Retirement planning has always been a challenging task, but it is even more so today.The coming generations of retirees face a complicated planning process, because funds need to last far longer than in the past. Medical advances and healthier lifestyles are giving retirees extra decades to enjoy life, but without employment income. Therefore, planning needs to begin much earlier to help ensure a secure and rewarding retirement for our clients.
Historically, "retirement" has been the very short period of time between the end of work and death. As early as the 1920s, some pioneering companies and states began providing retirement plans for employees and residents. The concept remained the exception, however, until 1935, when President Franklin Roosevelt signed the Social Security Act, making retirement possible for those who were over age 65.
This worked well, because 63 was the average life expectancy. Half of all potential beneficiaries of Social Security were dead before they were eligible for benefits, and those who did make it past 65 didn't live a lot longer. In 1942, legislation was passed that provided tax incentives for employers to begin retirement plans for employees, thus establishing the "three-legged stool" of retirement: public pensions, personal savings and employer pensions.
Retirement planning for the next several decades was relatively simple. Individuals would actually retire at age 65, expenses would decrease, and the retiree would live within his or her means. The planning also assumed that any investments would be needed immediately. A few years before retirement, asset allocation gradually shifted from equities to fixed-income securities, reducing volatility and producing the additional income needed.
This linear model of retirement made sense in an era of defined-benefit plans, where people worked for the same company all of their lives and got a gold watch on their last day. But times have changed.
The Baby Boom generation is nearing retirement age, and they are culturally known for often living beyond their means and having one of the lowest savings rates in the industrialized world. Add to that the demographic size of this generation and the extended American life expectancy, and these factors will place a huge strain on retirement funding.
Many Boomers may not have the resources to sustain a comfortable standard of living during retirement, particularly with a longer retirement period than their parents and grandparents. Boomers also got married later in life and had fewer children than their parents, which has altered the Social Security system. For example, the system once had 41.9 workers paying for one beneficiary; it now has only 3.3 workers per recipient. If current trends continue, there will only be 1.9 workers per beneficiary in 2030, radically influencing this program.
Finally, most of the old defined-benefit plans have been replaced by participant-directed defined-contribution plans -which force Boomers to take more responsibility for their retirement investment decisions. These decisions are not always wise ones.
These changes have created a need to look at retirement in a different light, and to consider new multifaceted strategies.
The new retirement
Obviously, a long life is great, but it requires assets to last longer and causes inflation to have a greater impact on planning assumptions.
This longer time horizon necessitates active planning, ideally starting in one's 30s. The planning should include annual strategic reviews to help ensure that goals are being met and that asset allocations continue to be appropriate for current risk tolerance and the projected time horizon.
Because of the impending burden on the Social Security system, financial advisors ought to expect and plan for change. Many believe, for example, that the start of maximum benefits should be delayed, or that the amount of benefits paid to recipients should be reduced. In his Aug. 27, 2004, address to Congress, Alan Greenspan made public his fears that Social Security and Medicare have promised more benefits than can be delivered. He suggested changing the system to encourage a longer working life. One thing is clear, however: Future retirees can't depend on just the Social Security benefit system as it is designed today.
In addition to their cultural lifestyle demands, Boomers will need more money in retirement than prior generations so they can care for their own retired parents, as well as themselves. Medical breakthroughs have prolonged the life we share with our loved ones, but it does contribute to extra costs that prior generations did not have.
A 2000 Roper/Starch survey revealed that 80 percent of the Boomer generation plans to work after age 65; some to supplement their retirement, others to stay active. The first wave of Boomers, it seems, is anticipating some of the changes ahead. But is it too late? Probably not, if they take an aggressive, active role in planning for retirement now.
Forming the plan
The first step in planning is understanding the client's vision of what retirement should be like. This picture should be made up of objective data, such as income and expenses, as well as subjective data, such as the client's likes, dislikes, fears and desires.
Once there is a clear understanding of the objectives, determine where the client is today by analyzing their balance sheet, income statement and cash flows. There are many questions to be asked: What are their fixed and variable costs? Which of these are mandatory, and which are discretionary? Which ones will change, and which will stay the same? What are reasonable growth and income rates to expect for assets as well as inflation?
Accurately identifying lifestyle expectations may be more critical to the process than defining the assets they currently have. A small miscalculation over a long period of time can make a huge difference. If expectations are unrealistic, that needs to be addressed up front. A reality check early prevents disappointment later.
Also, because of the increased duration of retirement, it is critical to create contingency plans for the unexpected. Will they need to support parents, children, grandchildren or siblings? Do they plan to stay in the area or move to another location? Will they downsize to a retirement community or stay at home? Can they weather the financial storm of a disability or protracted illness? What is the family's health history, and do they expect to live especially long?
All of these questions need to be addressed in the financial planning process, using an economic model that takes into consideration the balance sheet, income statement and cash flows to test various scenarios over the life of a client. Only then can the available solutions be examined.
When planning for an extended retirement, clients should be encouraged to be conservative, using longer-than-expected mortality rates and higher-than-average inflation rates. Cutting either of these variables too close may leave a significant and unpleasant shortfall when it is too late to correct.
For clients who are nearing retirement, and where there is a shortfall of projected assets, try to capitalize on existing opportunities, such as qualified plans, to ensure that they are being maximized.
To encourage retirement saving through employer-sponsored plans, Congress has developed so many plan types and designs that it is inexcusable that only 64 percent of employees at companies with more than 100 employees are covered by a retirement plan. Unbelievably, this number drops to 34 percent for companies with less than 100 employees.
Far too often, qualified plan participants contribute only the maximum amount that is matched by the employer, and nothing more. If the plan is generous, that may not be a problem. If the match is low, or poorly designed, participants can unwittingly shortchange their future because of a limit that has little relevance to their long-term goals.
This is often seen when there is no employer match or the match is 100 percent on only the first 2 percent of compensation. In this situation, participants will often choose to defer only 2 percent because that is all that is being matched by the employer, yet the maximum that can be put into a 401(k) in 2004 is 100 percent of compensation up to $13,000. And that's pre-tax.
The 50 and Over Club
Employees who are over 50 have a unique opportunity to make additional "catch-up" contributions of $3,000 over and above the normal limits for 2004. The annual deferral limit and catch-up amount are each increased by $1,000 per year for the next two years, enabling a person over age 50 to contribute $20,000 into their 401(k) plan in 2006.
The only dilemma is how much one can afford to contribute without sacrificing current living standards. A little belt-tightening today, however, may well mean a more comfortable future.
Business owners with a greater than 5 percent interest and those making more than $90,000 have a slightly different dilemma. They are both considered highly compensated employees and, due to the nondiscrimination rules for qualified plans, are limited in how much they can contribute to their retirement plans. These limits can be significantly lower than the annual limits mentioned earlier, and change each year. Plus, any excess must be refunded by the 15th day of the second month following the end of the plan year or a 10 percent excise tax is due.
In this situation, evaluate the design of the plan to see that it meets the client's objectives, and evaluate the cost/benefit options of potential design changes. Many times this can help HCEs maximize their contributions to as much as 25 percent of income up to $41,000 for 2004, and $42,000 for 2005.
In recent years, Congress has realized the effect of these limits and has attempted to reduce the impact. The catch-up contributions for those over 50, for example, are not included in the annual testing, and the maximum income limit for testing has been increased from $170,000 to $200,000.
Retirement planning is not, and should not be, limited to only employer-sponsored plans. Once contributions to an employer-sponsored plan are maximized, Roth IRAs are a good additional vehicle, if a client's income is below the phase-out limits (single, $95,000 to $110,000; married filing jointly, $150,000 to $160,000).
This type of individual plan is preferable to traditional IRAs for many reasons. For example, earnings are not taxed on a Roth IRA when taken out after a five-year holding period and after age 59-1/2. There is no limitation on participants in a qualified plan, and there are no required minimum distributions at age 70-1/2.
On the downside, the maximum contribution is $3,000 for the remainder of 2004, $4,000 for 2005 through 2007, and $5,000 for 2008 and later. There are catch-up provisions for Roths as well, which ratchet up over the next few years.
Another path to consider is nonqualified options, such as annuities and permanent life insurance, for tax-deferred growth. Be sure to keep a close eye on the cost/benefit ratios, and how they relate to the objectives of the client and the overall financial plan.
For many years, there has been debate over whether the cost of variable annuities outweighs the benefit of tax deferral when compared to a low-cost index fund.
In today's environment of low tax rates on capital gains and dividends, it is more important than ever for clients to consider whether variable annuities are the best choice. The tipping point is usually the amount of guarantees that cannot be provided through traditional investment vehicles lacking an insurance component.
Asset accumulation, a key component to any plan, is only half the equation. The next consideration is asset protection and risk management, including long-term care, disability, life insurance and supplemental medical insurance. Many of the Baby Boomers are part of the so-called "Sandwich Generation" because they care for both their parents and their children - leaving little time or money to save for retirement during their peak earning years.
Disability insurance is critical at this time. A disabling event could wipe out income and savings, while increasing expenses. For some, purchasing long-term care insurance for parents, in addition to themselves, may be wise, making sure they aren't saddled with the burden of elder care during their peak savings years or beyond.
Because life expectancy for women is longer than that of men, it is particularly important to plan for nonemployed surviving spouses to ensure that they have enough money to live their last years in comfort. This can be accomplished through the use of long-term care insurance, life insurance or a linked benefit policy, which is a combination of the two that delivers a death benefit if the long-term care portion is not needed.
Clearly, planning the retirement of the next generation of retirees is exponentially more complicated than the planning needed for preceding generations. The key to success for this next generation will be your early and ongoing professional guidance. The leadership of CPA financial planners is more critical than ever.
Douglas P. Hepburn, CPA, is a manager with Smart and Associates LLP, in Devon, Pa. Reach him at email@example.com. Reprinted with permission from the Pennsylvania CPA Journal.
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