Articles About Retirement Planning

On January 28th of 2014, President Obama delivered his State of the Union address, which laid out many of his administration's policy goals for the coming year, including a number of initiatives he intends to implement by executive order. Amongst the list was the creation of a new "MyRA" retirement account, a type of "safe, easy-to-use starting savings account" for Americans, intended to help improve the country's retirement savings shortfall.

As further details have emerged, though, it turns out that the MyRA may be little more than a standard Roth IRA, funded via payroll direct deposits, and invested into a government bond fund, albeit with $25 initial and $5/paycheck ongoing contribution levels that are smaller than what financial institutions typically allow. As a result, many critics of the new MyRAs have emerged, from those who think the accounts will create more confusion by adding to the patchwork of retirement account choices while creating little new value (and worse, defaulting young people into fixed income investments without a chance at the long-term growth of equities), to those who complain that since the accounts are still purely voluntary to contribute to and those contributions remain liquid and accessible (as is standard for all Roth IRAs) that participation will be limited and those in need will just tap the accounts to spend later anyway.

Nonetheless, the reality is that the new MyRA is unique in its ultra-low direct deposit contribution limits, and while its fixed-income investment option isn't ideal in the long-term, the MyRA is "forced" into a private Roth IRA rollover that can be reinvested in a more diversified manner anyway once the account balance reaches $15,000. As a result, even if the program just gains limited traction, there may be a significant boost of $15,000 MyRA "rollover planning" in just a few years. And given that the MyRA can be implemented by executive order without Congressional approval - as President Obama has stated he intends to do - the reality is that the MyRA really does appear to be coming soon, with a pilot program rolling out by the end of the year!

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While the first safe withdrawal rate research originated nearly 20 years ago, it was simply based on an analysis of the sustainable cash flows that could be drawn from a portfolio over a 30-year time horizon based on various historical scenarios, ignoring the impact of fees and taxes. Of course, in the real world clients must bear the cost and impact of both, which reduce not only the amount of growth that the portfolio enjoys over time, but also the level of sustainable cash flows.

In reality, though, extensive research has been done over the past two decades to model the impact of taxes (and fees) on safe withdrawal rates. The impact is not as severe as some might fear - it's not as though the safe withdrawal rate must be chopped by 25% for a client in the 25% tax bracket - due to the fact that taxes have a natural self-mitigating effect, as they are only due when the portfolio has appreciated (which is when it has the most money available to pay those taxes). Of course, if the account actually is a pre-tax IRA, though, the net spending really does have to be reduced for the entire marginal tax rate!

Although the application of these adjustments can become complex when combining taxable accounts, pre-tax retirement accounts, and tax-free Roth IRAs, the fact remains that a proper application of the safe withdrawal rate research should reduce a client's recommended spending to account for the future drag of taxes, along with investment expenses and advisory fees. On the other hand, the good news is that other factors can help to boost the safe withdrawal rate as well, including a client's greater diversification (i.e., more diversified than the original research assumptions), spending flexibility, and varying time horizon. Ultimately, all of these adjustments can be incorporated to arrive at an appropriate safe withdrawal rate recommendation for a client.

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Over the past decade, Monte Carlo analysis has been slowly replacing its retirement planning predecessor - the straight-line projection - which was overly reliant on a single distant outcome, with no acknowledgement of the potential impact of volatility on the final results and the success of the plan. By contrast, the virtue of Monte Carlo analysis is that it shows a range of possible outcomes, and quantifies results not with a single and inevitably inaccurate estimate of final wealth decades from now, but instead a probability of success/failure that captures how many of a wide range of outcomes are projected to be successful or not.

However, as Monte Carlo analysis has become increasingly popular, the focus has unfortunately shifted once again towards a single projected outcome - the probability of success/failure - without fully acknowledging the range of outcomes and their nuances, such as the fact that a plan with a higher probability of failure may actually be the more appealing option if it's accompanied by a less severe magnitude of failure. Perhaps most significant, though, is simply that the labels "success" and "failure" do little to connote the true reality - that "success" actually means an excess left over, and that failure merely means that some kind of mid-course adjustment may need to occur.

Yet the reality is that while these differences are arguably mere semantics and nuance, how results are framed matters, and can significant impact real world client behaviors, given the difficulty our brains have in trying to interpret Monte Carlo's probabilistic results. Which means if the truth is that "failures" merely require mid-course adjustments and that "successes" actually leave over excesses, perhaps it's time to relabel Monte Carlo results accordingly as "probability of adjustment" and "probability of excess" to ensure clients are making the proper decisions! 

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Starting savings efforts young, and taking advantage of the wonder of compounding interest, is a long-standing staple of financial planning advice. The longer the time horizon, the less that needs to be saved to achieve a retirement goal. Yet the caveat of such an approach is that while it's crucial to start saving initially, after the first decade or two the ongoing contributions have less and less impact, as the results are increasingly dominated - for better or for worse - by the portfolio returns.

In fact, by the time the retirement date approaches, the outcome becomes so dependent upon returns, that a poor final decade of performance can drastically derail the entire retirement plan. Saving steadily to grow a portfolio over the span of 40 years begins to look more like saving half the goal in the first 30 years, and quickly doubling the account balance and retiring. Of course, when viewed from this perspective, it suddenly becomes clear that the save-a-little-for-a-long-time approach to retirement is far riskier than most realize.

Ultimately, that doesn't mean people shouldn't start saving early for retirement. But it does recognize that a retirement plan that is heavily reliant on returns can have highly adverse outcomes, where the risk is not just the potential that wealth is significantly less than originally projected, but that retirement will have to be delayed significantly further than originally planned. In fact, perhaps it's time to talk less about risk as standard deviations and the volatility of wealth, and more about retirement date risk and the volatility of when the client will be able to retire, instead?

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In today's low-return environment, retirees have become increasingly stressed about the potential risk of outliving their retirement assets, which in turn has led to an increasing call for strategies that at least partially annuitize a portion of the portfolio. After all, a single premium immediate annuity (SPIA) provides a lifetime stream of income that by definition cannot be outlived, and the potential for long-lived retirees to earn mortality credits creates the potential to earn significantly more cumulative return than what bonds alone can pay. In fact, a great deal of research over the past decade has shown that partial annuitization of a portfolio can improve retirement income sustainability over portfolio-based strategies alone.

Yet in new research produced by yours truly, along with retirement researcher Wade Pfau, it appears that the prior research may not be entirely correct. While it's true that for extreme longevity scenarios, SPIAs provide an unparalleled return and enhance retirement outcomes, the strategy as commonly implemented is also an indirect form of a bucket strategy that disproportionately liquidates fixed-income assets in the early years and lets the rest of the (risky) portfolio run. By reducing withdrawals from risky assets in the early years, the exposure to potentially unfavorable return sequences is diminished, even as the total allocation to equities rises throughout retirement.

In fact, as the results show, the majority of the benefits commonly attributed to partial annuitization are actually just the indirect result of a bucket strategy that produces a rising equity glidepath. While SPIAs do still provide superior results for very long-lived retirees, it truly takes extreme longevity - i.e., married couples living beyond age 100 - before the contribution from mortality credits actually outweighs the benefits of just using a strategy that liquidates more fixed income in the early years and allows equity exposure to rise. Accordingly, the bottom line is that for retirees who truly want to hedge extreme longevity, the benefits of SPIAs remain unmatched, but for most retirees who will not live that long the reality is that SPIAs not only fail to provide benefits, but they can actually produce results inferior to just replicating the rising equity glidepath without annuitizing at all!

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A few weeks ago, the 2013 Trustees Report on Social Security was released, confirming once again that the Social Security system continues to pay out more than it takes in, remaining on a path that is ultimately unsustainable. Yet the details underlying the report reveal a more profound reality: that while Social Security as it is currently constituted is not viable in the long run, the downside of depleting Social Security is far less severe than we often make it out to be.

The reality of the Trustees Report is actually that, even if we do nothing to resolve Social Security in the coming decades, that the system will still be able to pay out 77% of its projected benefits in 2033 when the trust fund is depleted, and continue to pay out more than 70% of its projected benefits for the remainder of the century. In other words, even if we do nothing to fix the system at all, today's Generation X and Y young adults would still be anticipated to receive about 3/4ths of their anticipated benefits for their entire retirement.

And that's if nothing is done. If instead the woes of Social Security ultimately are addressed, through some combination of current and/or future benefit adjustments, and increases in the Social Security payroll tax rate, wage base, or the taxation of benefits, the shortfalls decline further and the ability to pay future benefits rises. Which means that ultimately, the most likely future outcome is a haircut of less than 23% of benefits for today's young adults, and that most future benefits will in fact still be funded. As a result, it's important to recognize the real state of the Social Security system, to ensure that clients receive appropriate advice in light of what isn't, and is, likely to be there when the time comes.

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Over the past several decades, the national savings rate has plunged, even as the system for retirement preparedness has shifted increasingly towards defined contribution plans that rely on workers choosing to save in order to succeed. The end result is a generation of baby boomers that have found themselves woefully behind on retirement, notwithstanding all the "save more and spend less" advice that has been laid upon them for years.

Yet recent research suggests that perhaps the key to resolving this is to stop telling people to cut their spending now and save more, and instead to simply encourage them to save more tomorrow, instead. While this doesn't necessarily solve the challenge of the baby boomer who is already on the eve of retirement, the research suggests that for those in Generation X and Generation Y who still have years or decades until retirement, it may be a far more effective approach. The concept is rather straightforward - just commit to saving most of next year's raise, instead of cutting your spending now - yet the simple elegance is backed by a number of important behavioral finance concepts, including aversion to a loss of current lifestyle and taking advantage of our tendency towards hyperbolic discounting to make (future) saving less painful.

While there are some real world challenges to implementing a Save More Tomorrow approach - in part because planners lack some of the tools necessary to fully automate the process the way it's been done in the early research - it nonetheless raises the question of whether our "traditional" approaches to retirement advice, like "save more and spend less" or "save X% of your income every year" are due for a radical rethinking. By focusing on saving more tomorrow - and by not spending more tomorrow - perhaps we can actually find a better path to guide today's future retirees towards success.

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Last week, President Obama released his proposed government budget for the coming 2014 fiscal year. Of course, the reality is that the budget itself is just proposed and has not yet been approved, and many of the suggestions contained in the budget may be reformed before being set forth in actual legislation (or fall by the wayside entirely, or be written into legislation that ultimately doesn't pass). Nonetheless, proposals in the President's budget often signal areas that the Administration may be targeting for reform, and/or line items that could end out as a bargaining chip in future legislation.

In the 2014 budget, the Administration reiterates several reforms that have been suggested in the past, including an array of high-net-worth estate planning crackdowns, and even a reversion back to the 2009 estate tax exemption and rates. However, the proposal also includes several notable new provisions, including a potential tax credit for establishing automatic enrollment retirement plans, a shift to chained CPI that could impact everything from Social Security benefits to income tax brackets to the return on TIPS, a series of estate planning crackdowns on GRATs, IDGTs, and dynasty trusts, and in what has already been picked up by the media as a controversial provision, a potential "cap" of $3.4 million on retirement accounts beyond which no further contributions would be allowed.

In addition, surprising new proposals outside of gift and estate planning were included, including favorable relief allowing inherited IRA rollovers and an extension to the tax-free treatment of mortgage debt cancelling in a short sale, and the elimination of Required Minimum Distributions for those with less than $75,000 in retirement accounts. On the other hand, the proposals also include an increase to Medicare Part B and Part D premiums, especially for higher income individuals, a potential cap on itemized deductions at a 28% tax rate (even if the individual has a higher tax bracket), and a new requirement that all stocks in the future must use average cost (eliminating the ability to make lot-level gain and loss harvesting decisions).

The reality at this point is that information and details on many of these provisions are still limited; nonetheless, we highlight all of the most important proposals that would impact financial planners and their clients, and consider their feasibility and the potential planning implications.

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