04.09

Rebuilding Your Nest Egg

By George McClure

Note: This article is educational in nature and should not be considered as legal or financial advice.

After the economic freefall of 2008, when the Standard & Poor’s 500 index fund plummeted 39.8 percent, and American family wealth fell by 18 percent, many professionals are looking to rebuild their 401(k) plans and IRAs, perhaps also altering their retirement plans. The good news is that, for defined benefit pension plans, the employer who is the plan sponsor bears the responsibility for rebuilding the pension fund, rather than the present or future pension recipient. But even there, the need for sponsors to put some $60 billion in those pension plans to meet more stringent funding requirements under the Pension Protection Act of 2006 may have accelerated the trend to freeze and discontinue DB plans [www.dol.gov/EBSA/pensionreform.html].

Early, mid, and late career professionals have different recovery strategies. The one common theme for all is not to bail out of their defined contribution (e.g., 401(k)) plans.

The Fidelity Investor's Quarterly (May 2008) discusses the market timing trap. A $10,000 investment in the S&P 500 in January 1980 would have earned more than $300,000 by December 2007. However, missing out on the best-performing 30 days during this period would have reduced the portfolio to roughly $83,000 - about 70% less than a portfolio fully invested during the full period.
Missing out on only the best five market days in this period would have cost $76,000; cutting growth to just $224,000.

Early career (graduation - 35 years old)

Early career professionals have time is on their side to rebuild their nest eggs. Where advice was given earlier to at least contribute enough to the 401(k) plan to earn the employer match, many employers have discontinued matching as the recession continues. But individual contributions should be stepped up to the maximum possible extent to help with the recovery. For workers under age 50, the maximum contribution for 2009 is $16,500. Some juggling is required for new grads to do this. For the 2007 new grad with a student loan, the average balance at graduation was $21,000 — and payments have to be made.

A new benefit under the economic stimulus package for first time home buyers is a refundable tax credit for purchases of a primary residence between 1 January 2009 and 30 November 2009. The credit is ten percent of the price of the home, up to $8,000, provided income is less that $75,000 for single buyers or $150,000 for couples. To qualify as a “first time” buyer, the taxpayer must not have owned a home in the previous three years and must live in the new home for at least three years, or pay back the tax credit [www.zillow.com/blog/8000-refundable-tax-credit-for-first-time-homebuyers/2009/02/17/].

In addition to 401(k) contributions, workers less than 50 years of age can put tax-deferred funds into IRAs, up to $5,000 this year. A non-working spouse, such as a stay at home parent, can contribute a like amount, as long as the worker’s W-2 income is not exceeded. If the worker has additional income from moonlighting, then another retirement account, a Simplified Employee Pension, or SEP, can be established.

Investment choices are the responsibility of the account holder. In general, a higher proportion of equities than cash and fixed-income securities is suitable for young professionals with a long working lifetime ahead of them before they need to tap the nest egg. One rule of thumb is to subtract your age from 100; the result is the percent to be invested in equities.

Target retirement funds, also called lifecycle funds, adjust the mix based on your age and expected retirement date. They are not a substitute for vigilance in making investment decisions, and may carry higher fees than simpler investments [www.consumerismcommentary.com/2008/06/18/target-retirement-funds-also-known-as-lifecycle-funds/].

Mid-Career (35-50)

The mid-career professional may be at greatest risk of cutting back on saving for retirement, having witnessed the swift erosion of account balances, and wondering if it’s worth continuing to throw good money after bad. The worst thing one could do is to cash out of a 401(k). Before age 59-1/2, there is a ten percent penalty, in addition to the tax due, for early withdrawal. Exceptions are in the event of separation from the employer, for disability, or heavy medical expenses. Another exception: taking a substantially equal stream of payments for at least five years. Stop doing it before five years or before age 59-1/2 (whichever is later), and the penalty will be due on all the money withdrawn [www.startribune.com/lifestyle/yourmoney/40443017.html?elr=KArksLckD8EQDUoaEyqyP4O:DW3ckUiD3aPc:_Yyc:aUUsZ].

Mid-career professionals may have set up 529 college savings plans to pay toward their children’s education. But those plans may have undergone shrinkage, too. Again, stay the course. Contributing to a 529 plan is worth it for the tax benefits alone [http://online.wsj.com/article/SB123758112211598861.html].

Be sure to review and understand the service charges you are paying for your 401(k) investment choices. Index funds require the least management, so they have the lowest charges. The U.S. Government Accountability Office (GAO) recently estimated that a 45 year old with $20,000 in his 401(k) would have $70,555 at age 65 if he is getting a 6.5 percent return and only paying 50 basis points (0.5 percent) in fees. However, increasing the fees by just one percentage point would leave him with only $58,400 at retirement age. AARP used those assumptions and realized that over 30 years, $20,000 with 0.5 percent in fees would grow to $132,287, while paying 1.5 percent in fees would reduce that growth to $99, 679 — a 25 percent reduction in the account balance. Even a difference of only 50 basis points, from 0.5 percent to 1.0 percent, would reduce the value of the account by $17,417, or a little over 13 percent over the 30-year period [http://aging.senate.gov/record.cfm?id=287603].

Late career (50 - retirement)

Saving the maximum is always a good idea; too few people in the late career stage are prepared for a comfortable retirement. Only about half of workers have any retirement plan. Of those with access to a 401(k) plan, only about two-thirds take advantage of it, and of those, only ten percent contribute the maximum amount allowed. At age 50, “catch-up” contributions are permitted — $6,000 more per year in a 401(k) and $1,000 more in a traditional IRA.

If your 401(k) plan sponsor offers a Roth option (only 25 percent do) consider it seriously. While there are salary limits in qualifying for a Roth IRA, there are no such limitations in selecting a Roth option in a 401(k) plan. You don’t get the salary reduction benefit when making the contribution, but there is no minimum required distribution in retirement either, and you can pass the balance along to your heirs.

Avoid ‘leakage’ in your retirement plan when changing jobs. Sixty percent cash out some or all of the balance when shifting employment. A better plan is to roll over the balance into an IRA, with a separate one for each employer plan — not part of your traditional IRA. That way, if you have isolated the amount from one employer, you can subsequently move it to a later employer’s plan.

If you have held an employer’s stock, received as matching contributions, in your 401(k) plan for a long time, it may have appreciated so that when doing a rollover it would be better to cash out the stock and pay the capital gains tax on the appreciation (after paying ordinary income tax on your cost basis) than to pay ordinary income tax on the whole amount later, if you included it in the rollover and took it out in minimum required distributions in retirement.

Fewer companies are offering a lump-sum distribution for retirement plans, especially now that the recession has added its weight to the need for full funding of pension plans under the Pension Protection Act of 2006. But if yours is one that does, inquire about the possibility of your employer, upon separation, buying you an immediate annuity with at least part of the proceeds. Institutional rates on annuity purchases are more favorable than rates for individual purchasers. Annuities can be arranged to pay out for fixed periods, for one lifetime, or for joint lifetimes for a couple. Such a vehicle can help to alleviate the danger that you will outlive your savings [www.chicagotribune.com/business/yourmoney/chi-ym-journey-0315mar15,0,7879507.story].

Another advantage of receiving payments through an immediate annuity is that any tax is due on the payments as received — not on the entire amount of the lump sum used to purchase the annuity [http://www.totalreturnannuities.com/ira-401k-rollovers.html].

Early retirement

Those who are fortunate enough to be able to contemplate retirement before age 65 will want to factor health insurance costs into their calculations. Even if an employer currently offers retiree health care, there is no assurance that this policy will continue in the future. The trend in employer-provided health care is that cost increases are borne mostly by the individual, as employers try to hold the line on benefits costs. There is the possibility that the cost of employer-provided health care benefits will become taxable as income to the beneficiary. COBRA provides that, in most cases (where there are 20 or more employees), an employer’s health plan can be continued for up to 18 months by a former employee, who pays the entire cost plus administrative fees [www.dol.gov/ebsa/faqs/faq_consumer_cobra.HTML].

Since your income will likely be lower in retirement than when you were fully employed, you may want to consider converting part of your IRA to a Roth IRA, before you have to start taking minimum required distributions (MRDs) from the IRA(s) at age 70-1/2. Roth IRAs are exempt from the MRD requirement. Try to pay the taxes due (from the Roth conversion) from other resources so you don't have to reduce the amount transferred to the Roth.

Regular retirement

If you delay regular retirement up to age 70, you will draw a larger monthly payment from Social Security. The difference is an additional 8 percent per year for each year you delay receiving the benefit. If you would draw $21,000 at age 62, you can wait to age 70 and draw $38,000 per year. By working longer, you will also reduce the number of years where you depend on your nest egg to fund your retirement. Regardless of the age at which you begin drawing Social Security, you qualify for Medicare at age 65. Medicare Advantage is a plan that costs the government more than plain Medicare, but includes some wellness and drug benefits. The White House is looking at ways to reduce this cost [http://blogs.wsj.com/health/2009/03/17/medicare-adviser-medicare-advantages-perks-cost-too-much/].

A new poll shows that sixty percent of workers over age 60 expect that they will delay retirement because of the recession. The delay may be only a year or two (24 percent) or working up to an additional six years (73 percent) to rebuild the nest egg. For 11 percent, they face the prospect of possibly never retiring [http://sev.prnewswire.com/computer-electronics/20090317/CG8461317032009-1.html].

Workers over age 70-1/2 are required to begin taking distributions from their traditional IRAs, but if they are still working they cannot contribute further to an IRA. However, they can contribute to a Roth IRA at any age, provided they fit within the qualifying income limits.

The minimum required distributions have been suspended for 2009, owing to the ravages to nest eggs from the serious market downturn. In December 2008, President Bush signed the Worker, Retiree, and Employer Recovery Act of 2008 which provides temporary relief from MRD rules for certain retirement plans and accounts. Under this provision, no minimum distributions are required for the calendar year 2009 from individual retirement accounts (IRAs, IRA Rollovers, Simple IRAs, SEP IRAs) and employer-provided qualified defined contributions plans (such as Retirement Plan accounts (Keogh accounts), 401(k), 403b, 457, etc.). Any annual minimum required distribution for calendar year 2009 from these accounts is not required to be made. The next required minimum distribution would be for calendar year 2010.

An MRD calculator, based on Table III in IRS Publication 590, permits you to factor in assumed growth during the distribution period [www.money-zine.com/Calculators/Retirement-Calculators/Minimum-Required-Distribution-Calculator/].

The IRS hasn’t proposed long-term relief for nest egg losses (recalculation to the new lowered account balance will automatically reduce the MRD amount due), but new regulations have recently been posted for victims of Ponzi schemes [www.irs.gov/newsroom/article/0,,id=205505,00.html?portlet=7].

What are your prospects?

A study on the effect of the working income replacement ratio on retirement lifestyle offers some insight. At a replacement ratio of 78 percent, a couple age 65 was studied with three retirement income and nest egg levels. The ground rules included withdrawing 4 percent of the nest egg the first year, then increasing the amount to match inflation. The nest eggs were $500,000, $1 million, and $2 million. The home was paid for.

At $500,000, the couple relied on the employer’s retiree health care or Medicare, and tried for a healthy lifestyle, because they couldn’t afford long-term care insurance. Entertainment included Netflix rather than the local multiplex. A reverse mortgage was a backup to cover high medical expense.

At $1 million, long-term care insurance was affordable. Some travel was in the picture. How long the nest egg lasted depended on investment returns.

At $2 million, there could be contributions to grandkids’ education or charity and a new car was affordable. Gifts to family members of stock at current low prices was feasible. The tax bill was higher. There was a 50 percent chance that one of the couple could live to age 92 or longer without depleting the nest egg.

In all three cases, a $20,000 per year pension was assumed. Without that supplemental income, the nest egg (which included rolled-over IRAs) would be depleted faster [http://www.walb.com/Global/Story.asp?S=9673457].

Outlook

With large national debt increases for economic stimulus, the big question is whether we will have stagflation or inflation down the road. If stagflation, paying down the home mortgage faster could be prudent, but if inflation is ahead, then the mortgage would be paid with cheaper dollars in the future.

The first five years after retirement are crucial to the health of the nest egg. Withdrawing too much shrinks the residual nest egg available for growth when the market recovers. (Ref. 5) The model was a 30-year retirement, with a static portfolio consisting of 55 percent stocks and 45 percent bonds, withdrawing 4 percent the first year and growing that by 3 percent in each successive year. The chance of not running out of money (probability of success) was 89 percent the first year, but if annualized returns over the first five years were less than zero, that dropped to 43 percent in the fifth year. If this happened in the second five years instead (with average returns in the first five years), annualized returns of zero or less cut the success probability to 57 percent.

One can conclude that in a poor economic climate, being especially thrifty in the first decade of retirement could be a good strategy. No lattes at Starbucks!

For retirees and those close to retirement, Treasury Inflation-Protected Securities (TIPS) are worth considering, since the stock market may stay down for a long time.

Younger workers should continue their 401(k) investing. Markets do eventually rebound; after the 1929 crash, stocks held for several decades outperformed bonds. Allocations to low-cost stock index funds are prudent. (Ref. 6)

References

1. IRS Publication 560 — Retirement Plans for Small Business

2. IRS Publication 575 - Pension and Annuity Income

3. IRS Publication 590 — Individual Retirement Arrangements (IRAs)

4. The IRS Tax Products DVD (Publication 1796) - www.irs.gov/formspubs/article/0,,id=108660,00.html

5. C. Fahlund, “Retirement Income: Repairing the Damage to Assure the Flow,” AAII Journal, February 2009

6. D. L. Domian and W. Reichenstein, “Stocks for the Long Term: Why Prospects Are Rosy,” AAII Journal, January 2009

7. K. Green, “There Goes Retirement,” Wall Street Journal encore feature, 14 Feb. 2009. http://online.wsj.com/article/SB123421515383065059.html [Describes experiences of retirees reentering the work force.]

George McClure is Technology Policy editor for IEEE-USA Today’s Engineer and a member of IEEE-USA's Committee on Transportation and Aerospace policy. Comments on this article may be submitted to todaysengineer@ieee.org.