RETIREMENT PLANNING – IT’S UP TO YOU!
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Baby Boomers Are Not Saving Enough;
2. A Friend’s Big Retirement Mistake
3. The Million-Dollar Boat – Don’t Go There
4. Simple Rules For A Secure Retirement
5. Happy New Year!
Hundreds of thousands of Baby Boomers, like me, receive this weekly E-Letter. Various statistics from numerous sources reach the same general conclusion: The vast majority of Baby Boomers are behind in saving for their retirement. This is a very serious problem, and as the Baby Boomers hit retirement age over the next decade, there will almost certainly be major problems for the economy and the financial markets.
Given this, and in light of the uncertain future of Social Security and the miserably poor savings rate in the United States, the topic of retirement planning is probably the most important issue regarding the future well being of you and your family. So, in this holiday issue of F&T E-Letter, we will address some retirement planning issues that I feel are paramount to reaching your financial goals.
Whenever I am asked a retirement planning question, my most frequent answer is, “It depends.” That’s because the laws, rules and regulations governing retirement plans are complex, and there are hundreds of exceptions and many little nuances that apply.
Even so, the basics of retirement planning are not rocket science, but are actually pretty simple:
1. Save as much as you can, as early as you can;
2. Invest wisely and diversify for the long-term; and
3. Never tap retirement funds until you actually retire.
Below I’m going to discuss some of the common mistakes people make with their retirement planning and the consequences they usually create. I’ll end up with some valuable common-sense rules to follow to help insure a secure retirement for yourself and your family.
A Very Bad Decision
Recently, a friend of mine quit a job with a company he had been with for over 20 years. He was considering starting a new business with his brother-in-law, so I admire his entrepreneurial instincts. However, something he told me made cold chills run up and down my spine. He said, “I have a lot of money built up in my 401(k), so I might just kick back and do nothing for a year or so and live off of that.”
While his decision to quit a good job with a national company may or may not turn out to be a good one, his desire to take a year off at the expense of his retirement savings is an exceptionally BAD IDEA! Not only will he be living off of money that is taxed an extra 10% for premature withdrawal, but he is also planning to spend the retirement savings he has accrued for the 20 years of hard work he performed for his former employer.
Even worse, he had already taken a participant loan out against his 401(k) balance, which cannot be rolled over into an IRA, so he already had a tax problem. For the sake of a short-term year of relaxation, he was unknowingly about to destroy his future retirement security.
Needless to say, I recommended against the idea, and it appears he has taken my advice. He went straight into the new business and, fortunately, is doing quite well so far. However, his situation and attitude toward accrued retirement planning is much more common today than anyone might suspect. A recent report from the Employee Benefit Research Institute (EBRI) stated that a significant number of all retirement plan distributions are SPENT rather than rolled over into another retirement plan or a rollover IRA.
In dealing with retirement planning issues, several troubling trends become evident. One such trend that we see is, the younger the person is who takes money out of their retirement funds, the lower chances are that those monies will ever be put back in or rolled over into another tax-deferred vehicle for retirement. This not only shows a lack of financial wisdom, but actually circumvents a number of laws passed to try to ensure the retirement security of retirement plan participants.
In the early days of retirement plans, there was no such thing as required “vesting” in your benefit. (Vesting simply means that the longer you work, the more of your accrued retirement benefit becomes yours.) While many early retirement plans did allow for vesting schedules, there was generally no requirement to do so. At many employers, if you actually stayed until retirement, you got your retirement benefit. If you left before retirement, too bad.
This led to widespread abuses where employers would fire employees just before retirement in order to avoid having to pay them any retirement benefits. The Employee Retirement Income Security Act (ERISA) was passed in 1974 to eliminate this and other abuses. One thing it did was to require the vesting of benefits over time.
With the recognition that the workforce has become much more mobile in recent years, additional laws have been passed since 1974 in order to accelerate vesting in retirement benefits. Under ERISA, full vesting could take as long as 15 years. Today, many plans provide for 20% vesting after only two years of service, with full vesting after six years. With the combination of earlier vesting and people changing jobs more frequently, the result is that more and more younger people are receiving retirement plan distributions. In many cases, these distributions are relatively small amounts of money, which means they are more likely to be spent rather than reinvested in another retirement plan.
What Are They Doing With The Money?
It’s impossible to know for sure what young participants do with the money they receive from their plans. The EBRI numbers indicate that a significant number of them are not rolling the money over into another plan, but what they are actually doing with these funds is hard to tell.
From my experience as an Investment Advisor, I can tell you that younger participants generally have smaller account balances, so the amount distributed to many of them does not seem substantial in their eyes. Some use the money to pay down debt; others use the money to live on while looking for a new job; and still others see the money as a windfall to be used as a good down payment on that new car or big screen TV or boat that they always wanted.
While I would advise against using retirement money for any of the above reasons, and while the fallacy of doing so seems so obvious, the fact is this happens all the time. For many young people, retirement is far, far away in the future, but the desire for a new car, new computer, boat, big screen TV – or whatever - is immediate.
The Million Dollar Boat
Let’s look at an example to determine exactly what the eventual cost of cashing out a retirement benefit might be for a young person. Young John Doe is 28 years old and has accepted a position with a new company. He worked for his former employer since he graduated from college at age 22, so he has six years of service and is 100% vested in his 401(k) plan balance of $25,000. Of this amount, $10,000 represents his pre-tax contributions, and the remaining $15,000 represents his employer’s matching contributions, plus earnings.
John’s new employer also sponsors a 401(k) plan, and it has a provision that allows new employees to roll over any balance from a previous plan into the new employer’s plan. Rather than rollover his $25,000 from his previous plan to the new one, John elected to take a full distribution from his old plan and use the 60-day rollover period to think about what to do. Under current law, the former employer is required to withhold 20% ($5,000) of the total distribution as a reserve for income taxes, so John receives a check for $20,000.
Poor John is already at a disadvantage. Under the law, he could have elected to have a direct rollover (all $25,000) from his former employer’s plan into either his new employer’s plan, or into an individual rollover IRA. By taking a direct distribution to himself, $5,000 has been withheld for taxes. If he rolls the full distribution over to an IRA, he will get back the $5,000, but only as a tax refund after he files his taxes next year. Thus, he must come up with the $5,000 out of other resources, or rollover only the $20,000 he received, leaving a $5,000 taxable distribution.
When springtime rolls around, John is still within his 60-day rollover period, but sees an ad for a super deal on a new ski boat for only $18,000. Even with tax, additional equipment, etc., the $20,000 he got from his plan will more than cover the costs. Now, John goes into full justification mode. He’s got to rationalize a good reason to use the money on a boat rather than rolling it over for retirement. The thinking process goes something like this:
* He’s only 28, so his Social Security retirement age of 67, is almost 40 years away – more than enough time to make up a measly $20,000;
* Even though there will be a tax bite on the distribution, he doesn’t have to worry about that until next year when he pays his taxes;
* And anyway, he always gets a tax refund, so that plus the $5,000 already withheld from the distribution will probably cover any additional tax he may owe;
* As a practical matter, $10,000 of that distribution was the result of his own pre-tax contributions, so that is really his money anyway; and
* The boat is RED with SILVER STRIPES, with a 300 hp inboard/outboard motor that will make him an automatic “chick magnet.”
You will note that not all of the justifications above make sense. That’s the nature of youthful justification. It doesn’t have to make sense, it just has to sound good.
So, let’s see what John has given up. In exchange for a tax-deferred benefit representing the retirement savings accrued during his six years of hard work, he has purchased a depreciating asset. Not only that, but a depreciating asset that has also been described as “a hole in the water into which you throw money,” but that’s a subject for another E-Letter.
The true cost of John’s decision is not just the tax bill on the distribution, or even the penalty tax due because he is under age 59 ½. The real cost is what he gives up at retirement by cashing out his accrued retirement benefit. By the time John retires in 39 years at age 67, the boat will be a distant memory. However, had he maintained his distribution in a tax-deferred account, here’s what he might have accumulated:
What seemed like a relatively small amount of money to John at age 28 can grow into a sizable sum of money via the miracle of compound interest over many years. Would you trade $25,000 now for a potential benefit of $240,000 to over $1,000,000 at retirement? Or, let’s put it another way: Would you pay a million dollars for a boat? Our friend in the above example might do just that, and the attitude toward retirement that he exhibited is far more common than you might suspect.
As I stated above, laws have been passed in recent years to make sure that our more mobile workforce does not walk away from accrued retirement benefits. However, many recipients of these distributions are circumventing the purpose of these laws by not keeping them in tax-deferred accounts. The net effect upon their eventual retirement is the same as if they had never vested in the benefit in the first place.
It may sound like I’m just picking on young people, but there are also many older participants who do not rollover their retirement distributions. Some have had a series of jobs where they accrued vested benefits, only to cash them out – pay the penalty and spend the money - every time they move to a new employer. At retirement, they are faced with a long work history but little or no retirement benefits to show for it other than Social Security. (However, they may have had a boat that was really nice a long time ago.)
A Few Simple Rules For A Secure Retirement
With so many employers discontinuing traditional pension plans in favor of 401(k) plans where YOU elect to participate or not, your retirement security is now really in YOUR OWN hands. The following simple rules can help you to build a retirement nest egg so that there is some “gold” in your golden years:
1. The first and most obvious rule is that you should elect to participate in any tax-deferred/retirement programs offered to you through your employer. Recent law changes have made it possible for even the smallest of employers to sponsor 401(k)-type retirement plans, even if the employer cannot afford to contribute to the plan or match employee contributions. If your employer does not sponsor a plan, ask him or her, to check out the SIMPLE IRA or a SEP IRA.
2. You should also contribute the maximum allowed every year to your own traditional or Roth IRA, even if you are covered by an employer’s plan. Currently, the maximum contribution to an IRA is $3,000 ($3,500 if over 50) for a single person, or $6,000 if both husband and wife are employed ($7,000 if both are over 50). These limits are set to increase to $5,000 by 2008 ($6,000 if over age 50). If you are not covered by an employer plan, you should be contributing to an IRA. For more information about Roth and traditional IRA contribution limitations, see IRS Publication 590 available on the IRS website (www.irs.gov).
Your contributions to a traditional IRA may not be deductible if you do participate in an employer plan. However, non-deductible IRA contributions still grow tax-deferred until you withdraw them after retirement, and growth attributable to Roth IRA contributions can qualify to avoid taxation altogether. In addition, some employer plans allow you to make after-tax voluntary contributions that also grow tax-deferred, and are invested along with the assets of the plan. Be sure to ask about this.
3. Once you decide to take advantage of all of the retirement savings vehicles available to you, you also need to maximize your contributions to these plans to the extent possible. If you can’t contribute the maximum percentages, do what you can and try to increase your percentage each year.
4. Another rule of successful retirement planning is to use time to your advantage. In a nutshell, this means to pile as much money up as quickly as you can when you are young. This gives the magic of compound interest the maximum number of years to work to your advantage. If you procrastinate about participating or maximizing your contributions while young, you lose valuable years for compounding.
Here’s an example of what I’m talking about. If an employee makes an annual contribution of $1,000 from age 25 until retirement at age 65, these contributions will grow to $486,852 assuming 10% interest per year. However, if he waits until age 35 before starting to contribute, the value at age 65 decreases to only $180,943, a difference of over $300,000!
This seems odd, since starting at age 35 results in only $10,000 less in contributions. However, the remainder of the difference is from fewer years for earnings to compound. In retirement planning, time – and the MIRACLE OF COMPOUNDING - are your best friends. Take full advantage of them!
5. When switching jobs, resist the temptation to spend retirement distributions. Take advantage of direct rollover opportunities to maintain the tax-deferred status of your accrued retirement benefits. I have clients who have multiple rollover IRAs, one from each former job. However, these IRAs continue to grow tax-deferred, and when combined, can amount to quite a nice retirement fund for these clients.
6. If you must borrow from your retirement funds, plan how and when you will repay the loan as soon as possible. I am not one to say that you should never borrow from your retirement funds; emergencies can happen. However, such loans should only be made as a last resort, and the money should be repaid ASAP.
When you borrow money from your retirement plan, it’s true that you get the benefit of a relatively low interest loan, and you pay the interest back to yourself. However, you are also taking the amount of the loan “off the table,” so to speak. It is not invested in the market; it will not participate in any market gains that may occur; and most of all, it is not getting the benefit of tax-deferred compounding.
7. If you are already at or near retirement, but have children and grandchildren who are starting their working careers, share this information with them and encourage them to participate in their employer’s retirement plan.
Many parents and grandparents try to help their children and grandchildren by giving them money for major purchases and other “necessities.” Other than a down payment for a home, I can think of no better gift than to make money available for them to maximize their participation in their employer’s retirement plan.
Most parents and/or grandparents never think about helping their kids maximize their contributions to their retirement plans because only the owner(s) of the plan(s) can contribute the money. Here is a way parents and/or grandparents can help that is rarely used or recommended. You can cover some of their monthly household expenditures, so that they can have the maximum percentage withdrawn from their pay and placed into the retirement plan. As they get salary increases and get on a better financial footing, you can either stop the assistance or redirect your gifts to be used for their kids (college planning, transportation, etc.)
Gifts that enable maximum participation in a tax-deferred retirement plan will pay dividends far beyond your lifetime, and in an amount that will be much greater than the value of the initial gift itself. Think about it!
8. Make wise investment decisions. Today, there are many investment options that are available to retirement plans, ranging from no-risk CDs to very high-risk products that can lose all the money you put in them. If you have read my E-Letters for long, you know that I recommend that most people should use professional Investment Advisors to help make their investment decisions.
While there are some Advisors, and some investment products, that are not available to retirement plans, there are many that you can access depending upon the plan’s list of investment options. Professionals can also assist you in determining the optimum mix of investment options available in your plan, known as “asset allocation.” This is one area where we may be able to help you. (More on this below.)
Most large companies with retirement plans have a Human Resources Department that should provide educational materials about investing and may be able to recommend qualified professionals to help make retirement plan investment decisions. Check with your Human Resources or Personnel Department staff to see if such resources are available.
All of the above can be summed up as follows: 1) Use every tax-deferred option available to you; 2) Save as much as you can in these plans, as early as you can; 3) Don’t borrow from your retirement plan unless absolutely necessary; and 4) Encourage your children and grandchildren to do likewise. The miracle of compounding should be fully understood by you and those you care about.
When it comes to how you invest those retirement assets, it gets more complicated. Like other investments, you want to diversify your retirement plan investments. Some plans have limited choices, while others have many different options. The key is that you want to invest wisely and for the long-term. After all, it is your future and none of us want to end up being a burden on our kids.
As noted above, there are professional Advisors and professionally managed investments that are available to many retirement plans, including individual IRAs. If you need help in this area, we at ProFutures Investments are happy to assist you. You can call us toll free at 800-348-3601 or you can visit our website at www.profutures.com.
Happy New Year!
In closing, let me wish you a happy and profitable New Year. I hope that you have benefited from the advice I have offered in 2003. I expect that 2004 will be another good year for the stock markets and several other investment sectors. If we can help, please let me know.
Finally, I appreciate all of the e-mail responses we get from readers of this E-Letter. Your comments and suggestions are appreciated, and we respond to all e-mails that request information or a reply.
Until next year,
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.