Target Date Funds (also known as life-cycle funds) are designed to make investing for retirement more convenient by automatically changing your investment mix or asset allocation over time. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash investments. Once you select a target date fund, the professional investment managers of the fund make all the decisions about asset allocation. Target date funds are aimed primarily at 401k investors who are not sophisticated about investing, but nonetheless are fully responsible for growing their 401k's into a retirement nest egg. Rather than trying to figure out how to allocate and re-balance savings between investment categories, target date funds focus on a specific end date (such as the year you reach retirement age). Investments are progressively rebalanced for you from aggressive/riskier investments to conservative/safer vehicles as you near retirement.

The following sample shows how a target date fund may change the mix of investments (stock, bonds, cash) over time. As target retirement date nears, the investment mix becomes less risky. This sample highlights a target date fund that carries the investor "through" retirement target date, rather than "to" the target retirement date.

The Wall Street Journal lists these 5 questions that 401k investors should ask about the target date fund they are considering before investing:

• What Is the Fund's 'Glide Path'?
• Is the Fund Intended to Get Investors 'to' or 'Through' Retirement?
• How Much Does This Fund Cost?
• Does This Fund Take a Strategic or Tactical Asset-Allocation Approach?
• Is the Fund's Portfolio Diversified Beyond -- and Within -- Stocks and Bonds?

Target dates vary widely in their investment approach and goals. It is important that the 401k investor learn about the target date fund by reading fund literature and asking questions like the ones shown above. The Department of Labor (DOL) and the Securities and Exchange Commission (SEC) recently published very helpful information bulletin on target date funds.

• accounting rule changes that will force governments to be more realistic about their pension plans and retiree health benefits
• disgruntled taxpayers bitter that public employees earn more and have better pensions and benefits than they do
• falling tax revenues
• rising retirement costs that are diverting huge sums of public money away from important public services
• high profile public pension abuses - both in public pension management and benefits

On top of all this, now comes an important academic study by Northwestern University finance professor Joshua Rauh showing that several large state pension plans can expect to be bone-dry out of money within a decade. In aggregate, state funds will run out of money in 2028:

Based on September 2009 asset values, if state pension fund asset returns have an average return of 8% going forward (the states’ typical assumption), states in aggregate will run out of funds in 2028. If average returns are 10% through 2045, the funds in aggregate will be roughly sufficient to cover liabilities to existing workers under the states’ actuarial assumptions. If average returns are only 6%, state funds in aggregate will run out in 2024. This analysis assumes that state inflation forecasts, which average 3%, are met. If inflation is greater holding the investment outcomes fixed, then even under the higher asset returns the funds will run out sooner, as many state systems provide inflation-linked cost of living adjustments (COLAs) to beneficiaries.

Illinois pensions are in the worst shape - expected to be broke in 2018. Next come Connecticut, New Jersey, and Indiana in 2019 followed by Hawaii, Louisiana and Oklahoma in 2020. A small number of state pensions (Florida, New York, Alaska, Nevada, and North Carolina) are in relatively good shape and are not expected to run out of money.

Once pension funds run dry, states will be forced to pay benefits (which in most cases are constitutionally guaranteed) on a pay-as-you-go basis. This means the full amount of the benefits will be paid from current tax revenue without the advantage of investment earnings. For many of the states, this could mean one-third or more of the state tax revenue would be devoted just to paying public employee pensions.

The information in following table summarizes the anticipated cashflow status of each state's pension. ¹

1. Data from Rauh, Joshua D., Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities (May 15, 2010). Available at SSRN: http://ssrn.com/abstract=1596679

We are big fans of keeping things simple whenever possible with easy to understand rules of thumb. That's why we were pleased to see a new report from Hewitt Associates that includes some well researched guideposts for retirement planning. Based on analysis of the retirement needs of 2.1 million employees at 84 large companies, the study finds that for employees who currently contribute to their employers retirement plan:

• on average will need to accumulate a retirement resources equal to 15.7 times times their pay at retirement to maintain pre-retirement living standards (e.g. $785k for a $50k salary)
• Social Security will provide, on average, retirement resources equal to 4.7 times pay
• other retirement savings - such as 401k's and DB pensions - will need to provide the remaining 11 time pay
• only about 18% of these employees are presently expected to satisfy 100% of their needs at retirement
• on average, workers who rely solely on a defined contribution plan to fund their retirement are projected to meet just 74% of their needs in retirement

Next time you ponder the question: How Much Should I be Saving for Retirement?, keep in mind the 15.7 factor. It's a well-researched yet simple way to target the retirement nestegg you need to work towards accumulating.

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:

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.

401k participants who were guilty of inertia in the last year have been rewarded.

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.

Click icon to search GAO publications.

• 401(k) Plans: Several Factors Can Diminish Retirement Savings, but Automatic Enrollment Shows Promise for Increasing Participation and Savings
• Retirement Savings: Better Information and Sponsor Guidance Could Improve Oversight and Reduce Fees for Participants
• 401(k) Plans: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers' Retirement Savings
• Fulfilling Fiduciary Obligations Can Present Challenges for 401(k) Plan Sponsors
• Information That Sponsors and Participants Need to Understand 401(k) Plan Fees
• 401(k) Plan Participants and Sponsors Need Better Information on Fees

There are challenges to building and saving through 401k plans. While low participation rates may be due, in part, to the fact that some workers participate in DB plans, there is also a large portion of workers who do not have access to an employer-sponsored retirement plan, as well as some who do not enroll in such a plan when an employer offers it. We found that for those who did participate, their overall balances were low, particularly for low-income and older workers who either did not have the means to save or have not had the opportunity to save in 401k's for much of their working lifetimes. There are also challenges workers face in maintaining savings in 401k plans. For example, 401k leakage--actions participants take that reduce the savings they have accumulated, such as borrowing from the account, taking hardship withdrawals, or cashing out the account when they change jobs--continues to affect retirement savings and increases the risk that 401k plans may yield insufficient retirement income for individual participants. Further, various fees, such as investment and other hidden fees, can erode retirement savings and individuals may not be aware of their impact. Automatic enrollment of employees in 401k plans is one measure to increase participation rates and saving. Under automatic enrollment, which was encouraged by the Pension Protection Act of 2006 and recent regulatory changes, employers enroll workers into plans automatically unless they explicitly choose to opt out. Plan sponsors are increasingly adopting automatic enrollment policies, which can considerably increase participation rates, with some plans' rates reaching as high as 95 percent. Employers can also set default contribution rates and investment funds. Though target-date funds are a common type of default investment fund, there are concerns about their risks, particularly for participants nearing retirement.

GAO-10-153T October 28, 2009
Highlights Page (PDF)   Full Report (PDF, 22 pages)   Accessible Text

Retirement Savings: Better Information and Sponsor Guidance Could Improve Oversight and Reduce Fees for Participants

American workers increasingly rely on defined contribution (DC) plans like 401(k) plans and individual retirement accounts (IRA) for retirement income. Together with other DC plans--401(a), 403(b), and 457 plans--these accounts hold about $7.1 trillion. As workers accrue earnings on their investments, they also pay a number of fees that may significantly decrease retirement savings over the course of a career. GAO examined: (1) the types of fees charged to participants and investments of various DC plans; (2) how DC plan sponsor actions affect participant fees; (3) how fee disclosure requirements vary; and (4) the effectiveness of DC plan oversight. GAO reviewed laws and regulations and consulted with experts, federal officials, service providers, and six plan sponsors.

Participants in DC plans and IRAs generally pay the same types of fees, regardless of the plan in which they are enrolled, such as investment management fees. However, participants in some plans are more likely to invest in products that may have higher fees. For example, we found that participants in 403(b) plans and individual IRAs are more likely to invest in products like individual variable annuities or retail mutual funds, which frequently charge more than other investments. According to experts, one reason for the different investments is that many 403(b) plan sponsors do not make group products available to participants. DC plan sponsors generally take certain actions that decrease participants' fees. Sponsors can help reduce participants' fees by, for example, offering cheaper investment products in which participants may choose to invest, like low-cost mutual funds. Sponsors may also pool assets to obtain pricing advantages. 401(k) and 401(a) plan sponsors frequently pool participants' assets to realize lower fees in mutual funds, but sponsors of 403(b) plans often do not. Instead, many 403(b) plan sponsors keep sponsor involvement to a minimum, which limits the opportunities to pool assets and decrease fees. Fee disclosure requirements vary depending on plan regulations and investment regulations. Sponsors of plans subject to Title I of the Employee Retirement Income Security Act of 1974 (ERISA)--which was enacted in part to protect the interests of employee benefit plan participants--are required to disclose certain documents to participants, which may or may not describe fees. For plans not subject to these laws, such as state and local government plans, some states impose disclosure requirements, and some do not. Fee disclosure requirements also vary based on the type of investment product in which participants invest. The Securities and Exchange Commission regulates some investment products, like mutual funds, while others are regulated by states' insurance agencies. Because different regulators require different disclosures, participants in DC plans and IRAs can invest in similar products but receive different information on fees. Labor oversees disclosure for participants of certain DC plans, while IRS oversees tax laws that underlie all DC plans, but both lack information that could strengthen oversight. Labor is responsible for enforcing requirements for disclosure--which may include fees--and the requirement that fiduciaries for some plans must ensure reasonable fees, and has proposed regulations to improve fee disclosure. However, Labor does not have the specific authority to collect information to help ensure that sponsors of certain 403(b) plans continue to protect participants' interests. While IRS does not oversee fees or fee disclosure, IRS oversees DC plans' compliance with the tax code. IRS does not collect information to easily enforce 457(b) plans' contribution limits and detect violations that may reduce federal tax revenue. In addition, IRS and other regulators do not routinely share information with one another to use resources effectively and help enforce a rule requiring reasonable fees.

GAO-09-641 September 4, 2009
Highlights Page (PDF)   Full Report (PDF, 22 pages)   Accessible Text

401(k) Plans: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers' Retirement Savings

Under federal regulations, 401(k) participants may tap into their accrued retirement savings before retirement under certain circumstances, including hardship. This "leakage" from 401(k) accounts can result in a permanent loss of retirement savings. GAO was asked to analyze (1) the incidence, amount, and relative significance of the different forms of 401(k) leakage; (2) how plans inform participants about hardship withdrawal provisions, loan provisions, and options at job separation, including the short- and long-term costs of each; and (3) how various policies may affect the incidence of leakage. To address these matters, GAO analyzed federal and 401(k) industry data and interviewed federal officials, pension experts, and plan administrators responsi- ble for managing the majority of 401(k) participants and assets.

The incidence and amount of the principal forms of leakage from 401(k) plans--that is, cashouts of account balances at job separation that are not rolled over into another retirement account, hardship withdrawals, and loans--have remained relatively steady, with cashouts having the greatest ultimate impact on participants' retirement preparedness. Approximately 15 percent of participants initiated some form of leakage from their retirement plans, according to an analysis of U.S. Census Bureau survey data collected in 1998, 2003, and 2006. In addition, the incidence and amount of hardship withdrawals and loans changed little through 2008, according to data GAO received from selected major 401(k) plan administrators. Cashouts of 401(k) accounts at job separation can result in the largest amounts of leakage and the greatest proportional loss in retirement savings. Most plans that GAO contacted used plan documents, call centers, and Web sites to inform participants of the short-term costs associated with the various forms of leakage, such as the tax and associated penalties. However, few plans provided them with information on the long-term negative implications that leakage can have on their retirement savings, such as the loss of compounded interest and earnings on the withdrawn amount over the course of a participant's career. Experts that GAO contacted said that certain provisions had all likely reduced the overall incidence and amount of leakage, including those that imposed a 10 percent tax penalty on most withdrawals taken before age 59?, required participants to exhaust their plan's loan provisions before taking a hardship withdrawal, and required plan sponsors to preserve the tax-deferred status of accounts with balances of more than $1,000 at job separation. However, experts noted that a provision requiring plans to suspend contributions to participant accounts for 6 months following a hardship withdrawal may exacerbate the long-term effect of leakage by barring otherwise able participants from contributing to their accounts. GAO also found that some plans are not following current hardship rules, which may result in unnecessary leakage.

GAO-09-715 August 28, 2009
Highlights Page (PDF)   Full Report (PDF, 52 pages)   Accessible Text

American workers increasingly rely on 401(k) plans for their retirement security, and sponsors of 401(k) plans--typically employers--have critical obligations under the Employee Retirement Income Security Act of 1974 (ERISA). When acting as fiduciaries, they must act prudently and solely in the interest of plan participants and beneficiaries. The Department of Labor (Labor) is responsible for protecting private pension plan participants and beneficiaries by enforcing ERISA. GAO examined: (1) common 401(k) plan features, which typically have important fiduciary implications, and factors affecting these decisions; (2) challenges sponsors face in fulfilling their fiduciary obligations when overseeing plan operations; and (3) actions Labor takes to ensure that sponsors fulfill their fiduciary obligations, and the progress Labor has made on its regulatory initiatives. To address these objectives, GAO administered a survey asking sponsors how they select plan features and oversee operations, reviewed industry research, conducted interviews, and reviewed related documents.

Plan sponsors commonly select certain noninvestment and investment features, and their decisions about which investment features to select generally have important fiduciary implications. According to industry research, most 401(k) plans offer a number of common features, such as employer contributions and loans for employees. Some of these decisions seldom involve fiduciary obligations set by ERISA because they are mainly business decisions related to establishing the plan. However, a sponsor's decisions about investment features, like the menu of investment options, entail important fiduciary obligations under ERISA. ERISA and its regulations stipulate certain requirements for these investment decisions, like offering diversified funds and prudently selecting and monitoring investment options. Various other factors also affect a sponsor's menu decisions, including the size of the plan and the role of external advisers and other providers. Plan sponsors face challenges in fulfilling their obligations when fiduciary roles are not clearly defined or when sponsors lack important information about arrangements between service providers. Fiduciary roles that are not clearly defined can lead to gaps in plan oversight. For example, several industry professionals noted situations when sponsors assumed they had delegated fiduciary investment advice for the selection and monitoring of investment funds to a service provider, but the service provider did not acknowledge that fiduciary role. Sponsors also have fiduciary obligations when selecting and monitoring one or more service providers. To fulfill these obligations, Labor's guidance indicates that sponsors should obtain information about service providers' compensation arrangements and potential conflicts of interest that could affect the service provider's performance. Labor and various industry practitioners have proposed new ways to improve fiduciary oversight that may address some of the challenges of unclear fiduciary roles and providers' arrangements. Labor takes various actions to monitor sponsors' fiduciary oversight of 401(k) plans and has made some progress on its regulatory initiatives. Labor's actions include investigating reports of questionable 401(k) plan practices, collecting information from plan sponsors, and conducting outreach to educate plan sponsors about their responsibilities. Labor is also proceeding with several initiatives to improve disclosures to participants, plan sponsors, government agencies and the public. For example, Labor recently published a proposed rule on the information that service providers must disclose to plan sponsors but is trying to resolve several questions before issuing a final rule. In addition, certain matters that GAO has asked Congress to consider would help Labor in its efforts to improve sponsors' fiduciary oversight. We previously suggested that Congress amend ERISA to (1) explicitly require 401(k) service providers to disclose to plan sponsors the compensation they receive from other service providers and (2) give Labor authority to recover plan losses against certain types of service providers even if they are not currently considered fiduciaries under ERISA.

GAO-08-774 July 16, 2008
Highlights Page (PDF)   Full Report (PDF, 52 pages)   Accessible Text

Information on 401(k) plan fee disclosure serves different functions for plan sponsors and participants. Plan sponsors need to understand a broad range of information on expenses associated with their plans to fulfill their fiduciary responsibilities. Sponsors need information on expenses associated with the investment options that they offer to participants and the providers they hire to perform plan services. Such information would help them meet their fiduciary duty to determine if expenses are reasonable for the services provided. In addition, sponsors also need to understand the implication of certain business arrangements between service providers, such as revenue sharing. Despite some disagreements about how much information is needed, industry professionals have made various suggestions to help plan sponsors collect meaningful information on expenses. Labor has also undertaken a number of activities related to the information on plan fees that sponsors should consider. Participants need fee information to make informed decisions about their investments--primarily, whether to contribute to the plan and how to allocate their contributions among the investment options the plan sponsor has selected. However, many participants are not aware that they pay any fees, and those who are may not know how much they are paying. Most industry professionals agree that information about an investment option's relative risk, its historic performance, and the associated fees is fundamental for plan participants. Some industry professionals also believe that other fees that are also charged to participants should be understood, so that participants can clearly see the effect these fees can have on their account balances.

GAO-08-222T October 30, 2007
Highlights Page (PDF)   Full Report (PDF, 22 pages)   Accessible Text

According to Labor's most recent data, there are an estimated 44 million active participants in 401(k) plans. As participants accrue earnings on their investments, they also pay a number of fees, associated with 401(k) plans. Over the course of the employee's career, fees may significantly decrease retirement account balances. For plan sponsors, understanding the fees they are being charged helps fulfill their fiduciary responsibility to act in the best interest of plan participants. GAO's prior work on 401(k) fees found that fee disclosures are limited and do not allow an easy comparison of investment options. GAO previously made recommendations to both Congress and Labor on ways to improve the disclosure of fee information to both plan participants and sponsors. Both Labor and Congress now have efforts under way to ensure that both participants and sponsors receive the necessary fee information to make informed decisions. These efforts on the subject have generated significant debate. This testimony provides information about the way fee information could be disclosed to benefit 401(k) participants and sponsors, focusing on 1) the information on fees that could be most useful for plan participants and plan sponsors and 2) how such information could be effectively presented. To complete this statement, GAO relied on previous work and also utilized information from Labor and from industry experts on the subject of fee disclosure to participants.

Fee disclosure serves different functions for plan participants and sponsors. Studies have shown that 401(k) participants often lack basic knowledge about the fees associated with their plan. Participants need information about the direct expenses that could be charged to their accounts. As we previously recommended and most experts agree, the expense ratio--a fund's operating fees as a percentage of its assets--is a fundamental piece of information for participants. Plan sponsors, in contrast, need a range of fee information to fulfill their fiduciary responsibilities. Sponsors need additional information on service providers, investment options, and revenue sharing arrangements to assist them in monitoring plan fees and determining whether they continue to be reasonable in light of the services provided. Labor has ongoing efforts designed to help participants and plan sponsors understand the importance of plan fees and the effect of those fees on retirement savings. Whether participants receive only basic expense ratio information or more detailed information on fees, presenting the information in a clear, easily comparable format can help participants understand the content of the disclosure. GAO's prior reports found that certain practices help people understand complicated information. For example, using clear language and a straightforward layout in a brief document can enhance the accessibility of financial information. Also, providing graphics and less text can both attract recipient attention and make detailed information more quickly and easily understandable.

GAO-08-95T October 24, 2007
Highlights Page (PDF)   Full Report (PDF, 24 pages)   Accessible Text ]]> http://www.401kplanning.org/401k-planning-books/gao-reports-of-interest/feed/ 0 http://www.401kplanning.org/another-report-paints-bleak-outlook-for-public-pension-plans/ http://www.401kplanning.org/another-report-paints-bleak-outlook-for-public-pension-plans/#comments Fri, 09 Apr 2010 15:36:38 +0000 admin http://www.401kplanning.org/?p=1900 We have been watching closely the emerging public pension plan funding problems and have suggested that the public sector may soon become the next big area for 401k growth.

A just released study from the Center for Retirement Research at Boston College paints a dire picture for the future of public defined benefit pension plans. The study is significant not only for its message, but also because the messenger (CRR) has historically been a staunch supporter of DB plans as the most efficient and effective means to provide retirement security to American workers.

Click image to access complete report

In April 2008, just months before the financial meltdown, a CRR review of state and local pension funding status at that time was titled "The Miracle of Funding by State and Local Pension Plans".

The current study analyzes current and near-term projected future funding levels for the same 126 large state and local pensions using the plans' own valuation data and methodologies - but now finds that the miracle has vanished. (It should be noted that there is significant debate and mounting concerns among governmental accounting experts that these valuation methods are too lenient and that the true public pension funding deficit is far worse than is being disclosed by the plans. The CRR report does not specifically address these concerns.)

But even setting aside this issue, the CRR report offers a very pessimistic outlook for public DB plans and no substantive or practical ideas to solve the problem:

"The conclusion that emerges from this update is that while states and localities were on a path toward full funding of their pension liabilities, they were seriously knocked off track by the financial crisis. The first glimpse of the dimension of the damage is becoming evident with the actuarial valuations for 2009. (Since three-quarters of plans have a fiscal year ending June 30, the 2008 valuations were closed before the crisis hit.) Between 2008 and 2009, the ratio of assets to liabilities for our sample of 126 plans dropped from 84 percent to 78 percent. But this decline is only the beginning of the bad news that will emerge as the losses are spread over the next several years. The ultimate outcome will depend on the performance of the stock market, but under our most likely scenario, funding ratios will decline to 72 percent by 2013.

The key question is what should be done. A major increase in contributions is not realistic at this time. States and localities may have only limited ability to increase employee contributions, because some state courts have ruled that the public employer is prohibited from modifying the plan for existing employees. Higher contributions from new employees will take a long time to have any substantial effect. Thus, if funding levels are to be restored quickly, the money must come primarily from tax revenues. But the recession has decimated tax revenues and increased the demand for state and local services. Thus, finding additional taxes to make up for market losses will be extremely difficult (emphasis added). One small step that would be viewed as a commitment to responsible funding would be for states and localities to at least pay their full ARC. Otherwise, the only option is to wait for the market and the economy to recover."

We, too, believe that finding additional tax dollars for public pension funding will be "extremely difficult" or, more accurately, near impossible in the next several years. The pressure will be extreme for state and local governments to mimic what has already taken place in the private sector and shift workers to a 401k-style retirement system.

]]> http://www.401kplanning.org/another-report-paints-bleak-outlook-for-public-pension-plans/feed/ 0 http://www.401kplanning.org/robs-rollovers-as-business-start-up/ http://www.401kplanning.org/robs-rollovers-as-business-start-up/#comments Fri, 09 Apr 2010 12:27:12 +0000 admin http://www.401kplanning.org/?p=1898

Anyone contemplating a ROBS transactions will want to read this IRS memo.

ROBS (Rollovers as Business Start-up) is the acronym used to describe a somewhat questionable technique used for starting a business with 401k rollover. The ROBS technique is controversial both because the IRS tends to frown on the practice and because of the extreme risk involved in taking one's retirement nest egg to start up a business.

Still, with bank financing for new businesses at a virtual standstill, ROBS has been heavily marketed as a legitimate financing plan particularly as a funding method to start a franchise operation. Several firms are marketing their services to walk entrepreneurs through the ROBS process - for substantial fees.

An IRS memorandum critical of the funding method describes the steps involved in a typical ROBS transaction:

• An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.
• The plan document provides that all participants may invest the entirety of their account balances in employer stock.
• The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point. there is still no ownership or shareholder equity interest.
• The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual's prior employer's qualified plan, or under a conduit IRA which itself was created from these amounts. Note that at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the
  distribution have been avoided. ¹
• The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
• The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
• After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be
  entitled to invest in employer stock.
• A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.

The IRS makes it very clear in this memo that they cast a wary eye on ROBS and detail numerous potential violations that could be triggered by these transactions. ROBS are considered technically legal, but fraught with dangerous pitfalls that could potentially cost you not only your retirement savings, but also extremely stiff IRS penalties and fees.

It goes without saying, then, that the legal, tax, and personal finance implications of using ROBS makes it absolutely essential for anyone contemplating this technique to have competent legal and financial advisors at their disposal.

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Notes:

1. Distributions from tax-deferred accumulation accounts would generally be taxed under IRC § 72, which specifies treatment for various forms of annuity or non-annuity payments. In general, a single sum distribution would be taxed as ordinary income, at the individual's effective tax rate. Of particular concern here, the distribution would generally also be subject to the 10% "premature distribution" penalty provided by IRC § 72(t), unless the individual was at least 59-1/2 years old on the transaction date, or met one of the other limited statutory exceptions. ROBS transactions effectively avoid all § 72 concerns.

]]> http://www.401kplanning.org/robs-rollovers-as-business-start-up/feed/ 3 http://www.401kplanning.org/auto-annuity/ http://www.401kplanning.org/auto-annuity/#comments Thu, 08 Apr 2010 12:44:49 +0000 admin http://www.401kplanning.org/?p=1897 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.

]]> http://www.401kplanning.org/auto-annuity/feed/ 0 http://www.401kplanning.org/older-workers-fare-better-through-crisis/ http://www.401kplanning.org/older-workers-fare-better-through-crisis/#comments Wed, 31 Mar 2010 01:02:01 +0000 admin http://www.401kplanning.org/?p=1894 There's no doubt that the financial crisis of 2008-09 has shaken up retirement planning like no other event in memory. Public defined benefit pensions, a mainstay of government employment, are teetering. Hundreds of companies have pulled the plug on matching contributions to 401k plans and are only now starting to reinstate them. And everywhere, workers - especially the oldest baby boomers - have been forced to rethink and remake retirement plans.

But a just released study from Boston College's Center for Retirement Research reaches a surprising conclusion: Even taking into account the massive losses brought about by the financial crisis, when viewed from a career-spanning perspective, early baby-boomers (those closest to retirement) have fared quite well in terms of financial market returns. The study looks at 401k investment returns over the careers of three hypothetical retirement savers:

• Early Boomers (age 50 in 1999)
• Late Boomers (age 40 in 1999)
• Gen Xers (age 30 in 1999)

The early boomer turned 60 in 2009 and was preparing for retirement just as markets hit bottom in March of that year. These workers - and their decimated retirement nest eggs - were the subject of countless stories highlighting the shortcomings of the 401k. How was it possible for someone to work and save diligently over an entire career only to have the rug pulled out from beneath them on the doorstep of retirement?

Even at the low point, early baby boomers realized 7.9% career market rates of return. More recently, as markets are recovering, career return rates exceed 9%.

But as devastating as the crisis has been, it is amazing to realize that even at the lowest point (March 2009) the career-long rate of return for an early boomer 401k saver was +7.9%! This is because these workers were old enough to benefit fully from the historic run-up in the stock market that occurred between 1982 and 2000. Late Boomers and Gen Xers, on the other hand, had to deal with precipitous market declines in 2000 and 2008 without the benefit of the 80's market boom.

None of this is to suggest that early boomers' retirement plans weren't tragically impacted by the 2008-09 financial crisis. They certainly were and, unlike younger generations, they do not have time to recoup losses. Moreover, percentages and rates of return mask the more fundamental problem that, by every measure, workers across all age cohorts have not (and are not) adequately saving for retirement. A healthy rate of return on a pint-sized nest-egg is not a formula for retirement success.

"As jarring as the financial collapse may have been for the Early Boomers, the market has actually treated them well over their lifetime. Hypothetical workers investing either all in equities or in half equities and half bonds have enjoyed fairly high returns compared with long-run averages. This agreeable outcome is the result of these workers having substantial assets during the long bull market that began in 1982 and ended in 2000.

Moreover, the market has treated Early Boomers a lot better than the subsequent cohorts. Late Boomers and Gen Xers never benefited fully from the 1982-2000 bull market and were hard hit by two market collapses. The Late Boomers are the most vulnerable, as they would need substantial returns in the future to end up with the same ratio of assets to income at age 60 currently enjoyed by Early Boomers."¹

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Notes:

1. Returns on 401k Assets by Cohort, Center for Retirement Research at Boston College, March 2010.

]]> http://www.401kplanning.org/older-workers-fare-better-through-crisis/feed/ 0 http://www.401kplanning.org/reasons-why-state-local-governments-will-shift-to-dc-retirement-plans/ http://www.401kplanning.org/reasons-why-state-local-governments-will-shift-to-dc-retirement-plans/#comments Thu, 18 Feb 2010 20:46:39 +0000 admin http://www.401kplanning.org/?p=1892 The public sector retirement landscape is dominated by expensive defined benefit (DB) pensions that provide government workers guaranteed income for life when they retire. A few states - Alaska and Michigan - require new hires to enroll in 401k-style defined contribution (DC) plans similar to the 401k's that predominate in the private sector. But economic conditions, budget constraints and other factors are forcing more state and local governments to consider switching from DB to DC retirement plans.

Here are our top reasons why we think the transition to DC retirement plans will spread in the public sector:

1. Public sector pay no longer lags the private sector - There was a time when government employees were paid much less than private sector workers of similar status. The pay differential was offset largely by good pensions, benefits and job security that public sector employment offered. But times have changed and there is now mounting evidence that public sector pay and benefits are well in excess of the private sector. An article in USA Today reported that, in 2008, "Overall, total compensation for state and local workers was $39.25 an hour — $11.90 more than in private business. In 2007, the gap in wages and benefits was $11.31...A full-time government worker receives benefits worth an average of $27,830 per year. A private worker's benefits are worth $16,598."

   As the public-private pay gap widens and becomes more publicized, taxpayers will press for reforms to bring pay and benefits in line with private sector compensation.

2. State & local budgets are distressed like never before - A recent article in Bloomberg noted:
   

   "The biggest financial crisis since the Great Depression is squeezing municipalities across the country. Since Vallejo, California, successfully petitioned for bankruptcy protection in May 2008, California’s towns, Detroit’s schools and Pennsylvania’s capital city of Harrisburg have all talked about Chapter 9...(municipalities are) talking about it more than they have since 1994, when Orange County, California, suffered through the country’s biggest municipal bankruptcy. Bondholders have to worry if it’s more than just talk. "

   The facts are:

   • government revenues have fallen precipitously in the recession
   • government costs - especially for pensions and healthcare - are rising at unprecedented rates
   • pension and retiree healthcare funds are not well funded and contribution deferral is no longer an option

   This adds up to mounting fiscal pressures to restructure public pensions.

3. Most taxpayers will never have DB pensions, so why should they have to pay for public workers to have them? - The phrase "public servant" may be out of step with today's reality. As already noted, average pay for public servants surpasses the average wage for their taxpayer-bosses. When it comes to pensions, the differences are even more striking: 90% of public sector employees have defined benefit pensions while only 20% of the private sector workforce get this benefit. Growing awareness of this inequity will pressure sponsoring governments to move towards 401k-type retirement plans.
4. Pension spiking and other abuses are fueling public anger - Defined benefit pensions are formula based and give extra weight to the last few years of a person's employment. In many cases, employees are allowed to boost their income in the last few years by cashing out accrued leave balances or by other means. This results in larger pensions - sometimes 25% larger - payable for life. Pension-spiking practices have been the subject of numerous news accounts in California and have helped fuel citizens' anger over public pensions.
5. The other shoe is dropping: Anyone know what OPEB stands for? - Expensive defined benefit pensions are only part of state and local governments retirement problem. These governments have also promised millions of workers that they will get health care and, sometimes, related benefits like life and dental insurance in retirement. Government financial reports refer to these promises by the acronym OPEB - other post-employment retirement benefits. No one knows how big the nation's total OPEB liability is. A November 2009 GAO survey of the 50 state and 39 large local governments tallied an unfunded liability for these 89 governments alone in excess of $530 billion. Other observers place the total OPEB liability for all state and local governments at $1 trillion or more. Whatever the actual number, there is no disagreement that it is huge and growing. The public is generally unaware of this issue, but they soon will become painfully aware of it as OPEB costs result in higher taxes and reduced public service levels - and more pressure to change the status quo.
6. Assumptions and numbers used by DB pensions are overly optimistic - Assumed annual 8% investment returns, "smoothing" losses over long periods, perpetual 30-year amortization schedules, and on and on. Public pension funding is complex and based on myriad arcane assumptions. These assumptions are sometimes modified - usually with an end goal of keeping employer contributions low and making things look better than they really are. Actuarial valuations for public pensions are not done according to the same standards that private sector valuations are required to follow. Indeed there is ongoing debate in the actuarial profession over whether it is appropriate and realistic to use fixed, non-market based earnings assumptions (typically 8%) for government pensions. According to one public pension actuary, changing standards to be more like the private sector (a distinct possibility) would be the death knell for public DB pensions:
   

   "The use of market-value rates to discount public pension plan liabilities would create greater contribution requirements and spur the replacement of public defined benefit plans with 401(k) plans...State and local (governments) would all have 401(k)s if we had to make contributions like that to provide for market volatility.”

7. Fixing Medicare and social security are more important than fixing state & local government pensions. - There are about 20 million state and local government workers, the vast majority of whom are covered by defined benefit pensions. Social security and Medicare, of course, are national retirement programs that affect at least ten time as many people and have their own serious funding issues as noted in the most recent annual reports of the two systems:
   

   "The financial condition of the Social Security and Medicare programs remains challenging...The drawdown of Social Security and HI Trust Fund reserves and the general revenue transfers into SMI will result in mounting pressure on the Federal budget. In fact, pressure is already evident. For the third consecutive year, a "Medicare funding warning" is being triggered, signaling that non-dedicated sources of revenues—primarily general revenues—will soon account for more than 45 percent of Medicare's outlays. A Presidential proposal will be needed in response to the latest warning. The financial challenges facing Social Security and especially Medicare need to be addressed soon. If action is taken sooner rather than later, more options will be available, with more time to phase in changes and for those affected to plan for changes."

   In coming years, the Social Security & Medicare funding crisis will compete with the state & local retirement funding crisis for taxpayer dollars. Our bet will be that the federal programs affecting nearly all workers will overwhelm concerns about public employee pensions.

8. Strong protections for existing DB benefits allow little flexibility - Reasonable people might suggest one fix for the public pension problem is to scale back benefits some degree for current retirees and/or currently active employees. The problem here is that state constitutions and statutes prohibit this. The Illinois Constitution, as an example, provides an explicit guarantee that makes it nearly impossible to modify benefits levels downward - even in a severe fiscal crisis:
   

   "membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

   Most other states have comparable constitutional, statutory, and/or common law pension guarantees. This makes changing pension benefit structure for new employees the only available avenue for relief.

Combined, these factors are certain to shake up the public sector pension world in the next few years. Formidable legal and political obstacles including will make changes difficult. But maintaining the status quo is simply no longer an option.

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