Retirement Savings Rates

A recent study brief from the Retirement Research Center at Boston College¹ sheds light on the rate of savings people will need to set aside to achieve a goal of successfully retiring with about 80 percent of their pre-retirement incomes.

The study “takes an 80-percent replacement rate as the goal, assumes Social Security benefits remain as promised under current law, then calculates the required saving rates for individuals at different earnings levels, at different starting and ending ages, and at different rates of return.” Here’s an example for a 25-year old average earner retiring at the full retirement age (67):

EXAMPLE: Person who is 25 in 2010, earning Social Security’s medium earnings of $43,000
Full retirement age (2052)	67
Income replacement goal at retirement	80%
LESS: Projected percentage of earnings replaced by Social Security	41%
EQUALS: Projected percentage of earnings needed to be replaced by savings	39%
Savings needed at retirement to fund the 39% replacement rate	$660,000
Required savings rate to achieve goal if savings contributions start at age 25 and earn 4% on average	12%
Required savings rate to achieve goal if savings contributions start at age 35 and earn 4% on average	18%
Required savings rate to achieve goal if savings contributions start at age 35 and earn 4% on average	31%

The central message of the study is similar to the message presented in numerous other studies and expert views:

(S)tarting early and working longer are far more effective levers for gaining a secure retirement than earning a higher return. This strategy of saving for a longer period of time is especially effective given the greater risk that comes from attempting to earn that higher return. And the further along an individual is in his career, the more effective working a few years longer becomes.

The study provides added value because it also presents specific target savings rate goals for 401k participants to measure themselves against. Following, for example is the full range of savings rates for medium earnings under varying rates of return and retirement age assumptions:

Even the most liberal assumptions used in the study for a medium earner (i.e. age start contributing at 25, retire at 70 and earn 7%) require a 3% retirement savings rate to achieve the 80% replacement ration. Sadly, many people are not even setting aside this much for retirement.

The complete study is available for free download by clicking here. It is well worth reading and using to measure the adequacy of your personal savings rate.

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Notes:

1. How Much to Save for a Secure Retirement, Center for Retirement Research at Boston College (CRR [↩]

5 Ways the Financial Crisis May Permanently Impact Your 401k and Retirement

As of early 2011, the financial markets had regained about 80% of their value from the October 2007 peak reached before the onset of the Great Recession. Citing this recovery, some observers have optimistically concluded that the long-term impact of the financial market collapse on workers’ 401k and retirement plans will be relatively minor. Also, many observers note that 401k employee contributions held steady throughout the recession – another positive factor.

But a top-level overviews of the financial market recovery can hide the permanent damage done to 401k and retirement savings for millions of workers. Here are five ways that the Great Recession permanently scarred 401k retirement savings for millions of American workers:

1. Older Workers – Older workers with substantial investment in equities were more negatively impacted as they were more likely to have had higher account balances prior to the downturn and thus to have suffered greater absolute losses than younger workers. With fewer years left in the workforce these workers may be unable to recoup their losses through additional saving and investment.



2. Employer Matches – As a result of the financial crisis and economic downturn, many plan sponsors reduced or suspended employer matching contributions and a large number of employees have been affected by these reductions. The Wall Street Journal reports that 20% of companies having 1000 or more employees suspended their matches during the recession. In addition to losing the matching contributions, a 401k participant forgoes the compounding investment income on those contributions. It is reported that recovery of the economy has spurred many companies to reinstate employer matches. But unless the reinstituted match is larger than it had been previously, a reduced or suspended match means lower contributions now and permanently lower account balances at retirement.
3. Extended Unemployment – The primary impact of the economic recession on millions of individuals and families has been unemployment or reduced wages. Either of these can induce plan participants to use their 401k assets for nonretirement related purposes. Extended unemployment almost certainly has a negative effect on an individual’s retirement income. The extent of the damage will vary, but whether through cessation of employee or employer contributions or even tapping into pension assets for near term needs, being out of work for any length of time is likely to affect a person’s ability to save and perhaps even the ability to preserve accrued retirement savings.
4. Tax Penalties – To make matters worse, in addition to eroding retirement savings, withdrawals from a 401k account prior to age 59-1/2 generally incur a tax penalty, an additional financial burden to bear. 401k leakage can represent a significant, permanent loss to retirement savings.
5. Small-Plan Terminations – Even before the Great recession, the number of small employer-sponsored retirement plans (i.e. under 100 members) were showing signs of decline. The total number of these small plans declined from about 630,000 in 2003 to about 626,000 in 2007, according to Department of Labor estimates. Although plan-termination data for 2008, 2009, and 2010 are not yet available, there is fear that the trend of declining small-employer 401k’s accelerated as these companies battled to survive.

The Tax You May Like to Pay on Your 401k Withdrawal

Nobody likes taxes unless they are the lesser of two evils. So when you have an opportunity to snag a lower tax rate, take it. Here’s such an opportunity for some 401k accounts.

Many workers own stock in their employer’s publicly-traded company (For example, you work for Chevron and you have Chevron stock in your 401k account). Often, this stock is rolled into an IRA when people retire because they think that this is their best option. The IRS, however, gives you another, often better option that could save you thousands of dollars when it’s time to retire and take your 401k withdrawal. ^{1 2}

When you eventually withdraw money from an IRA, whether to meet your expenses or Required Minimum Distributions (RMD), it will be taxed as ordinary income. This is your highest tax rate. And you’ll have to pay the same tax rate on company stock that you had rolled over to the account. But there is a way to avoid the tax on the stock’s Net Unrealized Appreciation (NUA) that is if you did your 401k withdrawal correctly years earlier.

The NUA is the difference in the stock’s value from the time it was purchased in your 401k account to the time you withdrew it from the 401k plan. If you withdraw the stock from the 401k, and NOT roll it over to an IRA as is often done, you will only pay ordinary income tax on the cost of the stock when it was acquired by the plan (hopefully, when the value was much lower years ago). As soon as you consummate a 401k withdrawal of the stock to a regular brokerage account you would simultaneously rollover the balance of your plan’s assets to an IRA. That way, the non-employer shares continue to grow tax-deferred. So the very good news is that even though you pay tax today on your 401k withdrawal of employer shares, the tax is only on the original cost of your employer’s shares AND you have locked in a favorable capital gains rate for later (assuming of course, that the government still offers a favorable capital gains rate in the future).

Years from now, when you get rid of the stock, you will only pay the lower, long-term capital gains rate on the NUA. And since the standard one-year holding period does not apply to NUA, you could sell the stock the day after consummate your 401(k) withdrawal and pay the lesser capital gains rate. However, to receive the capital gains rate on future appreciation, you must own the stock for more than one year. If not, you will have to pay the ordinary income tax rate.

Your loved ones also like this option.

When beneficiaries inherit IRAs, they must pay ordinary income taxes on all of those funds. Inherited NUA stock, however, gets a better deal. Heirs can take advantage of the same favorable treatment as you all because at the one moment in time, you correctly opted to make a 401k withdrawal of the shares. The heirs will receive the stock at your cost basis and pay tax on the NUA at the capital gains rate. Plus they get a special break if you had used the NUA rule: appreciation from the date you removed the stock from the plan to the date you died will receive a step-up in basis and pass income-tax free, under current rules.

So before you roll over your 401k into an IRA, as most people blindly do, check to see if you have shares of your employer’s stock as an IRA asset. If so, taking those shares as a 401k withdrawal and benefiting by an IRA tax break could save you a lot of cash.

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Article submitted by Retirement-Income.net. For more retirement planning information, please visit them at: http://www.retirement-income.net

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Notes:

1. - IRS Reg. 1.402(a)-1(b), (e)(4)(B), (e)(4)(D), http://www4.law.cornell.edu/uscode/search/display.html?terms=net unrealized appreciation&url=/uscode/html/uscode26/usc_sec_26_00000402—-000-.html [↩]
2. IRS Notice 98-24, http://www.irs.gov/pub/irs-drop/not98-24.pdf [↩]

Inertia and My 401k

in·er·tia [in-ur-shuh, ih-nur-] –noun

1. inertness, esp. with regard to effort, motion, action, and the like; inactivity; sluggishness.
2. Physics. the property of matter by which it retains its state of rest or its velocity along a straight line so long as it is not acted upon by an external force.
3. Medicine/Medical. lack of activity, esp. as applied to a uterus during childbirth when its contractions have decreased or stopped.

As 401k participants everywhere ponder “What should I do with my 401k in this current market” they may want to give some thought to the beneficial aspects of inertia.

Synonymous with “inactivity” and “sluggishness”, inertia is typically viewed as a negative characteristic in the 401k world. Indeed, the push by government and the 401k industry to make 401k’s a truly workable retirement solution has centered on introducing policies specifically designed to counter what we can call “bad” inertia. Examples:

Examples of “Bad” 401k Inertia
Inertia causes workers to fail to enroll in 401k plans, often missing out on company match	Response: automatic enrollment
Inertia keeps workers from increasing contributions as wages rise	Response: automatic contribution arrangement
Inertia at the root of workers opting for low-yield investment options such as money market accounts	Response: automatically place 401k participants in qualified default investment alternatives

But there apparently is a bright side to 401k inertia as well. Some commentators credit employee inaction in the face of the historic market collapse of 2008-09 as the primary reason behind the remarkable recovery of 401k account balances that has occurred in the past year. Relatively few 401k participants reacted to the market turmoil by reducing their 401k contributions or moving account balances from riskier asset classes that were hardest hit into “safer” investments. Doing so, of course, would have been the classic panicked behavior expected of amateur investors: selling at exactly the wrong time.

For whatever reasons, workers by and large stood pat with their 401k’s and were rewarded nicely. By the end of 2009, just 9 months after the market bottomed (DJIA @ 6,443 in March 2009) Fidelity and Vanguard both were reporting that most 401k participants had account balances higher than they did at the market’s peak in October 2007.

“I think the good news is inertia took over and most people did nothing. During the rebound from April (2009) on, the inertia value of the 401k is very good.”
- Jane Bryant Quinn as quoted in Employee Benefit News (4/1/2010)

“What to do with my 401k in this current market?” Consider setting a long-term course with regular 401k contributions, a solid 401k investment portfolio strategy and letting inertia take over from there.

Auto Annuity?

A few years ago government 401k regulations were modified to permit and encourage automatic enrollment of employees into 401k retirement plans. An employer that sponsors a 401k and that chooses to use automatic enrollment enrolls its employees in the plan automatically, by salary reduction, without requiring them to take any initiative or action in order to participate. Employees have to formally elect not to participate if they don’t want to be in the 401k.

Automatic enrollment generally is considered to be a successful tactic for countering employee inertia. Many employees – especially younger and low-moderate income workers – who in the past tended not to bother signing up are now being enrolled in the company 401k plan by default.

Now government agencies now are testing the waters to see if the inclusion by default concept should be considered for employees starting their retirement. The concern here is that, having accumulated a 401k nest egg during their working years, new retirees often tend to withdraw their 401k assets in a lump sum and may not fully understand the importance of making the money last throughout retirement.

In response, policymakers are seeking input on the notion of “automatically annuitizing” 401k balances at retirement to provide a lifetime income stream. Under this concept, all or part of a workers 401k balance at retirement could be turned into an annuity that pays a monthly benefit for life.

A recent request for information (RFI) put out by the Department of Labor seeks input from the public and industry experts on numerous questions about 401k “lifetime income options”. Several of the questions included in the RFI reveal there is a significant interest in the auto-annuity idea:

“11. Various “behavioral” strategies for encouraging greater use of lifetime income have been implemented or suggested based on evidence or assumptions concerning common participant behavior patterns and motivations. These strategies have included the use of default or automatic arrangements (similar to automatic enrollment in 401(k) plans) and a focus on other ways in which choices are structured or presented to participants, including efforts to mitigate “all or nothing” choices by offering lifetime income on a partial, gradual, or trial basis and exploring different ways to explain its advantages and disadvantages. To what extent are these or other behavioral strategies being used or viewed as promising means of encouraging more lifetime income? Can or should the 401(k) rules, other plan qualification rules, or ERISA rules be modified, or their application clarified, to facilitate the use of behavioral strategies in this context?

12. How should participants determine what portion (if any) of their account balance to annuitize? Should that portion be based on basic or necessary expenses in retirement?

13. Should some form of lifetime income distribution option be required for defined contribution plans (in addition to money purchase pension plans)? If so, should that option be the default distribution option, and should it apply to the entire account balance? To what extent would such a requirement encourage or discourage plan sponsorship?”¹

Clearly, government policymakers recognize that the move away from traditional defined benefit (DB) pensions that provide monthly pension benefits for life is permanent and won’t be reversed. Their challenge now is to find ways to tweak and strengthen the 401k system so that it becomes a viable means of providing long-term retirement security to American workers.

There are numerous practical challenges in the way of auto-annuitizing including the big problem of inadequate average 401k account balances. Still, the concept seems to be gaining momentum and is likely to be seriously considered and debated in the coming months.

The complete lifetime income options RFI can be found on the Department of Labor’s website. The questions asked in the RFI provide insights into the direction that 401k planning policy may be headed in the Obama administration. You can also publicly comment on the RFI at Regulations.gov. ²

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Notes:

1. US Department of Labor Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans – 2/2/2010 [↩]
2. Search for “RIN 1210-AB33″ to bring up current comments on the proposal as well as links to submit your comments. [↩]

New 401k Features to Watch For

401k’s have taken a lot of heat recently. The 2008 market meltdown spoiled retirement plans for millions of baby-boomers nearing retirement. Not only did 401k market values tumble an estimated $2 trillion, but scores of companies stopped matching employee contributions altogether. Time Magazine’s October 8, 2009 cover story even declared that it was “time to retire the 401(k)”.

But rumors of the 401k’s demise are premature. Despite many shortcomings, 401k’s will almost certainly remain the primary retirement program for US workers for decades to come. Cost-conscious companies are not about to get back into the defined benefit pension business. The federal government is in no position to take on retirement funding responsibilities beyond social security and medicare. And state and local governments, buckling under the weight of their own overly-rich DB pensions, may be the next big growth area for 401k-type retirement programs.

So if 401k’s aren’t going away, it makes sense to see what the next generation of 401k’s might look like. Here’s a brief look at some new 401k features to watch out for:

1. Auto-401k – Continued emphasis on automatically enrolling employees in company 401k’s and automatically defaulting employees into pre-selected investment funds. This movement is well underway and is strongly endorsed in federal legislation and supported by powerful interests like AARP. More focus will be placed on auto-enrolling all employees, not just new hires.
2. Auto-Contribution Escalation – More 401k programs will automatically step-up employee 401k contribution rates (e.g. 1% per year) until maximum threshold (e.g. 10% of pay) is reached. As with auto-enrollment, increases would occur by default and need to be specifically overridden by the employee.
3. Investment Options – Look for: 1) movement away from actively managed funds to lower-cost index funds, 2) greater use of “managed accounts” where an investment adviser places participants into a pre-mixed portfolio of funds based on factors like age, expected date of retirement, and risk tolerance, 3) more focus on maintaining low investment management and transaction fees and, 4) automatic re-balancing of investment portfolios.
4. Personalized Financial Advice – Online tools as well as face-to-face financial advice will cover broader spectrum of personal finance issues not limited to 401k investments.
5. Reporting & Disclosure – Pending legislation would require plan sponsors to provide clear and understandable fee disclosures on 401k investment options. Another recent piece of legislation would require sponsors to inform participating workers of the projected monthly income they could expect at retirement based on their current 401k account balance. The buzzword these days is transparency and 401k’s will include more reporting and disclosure to try and ensure that participants are fully informed about their retirement program.
6. More and Better Annuities – Unlike traditional pensions that pay a monthly benefit for life, 401k’s benefits last only until the account balance is depleted. Indeed, one of the shortcomings of 401k’s is that far too many participants take money out in a lump sum instead of planning for a steady benefit distribution. Look for a variety of annuity-based 401k withdrawal options in the future.
7. Retention of Participants Post-Retirement – Upon reaching retirement age, the norm has been for participants to take a lump-sum withdrawal from their 401k and roll it over to an IRA. Plan sponsors are realizing that this detracts from the plans asset base, increasing fees and lowering buying power. Participants are realizing IRA investments have higher fees and lack the fiduciary oversight and advice tools available in an employer’s 401k. Look for greater emphasis on retaining 401k participants into retirement.

Mistakes that Can Derail 401k Planning

Personal responsibility is a hallmark of 401k planning. So are personal mistakes. We all know that a market crash, job loss and other outside factors can wreak havoc on a 401k. But equally damaging are personal behavior obstacles that can get in the way of executing a retirement plan. These are behaviors totally within your control – if effectively recognized and dealt with. Here are some examples:

1. Procrastination and Inertia – It is human nature to put off doing things we don’t like, things we don’t feel comfortable doing or things we don’t fully understand. But in the world of 401k’s time really is money and procrastinating on actions like enrolling in your 401k, bumping up contributions, or reviewing and adjusting your investment mix can be costly indeed. Remedy: Just Do It! The cost of inaction is too severe as the following example shows:

	Mike	Bob
Starting Age	27	30
Annual Amount	$2,000	$2,000
Annual Return	8%	8%
Retirement Nestegg @65	$477,882	$374,204

.

Mike and Bob following the same retirement investment program with the only difference being that Mike got a 3-year head start. End result: The additional $6,000 dollars that Mike saved in the first three years becomes a $103,678 retirement savings advantage at age 65.

2. Information Overload – A big reason people procrastinate is that they feel overwhelmed with too much data and too many choices. This is especially true in the realm of investing. Some 401k plans offer participants dozens of investment funds to choose from. Result? Studies show that the more investment options offered, the more likely participants are 1) not to participate in the 401k and, 2) opt for “safe” bond or money-market funds if they do participate. Remedy: Keep things simple and stick with low-cost index mutual funds that mimic overall market performance. Research consistently shows indexing to be the best long-term 401k investment portfolio strategy.
3. Too Much Focus on the Short-Term – Too often 401k participants “buy high” and “sell low”. When markets tumble and things are at their gloomiest, individuals have had enough and opt to get out. Conversely, they often jump in when markets are riding high and news is favorable. (One study by Hewitt Associates showed that, in 2008, 9 of the 10 most active trading days for 401k participants occurred the day after a large market downturn.) Remedy: Again, keep things simple and understand that attempts to time the market almost always fail. Stick with a consistent “dollar-cost averaging” approach. This allows more shares to be purchased when prices are low and fewer shares to be purchased when prices are high. The overall result is a lower average cost per share.
4. Too Much Focus on Lump Sums – The single greatest risk that people face in retirement is longevity risk – i.e. outliving one’s assets. A study by McKinsey & Company projects that 1 in 5 retirees will live at least until 90, but run out of money at age 85. Yet the overwhelming majority of 401k participants opt to withdraw assets on their own schedule (often in a single lump sum), and only rarely convert them to a guaranteed lifetime annuity. One study found 3 out of 5 people were willing to exchange part of the guaranteed Social Security annuity for an immediate lump-sum of approximately equal actuarial value. Remedy: Do not let the general preference for lump sums over annuitized distributions drive your decisions. Take time to study the annuity option. Securing a guaranteed income stream for life may be you best defense against longevity risk.

Index Funds = Best 401k Investment Portfolio Strategy

You get what you pay for is one of those age-old cliches that has a lot of wisdom for daily living built into it. Generally, it’s a good principle to bear in mind when paying for goods or services – except, that is, when it comes to investment management services!

A new study by a couple of high-powered finance professors comes down squarely on the side of low-cost index funds as the best 401k investment portfolio strategy. Running thousands of simulations using actual returns (1984-2006) on more than 3,000 actively-managed mutual funds, the authors find that active “fund managers do not have enough skill to produce risk-adjusted expected returns that cover their costs.”

In other words, choose to pay high fees to get professional active investment management services and you are almost certain to end up worse off than if you had invested in passively-managed low-cost index funds. ¹

High investment management fees are one of the more insidious threats that 401k investors face. The following graph shows how a 1% higher fee can erode the value of a 401k account:

Unfortunately, tons of money are thrown into marketing actively-managed funds to 401k investors. In many cases, 401k participants are not sophisticated investors and follow the marketer’s pitch. It is incumbent upon 401k account holders to ask questions about fees and performance. For most 401k investors, the guiding principle should be “you don’t always get what you pay for – stick with low cost index funds.”

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Notes:

1. An index fund is constructed to match the components of a market index like the S&P 500 or Wilshire 5000. Because index funds do not rely on professional managers to “pick” investments, fund expenses are kept low. [↩]

Cuts in 401k Matches are Being Reinstated

Employer matching funds have been the target of corporate cost-cutting for more than a year now. Looking to preserve cash and slash personnel costs hundreds of companies – big and small – have reduced or suspended their 401k matches. In recession, the allure to cut 401k matches is strong: 401k cuts typically equate to 2 percent or 3 percent of payroll and can be swiftly implemented.

But as the recession eases, there are strong indications of a slowdown in 401k cuts. The Pension Rights Center maintains an unofficial list of employers that have changed or suspended 401k matches. A plot of the announcements listed on their website shows a sharp fall off from levels of early 2009.

In the same vein, two recent studies (By Fidelity and Watson Wyatt) note that many companies that reduced or suspended matches now indicate they plan to reinstate them in coming months:

According to Fidelity:

Fidelity also said companies which lowered or suspended their 401(k) match in the past year are starting to reinstate the match.

The company said a survey of plan sponsors shows 27 percent of employers said they had already reinstated the match or plan to reinstate it within the next 12 months. The trend is particularly true with larger plans of 5,000 participants or more, with 44 percent of those employers indicating they have either already reinstated or plan to reinstate their match over the next year.
According to Wyatt:

In the next six months, 35% of firms that snipped away at their matching programs are planning to bulk them up again, according to a recent Watson Wyatt survey. That’s up from 24% two months ago.

The return of the 401k match is, of course, great news. Matches are easily the best incentive for employees to make (or increase) their own contributions. When employers cut matches, worker contributions invariably fall off. Hopefully, the damage done by the recent round of 401k cuts can be quickly undone.

Factors That Impact Optimal Retirement Replacement Ratios

A new study from the Michigan Retirement Research Center (MRRC) sheds more light on the topic of retirement replacement ratios – i.e., the percentage of pre-retirement income that needs to be targeted to maintain living standards in retirement. This is key component of effective retirement budget planning.

Typical advice suggests that replacement rates should be 70 to 85 percent of pre-retirement income. Target replacement rates are thought to be less than 100 percent for three main reasons. First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement.

Interestingly, the MRRC study finds that 75% is the median optimal replacement rate for married couples – seemingly confirming the standard rules of thumb often used in retrement budget planning. However, the study cautions that, as is often the case, the median misrepresents the wide variation in optimal replacement ratios for households in differing situations. For instance:

1. Replacement rates for a married couple need to be higher than for an otherwise identical single person, both because of couples’ greater expected medical expenses in retirement and because of longer expected longevity for at least one partner. While the study found the median optimal rate for married couples to be 75%, the median optimal rate for singles was 55%.
2. Replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families, because the reduction (relative to their levels during the working year) in saving and taxes in retirement would be smaller for low income individuals and families.
3. High-income households need lower replacement rates than low-income households, because of their substantial reduction in average effective tax rates. Of course, the opposite point applies going forward: if one expects future taxes to rise, optimal target replacement rates for highincome households should reflect those expectations.
4. Other things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working.



5. Other factors (including medical costs, educational attainment, and taxes) affect optimal retirment replacement rates.

The study concludes that no single target replacement rate is appropriate for all households and that financial planning tools (like online calculators) relying on simplified, rule-of-thumb replacecement ratios need to be used with caution. This research includes findings that will be incorporated into the next generation of 401k planning and online tools.

Still, there is something to be said for retaining the understandable and teachable concept of a 75% retirement replacement ratio. The number of people who do even basic retirement planning (such as using an online retirement calculator)is far too small. Overcomplicating the retirement planning discussion runs the risk of keeping even more people away from serious planning efforts.

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