What You Can Do About The Pension Crisis
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. A Wobbly Three-Legged Stool
2. The ABCs of Retirement Planning
3. Avoid Retirement Planning Mistakes
4. Simple Rules For A Secure Retirement
In my February 14th E-Letter, I discussed the current state of pension plans in the US, and the fact that many workers can no longer count on having the benefits they have been promised over their working lifetime. As you might imagine, I got lots of responses from my readers. Some appreciated my simple explanation of how these plans work, while others expressed concerns about their own employers’ plans.
While some very large employers have frozen or terminated their pension plans, I want to make it clear that not everyone who is covered by such a plan should fear the worst. Many employers have well-funded retirement plans and will be able to make good on the promises to their employees. The main point I wanted to make is that it is important for you to stay informed about your pension plan, and ask lots of questions.
For those whose employers may be contemplating modifying their pension plans, I concluded that there appears to be very little that workers can do to prevent termination or freezing of benefits. However, this doesn’t mean that there is nothing you can do to better your situation. One of my conclusions was that workers now have to assume the responsibility for their own retirement security.
The only problem with the conclusion that employees must now fend for themselves is that we continue to see reports of how the Baby Boomers have failed to adequately save for their retirement. Perhaps they counted on their pension plan promises too much and decided to spend everything they made, hoping their employer would take care of their post-retirement needs.
In this week’s E-Letter, I’m going to discuss how you can take hold of the reins of your own retirement planning. However, while I can provide the advice about how to proceed, I cannot give you the discipline to forego spending in favor of putting money back for the future. Whether your retirement will be “golden years” or just “olden years” depends on you, so read on.
A Wobbly Three-Legged Stool
Since early in my securities career, I have always heard retirement planning discussed in terms of a three-legged stool. The typical worker should be able to count on three sources of retirement income: 1) employer-sponsored retirement plans; 2) government plans such as Social Security; and 3) personal savings.
At this point in time, however, all three of these legs appear to be a bit wobbly. As noted above, my February 14 E-Letter discussed how employers are forsaking their retirement promises. My January 11, 2005 E-Letter talked about how Baby Boomers have not saved enough for retirement, and we all know about the Social Security funding problem as discussed in my March 9, 2004 E-Letter.
It’s no wonder why many of today’s workers feel helpless about their retirement situation. It is unlikely that Congress will ever fix Social Security until their backs are literally against the wall. Likewise, many employers today appear to be far more concerned about their share price and executive compensation, rather than for the welfare of their employees. The only leg of the stool that you can completely control is that of personal savings, and it is in this area that the rest of this E-Letter will concentrate.
The ABC’s Of Retirement Planning
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, and are actually pretty simple:
1. Save as much as you can, as early as you can;
2. Don’t make mistakes such as tapping retirement funds before you retire; and
3. Invest wisely and diversify for the long-term.
In regard to the first item about saving as much as you can, we are fo rtunate to live in a time when there are more retirement plan options open to employers than ever. In addition, there are many more personal retirement planning opportunities than there have ever been. By taking advantage of all of the various retirement planning opportunities, a worker entering the workforce today is now more than ever able to be the master of their own retirement fate. I’ll discuss more about how to take advantage of these opportunities a little later on.
As for retirement planning mistakes, there are many that can occur. In most pension plans, workers do not need to worry about electing to participate or making their own investment decisions. However, more and more employers are electing to offer 401(k) plans where worker contributions are required for participation, and participants must also make their own investment decisions.
In light of the 401(k) revolution, perhaps one of the biggest mistakes that I see is not participating in employer retirement plans, especially when the plans offer matching contributions. I’ll discuss this in more detail below, but you probably can’t take responsibility for your own retirement well being if you fail to participate in your employer’s plan.
Another mistake that is almost as bad as not participating is electing investment options that are too conservative. Many employees have heard that retirement plan assets should be invested “prudently.” Unfortunately, some think that prudence means ultra conservative, so they invest only in fixed-rate investments and other low-yielding instruments that offer a high degree of principal protection.
In doing so, they can actually be acting imprudently, in that virtually all of these “safe” investments offer returns that barely keep up with inflation. That being the case, the accumulated value at retirement may have only the purchasing power of the original investment. It’s better than stuffing the money into a mattress, but just barely. Building a meaningful retirement benefit usually means taking some measure of risk in order to access potential returns that are greater than inflation. This way, your nest egg has the potential to not only grow in terms of absolute dollars, but also in terms of purchasing power at retirement.
Another common mistake made by 401(k) plan participants is failing to diversify their investments. Some will put all of their contributions into the fund that did the best last year. Unfortunately, the latest hot performers often fail to repeat the performance, and sometimes even struggle to have gains at all. Other participants try to diversify, but they don’t do enough homework to realize that some of the funds they are offered have virtually the same underlying stock holdings. So, while they are in a number of different funds, they may not be very diversified.
The mutual fund industry is picking up on the confusion surrounding making investment decisions. The result has been the introduction of “target” retirement funds and “asset allocation” funds. These funds seek to provide one-stop shopping by automatically diversifying among a number of different funds, and some even modify the mixture of funds as the worker gets older and nearer to retirement.
While I think that participating in a target or asset allocation fund is better than not participating at all, there are limitations to these mutual funds. First, they are really just a fund made up of other mutual funds, so there are sometimes higher fees than if you just invested in the underlying funds directly. Another limitation is that these funds typically invest only in the sponsoring mutual fund family’s funds. A single mutual fund family rarely (if ever) has all of the best performing funds in the various asset classes, so this practice may limit the ability to access management talent in other fund families.
Spending Retirement Benefits Early
Another mistake that retirement plan participants can make is receiving a retirement plan payout after changing jobs, and then spending the money rather than keeping it in a retirement plan. Studies have shown that the younger the person is who takes money out of their retirement funds, the lower the 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 also actually circumvents a number of laws passed to try to ensure the retirement security of retirement plan participants.
A recent report from the Employee Benefit Research Institute (EBRI) stated that 25.2% of lump-sum retirement plan distributions used all or part of it for new consumption. Fortunately, this number is down from 38.3% in 1993, but it is still shows a significant number of all retirement plan distributions are SPENT rather than rolled over into another tax-qualified plan.
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 or account balance becomes yours.) The Employee Retirement Income Security Act (ERISA) was passed in 1974 to eliminate pension plan abuses, such as when an employer would fire a worker just before retirement to escape paying promised benefits. ERISA required all plans to allow for 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 relatively young 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 a boat 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. One of my favorite illustrations of the problems with spending retirement plan money is called “The Million Dollar Ski Boat.” Space doesn’t permit me to include it in this E-Letter, but click on the previous link to see an illustration of just how imprudent spending an early distribution might be. [You may want to print the ‘Million Dollar Ski Boat’ story and give it to your children or grandchildren.]
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 whether 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 $4,000 ($5,000 if over 50) for a single person, or $8,000 if both husband and wife are employed ($10,000 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. Even so, 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 as much as you can and try to increase your percentage each year. This is especially important if your employer provides a matching contribution in your 401(k) plan.
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. While many 401(k) plans have participant loan provisions, it is best to never borrow from your retirement funds. However, if you find that 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, since 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.
In addition, if you change jobs with an outstanding 401(k) loan, it cannot be rolled over to an IRA. Instead, it is typically treated as a taxable distribution, complete with a 10% penalty tax if you are under age 59 ½. Thus, my best advice is to “JUST SAY NO” to participant loans, but if you must access your retirement funds in this way, do so only as a last resort.
On a related note, some 401(k) plans also have “hardship withdrawal” privileges. Unlike a participant loan, hardship withdrawals are taxable distributions from your plan to cover a legitimate emergency expense that you cannot meet from other resources. Again, you should resist any urge to access funds via this provision. Qualifying for a hardship withdrawal is difficult, and unlike a participant loan, the amount you receive is immediately taxable to you, including a 10% penalty tax if you are under age 59 ½. Plus, not being a loan, you can’t pay the money back to your plan to grow for your retirement. Thus, these distributions are rarely ever a good idea.
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. If their employer provides a matching contribution, the result can even be greater than the dollar value of your assistance, since the contribution plus the match goes to work for their retirement. As salary increases allow for 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, especially where there is an employer matching contribution, will pay big 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. Many 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.
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. Professionals can not only help you evaluate the various investment options, but 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.)
Please note that the above list of simple steps is not meant to be an exhaustive list of steps you can take to maximize your retirement savings. Instead, it is an attempt to hit the “high points” and provide a basic foundation for retirement planning.
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 assets. 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.
I realize that many of my readers may want to take responsibility for their retirement, but are not comfortable making investment decisions. There’s a lot to know about the mix of different types of investments at various ages, which funds may be the best alternatives, and whether employer stock should be considered.
This is where we might be able to help. If you are having trouble managing your own 401(k) or self-directed IRA assets, give one of our knowledgeable and experienced Investor Representatives a call at 800-348-3601, or e-mail us at firstname.lastname@example.org. We can help you cut through the maze of investment alternatives and arrive at a mix that is suitable for your age, risk tolerance and financial goals. The call and the assistance are free of cost and obligation, so give us a call today.
Very best regards,
Gary D. Halbert
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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.