How Much Will Social Security Replace?

A basic question all retirement savers need to ponder is: how much income will Social Security replace?

Conventional wisdom holds that retirees will need about 80% of their pre-retirement income in order to maintain their lifestyles. ¹

For most, Social Security can be expected to provide a large chunk of that 80% — but just how much?

Some answers come from the The 2010 Annual Report Of The Board Of Trustees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds. This is the annual report card for the Social Security system covering nearly 250 pages and packed with detailed charts, tables and financial statistics. One table in particular provides useful insights into the amount of pre-retirement you can expect Social Security to replace in the years ahead.

Pre-Retirement Earnings Level	Retirement at Normal Retirement Age	Retirement at Age 65
Lower Earner (Career-average earnings about 45 percent of the national average wage index (AWI), or about $19,388 in 2010.)	54% – 56%	49% – 52%
Medium Earner (Career-average earnings at about 100 percent of the AWI, or about $43,084 in 2010.)	40% – 42%	36% – 38%
Higher Earner (Career-average earnings at about 160 percent of the AWI, or about $68,934 in 2010.)	33% – 34%	30% – 32%

As you can see, Social Security can be expected to replace one-half or more of pre-retirement income for workers having relatively low earnings over the course of their careers. As career earnings increase, Social Security replaces a smaller portion of retirement income meaning that these workers need to rely more on 401k’s, other retirement savings and, increasingly more likely, continued employment in order to achieve the 80% replacement goal.

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Notes:

1. There is much debate over whether 80% overstates or understates income needs in retirement. One study by Georgia State University researchers shows needed replacement rates ranging from 78% for two-earner, higher income couples to 94% for two-earner, lower income couples. For this discussion, we can assume 80% is an overall accurate income replacement target. [↩]

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.

Consistent 401k Employee Contributions are Critical to Retirement Savings

It seems like reports about Americans’ retirement savings have been nothing but bleak since the onset of the Great Recession in 2008. But a new report from Fidelity Investments show that workers who made consistent 401k employee contributions over the past ten years have seen their 401k balances more than triple – despite the devastating investment losses of 2008-09.

Fidelity is the nation’s largest provider of “workplace retirement savings plans”, managing 11 million 401k accounts for nearly 17,000 corporate employers. Fidelity issues an annual 401k report card showing the changes in the average 401k account balances of its clients. for 2010, the news was surprisingly upbeat:

The average 401k account balance rose to $71,500 at the end of 2010, reaching a 10-year high since Fidelity began tracking the data based on the industry’s largest participant base of 11 million 401k accounts. For participants who were continuously active for the past 10 years ¹ , their average balance increased to $183,100 at the end of last year from $59,100 at the end of the fourth quarter 2000. Average participant deferrals remained at 8.2 percent for an eighth straight quarter ²

Bear in mind that just two years ago, Fidelity’s 401k report found the average 401k account balance had fallen 27% in 2008 from $69,200 to $50,200. Here are the average 401k account balances reported by Fidelity as of the end of 2010:

20-24	25-29	30-34	35-39	40-44	45-49	50-54	55-59	60-64	65-69	Over 70
$3,500	$11,700	$25,300	$42,500	$59,900	$81,100	$105,400	$122,400	$120,600	$122,900	$96,700

401kPlanning offers a free 401k calculator that can clearly illustrate the importance of making regular 401k employee contributions. For example, a 30 year-old making $40,000, who is just starting to save for retirement by setting aside 5% of his pay can expect to accumulate a half-million dollars at age 65 ((Assumes 3% annual salary increase and 8% return on investments) – with no matching employer contribution! If the same worker is lucky enough to be with an employer that matches 50% of his contributions, he can expect to amass $750,000 at retirement age.

Bottomline:It is proven fact that needs to be clearly understood by 401k planners that starting to save early and consistently for retirement by making reasonable 401k employee contributions provides the best chance to meet retirement expenditure goals.

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Notes:

1. “Continuously active” means10-year continuous participants were both actively employed by a plan sponsor and had a balance for the full 10 years. Account balance growth is attributed to both contributions and market activity. [↩]
2. This includes both employee pre- and post-tax contributions, but excludes employer contributions. [↩]

GAO Reports on Growth of 401k of Target Date Funds

The meteoric growth of 401k automatic enrollment has been accompanied by equally impressive growth in the use of target date funds (TDF) as the default investment option for 401k participants who don’t want to be heavily involved with investment decisions. ¹

TDF’s “Target Date Funds” are investment funds that invest in a mix of assets, and shift from higher-risk to lower-risk investments as a participant approaches their “target” retirement date. TDF can benefit 401k investors in several ways:

• By automating investment decisions, they relieve DC plan participants of the burden of deciding how to allocate their retirement savings among equities, fixed income, and other investments.
• Provide professionally developed asset allocation based on their planned retirement date.
• Can help 401k participants avoid common investment pitfalls, such as a lack of diversification and a failure to periodically rebalance their assets.

But despite their many benefits, a new Government Accountability Office (GAO) report on target date funds finds that TDF’s have some problems that need to be addressed:

1. TDF’s are intended to simplify investment decision-making for 401k participants uncomfortable with the nuances of investing. But TDF’s can still be quite risky. Indeed, the GAO report was spurred because some TDFs designed for those expecting to retire in 2010 experienced major losses during the financial market downturn of 2008-2009, placing the retirement security of many participants in jeopardy. In one case, a TDF designed for participants retiring in 2010 lost over 40 percent of it value. Bottomline: 401k participants contributing to TDFs still bear the full burden of investment risk.
2. TDF’s with seemingly comparable target dates and investment objectives can vary widely in terms of investment allocations, risk profile, and performance. For example, GAO found that among 5 TDF funds it reviewed with similar target dates, equity (or stock) investments at the target date ranged from 33 percent to 65 percent (see graph).
3. Similarly, retirement and investment philosophies of TDF fund managers have wide variances, even for TDF’s with comparable targets. Some TDF’s focus on arriving at the target date without major losses while other TDF’s goal is to assure that assets are not depleted throughout a retirement that may extend 30 years beyond the target date. Whether a TDF focuses on getting you to retirement or through retirement is an essential factor to understand.

TDF’s are definitely here to stay. Their growing popularity and appeal for 401k participants seeking to simplify retirement planning and investing is unquestioned. But these benefits should not come at the expense of complacency. The GAO calls for greater transparency, participant education and disclosure regarding TDF assumptions be provided.

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Notes:

1. See “What is a Target Date Fund“ [↩]

Using 401k Rollover to Start a Business

We previously wrote about the growing popularity of starting a business with a 401k rollover. We noted that the IRS considers the ROBS¹ practice “questionable”, though not necessarily abusive.

The IRS initiated a project in 2009 to further study the ROBS issue. This involved sending a questionnaire to plan sponsors asking about the ROBS plan record-keeping, reporting and other pertinent matters.

Recently, the IRS released a sobering finding from the ROBS project:

Preliminary results from the ROBS Project indicate that, although there were a few success stories, most ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (business and personal), liens (business and personal), and corporate dissolutions by individual Secretaries of State. Some of the individuals who started ROBS plans lost not only the retirement assets they accumulated over many years, but also their dream of owning a business. As a result, much of the retirement savings invested in their unsuccessful ROBS plan was depleted or ‘lost,’ in many cases even before they had begun to offer their product or service to the public.

Additionally the IRS ROBS project found serious reporting deficiencies with many of the ROBS plans they surveyed and noted these additional areas of concern:

• After the ROBS plan sponsor purchases the new company’s employer stock with the rollover funds, the sponsor amends the plan to prevent other participants from purchasing stock.
• If the sponsor amends the plan to prevent other employees from participating after the DL is issued, this may violate the Code qualification requirements. These types of amendments tend to result in problems with coverage, discrimination and potentially result in violations of benefits, rights and features requirements.
• Promoter fees
• Valuation of assets
• Failure to issue a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., when the assets are rolled over into the ROBS plan

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Notes:

1. ROBS is an arrangement in which prospective business owners use their retirement funds to pay for new business start-up costs. ROBS plans, while not considered an abusive tax avoidance transaction, are questionable because they may solely benefit one individual – the individual who rolls over his or her existing retirement funds to the ROBS plan in a tax-free transaction . The ROBS plan then uses the rollover assets to purchase the stock of the new business. [↩]

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. [↩]

Study Surveys Reasons Behind 401k Employer Match Suspensions

It’s no secret that lost 401k company matches have been one of the most visible casualties of the current recession. Scores of companies have reduced or eliminated 401k matches as a quick-fix cost-cutting strategy and as an alternative to layoffs. According to one study, about 5% of 401k participants were affected by employer match suspensions in 2009. (List of companies suspending 401k match.)

Although there is no legal requirement for employers to make 401k contributions, the vast majority of companies do match employee contributions to some level, according to the Profit Sharing/401k Council of America.

A new study from the Center for Retirement Research at Boston College delves into the determinants of why companies suspend matches. Their main findings are not particularly surprising: Companies most likely to have suspended 401k matches in 2009 tended to be:

1. Larger Companies
2. In the manufacturing sector
3. Exhibiting liquidity constraints

Somewhat surprisingly, neither a company’s profitability nor the presence of a defined benefit pension program were significant factors in explaining match suspensions.

The study concludes:

The recent financial crisis and ensuing recession has once again sorely strained 401(k) participants. As in 2000, employees have been reminded that they are on the hook for financial risk. At the same time, it is once again clear that the employer match, a valued component of 401(k) plans, is neither mandatory nor permanent. About 5 percent of active participants in 401(k) plans have seen their employer’s match suspended. The key cause of this phenomenon is likely a lack of liquidity on the part of employers, which renders them unable to continue their previous contributions. As the crisis abates, companies appear to be restoring the match. If this trend continues, the suspensions may have done little harm and may have been better than the alternative of cutting payroll or laying off workers.

The CRR study was done at a macro-level by a correlating of company data submitted on federal form 5500 filings with financial data fro Standard & Poors. The study did not delve into the actual decision-making that leads firms to determine that they will suspend their match. For example, it would be interesting to examine whether cutting the 401k match is a first resort or a last resort in the menu of cash preservation techniques that liquidity constrained firms choose from.

Our fear is that 401k matches are becoming the cash preservation tool of choice because they can be implemented relatively easily, swiftly and have a big and immediate impact (2% – 4% of payroll). If this is the case, it does not bode well for workers who can expect to weather 3-5 recessionary period over a 40 year working career.

Bill Would Require Lifetime Income Statements Be Provided

Social Security mails benefit projection statements annually detailing the projected monthly benefit participants can expect to receive at retirement. Now, U.S. Senators Jeff Bingaman (D-NM), Johnny Isakson (R-GA), and Herb Kohl (D-WI) want 401k plans to also provide lifetime income reports. According to an announcement on Senator Bingaman’s website:

The Senators’ Lifetime Income Disclosure Act (S. 2832) would require 401(k) plan sponsors to inform participating workers of the projected monthly income they could expect at retirement based on their current account balance. The measure is patterned on the Social Security Administration’s annual statements, which are mailed annually to working Americans to inform them of estimated monthly benefits based on their current earnings. Congress mandated annual Social Security statements in 1989, and they have proven to be very useful to workers in preparing for retirement.

By providing similar information for 401(k) plans, the Lifetime Income Disclosure Act would give American workers a more complete snapshot of their projected income in retirement.

Specifically, under the Act, defined contribution plans subject to ERISA – including 401(k) plans – would be required annually to inform participants of how the account balance would translate into guaranteed monthly payments – a “retirement paycheck for life” – based on age at retirement and other factors.

To ensure there is no material burden or potential liability on employers who voluntarily sponsor 401 (k) plans, the legislation directs the Department of Labor issue tables that employers may use in calculating an annuity equivalent, as well as a model disclosure. Employers and service providers using the model disclosure and following the prescribed assumptions and DOL rules would be insulated from liability.

As far as Congressional bills go, the Lifetime Income Disclosure Act is relatively simple and straightforward – only six wide-margin, double-spaced pages in length. The heart of the bill is comprised of three sections setting forth the type of lifetime income disclosures to be made:

1. DISCLOSURE — A lifetime income disclosure shall set forth the annuity equivalent of the total benefits accrued with respect to the participant or beneficiary.



2. ANNUITY EQUIVALENT OF THE TOTAL BENEFITS ACCRUED — For purposes of this subparagraph, the ‘annuity equivalent of the total benefits accrued’ means the amount of monthly payments the participant or beneficiary would receive at the plan’s normal retirement age if the total accrued benefits of such participant or beneficiary were used on the date of the lifetime income disclosure to purchase the life annuities described in subclause (III), with payments under such annuities commencing at the plan’s normal retirement age.
3. LIFE ANNUITIES.—The life annuities described in this subclause are a qualified joint and survivor annuity (as defined in section 205(d)), based on assumptions specified in rules prescribed by the Secretary, including the assumption that the participant or beneficiary has a spouse of equal age, and a single life annuity. Such annuities may have a term certain or other features to the extent permitted under rules prescribed by the Secretary.

Details concerning the assumptions to be used and implementation rules are left for the Labor Department to determine.

With the transition from defined benefit pensions to 401k’s, Americans have been forced to assume greater responsibility for their own retirement funding. Too many are ill-prepared for the task. If the defined contribution retirement model is to succeed, it is critical that workers be better educated on retirement issues and provided good information on which they can base their savings decisions. Senate Bill 2832 appears to provide a low-cost, common-sense way to greatly improve 401k planning.

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.

IRS Announces 2010 Contribution Limits

The IRS has issued the cost-of-living adjustments for 2010 that affect employee benefit plans. Most 2010 limits applicable to 401k and other plans will remain at their 2009 levels.

There are several “limits” that apply to 401k plans under the Internal Revenue Code (IRC). The limits are found in various sections of the IRC. 401k plans must comply with the various IRC limits to maintain tax-qualified status. The Internal Revenue Service (IRS) annually increases 401k plan limits to reflect changes in the Consumer Price Index (CPI). Often, adjustments are made only if the change in the limit attributable to the CPI exceeds a certain threshold (e.g., $1,000 or $5,000).

The table below shows the primary 401k plan limits in effect for 2010 and 2009. Brief descriptions of the various limits are also provided.

Maximum Deferral and Threshold Limits for 2009 and 2010
Limit	2010	2009
Elective Deferral Maximum for 401(k) Plans and 403(b) Plans – IRC § 402(g)(1)	$16,500	$16,500
Elective Deferral Maximum for 457 Plans – IRC § 457(e)(15) – (below note a)	16,500	16,500
Catch-Up Limit (Age 50 and Older) for 401(k), 403(b), and 457 Plans – IRC § 414(v)(2)(B)(i)	5,500	5,500
Maximum Contribution to a Qualified Defined Contribution Plan – IRC § 415(c)(1)(A) – (below note c)	49,000	49,000
Maximum Compensation Limit – IRC § 401(a)(17) – (below note d)	245,000	245,000
Highly Compensated Employee Salary Threshhold – IRC 414(q)(1)(B)	110,000	110,000
IRA Contribution Limit	5,000	5,000
IRA Catch-Up Limit (Age 50 and Older) – IRC § 219(b)(5)(B)(ii)	1,000	1,000
Social Security Maximum Taxable Earnings – OASDI	106,800	106,800

note a – Elective deferrals are voluntary agreements in which employees elect to forego current income in return for the employer’s contributions to retirement or other benefit plans. Elective deferrals are available for a variety of tax-qualified retirement plans, including 401(k) plans.

note b – 401k plan participants who are or will be age 50 or older by the end of the plan year may voluntarily make additional “catch-up” contributions to the plan, above the maximum elective deferral limits. The maximum catch-up contribution is the lesser of (1) a specific dollar amount (the “catch-up dollar limit”) or (2) the participant’s compensation for the year reduced by any other elective deferrals made during the year.

note c – IRS limits the maximum “annual additions” that can be made to a member’s defined contribution plan account to the lesser of $49,000 in 2010, or 100% of annual compensation. In this context, annual additions include employer and employee contributions, as well as forfeitures.

note d – IRS limits the amount of compensation that can be taken into account by the plan, for the purpose of determining benefits and contributions, to $245,000 in 2010. For private sector plans, even if a plan member earns more than this amount, only $245,000 may be used in 2010 to calculate employee contributions to, or benefits provided by, the qualified plan.

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