal funds generated, specifically savings and often higher future income are used as the principal approach to support future capital needs.

Although we make important decisions on an overall organizational basis, as a business does, we fund each objective separately, using a capital needs approach.

We often restrict our use of a formal capital needs analysis to items of great significance to our goals, such as the purchase of a house, life insurance needs, disability needs, and retirement needs.

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Retired Households

Planning continues throughout retirement. Retirement planning must be reviewed periodically

for goals as well as current and projected assets change.

The outcome can be an alteration in savings, cost of living, or other retirement strategies.

One of the greatest changes may occur in the post-retirement period.

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Retired Households, cont.

Common risk factors include:– Health difficulties forces retirement at an earlier age than

expected.– Your company forces you to take early retirement or you

are terminated and at an advanced age cannot find a replacement job.

– Medical bills are higher than expected, and later in life costly human care assistance is needed at home or at a facility.

– The investment returns proved lower than expected.– Planning for retirement was not done in a logical, structured

way; often it was not done at all.

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Retired Households, cont.

Common alternatives are:– Cutback in cost of living.– Moving to a lower-cost region.– Receiving help from others. Typically, financial aid can come

from children.– Taking a part-time job. An exception to the cost only

emphasis. As people age more time is spent on estate planning

for other household members, elder care matters in case of physical or mental impairment and gifting and bequests.

Strategies may not only be legal or insurance-related but can include moving closer to children.

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Chapter Summary

Of the two types of pension plans, qualified and nonqualified, generally only qualified plans allow for a tax deduction for plan deposits.

Tax-deferred annuities are nonqualified retirement plans in which after-tax dollars are contributed.

Generally, only Social Security is indexed for inflation. A home may be considered a retirement asset if the

owner intends to sell it at some time in the future. Even without that statement a home may be sold in a financial emergency.

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Chapter Summary, cont.

Four particularly important types of risks in retirement planning are inflation, investment including withdrawal risk, longevity risk, and health risk.

Annuities deal with longevity risk. You can get a fixed sum regardless of market fluctuations.

Inflation-adjusted withdrawal rates of 3 percent to 4 percent annually as a percentage of original capital appear possible for 30-year retirement periods.