Debunking Retirement Planning Myths

Transcription

1 June 2007 Prudential s Four Pillars of Retirement Series Debunking Retirement Planning Myths by Robert A. Fishbein IFS-A Ed. 5/2007

2 Debunking Retirement Planning Myths As the American population ages, more and more media attention is being focused on the subject of retirement planning. This coverage often distills complex financial and tax concepts into simple rules of thumb in order to make retirement planning more accessible. While these rules of thumb can be helpful places to start, they can also lead to overgeneralizations even myths about a retirement planning principles. In the pages that follow, the thinking and facts behind some of these myths are explained so that, hopefully, they can be better understood. Myth 1 Saving for College Should Be a Top Priority There are many different tax-favored products and strategies designed to help save for college education expenses. The taxfavored status of college savings vehicles, such as 529 plans, conveys the Congressional judgment that parents and grandparents (and others) should be encouraged to save for college for their children and grandchildren. While saving is almost always a good thing, and saving for college is certainly responsible and admirable, it may be unwise to the extent it reduces retirement saving. For one thing, the tax advantages of saving for retirement are generally greater and provide more economic benefit over the long haul. For another, college savings outside of a retirement vehicle generally are considered when determining how much a child or parent must contribute for annual college expenses; if college saving occurred at the expense of retirement saving, the family experiences the double-whammy of undersaving for retirement and potentially missing out on needed financial assistance for college. Retirement savings foregone in a given year is a lost opportunity that cannot be recovered, as contributions to employment-based retirement plans, IRAs, and Roth IRAs are limited each year. As a general rule, it is better to maximize retirement savings first, even to the exclusion of separate savings for college. One can always borrow to pay for a child s college education, but there are limited (and potentially costly) ways to borrow for retirement. Furthermore, retirement savings can usually be utilized to the extent needed to pay for college. Many 401(k) plans allow for loans, which could be used to help pay college tuition, and the tax law provides an exception to the 10% penalty tax for amounts withdrawn from an IRA to cover higher education costs. Of course, to the extent such IRA funds are before-tax amounts, taxes would be due on the amount withdrawn. 2 Prudential s Four Pillars of Retirement Series

3 Myth 2 It Always Makes Sense to Maximize Contributions to a 401(k) Plan While saving as much as possible in a 401(k) is the best approach for most people, there are circumstances in which this may not be the optimal course of action. The advice to maximize contributions to a 401(k) is generally premised on the fact that such contributions defer income tax on the contributed amounts. However, there are alternative tax-favored savings vehicles that could be considered and might be better for some individuals in certain circumstances, particularly when there is no company match provision in the 401(k). For some, the tax deferral benefit of the 401(k) will not truly exist if the funds will be taxed later at a higher rate (see Myth 8) once withdrawn. In this example, it may be better to contribute to a Roth IRA, paying tax up front, and then accumulate assets on a tax-free basis, particularly since a Roth IRA is not subject to the Required Minimum Distribution rules normally applicable to IRAs and 401(k) plans. Another factor may be the alternative minimum tax (AMT), an income tax regime that applies to more and more taxpayers. One strategy to minimize the adverse impact of AMT is to frontload income to the greatest extent possible. Contributing to a 401(k) plan runs counter to this strategy, since it will result in the deferral of an otherwise currently taxable amount. Maximizing contributions to a 401(k) can be an important and very beneficial component of an overall retirement plan. However, other retirement and income tax planning strategies should be seriously considered, particularly when there is not a company match feature in the 401(k). Myth 3 I Will Need Life Insurance as Long as I Live Life insurance is sometimes sold on the basis of there being a certain life insurance need for the entirety of one s life. For some, though, life insurance needs diminish over time. As we pay down our mortgages, as our children graduate from college, and as those children assume financial independence, the replacement income needs brought about by a premature death arguably decrease. (An important exception to this may be the need for replacement retirement income see Myth 4.) The current federal estate tax exemption of $2 million means that many individuals will not have to worry about estate taxes. Assuming Congress does not act to reduce the exemption amount, many individuals may not need life insurance for estate conservation purposes. Myth 4 Once I Retire I Won t Need Life Insurance While we can sometimes overestimate our life insurance needs at older ages (see Myth 3), we can also fail to see those situations in which life insurance may be needed later in Debunking Retirement Planning Myths 3

4 life. Baby Boomers are bearing some of the financial burden of caring for aging parents, and life insurance may be a way to provide for those parents if the child predeceases them. Life insurance can also be a way to provide for heirs (particularly from a previous marriage) without effectively disinheriting a current spouse. Parents with a special needs child would also likely continue to need life insurance to ensure that child has a continuing source of funds to pay for living expenses. Perhaps the most common and frequently overlooked need for life insurance in retirement is to replace the lost income benefits upon the death of a spouse. This is particularly true for Social Security benefits; upon the death of a spouse, the survivor will be entitled to the greater of his or her benefit or that of the deceased spouse. However, the lower benefit that had been received will now end, and the result will be an overall loss in household income. Assumptions that living expenses will also decline after a spouse s death potentially ignore several factors. First, the cost of housing, real property taxes, utilities, and other regular expenditures will likely remain the same or increase, due to inflation, for example. Second, the healthcare costs of the surviving spouse will almost certainly increase as he or she ages. Finally, the loss of the lower Social Security benefit will become more significant over time due to inflation (that is, the lost income would have been adjusted annually for inflation, and that inflation hedge is lost). Life insurance, then, can be used in retirement to help replace the lost Social Security benefit income stream upon the death of a spouse. As with many of the debunked myths on this list, Myths 3 and 4 show how complicated retirement planning is, and the importance of individually evaluating each situation. Myth 5 Estate Planning Is for the Wealthy Wealth preservation is an important motivation for estate planning for those with significant assets, but there are several reasons why everyone needs to do some estate planning. By having a will, an individual can decide who will receive his or her assets. If a person dies without a will, the decision as to how to distribute assets is left to state intestacy rules, which may or may not be consistent with the individual s wishes. If children are in the picture, a will is also the document by which an individual decides several other critical matters. For example, who will care for any minor children? In the absence of a will appointing guardians, the state judicial system will be involved, which can be a time-consuming and potentially costly process. The decedent s wishes as to guardianship may or may not be known or followed in the process. A will also provides for how the decedent s property will be distributed to heirs. While individuals may not think they have enough wealth for this to matter, they may, for example, fail to consider life insurance in the equation, or ignore the implications of a young child having control over an inheritance. Consider a situation where a 4 Prudential s Four Pillars of Retirement Series

5 person has only $100,000 in property and $100,000 of life insurance protection through an employer group life plan. Consider further whether such a $200,000 legacy should be distributed outright to a 22-year-old, who might think it is time for a vacation to Hawaii or time to buy that expensive sports car. If your answer is that $200,000 is too much for a 22-year-old to manage and spend responsibly, then a will with a trust can be the solution. Such a trust can provide for an inheritance to be held, invested, and distributed by the trustee in accordance with the decedent s instructions. For example, the trustee could be directed to distribute trust income annually, and to distribute the trust corpus (or principal) in three parts as the child attains ages 25, 30, and 35. This type of distribution strategy allows for the child to get used to having an income flow, and helps minimize the chance the inheritance will be wasted or used in a manner contrary to the desires of the decedent. A complete estate plan should also include a power of attorney, living will, and health care proxy. A power of attorney is the document by which an individual designates another person to act on his behalf with respect to financial matters in the event of incapacity (anything from a broken leg to Alzheimer s, depending on the type of document prepared). If you think a power of attorney is only for the wealthy, consider the soldier who is sent to Iraq and needs a spouse or parent to have the ability to pay bills and conduct other financial transactions on his behalf during his tour of duty. There are, of course, countless other scenarios when a power of attorney will be useful. A living will is the document by which an individual chooses the types of medical care that he wants, or does not want, if he becomes incapacitated and, generally, is in a terminal or persistent vegetative state. If you don t think a living will is important, then remember the Terri Schiavo case and how the lack of clarity with regard to her wishes resulted in family discord, a legal dispute, and associated medical and legal costs. Regardless of one s personal views on withdrawing medical support, clarity regarding these end-of-life issues can reduce family grief and expense. Since it is difficult to anticipate all possible medical scenarios, it may be more important to execute a healthcare proxy. Unlike a living will, in which an individual makes healthcare choices in advance, a healthcare proxy allows the individual to choose another person to make healthcare decisions for him in the event he is unable to do so. Again, failure to plan for such circumstances can lead to confusion and family discord at a difficult time, since there might not be agreement as to who should make decisions when it comes to healthcare matters. Myth 6 Social Security Will Cover My Retirement Income Needs In 2006, Social Security provided, on average, only 41% of pre-retirement income.* If this isn t bad enough for those who assume that *Social Security Administration, Performance and Accountability Report for Fiscal Year 2006, page 10. Debunking Retirement Planning Myths 5

6 Social Security will cover most or all of their retirement income needs, this income replacement percentage could decrease if Congress addresses the long-term solvency issues with Social Security, Medicare and Medicaid. Among possible Social Security solutions are increasing the age for full retirement, decreasing the current benefit, or both. Any of these approaches would have the effect of further decreasing the percentage of pre-retirement income replaced by Social Security. Perhaps the most serious consequence, though, for those who assume that Social Security will provide much or most of their retirement income is that there will be less urgency to save for retirement. This adverse consequence links to another component of Prudential s research findings: namely, that more and more future retirees plan to work in retirement. While some retirees may choose to work in retirement for health or lifestyle reasons, many will do so because pre-retirement savings combined with Social Security will provide no real choice. The failure to understand the diminishing impact of Social Security also points out a fundamental truth about the retirement landscape. Those who save early and consistently will have the best chance to ensure that they don t outlive their assets. While it is never too soon or too late to start retirement planning, saving is the critical action. All of the investment, tax, and retirement product strategies available to help meet retirement goals are, relatively speaking, secondary, if not ancillary, to consistently saving for an extended period of time. A corollary is that, once saved, retirement funds should be left for retirement and not accessed for nonretirement purposes (but see Myth 1 for a possible exception to this rule). Myth 7 Elect Social Security as Early as Possible According to Social Security Administration figures, 72% of all individuals commence Social Security at the early retirement age of 62. The choice to elect early Social Security benefit payments at this age results in a reduction of the Social Security benefit otherwise payable at the full retirement age (historically age 65, but gradually increasing to age 67). Depending on how long the individual lives after electing Social Security benefits, the choice to elect early benefits may result in a significant reduction in benefits received over time. Since mortality projections suggest that many of those choosing early Social Security benefits would be better off waiting until the full retirement age, why are so many making an unwise economic choice? Some individuals might have a pressing economic need that discourages delaying receipt of Social Security benefit payments. Others might have an aversion to deferring receipt of a benefit that has already been paid for, or may fear losing a paid-for benefit in the event they die before receiving some or a significant amount of the benefit. And yet another reason might be concern with the viability of the Social Security system itself. Notwithstanding the various reasons for choosing Social Security benefits as early as age 62, the right economic choice for many could be to wait. Before electing early Social 6 Prudential s Four Pillars of Retirement Series

7 Security, then, an individual should carefully consider his individual health, mortality expectations, and the longevity insurance protection inherent in the Social Security lifetime benefit. When it comes to planning for one s longevity, delaying Social Security and thereby increasing the lifetime benefit payable is a very powerful planning strategy. Myth 8 Income Taxes in Retirement Will Be Lower Many financial strategies are premised on the notion that an individual s income tax burden will be less in retirement. While it is difficult to make any prediction about future legislation, federal income tax rates appear to be at a historic low. The top marginal federal income tax rates have fluctuated over time, but were in the 50% to 92% range from 1946 to From 1986 to 2002, the top marginal income tax rate was generally around 39.6% (though for a relatively brief period the rate ranged from 28% to 31%). The current top marginal rate is 35%. Considering today s historically low income tax rates, coupled with the federal government s existing budgetary constraints, it may be necessary for Congress to increase income tax rates in the future. Therefore, from the perspective of the federal income tax, there is reason to believe that income taxes may go up over the next decade as the Baby Boom generation retires. Additionally, increasing payroll taxes and/or increasing means testing for some benefits could address the entitlement program funding deficit. In fact, means testing was recently introduced for Medicare Part B premium payments, meaning that, for the first time, middle and high income earners are required to pay a greater Medicare Part B premium. The possible increase in income, employment and other taxes could well mean that the tax burden for retirees will increase in retirement, with implications for how much a retiree will need to save for retirement and what types of savings vehicles the individual should use. For example, an anticipated increase in income tax suggests that one should consider a Roth IRA, since the tax would be paid at today s lower rates rather than tomorrow s higher rates. Myth 9 Living Expenses in Retirement Will Be Lower Many financial professionals suggest that living expenses will be lower in retirement and will continue to decrease over time. This theory presumably assumes that one s mortgage will be paid off before retirement, and that as the retiree ages he will gradually incur less travel or entertainment costs. Unfortunately, the future retiree appears to be less likely than those in prior generations to have paid off mortgage indebtedness at retirement. Furthermore, Prudential Financial research shows that the costs of healthcare, which are more likely to be incurred after the first phase of retirement, may actually mean that retirement expenses increase over time. Since one can argue that living expenses might remain the same or even increase in retirement, it may make sense to consider cost-of-living increases in retirement income planning. Debunking Retirement Planning Myths 7

8 Myth 10 Take Retirement Distributions From Taxable Investments First The traditional theory for taking retirement distributions is to withdraw taxable investments first, then partially tax-favored investments (such as a mutual fund), and then tax-favored investments (such as an IRA). The idea is to maximize the tax deferral benefits associated with tax-favored investments. In an ideal world where tax laws and rates are constant, this theory is valid for maximizing how long retirement assets will last for the individual. Unfortunately, tax rates are not constant, whether due to Congressional action that has created a tax code where rates are scheduled to increase in the future, or due to personal circumstance. Moreover, the traditional theory does not always maximize assets for heirs, since it can result in the distribution and transfer of a built-in tax liability on assets that would have otherwise avoided income tax if held until death. For example, under the traditional theory, one might liquidate stock instead of IRA assets, thereby triggering a capital gains tax. However, if IRA assets are passed to an heir, the heir will pay income tax on the built-in tax liability (which can be on most or all of the account value). In contrast, if stocks are passed to an heir, the heir will receive a step up in basis (or the value deemed to be tax-free) equal to the date of death value rather than the original purchase value, and will not be subject to as large a taxable gain as would have been experienced by the decedent. The best strategy for making retirement distributions is not always the traditional method. Individuals, with the help of a financial professional, should understand that there may be an alternative strategy that better supports their asset longevity and wealth transfer goals. Myth 11 Annuities Are Complicated, Expensive and Unnecessary Annuities can be complicated, and, relative to other products without insurance guarantees, can seem expensive. There is generally a negative bias in the media about annuities. However, annuities are essential to solving the core problem of the modern retirement namely that individuals are being forced to manage more and more investment and longevity risk. Let s break that down a bit. For starters, fewer individuals today are covered by traditional defined benefit pension plans, which provide guaranteed retirement income for life. Social Security provides less and less of one s retirement income (see Myth 6), and there is uncertainty with respect to the amount of future benefits under the program. So, of the two most prevalent sources of lifetime retirement income, one is not widely available anymore, and the other may be reduced in value. The most common replacement for the traditional defined benefit plan is a defined contribution plan (such as a 401(k) or 403(b) plan), which enables savings but generally does not help manage investment risk and longevity risk. 8 Prudential s Four Pillars of Retirement Series

9 What do we mean by investment risk and longevity risk? At the time of retirement, a defined contribution plan provides an individual with an asset value that must be invested and withdrawn over retirement. The investment risk is the risk that investments will not result in the anticipated return and that the asset, as a consequence, will not provide the anticipated amount of retirement income. The longevity risk is the risk that the individual will live longer than expected and that the asset will be exhausted during retirement. Under a defined benefit plan, the employer promises to make monthly retirement payments for as long as the individual lives, so the employer assumes both the investment and longevity risk. In contrast, under a defined contribution plan, individuals bear both the investment and longevity risk. Many individuals are unprepared or ill-equipped to manage these complex risks increasing the likelihood of their running out of money in retirement. In terms of product solutions for managing the investment and longevity risks to retirement income, annuities are virtually the only way for an individual to convert retirement savings into a guaranteed stream of income. There are many different types of annuities, which can be quite confusing, but the concept of an annuity to lock in a guaranteed lifetime payment stream is a fundamentally sound notion. Moreover, annuity product innovation now allows for the creation of a guaranteed lifetime income stream without the rigidity of traditional annuitization. This feature, referred to as a guaranteed lifetime withdrawal benefit, provides a guaranteed stream of income, affords the contractholder a degree of investment control over assets, and allows any remaining account value to be passed along to heirs. Keep in mind that annuity guarantees are based on the claims-paying ability of the issuing company. Myth 12 Medicare Pays for Long-Term Care The reality is that Medicare pays for very little long-term care. By design, Medicare provides coverage for some long-term care services, generally associated with a recovery period after an illness. But the vast majority of long-term care can only be paid for with personal savings, by spending or giving away one s assets and qualifying for Medicaid, or by the purchase of long-term care insurance. The use of personal savings is a solution for those with the means to self-insure against the risk of incurring long-term care expenses. For others, giving away assets is a popular approach, since it seeks to preserve the estate for the children while getting the government to pay for the long-term care. Recent legislative changes, however, have made it much more difficult to transfer wealth and qualify for Medicaid. Further, Medicaid-approved long-term care facilities may not provide the desired level of care. Given the potential for increasing healthcare costs in the later stages of retirement (see Myth 9), a long-term care insurance policy should be considered to ensure against healthcare costs that would otherwise thwart retirement plan goals. Debunking Retirement Planning Myths 9

10 Conclusion As the 76 million Baby Boomers near retirement, more and more press coverage has been devoted to retirement and tax planning ideas. Unfortunately, retirement and tax planning is not a simple topic, and the abundance of literature may, in an attempt to simplify matters, actually make things more confusing. Retirement planning is complicated and requires the guidance of experienced financial, tax, and legal advisors. Ultimately, the desire to reduce retirement planning to simple rules of thumb can be a recipe for error. If there is one simple rule to retirement planning, it might be: start as soon as possible, save as much as possible, and consult with financial, tax, and legal professionals as needed. 10 Prudential s Four Pillars of Retirement Series

11 What Is a Variable Annuity? A variable annuity is a contract between you and an insurance company, whereby the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You can make a single purchase payment or a series of purchase payments, and there are generally no contribution limits. Variable annuities offer a wide range of professionally managed investment options, guaranteed death benefits, and a variety of payout options including guaranteed income for life. Plus, any investment gains grow tax-deferred. When you need income, annuities generally offer, without charge, annual access up to 10% of purchase payments. Withdrawals are subject to ordinary income taxes and, if taken prior to age , a 10% federal income tax penalty may apply. Withdrawals exceeding a specified annual amount may be subject to a withdrawal charge, which is assessed for a period of time and generally reduces each year. Withdrawals will reduce the living and death benefits. The costs vary depending on the annuity and include the cost of: issuing and maintaining the contract, the base death benefit, and investment management expenses. Many variable annuities also offer guaranteed optional living and death benefits that, for an additional fee, can help provide an added measure of security during your lifetime, and for your beneficiaries. All guarantees are based on the claims-paying ability of the issuing company. Your financial professional can help determine which annuity product, optional benefits, and investment allocation may be suitable for your retirement needs. Please read the prospectus for full details, including all fees and charges. Investors should consider the variable annuity contract and the underlying portfolios investment objectives, risks, charges and expenses carefully before investing. This and other important information is contained in the prospectuses, which can be obtained by contacting your financial professional. Please read the prospectuses carefully before investing. Prudential Financial, its distributors and their respective representatives do not provide tax, accounting, or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Please consult your own independent advisor as to any tax, accounting, or legal statements made herein. Tax deferral is already provided by a qualified plan, such as 401(k)s. For an additional fee, the annuity provides a guaranteed death benefit and the ability to receive lifetime income. Payments of guaranteed principal and income, as well as living and death benefit guarantees, are contingent upon the claimspaying ability of the issuing company. Guarantees do not apply to the investment performance or safety of the underlying subaccounts in the variable annuity. Optional living and death benefits are available for an additional fee and may not be available in all states. Variable annuities are for retirement purposes and are subject to market fluctuation, investment risk, and possible loss of principal. Life insurance and annuity contracts contain exclusions, limitations, reductions of benefits and terms for keeping them in force. Your licensed financial professional can provide you with costs and complete details. Life insurance is issued by The Prudential Insurance Company of America and its affiliates. Variable annuities are issued by Pruco Life Insurance Company (in New York, issued by Pruco Life Insurance Company of New Jersey), and distributed by Prudential Investment Management Services LLC (PIMS). All are Prudential Financial companies located in Newark, NJ. Each is solely responsible for its financial condition and contractual obligations. Indirectly through subsidiaries, Prudential Financial, Inc. owns 38% and Wachovia owns 62% of Wachovia Securities LLC. Prudential Financial, Prudential and the Rock logo are registered service marks of The Prudential Insurance Company of America and its affiliates. VARIABLE ANNUITIES: ARE NOT FDIC INSURED MAY LOSE VALUE ARE NOT BANK OR CREDIT UNION GUARANTEED Debunking Retirement Planning Myths 11

12 Prudential s Four Pillars of Retirement The Four Pillars of Retirement represent the foundation of retirement security today, from Social Security to the choices made in retirement. Prudential uses these pillars as a framework for research reports, press releases and other information about the retirement issues and challenges facing Americans today. SOCIAL SECURITY EMPLOYMENT- BASED PLANS PERSONAL SAVINGS RETIREMENT CHOICES To learn more, visit The Prudential Insurance Company of America, 751 Broad Street, Newark, NJ ALL RIGHTS RESERVED. Prudential Financial, Prudential and the Rock logo are registered service marks of The Prudential Insurance Company of America and its affiliates. RTLS-D2671