Articles About Retirement Planning

When it comes to navigating the world and understanding our surroundings, abstraction (i.e., the process of extracting the higher-level essence of something to formulate general ideas of concepts) is very important. We are constantly formulating and updating mental maps of our world for the purpose of carrying out goals. Abstraction is particularly relevant in a field like financial planning, where we deal with abstractions that are not only more complex than simple, physical objects (e.g., a tangible concept like a chair), but also that represent concepts that are complex and abstract themselves (e.g., the concept of preparedness for retirement).

One difficulty with developing abstractions is that ‘ideal’ levels of abstraction are simply not self-evident. In one context, a ‘high-resolution’ abstraction (e.g., one with very specific information, like the scientific name for a certain species of rattlesnake, 'Crotalus atrox') may be ideal, whereas in another context a ‘low-resolution’ abstraction (e.g., a broader, less detailed description, such as ‘living organism’) may be best. Yet, in other circumstances, some middle-ground abstraction (e.g., ‘rattlesnake’) may be most useful. The level of abstraction that is ideal depends on many factors such as one’s environment, the knowledge level of those we are communicating with, and the need to convey certain pieces of information. This is why a group of advisors can communicate just fine using industry jargon, while that same industry jargon could be a barrier to communicating with a client.

Perhaps one of the best abstractions ever developed within financial planning is the Morningstar Style Box. By capturing two of the most crucial dimensions of equity returns within a single, easy-to-read graphic, the Morningstar Style Box conveys a tremendous amount of important information about a stock portfolio in a highly efficient manner. The Morningstar Style Box also has the advantage of reporting two primary dimensions, which lends itself to presentation in a two-dimensional graphic that remains easy for our brains to interpret. However, once we get out to three dimensions (and particularly four or more dimensions), the added complexity can actually diminish our understanding rather than enhance it.

Despite the success of abstractions such as the Morningstar Style Box, however, abstractions used for many other key concepts within financial planning are severely lacking. For instance, ‘probability of success’ – the primary metric used for conveying preparedness for retirement within most modern planning software – is known to have a number of issues. In particular, ‘probability of success/failure’ entirely misses the dimension of ‘magnitude of success/failure’, which is highly important for developing a rich qualitative understanding of a retiree’s plan dynamics. For instance, a plan with a high probability of failure and a low magnitude of failure is qualitatively different than a plan with a high probability of failure and a high magnitude of failure, but in a world where only ‘probability of success’ is reported, then these two plans will look identical.

Notably, the problem with many Monte Carlo-based retirement analyses is not necessarily with Monte Carlo itself, but with trying to find a better abstraction for communicating Monte Carlo results. At a minimum, an ideal abstraction likely needs to cover both relevant likelihood and magnitude of success/failure. Furthermore, an ideal abstraction should convey that success/failure themselves can be a bit inaccurate in a world where ‘adjustment’ can avoid the most extreme outcomes. And finally, we also want to consider what may even be most important to report to a client in the first place, as it is possible that Monte Carlo metrics can largely live behind the scenes while planning results can be reported in a manner that is more directly relevant to clients (e.g., How much can my portfolio go up/down before I have to make a change? How big of a change would I need to make?).

Ultimately, the key point is to simply acknowledge how financial advisors abstract results that are reported to clients matters. The ideal level of abstraction is not self-evident and varies by context, but it is quite clear that ‘probability of success’ leaves a lot to be desired. We’re still at an early stage of figuring out what those abstractions may be, and most dominant platforms currently have quite limited ability to report anything other than the focal point of ‘probability of success’. We, as advisors, should be thinking about developing better ways to communicate with clients and, if the current tools don’t provide ideal levels of abstraction, letting software providers know that we want more than ‘just’ probability of success!

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Retirement income guardrails strategies – i.e., planning strategies that predefine thresholds that would trigger an increase or decrease in retirement spending – have been noted to have some significant communication advantages for managing retirement spending expectations. For instance, an approach like Guyton-Klinger’s guardrails – perhaps the most popular guardrails strategy of all – can be presented in a manner that not only tells a client when a spending change would occur, but also how much of a spending increase or decrease would result from ‘hitting’ a guardrail. The caveat to such approaches, however, is that guardrails strategies are generally based on portfolio withdrawal rates, which can be rather crude metrics that may not capture a lot of retiree-specific nuances that could warrant the use of higher or lower guardrails in a given retiree’s situation.

By contrast, one of the most significant strengths of Monte Carlo simulations is their ability to incorporate retiree-specific nuance into a simulation. From capturing unique cash flows and goals to varying longevity assumptions and portfolio composition, Monte Carlo simulations shine in their ability to model scenarios that better reflect a given retiree’s goals and preferences in retirement. The caveat to Monte Carlo simulations, however, is that there are a number of weaknesses regarding the communication and presentation of the results these simulations provide. The common focal point for reporting Monte Carlo simulation results is the ‘probability of success’ of a plan, which is not only often misunderstood by retirees (e.g., by assuming ‘failure’ is more devastating than the ‘adjustment’ that failure scenarios actually imply), but also ignores entire dimensions of planning results (such as the magnitude of spending change) that are crucially important to setting both good short- and long-term retiree expectations regarding retirement income planning.

Fortunately, however, bringing these two approaches together can provide the best of both worlds, as ‘probability-of-success-driven guardrails’ capture both the communication advantages of the guardrails approach and the analytical advantages of Monte Carlo simulation. Essentially, an advisor would define an initial probability of success target (e.g., 95%), an upper probability of success guardrail (e.g., 99%), a lower probability of success guardrail (e.g., 70%), and some spending adjustment rule in the event that a guardrail is hit (e.g., reset to the initial target 95% probability of success). With these parameters in place, an advisor could then solve for dollar values (both portfolio levels and spending levels) that would summarize the guardrails and the changes that would occur in the event that they are hit, and then communicate that to a client, which provides information that is far more insightful to the client than merely telling them what spending level is associated with an X% probability of success.

Furthermore, while software could ideally help speed up the process for advisors and provide some more relevant long-term metrics, the most fundamental advantages of the probability-of-success-driven guardrails approach involve managing shorter-term expectations, which can be captured using even the most basic Monte Carlo simulation software and without ever needing to utter ‘probability of success’ to a client (unless the client wants the detail, of course). Additionally, advisors could easily substitute historical simulation, regime-based Monte Carlo, or other more advanced modeling methods for traditional Monte Carlo simulation at the modeling level, and still carry out the process of communicating results in a simpler and more effective manner to clients.

Ultimately, the key point is simply to acknowledge that probability-of-success-driven guardrails can bring together both the analytical advantages of Monte Carlo simulation and the communication advantages of guardrails approaches, providing advisors with an opportunity to have better conversations with clients regarding their Monte Carlo results!

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In 1999, the Social Security Administration began mailing paper copies of Social Security statements to most American workers that summarized their personalized retirement and disability benefits. While these statements were a valuable source of information for workers to understand their future benefits, budget cuts in 2011 ultimately precluded the Administration from continuing to mail paper statements to all workers. However, the Social Security Administration did make online statements available for workers who went through a simple process to establish an account. Whatever the means of access, though, the annual Social Security statement remains the most straightforward way to both know what Social Security benefits are anticipated to be in the future (at least on the worker’s current earnings trajectory), and to spot discrepancies that could be corrected to increase future benefits as well!

Given the likelihood that the Social Security Administration will continue its current practice of not mailing statements to most workers for the foreseeable future, the primary way financial advisors can help clients access their annual Social Security statements is online via a “my Social Security” account.

Once clients establish their my Social Security account and access their Social Security statements, advisors can review these statements with their clients and use them to verify the client’s reported work history, review current estimates of anticipated Social Security benefits, and explore how the benefits align to the client’s retirement income needs. (Though it is important to note that while advisors can help guide clients through the process of creating a my Social Security account (if their clients don’t have one already), they cannot create such an account for their clients, even with the client’s consent!).

Page 1 of the Social Security statement indicates that Social Security benefits are meant to be a supplementary source of income in retirement. This can be an opportune time to discuss a client’s overall sources of income, reviewing anticipated income to be provided by Social Security benefits, current retirement savings, other retirement income sources like a pension, and the potential need for guaranteed income products such as annuities.

Page 2 of the Social Security statement includes a summary of the worker’s estimated retirement, disability, family survivors, and Medicare benefits. Notably, these benefits do not adjust for inflation (i.e., they are reported in current dollars, not future dollars with projected inflation adjustments). Retirement benefit projections also generally assume that the income a worker earned last year will be how much they will continue to earn, in inflation-adjusting dollars, each year until they reach their retirement age. If there are no reported earnings from the prior year, but there are earnings from the prior-prior year, the earnings from the prior-prior year will be assumed through retirement age. Though if a worker has no earnings from either the prior year or the prior-prior year, the Social Security Administration will assume that there will be no future earnings when projecting future benefits.

Page 3 of an individual’s Social Security statement details the earnings that the Administration has on file for each year since an individual began working. Advisors should encourage clients, especially those who are long-term self-employed individuals, to carefully review the earnings history on their statements. If an error or omission is identified, the mistake should be corrected as soon as possible by providing evidence (e.g., old Form W-2s or pay stubs, and/or tax) of the under-reported income to the Social Security Administration.

Ultimately, the key point is that a client’s Social Security statement can provide an advisor with valuable information, help clients to better understand their future potential Social Security Retirement Benefits (or fix their projected benefits if historical earnings are missing!), and serve as a launching point for deeper conversations with the client to explore how they can meet their financial planning goals!

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With the rise of Monte Carlo analysis as the most commonly used method of conducting retirement projections for clients, 'probability of success' has become the focal point for communicating retirement preparedness to clients. While a number of issues with framing results around probability of success have been noted – from not accounting for the magnitude of failure, to not acknowledging that small 'adjustments' can often save a 'failing' plan, and even some biases related to how we think about 'wrong' probabilistic forecasts – there is an additional issue with the current usage of Monte Carlo analyses that has gone largely unnoticed: If you are doing ongoing planning for a client who is willing to adjust their spending, then the norms that have emerged – particularly strong negative perceptions of planning results below 70% probability of success – may not be as problematic as most advisors (and clients!) think. In fact, a 50% probability of success (or lower!) may be reasonable for retirees who are willing to make spending adjustments.

One concern when reporting Monte Carlo results to a client framed around ‘probability of success’ is that anything less than 100% can sound scary. Consider a 50% probability of success: ‘Failing’ one-out-of-two times when failure implies running out of money in retirement simply does not sound acceptable. Such a result can make clients feel that they are unprepared for retirement and that they must save even more or retire even later so that they can achieve a higher probability of success. It is important, however, to think carefully about what a 50% result actually implies. First, this metric alone actually tells us nothing about how severe 'failure' is. If 90% of a client's desired income comes from guaranteed income sources, then 'failure' is capped at a relatively modest 10% cut in a client's income, which is not ideal but far from devastating. Moreover, adjustments can often save a 'failing' plan, so simply shifting a 50% probability of success framing to a 50% probability of adjustment can take a lot of sting out of that result.

Additionally, the difference between setting spending based on a one-time projection versus ongoing projections should be acknowledged, as these two approaches are fundamentally very different. If you only had one opportunity to select a spending level and you were forced to stick with that no matter what happened in the future, then selecting a spending level with a 95% (or higher) probability of success may make a lot of sense. But the reality is that planners generally provide ongoing projections for clients, and even those who provide one-time plans will recommend periodic updates. And if a retiree is going to keep their plan up to date (which allows for opportunities to identify when a plan is veering off course and adjust as needed), then planning to a 50% probability of success (i.e., a plan that needs to be adjusted one-out-of-two times) is not nearly as scary. Furthermore, it should be noted that a 50% probability of success means adjustment at any point in time in the future, and not necessarily even an adjustment in the near future.

To examine what planning using lower probability of success levels actually looks like, we compare planning outcomes using spending levels continually adjusted to maintain a constant 95%, 70%, 50%, and 20% probability of success throughout retirement using actual historical outcomes going back to 1871. What may be surprising is that we find that median, minimum, and maximum spending levels throughout 30-year retirement periods are actually quite consistent regardless of the probability of success used! In other words, if you are going to adjust spending on an ongoing basis, then returns experienced end out being the largest factor in determining how much can be spent, with income shaded either slightly higher (lower probability of success) or lower (higher probability of success) based on the success level targeted. Where we do see larger differences (although still smaller than many might anticipate) is with respect to terminal wealth levels, which suggests that when using Monte Carlo analyses for ongoing clients, the probability of success level targeted is actually more about a trade-off between income and legacy than any genuine difference in the risk that a portfolio will be depleted.

Since our intuitions generally tell us that a 50% probability of success is insufficient, advisors may wish to further consider how Monte Carlo results are framed to clients. Presenting clients with a range of potential strategy considerations may be beneficial in helping explore what best fits a client's preferences. Furthermore, advisors should give thought specifically to what probability of success level best balances the trade-off between income and legacy for a client. Unfortunately, current planning tools do not make illustrating these types of dynamic strategies easy, but ultimately, the key point is that choosing a probability of success level to use is not as simple as being able to apply a one-size-fits-all rule or a natural tilt toward being 'conservative' for the sake of not running out of money. For those retirees who are willing and able to make needed adjustments along the way, a 50% (or lower!) probability of success may provide a better result than most advisors (and clients) realize!

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Recognizing that retirement saving is an important goal for many individuals, and an employee benefit that many job-seekers commonly screen for as they consider new employment opportunities, business owners commonly offer employer-sponsored retirement plans, such as 401(k) plans, to attract (and keep) their employees. For small business owners, though, the hassle and expense of setting up and running such plans can be a serious hurdle to offer competitive benefits for employees, and often are the reason that some small business owners have no retirement plan benefits in place to begin with! In an attempt to help small business owners offer employer-sponsored retirement plans to their employees, Congress has passed various pieces of legislation, one of the most recent being the December 2019 SECURE Act, which for the first time created a new “Pooled Employer Plan” (PEP) intended to make it easier for small business owners to establish and administer a 401(k) plan.

Notably, Multiple Employer Plans (MEPs) to facilitate employer-sponsored retirement plans for small business owners by allowing multiple employers to pool together and create one single plan for all of their respective employees have existed for many decades. But they have failed to rise in popularity, mainly because of limitations established by the IRS and Department of Labor (DOL) over the years, including the IRS’ “one bad apple” rule that can disqualify an entire MEP if one single participating employer fails to follow the plan’s requirements, and the DOL’s “nexus” rule that required an MEP’s participating employers to be in the same general line of business. The SECURE Act’s recently introduced Pooled Employer Plan (PEP) version, however, eliminated these limitations, clearing the way for multiple employer 401(k) plans without being in the same line of business, and with a pathway to remove an employer that fails to comply with the plan’s rules (without disqualifying the rest).

In order to create and offer a PEP, the plan provider must become a designated “Pooled Plan Provider” (PPP), registered with the Department of Labor, and serving in a fiduciary capacity as the plan administrator and performing all of the plan’s 3(16) fiduciary administrative duties.

Notably, RIAs (and broker-dealers) will be allowed to serve as PPPs, creating the potential that advisory firms could establish their own ‘private PEP’ for their small business owner clients (and gaining the efficiencies as the plan provider). However, there are several issues that advisory firms should understand before deciding to commit to a role as a PEP’s Pooled Plan Provider. Most significant is the fact that by providing investment services to the plan (and managing assets for an AUM fee) while serving as the PPP, there is potential for creating a Prohibited Transaction, as the Internal Revenue Code Section 4975(c)(1) disallows a plan fiduciary from dealing with the income or assets of a plan for their own interest, or from receiving compensation from the plan in connection with transactions involving the income or assets of the plan… with penalties for such Prohibited Transactions starting at 15% of the amount involved and, if not rectified in a timely manner, can be as high as 100% of the amount involved! Whether or not the DOL releases legislation that will provide for a Prohibited Transaction Exemption addressing the challenge created by IRC Section 4975(c)(1) is yet to be seen.

Ultimately, while the PEP may become a valuable tool for small business owners to be able to offer employees competitive retirement plan options, RIAs will need to carefully consider whether to choose to take on the role of a PPP for their small business clients plans and the associated ramifications if they do choose to do so… including asking the question of whether branching out into plan administration would actually result in more business anyway, or if it will be better to find a third-party administrator (TPA) to partner with instead?

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For many Americans, Social Security income plays an integral role in retirement planning, and while retirement planning is generally straightforward for Americans with income solely from US employment that pays into Social Security, the situation becomes more complex when income from multiple countries is involved. As working in a foreign country may not count towards US Social Security benefits, either reducing benefits or even rendering the worker with insufficient quarters of coverage to be eligible for Social Security benefits at all. In addition, receiving non-US pension or foreign Social Security benefits can impact US benefits, and there is the potential for double-taxation of benefits when more than one country seeks to tax the same individual (the foreign country because the US citizen lives there, and the US because it taxes all citizens on all of their income worldwide!).

In this guest post, Jonathan Lachowitz – Founder of White Lighthouse Investment Management, which specializes in cross-border retirement planning – explores some of the cross-border planning issues that financial advisors and their clients face in the context of Social Security when there is residency or past work experience outside of the United States. For these clients, the main factors that will affect their Social Security benefit are how long they contribute to the US Social Security system, whether they are entitled to a foreign Social Security pension, and the presence of a tax treaty and/or a Totalization Agreement with the country in which the overseas work has been (or is being) done.

Totalization Agreements are currently in place with 30 countries and serve not only to eliminate double taxation (i.e., taxes paid by employers and employees in both the US and the foreign country) of the same income being taxed for Social Security programs by more than one country but also to coordinate the accrual of worker’s benefits when they have been employed in multiple countries. These agreements also typically include a “detached worker” provision that exempts an employee from their local (temporarily-foreign-country) Social Security taxes for up to five years while continuing to pay into their own national Social Security program.

The Windfall Elimination Provision (WEP) is another consideration to take into account when planning for an individual’s Social Security benefit when they have years of service abroad. As while the WEP was initially established to more fairly adjust Social Security benefits for workers who earned income eligible for Social Security benefits alongside other income from US state and local government jobs that were not covered by Social Security, it also applies to individuals who receive both US Social Security benefits and a foreign pension benefit that does not pay into the US Social Security system. The WEP prevents workers who receive benefits from a non-covered plan (that did not pay into Social Security, and thus would not be factored into the employee’s income history used to calculate their US Social Security benefit) from receiving more US Social Security benefits as though they were long-time lower-wage earners.

Fortunately, Congress has provided for a Foreign Tax Credit, which prevents a US taxpayer from having to pay tax on eligible foreign income taxed by both the foreign country and the US, and the Foreign Earned Income Exclusion, which allows a US taxpayer who meets either a bona fide residence test or a physical presence test to exclude up to $107,6000 in foreign income from US income taxation. However, only the Foreign Tax Credit or the Foreign Earned Income Exclusion – not both – can be used by an eligible worker. And in practice, the FEIE generally will not apply to Social Security and other retirement benefits, as it’s not considered earned income at the point of receiving payments or taking retirement account withdrawals.

Ultimately, cross-border retirement planning can be a complex yet rewarding area that financial advisors can address with clients who have earned income from more than one country. By understanding the role of international tax treaties, Totalization Agreements, and the social security benefit systems offered by other countries, financial advisors can help their cross-border clients optimize their retirement income and Social Security benefits.

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As an initial response to the economic devastation created by the COVID-19 pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act back in March, a $2+ trillion emergency fiscal stimulus package. In addition to several notable provisions, such as direct government payments to taxpayers and the elimination of the 10% early withdrawal penalty on distributions from retirement accounts, the CARES Act also suspended required minimum distributions (RMDs) for 2020 for IRAs, 401(ks), and other defined contribution retirement plans.

Unfortunately, the CARES Act didn’t address those who had already taken their RMD(s) – or at least what they thought were RMDs at the time – earlier in the year, but in April 2020, the IRS issued Notice 2020-23, which started to address this issue. More specifically, the Notice extended the rollover window deadline for distributions taken on or after February 1, 2020 to the later of July 15, 2020, or (the regular) 60 days after the distribution was received.

On June 23rd, 2020, the IRS further expanded its relief for early-year would-have-been-RMDs, when it issued Notice 2020-51. Notice 2020-51 provided unprecedented relief for many taxpayers, by not only (further) extending the rollover window for distributions that would have been 2020 RMDs (but for the CARES Act) to the later of August 31, 2020, or (the regular) 60 days after the distribution was received, but also by allowing taxpayers to ignore the prohibitions on completing multiple IRA rollovers in a 365-day period (the once-per-year rollover rule) or a rollover of a distribution from an inherited retirement account, that normally apply. The cutoff date for this unprecedented relief, however, is rapidly approaching, advisors have been fielding a flurry of questions from clients regarding the rollback guidance.

As a starting point, many clients are wondering if they have any options available if they miss the deadline. Unfortunately, distributions received more than 60 days ago, or for which a rollover would violate the one-per-year rollover rule, or that were made from an inherited IRA (401(k), or other defined contribution plan) generally won’t be able to be rolled back after the August 31, 2020 deadline. The sole exception to the hard deadline of August 31,2020 is for IRA, 401(k), and other defined contribution retirement plan owners (not beneficiaries) who can treat an early 2020 distribution as a Coronavirus-Related Distribution. More specifically, such distributions, as defined by Section 2202 CARES Act, can be returned up to three years after the date of distribution.

Meanwhile, some clients have asked what their options are if they took more than the required minimum distribution and would now like to roll those back. Unfortunately, unless such individuals are still within the 60-day window, or they can treat their distribution as a Coronavirus-Related Distribution, the portion of their distribution in excess of what would have been their 2020 RMD will not be eligible for return.

Another very common question has been around what happens when a client took an in-kind distribution earlier this year to satisfy their required minimum distribution. In many instances, the value of the distributed asset may have appreciated substantially since they were distributed. If the distribution was made from an IRA, retirees must return the same property that was taken out  (as if the distribution was never made in the first place), regardless of how much the value of the property increased (or decreased) in the past few months. For those who may have already (incorrectly) returned cash to try and complete a rollover of the in-kind distribution, two steps are required to ‘fix’ the ‘problem’ without any penalties. First, the same property must be rolled back by the August 31, 2020 deadline. Second, the cash, along with any gain/loss attributable must be distributed as an excess contribution, by October 15, 2021.

Ultimately, the key point is that time is running short to return unwanted RMDs from retirement account, and while it’s possible for a limited number of retirees to classify prior distributions as Coronavirus-related distributions, the majority of individuals must take action by August 31, 2020 if they are to rollover an early year distribution that would have been an RMD, if not for the CARES Act. And while it’s possible that further relief for such amounts may be included in future stimulus bills by Congress, retirement accounts have already been specifically addressed with historic guidance, making it less likely that we’ll see future RMD relief from either Congress or the IRS.

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