RETIREMENT PLANNING PROGRAMS

For many people, a cornerstone of retirement planning is participation in an employer-sponsored savings program. Ideally, this should start early in one’s career to maximize the effects of compound interest. Additional retirement programs are available to self-employed persons as well as individual retirement accounts (IRAs) for all workers with earned income.

Most employer retirement programs are qualified plans, meaning they qualify for special tax benefits. For example, a plan must be in writing and cannot discriminate among employees at different salary levels. In return, employers receive a tax deduction for their contributions and employees need not include these employer contributions in their taxable income. In certain situations (e.g., to attract highly paid executives), companies may offer nonqualified savings programs.

Types of employer retirement programs

There are four major types of qualified employer-sponsored retirement programs: pensions, profit-sharing and stock ownership plans, salary reduction, and thrift plans.

Pensions. Defined-benefit pensions provide benefits according to a formula based on income and/or years of service (e.g., two percent for each year of employment multiplied by a worker’s highest three or five year’s average pay). Benefits are unaffected by investment gains and losses and employers shoulder the risk of accumulating sufficient funds. Employer contributions are calculated according to actuarial tables.

Defined-contribution pensions provide benefits based on the performance of workers’ individual retirement savings accounts. Employers make contributions based on a fixed or variable percentage of pay, and workers receive the amount contributed plus plan earnings. Thus, employees shoulder the investment risk.

Cash-balance pensions became increasingly popular during the 1990s. Benefits accrue at an even rate throughout workers’ careers, in contrast to the higher benefits toward the end of a career offered by defined-benefit pensions. Employers contribute a percentage of workers’ salaries and credit a return that is generally tied to a market index. Cash-balance plans are controversial because workers with long service often earn less than they would have if their employer retained a defined-benefit plan. Some workers have responded with charges of age discrimination.

Profit-sharing and stock ownership plans. Profit-sharing plans allow employers to make flexible contributions contingent upon company profits. There is no requirement that contributions be made annually. Instead, they are decided by a corporation’s board of directors and can be lean or generous, depending on company earnings. Because of the uncertainty of payment, profit-sharing plans often supplement a pension. The maximum allowable contribution is $40,000 or 100 percent of compensation; if less, beginning in 2002.

Stock bonus plans are similar to profit-sharing plans, except that contributions do not depend upon profitability and are made in the form of company stock. Employee stock ownership plans (ESOPs) provide shares of company stock as an employer’s retirement fund contribution. They provide a ready market for corporate stock, a feeling of participation in company management, and an incentive for employees to work hard.

Incentive stock options are sometimes provided to nonmanagerial employees, especially in start-up companies. They allow the holder to receive cash or stock after a specified vesting period, generally three to five years. Many people use this money for retirement.

Salary reduction plans. These plans allow workers to save a portion of their income, tax-deferred. These plans are named for specific sections of the tax code.

401(k) plans allow employees of for-profit corporations to save up to $11,000 (year 2002 limit) annually for retirement. The contribution and earnings are tax-deferred until withdrawal. Many employers also match employee contributions by a certain percentage and allow participants to borrow up to half of their account balance. The deferral limit will increase to $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006.

403(b) plans are available to employees of non-profit organizations, such as public schools, hospitals, and public and private universities. The 2002 contribution limit is also $11,000 and gradually rises to $15,000 like 401(k)s. Fewer employers match contributions because many participants are public employees. Plans include catch-up provisions for workers who did not contribute fully in the past.

457 plans are available to state and local government workers and tax-exempt organizations. The maximum 2002 contribution is $11,000 and employer matching is rarely available.

For all of the above plans, participants age 50 and older who have made the maximum deferral can contribute an additional ‘‘catch up’’ amount: $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006 and later.

Thrift plans. These are after-tax, employer-sponsored savings programs. In other words, workers cannot deduct their contributions from gross income, as is possible with salary-reduction plans. Employers generally match thrift plan contributions at a certain rate. For example, with a 50 percent match, an employer would contribute fifty cents for every dollar saved by employees.

Plans for the self-employed

Simplified employee pension plans (SEPs) allow business owners to contribute to special IRAs for themselves and their employees. The contribution limits are 15 percent of earned income for employees and 13.04 percent for the owner. SEP contributions are a business tax deduction and can be forgone in low earning years. Required paperwork is minimal. Salaried workers with outside self-employment income can also use SEPs.

Keogh plans allow self-employed persons to contribute the lesser of 100 percent of net self-employment income, or $40,000, starting in 2002. Contributions must also be made for all eligible employees. Several types of Keoghs are available. A major disadvantage is an annual disclosure form that must be filed with the IRS.

The Savings Incentive Match Plan for Employees (SIMPLE) is available to businesses with no more than one hundred employees. Employees can contribute up to $7,000 annually in 2002 and employers can match up to 3 percent of workers’compensation. Like SEPs, SIMPLEs have low administrative responsibility, compared to Keoghs. Contribution limits will be increasing to $8,000 in 2003, $9,000 in 2004, and $10,000 in 2005.

Individual retirement accounts (IRAs)

An IRA is a personal tax-deferred savings plan that can be set up at a variety of financial institutions. The maximum annual contribution is $3,000 in 2002–2004, $4,000 in 2005–2007, and $5,000 in 2008 and later, and earned income from a job or self-employment is required. IRAs are not an investment, per se, but, rather, an account for which a variety of investment products (e.g., stock, CDs, mutual funds) can be selected.

Traditional deductible IRAs offer a double tax benefit: tax-deferred growth and a federal tax deduction for the contribution amount. Income limits ($44,000 of adjusted gross income for singles and $64,000 for joint filers in 2002) and availability of a qualified employer plan determine eligibility for a tax deduction.

Roth IRAs provide no up-front tax deduction. However, earnings grow tax-deferred and withdrawals are tax-free if made more than five years after a Roth IRA is established and after age 59 1/2. Unlike traditional IRAs, Roth IRAs don’t require minimum distributions after age 70 1/2, and contributions can continue after this age if a person has earned income. Roth IRAs are available to single taxpayers with up to $110,000 of adjusted gross income ($160,000 for married couples).

Traditional nondeductible IRAs offer neither an up-front tax deduction nor tax-free earnings. Still, they provide tax-deferred growth and are generally better than taxable accounts for taxpayers that don’t qualify for other IRA options.

Starting in 2002, persons aged 50 and older may make additional ‘‘catch-up’’ contributions to either a traditional or Roth IRA. An additional $500 can be saved in 2002–2005 and an extra $1,000 in 2006 and later.

To determine which IRA is best, based on personal factors such as age and household income, individuals can check one of the IRA calculator links on the website www.rothira.com. It should be noted that withdrawals before age 59 1/2 from IRAs, salary reduction plans, and plans for the self-employed are considered premature distributions. A 10 percent penalty will be levied, except in specific instances like disability, in addition to ordinary income tax at an investor’s marginal tax rate (e.g., 28 percent).

Getting help: hiring professional advisors

Some people seek professional assistance with retirement planning, often because they lack the time or expertise to do investment research, or because they are faced with an immediate decision, such as handling a lump-sum pension distribution or evaluating an early retirement buyout offer. There are many types of financial advisors, including bankers, accountants, insurance agents, employee benefit counselors, and stock brokers. In addition, over 250,000 professionals call themselves financial planners. Many have earned the certified financial planner (CFP) or chartered financial consultant (ChFC) credential or are certified public accountants with a personal financial specialist (CPA/PFS) designation. To select a financial professional, consider the ‘‘three Cs’’: credentials, competence, and cost.

Credentials. Certified financial planners are licensed by the Certified Financial Planner Board of Standards (CFP Board) to use the CFP marks upon successful completion of a ten-hour examination, three years of financial planning experience, and a biennial continuing education requirement. The names of local CFPs can be obtained at the CFP Board’s website, www.cfpboard.org.

Chartered financial consultants receive the ChFC designation from The American College, located in Bryn Mawr, Pennsylvania. ChFCs must also have three years of professional experience, pass exams, and complete continuing education courses. Information is available on the Society of Financial Service Professionals’ website, www.financialpro.org.

CPA/PFS designees are certified public accountants who have passed a financial planning exam and a rigorous tax exam, and who have met continuing education requirements. Additional information is available on the website at www.cpapfs.org.

Competence. Financial advisors with more than $25 million of assets under management are required to register with the U.S. Securities and Exchange Commission, while smaller firms must register with state securities regulators. Investors can call the North American Securities Administrators Association (NASAA) at 1-888-84-NASAA, or their state securities agency, to obtain information about specific financial professionals. These agencies can access the Central Registration Depository (CRD), which contains licensing and disciplinary information about financial advisors nationwide.

Cost. Financial planners are generally compensated in one of four ways: through salary, fees, commissions, or a combination of fees and commissions. Fee-only planners are compensated entirely by their clients. The fee can be an hourly rate, a fee per plan, or a percentage of assets under management. Commission-only planners receive commissions from the sale of products such as mutual funds. Some advisors charge both fees and commissions or use commission income to offset all or part of the fees charged for financial advice.

Those wanting to hire a financial advisor should follow this six step process:

1. Obtain referrals from other people or professional organizations
2. Call several planners for information about their services
3. Check planners’ references and CRD registration information
4. Interview several planners and ask questions such as: What services do you provide? How are you compensated? What is your investment philosophy? How often will my financial plan be reviewed? May I see a sample financial plan?
5. Assess your comfort level with each financial planner
6. Hire a financial planner upon receipt of a written agreement

Getting help: retirement planning tools

Software programs, worksheets, and online financial calculators are available to assist with retirement decisions. These tools are only as good as their underlying assumptions about key variables, however. One of the simplest retirement planning tools is the American Savings Education Council’s Ballpark Estimate (see www.asec.org). This one-page form consists of just six steps but makes certain assumptions about longevity and investment return. Another popular website is www.financialengines.com, which predicts an investor’s probability of reaching his or her retirement goal. Other sources of retirement planning tools include investment companies and county Cooperative Extension offices.

According to the 2000 Retirement Confidence Survey (RCS) conducted by the Employee Benefit Research Institute, 53 percent of American workers have calculated how much money they need to save for retirement, up from 35 percent in 1993. The 1999 RCS also found that those who have done a retirement-savings need calculation have saved considerably more than those who have not. The study found that the median amount accumulated by households that have tried to figure out how much money they will need is $66,532, compared with a median of $14,054 accumulated by those who have not done a calculation.

Getting help: formal retirement planning education

With so many retirement savings programs available at worksites, formal retirement-planning education is often provided by employers. Benefits to program sponsors include workers who more fully appreciate their employee benefits package, improved morale and productivity, and increased participation in tax-deferred retirement plans. Employers also offer educational seminars to comply with section 404(c) of ERISA (the Employee Retirement Income Security Act) and to head off future lawsuits by employees who inadequately prepare for retirement.

The U.S. Department of Labor (DOL) encourages employers to provide ‘‘sufficient information’’ so employees can make informed investment decisions. Section 404(c) permits employers to provide certain information to employees without increasing their fiduciary liability. A 1996 interpretation of section 404(c) identified four categories of financial education that do not constitute the rendering of investment advice:

• Information about an employer’s specific retirement plan
• General financial and investment information
• Information about asset allocation models (e.g., the historical performance of combinations of stocks, bonds, and cash)
• Interactive materials (e.g., worksheets and computer analyses)

Implementing a financial education program with any or all of these four categories can assure employers that they will not lose their exemption from fiduciary status as set forth in ERISA 404(c). In addition, employers must provide plan participants with at least three different investment choices and independent control over their accounts.

There are also benefits to workers who participate in formal retirement-education programs. Several studies have found that workers who attend retirement-planning seminars save more money and make wiser asset allocation decisions. Asset allocation is the placement of a certain percentage of investment capital within different asset classes (e.g., 50 percent of an investor’s portfolio in stock, 30 percent in bonds, and 20 percent in cash).

The 1998 Retirement Confidence Survey found that, among workers who received educational material or attended employer seminars about retirement planning during the previous year, 43 percent reported that the information led them to both change the amount that they contribute and reallocate the way their money was invested. In addition, 41 percent said employer-provided information led them to begin contributing to a retirement savings plan. Similar results were found from a survey of almost 700 plan sponsors by Buck Consultants, a worldwide human resources consulting firm. This study found that, of companies providing financial education programs, 60 percent reported that their employees were making larger plan contributions and 58 percent reported that employees were becoming less conservative in their investment choices.

Some employers go beyond retirement planning and provide seminars on credit and cash management. Others provide individual financial counseling. Especially difficult to reach are low-wage workers. Employers can help employees increase their take-home pay through the IRS earned income credit tax program and by providing services (e.g., child care) that would otherwise consume scarce take-home pay. Savings campaigns, such as saving one percent or more of pay, may also be effective, particularly when employer matching is provided.

Unfortunately, some employers focus their educational efforts on older workers that are within ten years of retirement. This is unfortunate because the earlier one gets started, the less one needs to save. Compound interest is not retroactive. For every decade a worker postpones saving, he or she needs to save about three times more to accumulate a specific sum. For example, a 20 year old needs to invest only $67 per month to accumulate $1 million by age 65. By waiting until ages 30, 40, and 50, the monthly savings amount needed increases to $202, $629, and $2,180, respectively, assuming an 11 percent average annual return.

Summary

A number of tax-deferred retirement plans are available to employees and self-employed persons. Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, contribution limits have been increased and catch-up provisions established. Some retirement savings programs (e.g., 401(k)s) allow an up-front tax deduction of the amount contributed, in addition to tax-deferred growth of the principal. Additional information is available through professional financial advisors, retirement-planning software and worksheets, websites, and employer educational programs. The sooner one starts to save, the longer compound interest will work its magic. Even small dollar amounts add up. A $20 weekly deposit earning a 10 percent average return over forty years will grow to $506,300.

Barbara O’Neill

See also Annuities; Assets and Wealth; Consumer Price Index and COLAs; Estate Planning; Individual Retirement Accounts; Retirement Planning; Savings.

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