Asset Classes: Stocks and Bonds

The world is made up of two types of people: those who break up humanity into two types, and those who don’t. And the world of retirement investments is made up of two asset classes: equity (aka, stocks) and fixed income (aka, bonds).

OK. That last sentence is a bit of an overstatement (which I’ll come back to in a minute). But mostly it’s stocks, of one kind or another, or bonds, of one kind or another. Just two basic asset classes. When it comes to investing your retirement assets, your most fundamental decision is “How do I allocate my assets between those two choices?” Think of it as having your hand on a big dial. Should it be tuned all the way one way or the other, or somewhere in between? Like tuning your stereo. Is it tuned all the way to the bass end or all the way to the treble end? Most likely it’s somewhere in between. (Unless you’re one of those teenagers in the car next to me at a traffic light, with a really loud stereo, and the windows open. And when you bought the car you got ripped off, because the music system only seems to have bass. And you’re using it as some sort of evil secret weapon to cause nearby buildings, and my innards, to shake apart. But I digress.)

So what can you say about these two asset classes?

Stocks. The fundamental nature of investing in stocks is that you own a small piece of a profit-making business. Your share of the business’s profits will either be paid out to you as dividends, or will be retained by the company to meet expenses and fuel further growth. (Because of your tiny equitable ownership of the company’s profits, stocks are often called “equities.”) Your hope is that the company will keep growing in profitability, causing its price on the stock market to go up, and that it will keep paying—or even better, increasing—its regular dividend. But nobody is guaranteeing that this will occur. And nobody is promising to repurchase your stock when you need to turn it into cash to spend; rather, you are relying on the existence of a fluid market—the stock market—to assure yourself that there will be a buyer when you are ready to sell.

Bonds. The fundamental nature of investing in bonds is that you are lending money to the bond’s issuer, and the issuer is promising to repay the amount borrowed, plus interest. You do not benefit from the issuer’s profitability, except indirectly as that bears upon its ability to make good on its promise to repay. A bit of jargon clarification: I am using the word “bonds” to refer to the broad asset class of fixed income investments. Actually, not all fixed income investments are “bonds” in the strict sense of the word, but I will continue to use that nice short single word instead of the more awkward, but technically accurate “fixed income investments.”

To be sure, there are asset classes other than stocks and bonds, but chances are they won’t be part of your retirement investments. Of course there’s real estate. But that’s pretty illiquid, and you probably already have a big percentage of your wealth tied up in your home. There’s commodities. And precious metals. And hedge funds—whatever that means—might be thought of as an asset class. But it’s difficult for an individual to invest in these more arcane asset classes with any degree of confidence. Pretty much, it’s just stocks and bonds.

Professional investors recognize many subcategories of these two asset classes (e.g., U.S. stocks vs. international stocks; long-term bonds vs. short-term bonds). And indeed your assets should be diversified among different sub-asset classes.

There are also hybrid asset classes, with characteristics of both stocks and bonds.

And asset classes with special features attached that make them a little different from either stocks or bonds; like treasury inflation-protected securities, with their annual cost-of-living adjustment; or annuities with their repayment term tied to your heartbeat. These can be thought of as “bond-like,” and put onto the bond side of the dial.

Ultimately, all of your retirement investments can be thought of as one asset class or the other. Your most fundamental and important investment decision is how far up to tune the equity dial.

The Overwhelming Importance of Your Investments

How well you invest the assets in your retirement savings buckets is important to your retirement security. Very important. Immensely so.

There’s two reasons for that. One is that investing is within your control. It’s one of only two main dials you have any significant control over. (Your other big dial is where you draw the line between spending and saving.) To be sure you’ve got lots of little dials, switches and levers you can tweak—selecting your savings bucket, asset location, spigot planning, and the like—but they are small in comparison to the investment decisions you make. (Which is not to say they should be ignored. Lots of smart little decisions can add up to big results, as illustrated in February 17’s post.)

So much of the rest is out of your control. How much will your employer contribute to your retirement? Will Social Security still be around when you retire? What’s the price of an annuity? What is inflation doing to your standard of living? Will you face a costly medical emergency? What is the stock market doing? All beyond your control. But how you choose to invest is something you can influence.

The second reason investing is so important is the overwhelming proportion investment returns are of your total asset-based retirement spending, compared to dollars you (and perhaps your employer) actually contribute. Which is ironic, since you have to work so hard to earn those dollars. And you have to exercise such admirable discipline to refrain from spending them on toys and candy. While that work and discipline is necessary to get the dollars into your savings bucket in the first place, time and the markets can then do the vast majority of the work. You just have to sit back and invest wisely. No further sweat involved. (Keep reading; there’s a punchline coming.)

Just how big a component of your spending are your investment returns? Surprisingly big. How about 97%? Here’s an example.

Example. Oscar starts saving for retirement at age 25—as soon as he embarks on his career (as a professional grouch) after college. Following his impeccably thought-out retirement savings plan, he saves 7.99% of his $50,000 starting salary, and then consistently saves 7.99% of his salary every year for his whole working life. Oscar earns raises every year that keep pace with inflation (of 3.05%). (The pay for being a grouch is decent; but the psychic benefits are huge.) If he retires at age 65, Oscar will set aside an aggregate of $317,835 during his 41-year saving period. Good boy, Oscar. Assume his investments earn an average of 9.61% per year prior to retirement. By the time he stops working, his retirement savings account will be worth $2,409,563. Oscar then implements a rational retirement spending plan. He plans to spend 6% of his retirement account each year during retirement, ratably increasing that percentage to 8% as he ages from 65 to 100. Assume that his investments earn 8.35% after retirement. Under that scenario, he will begin spending $144,574 per year at retirement, gradually increasing that to $307,166 per year by the time of his death—an aggregate of $8,034,965 during his 35-year retirement. His account at death will still be worth $3,853,084. That’s a total of $11,888,049, of which only $317,835, or 2.67%, is Oscar’s own contributions. Investment returns account for the rest—a total of 97.33% of Oscar’s asset-based retirement security.

So the hard part—working and sweating, saving and abstaining—accounts for just 3% of Oscar’s retirement. And the easy part—sitting back and investing wisely—accounts for 97%. Tres ironic.

And here’s the punchline: It turns out to be very hard to be a wise investor. In fact, I think there’s simply no such thing as smart investment decisions. The best you can achieve is avoiding foolish actions. So that’s what then counts for smart—the absence of foolishness. It doesn’t sound like a difficult standard, but I fear that the bar is very high indeed.

Pension Funds and the Public-Private Investment Program

An open letter to Treasury Secretary Timothy Geithner.

Dear Secretary Geithner:

Last week you introduced the world to the Public-Private Investment Program (or P-Pip as it has come to be called), as part of your multi-pronged attack against toxic assets, our banks’ current seeming unwillingness to lend, and the economy's heebie-jeebies. Like all good citizens, irrespective of political party or economic creed (except perhaps Rush Limbaugh), I want your efforts to succeed. In that spirit, I offer a bit of advice to improve the program.

Here it is: Have the IRS and Treasury Department immediately issue an announcement that pension funds and other tax-exempt entities will not suffer any negative tax consequences if they participate in the program. To be more specific, declare (or is it clarify?) that pension funds, 401(k) accounts, Individual Retirement Accounts, charitable endowments, private foundations, and other tax-exempt entities, will not incur Unrelated Business Income Tax (UBIT) from the investment returns they hope to earn through P-Pip.

I know you know what I’m talking about. But let me clarify anyway. Pension funds and other such entities enjoy a valuable tax exemption on their investment income. But there are a few exceptions to that exemption that can nonetheless cause them to incur an income tax, called UBIT. One of these exceptions crops up when a pension fund uses debt financing to purchase its investments. Your Public-Private Investment Program anticipates the use of substantial leverage by its investors, up to 85%. In the absence of some special exception this would cause an investing pension fund to incur tax on 85% of its returns attributable to its P-Pip investment. Even if the leverage is non-recourse. And even if the leverage is incurred inside a partnership of which the pension fund is just a small vote-less partner.

(There's a way leveraged investment partnerships now avoid UBIT by creating off-shore partnerships. But does the U.S. Treasury and the F.D.I.C really want to be seen as creating special purpose entities in off-shore tax havens? I think not.)

Now, there’s nothing per se illegal about a pension fund using leverage and incurring a little bit of UBIT. It might be a reasonable price to pay for a good return. But a lot of pension funds avoid UBIT anyway: It shaves their net return, causes a double tax, requires the filing of an income tax return, even requires them to obtain their own taxpayer identification numbers which they often don’t otherwise have to do. It adversely changes the whole risk-reward calculus.

Most important, you sure don’t want the Treasury Department perceived as playing a game of “Gotcha!” with its tax-exempt citizens. Imagine, on the one hand saying, “Please do your patriotic duty and pick up your fair share of the nation’s toxic trash. Oh, and by the way, we forgot to tell you, Mr. Tax-Exempt Entity, you owe us tax dollars if things work out. Gotcha!”

So removing the threat of UBIT for tax-exempt investors will open up a vast additional market for your P-Pips that would otherwise avoid them. And it would also prevent unsophisticated tax-exempt investors from unwittingly getting caught in a UBIT trap.

An aside: I’m not actually sure there’s a way for the IRS or the Treasury Department to avoid UBIT here. It may be beyond your legal authority, requiring action by Congress. But if the IRS or Treasury purports to issue a special waiver that’s beyond its authority, who’s going to complain? You know what I mean?

Respectfully,
The Two-Legged Stool (a concerned citizen)

Pros and Cons of Special Tax Treatment for Employer Stock

In the last two posts I discussed special tax treatment for employer stock distributed to you out of your company’s retirement plan—sometimes called NUA treatment. But maybe it’s not so special after all. As pointed out in yesterday’s post, rolling over the stock into an IRA precludes NUA treatment, and vice versa. So which will it be? Door Number One or Door Number Two? Pay a lower capital gain tax, or get (likely) greater tax deferral with an IRA rollover. This is the same broad category of question that arises in other guises. See, for example, March 23’s post.

The issue is made extra difficult because you face two uncertainties, rather than just one. Usually, the issue of short-term low tax vs. long-term tax deferral turns on projecting when you will have to take distributions from your IRA; which is governed by a combination of the required minimum distribution rules, and your need to meet your living expenses. But with NUA treatment another uncertainty is added to the mix. When will you want to sell the employer stock you received, not because you need the money, but because it no longer fits into your investment planning? When you worked for the company, you were all, like, “Rah, rah, rah. This stock is going up, up, up” That was then. Now you’re like, “Whoa! Too many eggs in one basket. I’d better diversify this puppy.” Think Enron.

So for reasons of diversification, one would expect (one would certainly hope) that you’ll be selling a good chunk of that stock soon. So where should that sale occur? Inside the tax-sheltered environment of your IRA, knowing you’ll eventually pay a higher tax as the proceeds are distributed? Or outside the IRA, where you pay a smaller capital gains tax upon sale, but likely earlier than you otherwise would have, and without the further advantage of investing the sale proceeds in a tax-exempt environment? And even if you don’t plan to sell a bunch of stock for diversification purposes, you still might have to sell a chunk of it to raise the cash to pay the tax on the part of the stock that’s not Net Unrealized Appreciation, i.e., the trustee’s cost basis.

It’s not easy. My rule of thumb is (and rules of thumb are always wrong), when in doubt, opt for the long-term benefits of the IRA, and forego the siren lure of the lower capital gain tax rate. Or just opt for NUA treatment on a small portion of the stock—the portion that you’re not going to shortly diversify—say, 5% of it—and roll over the balance into your IRA. But that’s just me.

Qualifying for Special Tax Treatment for Employer Stock

In yesterday’s post I described special tax treatment that applies to certain distributions of employer stock from your employer’s retirement plan. But I didn’t say how to qualify for this deal. Having dealt with the cart, I will now get back to the horse. What conditions do you have to meet to qualify? Here they are in a nutshell.

• The distribution must be from a qualified plan, i.e., a plan that meets all the arcane qualification requirements for tax-favored status under the Tax Code. That includes 401(k) plans, profit sharing plans, and money purchase pension plans. It does not include Individual Retirement Accounts, 403(b) plans and 457 plans.
• The sponsoring employer must be a corporation.
• Some or all of the distribution must be in the form of stock in the employer.
• The distribution must have been made after or on account of one of the following events:

• On account of your death
• After you have attained age 59-1/2
• On account of your separation from service with the employer.

• You must not have rolled over the employer stock to an IRA. Once you do a rollover, that amounts to an irrevocable election not to take NUA treatment on the stock rolled over.
• The qualified plan must distribute the entire balance of your account.
• If your employer maintains two or more plans of the same type, you must also receive the entire balance of your account under any qualified plan of the same type maintained by your employer.

That last requirement sounds pretty mystifying. It also gets to a question raised by a reader. Here’s a little bit of explanation. The Tax Code recognizes three “types” of qualified retirement plans for purposes of meeting that last requirement. They are: (i) pension plans, (ii) profit sharing plans, and (iii) stock bonus plans. (To make your life difficult, the IRS has said that a qualified plan might fall into two types at once.)

The specific question a reader asked, in a comment to February 19’s post, is which “type” does an ESOP fall into. That question is either easy to answer or it’s hard. An “ESOP,” or Employee Stock Ownership Plan, in the strict Tax Code-defined sense of the word, must either be a money purchase pension plan (unusual) or a stock bonus plan (more typical). It can’t be a profit sharing plan. Easy answer.

Now here’s the hard part. People often use the term “ESOP’ in a looser sense. Like Humpty Dumpty, they use words to mean what they want. And you might sometimes hear a profit sharing plan that’s designed to invest in employer stock referred to as an “ESOP” in which case it falls into the profit sharing type, just like a 401(k) plan. In that case, an employee would have to receive lump sum distributions from both the 401(k) plan and the Humpty Dumpty "ESOP" to qualify for NUA treatment. The bottom line: If you get a lump sum distribution from your employer’s “ESOP”, and the employer also maintains a 401(k) plan, better ask the employer whether the “ESOP” is a stock bonus plan, a profit sharing plan, or both.

One other clarification. In her comment, the reader slightly misstated the requirement in the last bullet point. She wrote, “it's my understanding that you must take a lump sum distribution from all qualified plans of that employer in the same calendar year in order to receive NUA treatment on the select shares. This includes pension, profit sharing and stock bonus plans.” That’s not quite right. You don’t need to take lump sum distributions from all qualified plans to be entitled to NUA treatment—just qualified plans of the same type. So if you get a lump sum distribution from a stock bonus plan, and leave your account sitting in the 401(k) profit sharing plan, you can still qualify for NUA treatment on the employer securities included in the stock bonus plan distribution.

Whew! I’m glad I cleared that up. I haven’t been able to sleep.

Tomorrow, I’ll discuss the pros and cons of taking NUA treatment.

Special Tax Treatment for Employer Stock

The Beach Boys said it best. Rah, rah, rah, be true to your school. In that spirit, the Tax Code grants special tax benefits to investment of your employer retirement plan account in stock of your employer. These tax goodies were enacted before anyone ever heard of Enron.

A reader has asked an arcane question about qualifying for this special tax treatment. I’ll get to that tomorrow when I discuss how to qualify. For today, I will first focus on just what that tax treatment is.

Here’s the deal, in a nutshell. If you receive a distribution of employer stock from your employer’s tax-favored retirement plan, and that stock has appreciated in value since the plan bought it, you can pay tax on just a portion of the distribution—i.e., the amount the stock cost the trustee of the plan—and defer tax on the appreciation until you actually sell the stock. Upon that sale, the appreciation is taxed as long-term capital gain, often at a lower rate than ordinary income. (That balance is called Net Unrealized Appreciation, or NUA for short, and the special tax deal is sometimes called “NUA treatment” by the jargonistas.)

For the interested, here’s a summary of the whole picture:
• The amount currently subject to income tax is not the fair market value of the employer stock. Rather it is the original cost to the plan of the employer stock, which might be a fraction of its value, particularly if you have been a plan participant for many years, and much of the stock was purchased a long time ago. Unfortunately, just about everybody has experienced a bad case of NUA shrinkage over the last year or so.
• The plan trustee will report both the stock’s original cost and its fair market value to you on a Form 1099-R at the time of the distribution.
• Taxation of the difference between the current fair market value and the plan’s original cost—the stock’s NUA—is delayed until you sell the stock.
• Your tax basis in the employer stock is its fair market value, reduced by the NUA. In other words, your tax basis is the amount you paid tax on.
• When you sell the stock, you are entitled to treat the NUA as long-term capital gain regardless of how long you (or the employer retirement plan) have held the stock. Long-term capital gain is often taxed at a lower rate than ordinary income.
• Any additional appreciation between the date of distribution and the date of a later stock sale is treated as long- or short-term capital gain, depending on how long you have held the stock, measured from the date the retirement plan distributed it to you.
• If you are under age 59-1/2 at the time of the stock distribution, you will be subject to a 10% penalty tax on the stock’s original cost, unless an exception applies, as discussed in February 19’s post. You will not be subject to the 10% penalty tax on the NUA, even if you sell the stock before age 59-1/2.
• If the lump sum distribution includes cash as well as employer stock, you may roll over the cash in a tax-free rollover, and enjoy NUA treatment on the stock.
• Or you may roll over the employer stock to an IRA or other tax-favored retirement plan, foregoing NUA treatment in favor of continued tax deferral.
• You may also roll over part of the employer stock and take NUA treatment on the balance.
• If you die still holding the employer stock, the NUA is taxed to your heirs (as long-term capital gain) when they sell the stock. They do not get a new stepped up tax basis in that part of the stock’s appreciation, as they do with other appreciated assets.
• If you are entitled to NUA treatment, you don’t have to take it. You may waive it, typically by opting instead to roll over the stock to a traditional IRA, or by paying ordinary income tax on the distribution.

So that’s it in a nutshell. Tomorrow I will discuss the requirements for qualifying for this deal. And in a later post, I’ll discuss how to determine whether to take advantage of it. It’s often not as good a deal as it’s cracked up to be.

Retirement Weights and Measures

Yesterday’s post had some good stuff buried in it. (If I may be so immodest.) Its main thrust was to explore how much of your recent stock market losses you might be expected to make up with an additional year of work. But an important underlying predicate needs to be highlighted: Money is meaningless.

Whoa! Money is meaningless?

By that I don’t mean “the moon and the stars are for everyone,” or anything like that. Rather, I mean that a pile of bucks is simply too abstract for us. We can’t grasp its value. We need to find personal equivalencies—our own individual metric system of weights and measures—to translate a large savings bucket—or a large loss in a savings bucket—into what it means for us personally.

Take Ernie for instance, from yesterday’s post. He suffered a $430,000 loss in his $1,200,000 retirement savings bucket during the recent Unpleasantness in the financial markets. What does that mean? What are its equivalencies?

Money Equals Allowance. Ernie found that, for him, based on where he is in life (the cusp of retirement), $430,000 equals $17,000 of annual retirement spending; allowance if you will.

Money Equals Lifestyle. Ernie might take the next step and mentally tote up the adjustments in his lifestyle he would have to make to fill a $17,000 gap in his budget. Dinners out; vacations; how frequently he changes his razor blades; perhaps moving to a less expensive home. Whatever. (Me? I used to like to buy the books I read; now I use the library. Other adjustments as well.)

Money Equals Future Years. If Ernie were not on the cusp of his retirement, and was planning to work anyway, he could project how many years of average investment earnings it would take for his savings bucket to grow back to its pre-Unpleasantness value.

Money Equals Past Years. If he wanted to, Ernie could comb through his account statements and count how many years back he’d have to go before his savings buckets were as low as they’ve recently gotten. Knowing that might be important to Ernie. There’s a lesson in there somewhere.

Money Equals Expectations. It might be instructive for Ernie to go back over his past few years’ annual statements to see how his expectation for his future retirement fluctuated with the ups and downs of his savings buckets. Which year’s expectation was the most realistic? It’s human nature to focus on the very highest, thereby ratcheting up our expectation for the future. But then we are left bemoaning the inevitable drop in expectation. Was our highest expectation ever the most realistic? Likely not; but it’s the one we measure against.

Money Equals Work. Ernie projected that it would take about four more years of working, at a time he was ready to retire, to make up his $430,000 loss.

Money Equals Peace of Mind. Ernie feels more financially vulnerable than he did a year ago. I don’t know how to measure that. Perhaps he can count the number of additional pharmaceuticals he now takes to be able to sleep at night. Or perhaps his new-found fear of losses has caused him to adjust his asset allocation to one that’s less equity-oriented; one that trades off higher projected allowance for greater stability.

How do you translate your money into something you value?

What’s a Year of Work Worth?

A reader has raised a good question. What’s it likely to be worth to your retirement income if you delay retirement and work another year? This is a popular concept for those baby boomers on the cusp of retirement whose retirement savings have been decimated by the recent market collapses. Let’s look at a number of factors and see how you might project an answer. I’ll use an example.

Example. Ernie (remember him from January 16’s post?) was planning to retire in 2009. He had saved enough—he thought—to replicate his working-years’ lifestyle, taking into account Social Security, some common expense adjustments, etc. His savings goal had been $1,198,750, but last year, instead of growing his savings buckets by 4.5%, the buckets shrank by 33%, leaving him with $767,000. Ernie had planned for his savings buckets to provide $47,950 of his retirement spending, which is 48% of his $100,000 salary. (Ernie is using the 4% Plan as his retirement spending plan, as described in January 13’s post.) But now he’s far short of his original goal; he only has enough for $30,680 ($767,000 x 4%), which is $17,270 short of his annual spending goal. That's a big deficit. How much of it can he make up by working a year? Let’s look at some of the factors, and see if we can ballpark a projection.

I’ll try to express all factors in terms of a common yardstick, to get a sense of how important each factor is to Ernie’s retirement security. I’ll use Ernie’s $100,000 salary as a common yardstick. Salary is a good choice, since it’s a number one can easily relate to. So Ernie’s $17,270 spending shortfall is 17.3% of his salary. How much of that can he make up with a year of work?

A Year of Investment Return. By delaying a year, Ernie’s savings buckets grow by a year’s worth of investment returns. In Ernie’s case, he projects that to be 4.5%. That will make up $1,381 of his spending shortfall, which is 1.38% of his salary. This is one of the bigger factors he will benefit from with his year of work. But remember, little things add up.

Where did those figures come from? To get his projection of 4.5% real (inflation-adjusted) return, Ernie applied historical averages to his asset allocation (50% equities and 50% fixed income), and reduced the result by historical average inflation. What?! You don’t think historical averages make sense in today’s environment? Well, what’s your prediction, Kreskin?

Since Ernie’s using the 4% Plan to translate savings into retirement spending, he multiplies his 4.5% growth by 4% to translate that into how much additional retirement spending he can generate after a year—the equivalent of 0.18% of his savings bucket; which, as I said, is 1.38% of gross salary in Ernie’s case.

A Year of Reduced Life Expectancy. By working another year, your life expectancy is reduced by a year, which ought to translate into a slightly increased spending rate. You don’t know how long you’re going to live, but you do know it’s going to be one year less a year from now. Maybe even less, if your job is particularly taxing. Or you’re an ice-road trucker. In Ernie’s case, however, he is using the 4% Plan, which fails to take this factor into account—one of the things I don’t like about it. But if you are using the 4% Plan, then you too should ignore this factor.

You can nonetheless project what this factor might be worth. One way to ballpark it is to consult your insurance advisor—or do this yourself on the internet—and see how the cost of an annuity (or a joint and survivor annuity if you're married) drops for someone who is one year older. Not that you’ll necessarily buy an annuity; but the relative costs provide a measure of the benefit of waiting a year. Ideally, you’ll price inflation-adjusted annuities to get a more realistic idea.

Or perhaps you employ a retirement spending method that does take into account your ever-shrinking life expectancy. One such plan starts out with distributions of 6% of your savings buckets at age 65, and then that percentage grows by 0.067% per year until it reaches 8% at age 95 (where it remains no matter how ancient you get). If Ernie were using that retirement spending plan, he would project a retirement spending benefit of 0.067% of his savings buckets, or $511 per year. That works out to 0.511% of his $100,000 salary.

A Year of Personal Retirement Savings. By working a year, you can add some savings to your savings buckets. For example, since Ernie uses the 4% Plan, he projects that every $100 he saves this year picks up $4 of his retirement shortfall. Another way to look at that is that every 1% of salary he saves makes up 0.04% of his salary of his 17.3% spending shortfall. Unfortunately, this close to retirement, adding to savings, while necessary, just doesn’t go that far.

How much should Ernie save in this last year? Good question. The wrong answer is for him to continue at whatever rate he’d been saving. Let’s say Ernie has a $100,000 salary and in recent years has been saving a percentage that he recalculated each year, and which worked out to be 8.4%, or $8,426 (see January 22’s post). Should he save $8,426 this year? No. Things change, and 2008 was a year of big changes. Remember the primary principle: you want to treat the Future You and the Present You equally. So you (and Ernie) should increase your savings this year to an amount that brings your current spending down to your new, unfortunately reduced, projected lifestyle. I’ll get back to this in a minute.

A Year of Employer Contribution to Your Savings. If you work for a company that matches your personal savings to some degree, then you can figure that your employer will add something during this year of additional work. (Although the press reports that a lot of employers are dropping their matching contributions in 2009 in light of the uncertain economy, the cheapskates.) Ernie’s employer has historically matched 50% of his contribution. But only up to a limit; i.e., only counting savings of up to 6% of his salary. So he figures his employer contribution will be $3,000, which will increase his retirement income by $120. That works out to 0.12% of his salary (50% x 60% x 4%).

Social Security Actuarial Increase. Part of your—and Ernie’s—retirement income comes from Social Security. Ernie’s benefit happens to be $18,000, which works out to be 18% of his $100,000 salary. By waiting a year to start taking Social Security, he gets an actuarial increase of 8% in his benefit, which works out to be 1.44% of his salary (18% x 8%), or $1,440. It turns out that this is the single biggest factor in helping to make up Ernie’s 17.3% shortfall.

Social Security Benefit Increase. If Ernie follows the typical career pattern of increasing compensation, another year of work will increase his average salary on which his social security benefit is computed. This is a tough factor to ballpark, however, since the formula for computing benefits is so complicated. It’s based on a 35-year average wage history; and to make it more complicated, your prior years’ wages are hypothetically increased by changes in the average wages paid to all U.S. workers. You can go on the Social Security website and use their calculators to see what another year of high salary might mean for you. In Ernie’s case, based on his whole career’s wage history, he figures one more high-earning year will cause an early-career low-earning year to drop out of the calculation, and increase his benefit by about $333, or 0.33% of his salary.

Pension Increase. If your employer is one of the shrinking pool that still offers a traditional pension plan, another year of work might increase your pension benefit in up to three ways. Since pension plans vary greatly in design, it’s hard to say anything concrete, but here are three potential ways in which you might benefit:
• Credit for another year of service if you haven’t already reached the maximum number of years counted under your plan.
• If your next year’s salary is higher than your average, that could increase your pension. In lieu of the wage-indexing that Social Security employs, many private pension plans just look at your highest five-year average to determine your benefit, which accomplishes a sorta’ analogous inflation-based increase.
• If your pension plan offers an actuarial increase for delaying retirement, like the Social Security system does, you might benefit from that.

Ernie’s employer does not provide a traditional pension, so this does not affect him. But maybe yours does.

Ernie’s Additional Year of Savings. Back to the question of how much Ernie should save out of his extra year of work. We figured his projected retirement spending shortfall to be $17,270. Additional investment earnings, employer contribution and Social Security benefit will make up for $3,274 of that, leaving him with a remaining shortfall of $13,996. Since he uses the 4% Plan, he will need to save an additional $349,900 (=$13,996 / 4%). Which is 3-1/2 times his salary! Ain’t gonna’ happen. Instead, to treat the coming year’s Ernie the same as Future Ernies, he can reduce his annual retirement spending goal by $13,105, save $21,531 out of his final year’s salary (instead of the $8,426 he was used to saving). This will further reduce his spending deficit by $861 (4% x $21,531), from $13,996 to $13,105. He’ll have to live on $13,105 less this year and in the future.

Years of Additional Work. Can Ernie find enough fat in his budget to reduce his anticipated annual spending by $13.105? If not, maybe he’d better plan on working a few years instead of one. How many? Well, if his extra year of work got him $4,135 closer to his spending goal, a total of about four is projected to make up the whole $17,270. (The arithmetic is really pretty complicated, but four years is about right.)

So that’s Ernie’s choice: Work four more years or reduce his lifestyle by $17,270. Or something in between. What would—or will—you do?

I’m sure I haven’t thought of everything. If you have identified other factors of how delaying retirement affects your projected retirement spending, please post a comment or send me an email.

Short-Term vs. Long-Term Tax Savings

Yesterday’s post discussed an issue that arises frequently in different guises. Yesterday, the specific question was whether the cost of delaying a Roth conversion from 2009 to 2010 outweighs the benefit of 2010’s special sale on Roth IRA conversions.

Now here is another similar question in a form that arises all the time, not just in 2010. Convinced of the long-term benefit of Roth-ification, you have decided to Roth-ificate a large pre-existing traditional IRA you’ve accumulated over many years. Fortunately, you have a stash of funds in a taxable investment account to pay the tax cost of doing so. If you do it all at once, some of your IRA will be Roth-ificated at your current marginal tax bracket of, say, 28%, but some will be layered onto the next tax bracket of 33%; and maybe some will cost even more, at 35%. Alternatively, you can spread out the process over a few years and keep the tax cost of the whole thing at 28%. Which is your better option?

It turns out, you have to know a lot about how you approach your retirement planning before you can even begin to answer the question. Consider this chain of reasoning:
• Obviously, an important factor is the rate at which you project your traditional IRA will grow.
• But wait! Another important factor is the rate at which you project your taxable investment account will grow, since this is the savings bucket which will be diminished each time you pay the tax cost of Roth-ification.
• But wait! Those two factors depend on your asset allocation. Obviously you are going to project a different growth rate for your fixed income investments than for your equity investments. So what’s your projected long-term asset allocation?
• But wait! You should be rebalancing your asset classes periodically—at least I hope you are—particularly after you have spent a big chunk of dollars out of your taxable account for the privilege of converting a piece of your traditional IRA to a Roth IRA. So do you intend to rebalance after each annual tax expenditure?
• But wait! Which asset classes are in each of your savings buckets? Maybe you wisely engage in asset location planning as described in February 13’s post, so that you prefer to house your equities in one type of savings bucket and your fixed income in a different savings bucket. So to answer the questions posed in the first two bullet points, you have to know your asset location plan. What’s your asset location plan?
• But wait! You can’t properly adopt an asset location plan until you know which savings bucket you plan to tap first after you retire. In February 12’s post I called that spigot planning. So what’s your spigot plan?
• But wait! How can you adopt a spigot plan without knowing how much you plan to spend each year; how do you plan to make those savings buckets last a lifetime? So you have to know your retirement spending plan. What’s your retirement spending plan?
• But wait! You can’t really adopt a retirement spending plan until you project how much you’ll have at retirement. For that, you need a retirement saving plan—how much you plan to save each year during your working years. What’s your retirement saving plan?
• But wait! Your annual retirement savings have to go somewhere. You’ll need to prioritize which savings buckets to add your annual savings to, as illustrated in March 2’s post. What’s your bucket destination plan?

It’s all a vast seamless web, isn’t it. It’s like you have to project the entire course of your life in order to make a seemingly simple tax decision. No wonder people are short-sighted. It’s so much easier.

2009 vs. 2010 Roth IRA Conversion

Let me share with you a real-life issue presented by a reader: He has a traditional IRA which he would like to convert to a Roth IRA. His 2009 modified Adjusted Gross Income is under $100,000 so he can do it this year. Or he can do it in 2010, regardless of his AGI. Remember, if he does the Roth conversion in 2010, that’s the year of the IRS’s Great Roth Sales Event. You have the option of spreading the taxable income from a 2010 conversion over two years, 2011 and 2012, as described in February 28’s post. So which is the better option?

Here are the considerations we came up with:
• There’s always the possibility that Congress changes the law and eliminates or restricts Roth conversions beginning in 2010. So that factor favors the 2009 conversion. Grab it while you can.
• Some people harbor the fear that some time in the future a deficit-strapped Congress will renege and make Roth IRA distributions (or part of them) taxable. I personally don’t think that’s very likely. But, hey, you never know. But that gets to whether any Roth conversion is wise, not when to do it. So, that’s a push.
• What are your tax brackets in 2009, 2011, and 2011? A low tax bracket year is a factor favoring the Roth conversion in that year.
• If you expect to have high income in 2011 or 2012, you can’t ignore the possibility of a tax rate increase, as has been proposed. And if you are thinking about converting a large IRA, the conversion itself will make you a high-income person for that year.
• If you expect your IRA to grow with investment earnings, that growth favors doing the Roth conversion now. Waiting nine months until 2010 will increase the amount of income that’s taxed in order to get a given portion of your IRA converted.
• The IRS’s Great Roth Sales Event in 2010 favors waiting until 2010. You get the benefit of a bit of tax deferral. How much is that worth? I ballpark it as making a Great Roth Sales Event conversion about 7.5% cheaper than a regular 2009 conversion, assuming the same tax brackets in 2009 as 2011 and 2012. Here’s where I get that number: In 2010, the IRS lets you defer half the taxable income for one year, and half for two years. That’s an average of 1.5 years’ deferral. Add another year of tax payment deferral you get by waiting for 2009 to turn into 2010. If you invest the expected tax cost in a tax-exempt money market fund, you might project 3% per year return. So that works out to a 7.5% discount on the tax.
• How does that 7.5% discount compare to your projected growth in the IRA over the next nine months? If you’ve got your IRA invested in fixed income investments, that factor favors waiting until 2010, since your IRA is not likely to grow by that amount in nine months. On the other hand, if your IRA is invested in equities, it’s been hammered pretty hard over the last 17 months. Is it time for the turnaround we’re all dreaming about? Ask yourself, are you feeling lucky?
• Here’s an important bit of advice. Whenever you do the Roth conversion, whether it’s March 2009 or during the IRS’s 2010 Great Roth Sales Event, estimate your tax cost based on the market value of the converted IRA and invest that conservatively while you wait for tax payment day to roll around. Particularly if you’re taking advantage of the 2010 Sale. Payment may be delayed, but the tax will soon be due. You don’t want to get whipsawed by investing the IRS’s interest-free loan in equities, which then go down in value before tax bill date arrives.
• There might be another factor that comes into play. If you delay the conversion until 2010, how will you be investing the money that's outside your IRA for the next nine months? The arithmetic three bullet points ago assumed it’s invested in a tax-exempt money market. But what if you’ve got it invested in equities, or in the same mix of equities and fixed income as your IRA? (The caution urged in the last bullet point gets triggered by the Roth conversion, but doesn’t necessarily apply while you’re waiting nine months to convert.) That tends to increase the breakeven rate of growth at which the 2009 conversion beats the 2010 conversion.

So which is better, 2009 conversion or 2010 Great Roth Sales Event conversion? Bottom line, nobody knows. If you can think of a factor I’ve left out, please post a comment or send me an email. TheTwoLeggedStool@gmail.com.

The Grandchild’s Inherited Retirement Account

Yesterday’s post discussed the likelihood of leaving your children an inheritance—in particular an inherited retirement account of some kind.

As long as inheritance is likely, you might consider skipping your children and leaving some or all of your unspent retirement account to your grandchildren, especially if your kids are doing well enough on their own.

There’s three reasons this might be a particularly good idea. First, your grandchildren may still be facing their high-cost years and can better use the money. You know: college education, their first house, the cost of raising their own kids. Second, being younger, they may not yet have reached their peak earning years, and might therefore be in a lower income tax bracket—a consideration in the case of a traditional IRA which throws off lots of taxable income. Third, their younger age means they are allowed a longer period over which to stretch out distributions.

Here’s an example. Let’s say the facts are almost the same as in yesterday’s post: Three brothers each with a $100,000 account—a taxable investment account, a traditional IRA and a Roth IRA. But their named beneficiaries, instead of being their children, are their granddaughters (Patty, Maxine, and Laverne) . And they are age 25, with a life expectancy-based distribution period of 58.2 years. Here is the inflation-adjusted annual after-tax distribution each of the girls projects:

Patty (taxable account): $3,821 per year
Maxine (traditional IRA): $3,727 per year
Laverne (Roth IRA): $5,325 per year

But if instead the girls take only required minimum distributions, and reinvest the proceeds, here is what they project they can accumulate over a 59-year distribution period:

Patty (taxable account): $3,827,572
Maxine (traditional IRA): $4,671,516
Laverne (Roth IRA): $6,673,594

Myth has it that Einstein thought compound interest to be one of the miracles of the universe. And that was before the advent of IRA’s.

The Unintentional Inherited Retirement Account

Chances are pretty good your kids are going to inherit a retirement account from you. “No way!” you say, “I’m spending that on me!” “Way!” I reply.

As previously pointed out in prior posts, your inability to predict the future—how long you will live, what your investments will earn, what financial emergencies will befall you—will lead you to avoid draining your savings buckets dry. Like it or not, inheritance is a by-product of uncertainty.

And if you engage in clever spigot planning in an effort to boost your own retirement spending—as I am sure you will—chances are pretty good the last bucket standing will be a tax-favored retirement account of some kind—either a traditional retirement account or a Roth retirement account, or perhaps some of both.

To put an even finer point on this prediction, chances are pretty good your retirement account (or accounts) will be IRA’s rather than 401(k) or other employer plan accounts. Why? Because somewhere along the way, after you have left employment, you will have rolled over your employer plan accounts into IRA’s, due to the greater control you can exercise over them compared to the potential restrictions of employer plans (as pointed out in February 18’s post).

So your kids are probably in for an inherited IRA despite your best efforts to die broke. What’s it worth to them?

Here’s a little thought experiment. Picture three different brothers, Huey, Dewey and Louie. Each dies with a $100,000 account left to his sole 45-year old daughter, Patty, Maxine and Laverne, respectively. The only difference is that Patty’s inheritance is in an ordinary taxable investment account; Maxine’s is in a traditional IRA, and Laverne’s is in a Roth IRA. These are all different animals, so they are worth something different to the girls. How can we compare their values? Here’s one way. Since the IRS assigns a 45-year old beneficiary a 39-year distribution period, as described in yesterday’s post, we can ask how much of an after-tax inflation-adjusted stream of payments might the different savings buckets be projected to provide the girls over a 39-year period. Using reasonable assumptions, here’s what the girls project:
Patty (taxable account): $4,582 per year
Maxine (traditional IRA): $4,154 per year
Laverne (Roth IRA): $5,934 per year

The results are not terribly surprising. Laverne’s Roth IRA gives her the largest payout (by a wide margin), since she benefits from both a tax-exempt savings bucket and tax-free distributions. Patty comes in second with her taxable investment account; she has to pay tax on her investment earnings, but not on any distributions from the bucket. And Maxine comes in third with her traditional IRA; she benefits from a tax-exempt savings bucket, but the tax she has to pay on distributions outweighs that benefit.

But now let’s look at it another way. What if the girls have other sources of spending, and instead choose to let the inherited money continue to be reinvested? In other words, they’re savers rather than spenders. Maxine and Laverne take IRA distributions only in the minimum amount required by law, and then reinvest the after-tax amount remaining in a taxable investment account. By the end of 39 years, the IRA’s will have been completely distributed into taxable investment accounts just like Patty’s. Then the amount of after-tax dollars the girls project they can accumulate over 39 years will be as follows:
Patty (taxable account): $1,151,334
Maxine (traditional IRA): $1,156,783
Laverne (Roth IRA): $1,652,547

In a surprise reversal, over 39 years Maxine’s $100,000 IRA turns into a taxable account worth (a bit) more than Patty’s $100,000 taxable account. The benefit of the traditional IRA’s tax-exemption, combined with the slow stretching out of distributions, ends up overcoming the detriment of having to pay income tax on the distributions. It’s a miracle!

Either way, your kids’ unintentional inheritance can give them a leg up on their own retirement planning. Rest in peace.

Post-Death Required Minimum Distributions

In yesterday’s post, I summarized how death affects your retirement accounts. An important component of that, left hanging, are the Required Minimum Distribution (RMD) rules that apply to your account. What’s the minimum amount that must be taken by your beneficiary each year?

First let me set the scene. Your spouse died years ago. (If your spouse is alive, chances are pretty good she is your beneficiary, and she will do a rollover as described in March 17’s post. Then this whole discussion will apply to her retirement account after her death.) You have named your child as beneficiary. You die. Quel dommage. Here are the rules that govern your child’s Required Minimum Distributions.

General Rule. Each year, beginning with the year after your death, your child must take at least a certain minimum amount. As in life, that minimum is determined by dividing the account’s January 1 value (or the day before’s value) by a divisor.

The divisor in that first year after your death is the child’s life expectancy, which can be found in Table I of Appendix C to IRS Publication 590, which can be found on the IRS’s website, here: http://www.irs.gov/pub/irs-pdf/p590.pdf. This is the only number your child has to look up. Every year following that first year after your death, your child simply reduces the divisor by one. It eventually reaches zero, and the account will be depleted in that final year.

For example, if your child attains age 45 in the year after the year of your death, the appropriate divisor starts out at 38.8. Then the next year it’s 37.8, then 36.8, and so on. Your child gets to stretch out distributions for 39 years. It’s like you’ve bequeathed her a source of retirement income, only one that starts now rather than age 65. What a nice parent you are!

Five Year Rule. There’s an alternative option that applies to all Roth accounts, and to traditional retirement accounts where the owner died before the date his lifetime RMD’s were required to begin. In that case, instead of stretching out distributions over his life expectancy, the beneficiary can take distribution of the whole account by the end of the fifth year after the year of your death. It can be sprinkled out over that six calendar year period, or taken all at once. Remember, this Five-Year Rule is an option, and it’s usually inferior to the General Rule.

Multiple Beneficiaries. What if you have named multiple children as beneficiary? Then as long as they split up the retirement account, they can each determine their RMD based on their individual life expectancy. And splitting the account is something they will want to do anyway, to eliminate a potential avenue for sibling strife.

Other Individual Beneficiary. What if the beneficiary is a human other than a child? If your surviving spouse is the beneficiary, she gets options not offered to other humans, the most important of which is the right to roll over your account into an IRA of her own, as described in March 17’s post. If the beneficiary is a human being other than your spouse, such as a domestic partner, they are treated the same as a child. But of course their own life expectancy governs their RMD’s.

Grandchild as Beneficiary. What if your beneficiary is your grandchild? Congratulations! You’ve just accomplished some clever tax planning. Grandchildren are treated the same as children, except that they tend to have a much longer life expectancy. For example, a 25-year old grandchild is given 58.2 years over which to stretch out distributions compared to 38.8 years for a 45-year old. The tax benefits can be impressive.

Non-Human Beneficiary. What if you’ve named your estate, or a trust, or some other non-human beneficiary? Then your beneficiary’s RMD’s depend on when you died and the type of account you’ve got. In either case, the required distribution period gets severely truncated. Here are the two possibilities:
1. Roth Retirement Account, or Death Occurs Before RMD’s Required to Begin. In this case, your non-human beneficiary must take distributions in accordance with the Five Year Rule described above.
2. Traditional Retirement Account, and Death Occurs After RMD’s Required to Begin. In this case, your non-human beneficiary must take minimum distributions over your remaining life expectancy. Huh!? Come again? Aren’t we assuming here that you just died? What’s your life expectancy when you’ve just died? Well, the IRS says you’ve got one. You may not have a pulse, but you’ve got a life expectancy. Look up the single life expectancy (in that table in IRS Publication 590) for someone of your attained age in the year of your death. Then subtract one for each year that has elapsed. For example if you die in 2010 and you would have attained age 80 that year, the single life expectancy for an 80-year old is 10.2. So your beneficiary’s divisor in 2011 is 9.2; in 2012 it’s 8.2; and so on.

It all sounds pretty morbid to me. In tomorrow’s post, I will explore the implications of the General Rule.

Death and Your Tax-Favored Retirement Accounts

OK. Here’s what happens after you die. First, you get buried. Then your kids mourn. Then they wonder what kind of retirement accounts you left them. Wouldn’t you like to know how your kids will be taxed on these accounts? No? You don’t care? Well, then you can skip today’s post. But if you’re curious, read on.

Here are the ground rules. I hope they clear up a few potential misconceptions.
• Your Will is irrelevant. It’s your named beneficiary as recorded in your Beneficiary Designation Form who becomes entitled to the account. You remember that form. You filled it out thirty years ago before your second and third children were born, and then forgot about it. It’s in a drawer somewhere. Or maybe not. And it doesn’t matter if you don’t have a copy, because it’s what’s on file with the IRA or 401(k) Trustee that counts. If they haven’t lost it.
• If you’re not careful how you fill out your beneficiary form, your family can end up with unintended results. If you name your children equally as beneficiaries, it’s important to take into account the possibility that a child will predecease you. It’s not the natural order of things, but it happens. Then when you die, that predeceased child’s share might end up going to his siblings rather than his children, as most people would want. To take this possibility into account, you can name as beneficiaries, “my children, equally per stirpes.” Which is the Latin-legalese way of saying “if a child predeceases me, his share goes to his children, but if he leaves none, only then to his siblings.”
• As described in yesterday’s post, if your surviving spouse is your beneficiary, your death can be a non-event.
• Neither your beneficiary nor your estate gets hit with income tax solely as a result of your death. Your beneficiary is only taxed when and as he or she takes distributions from the account.
• If your beneficiary is under age 59-1/2, she will not be subjected to a 10% penalty tax because this comes within the “death” exception to the penalty. (The result is different if the beneficiary is the surviving spouse, and she opts for the surviving spouse’s rollover, as described in yesterday’s post.)
• If you made non-deductible contributions to a traditional retirement account, they are not lost as a result of your death. Your beneficiary gets to gradually recover them tax-free just as you would have had you lived long enough, as described in February 15’s post.
• If your tax-favored retirement account is a Roth account (i.e., either a Roth IRA or a Roth 401(k)or Roth 403(b) account), then it is subject to the Roth tax rules, as described in March 4’s post. That means that distributions occurring at least five years after you first made Roth contributions are tax-free to your beneficiaries. (An aside. It’s conceivable that the Required Minimum Distribution rules will require your non-spouse to take a distribution before the five-year Roth clock has run, resulting in a distribution that might be partially subject to tax, as described in March 5’s post. I think Congress messed up on this point.)
• Your retirement account is not immediately depleted by estate taxes as a result of your death. If you are one of the lucky few wealthy enough to generate an estate tax at death, your retirement accounts are thrown in there with all your other wealth in determining that estate tax. But the estate tax is then generally paid by your executor out of your non-retirement account assets; not out of the retirement account itself. So while your retirement account generates an estate tax, it is not necessarily reduced by that estate tax.
• Your beneficiaries can then take distributions in any amount they want, as long as it’s at least the amount required by the post-death RMD rules.
• If your account is in an employer plan, and your beneficiary is not your spouse, he or she is permitted to do a sorta’-rollover into an IRA after your death. The purpose of this sorta’-rollover is to fix the following problem, which used to be all too common. Let’s say you died with a 401(k) account and named your child as beneficiary. The RMD rules (as you’ll see in tomorrow’s post) would permit your child to take distributions over her lifetime; but the 401(k) plan might well require your child to take a lump sum distribution. After all, employers don’t want to be bothered with the administrative burden of accommodating the tax planning needs of former employees’ children. So all potential tax deferral would end at your death. To fix this, the Tax Code now allows the child to roll over such a lump sum distribution into the child’s special purpose sorta’-rollover IRA. Then the child can stretch out distributions from the IRA (and taxation) over her lifetime. Unlike the spouse’s rollover described in yesterday’s post, the child can’t use the joint life expectancy of her and her named beneficiary to determine these RMD’s. Which is why it’s just a sorta’-rollover rather than the full-fledged rollover that a spouse can effectuate.

In tomorrow’s post I will (finally) describe the post-death RMD rules.

The Surviving Spouse’s Rollover

A few posts ago I began a description of the Required Minimum Distribution rules. I want to round that out by describing how they operate after your death. As if you care at that point.

But before getting into the details, which I will do in tomorrow’s and the next day’s posts, I suggest that you think about the post-death RMD rules as only applying after the death of both you and your spouse. You can think of yourselves as a single economic unit, because that’s how the drafters of the Tax Code thought of you when they made up these rules.

When it comes to your tax-favored retirement accounts, the Tax Code has created a mechanism for the surviving spouse to roll over the deceased spouse’s retirement account into an IRA of her own (or into an employer plan, if the surviving spouse’s employer’s plan accepts such rollovers). This type of rollover is available whether the deceased spouse’s account was a 401(k) plan account, a traditional IRA, a Roth IRA or any other type of tax-favored retirement account. And, for the most part, it’s only available to a surviving spouse—not to the kids, not to domestic partners, just opposite sex surviving spouses. (I’ll discuss a partial exception to that statement in tomorrow’s post.)

Here’s a few ground rules. First, for the surviving spouse to be able to take advantage of this, she must be named as beneficiary of the account. No surprise there. The surviving spouse can’t do anything with the account unless she’s entitled to it, and she’s only entitled to it by virtue of being named beneficiary.

In any case, this is how most people do it: “If I die [what’s with this “if”?], all to my Wife. But if she has predeceased me, then to my kids.” Where you often see something more complex is in second marriages, where each spouse wants to be sure the account is not diverted to the second spouse’s kids from a different marriage. Then they might name a trust of some sort as beneficiary, in which case there’s no opportunity for the surviving spouse to do a rollover, even if she is a beneficiary of the trust. But I digress.

The second ground rule relates to Roth-ness. If the deceased spouse’s account is a Roth IRA or Roth 401(k), the surviving spouse can roll it over into a Roth IRA. If it’s a traditional pre-tax account, the surviving spouse can roll it over into a traditional IRA. In this way, the account retains its character as either a Roth account or a traditional account. So the family doesn’t end up either double taxed or avoiding income tax. Makes sense.

The third ground rule is that for the rollover to be available, the surviving spouse must be entitled to get a distribution from the deceased spouse’s account. That’s never a problem with IRA’s. It’s almost never a problem with employer plans either, but it might be. It’s conceivable that the deceased spouse’s employer’s plan says, for example, that upon his death, distributions must be spread out in annual installments over more than 10 years. In that case, a rollover would not be available to the surviving spouse. But such a provision would be unusual.

Once the surviving spouse has met the ground rules, she can roll over the tax-favored account into an IRA of her own. Then here’s what happens. It’s like her spouse’s death was a non-event for tax and retirement plan purposes:
• No income tax just yet
• Continued tax exemption on investment earnings within the account
• Surviving spouse gets to control the investments
• Surviving spouse gets to control the rate at which distributions are taken (subject to the Required Minimum Distribution rules)
• Surviving spouse gets to name her own beneficiary (the kids, presumably) in the event of her death
• Required Minimum Distributions don’t begin until surviving spouse reaches age 70-1/2
• Once surviving spouse reaches age 70-1/2, RMD’s are based on her age and beneficiary, not the deceased spouse’s age
• If surviving spouse is not yet 59-1/2, distributions to her will be subject to a 10% penalty unless an exception applies (summarized in February 19’s post)
• Surviving spouse can do further rollovers, for example if she wants to change the institution where her retirement funds are invested

As you can see, for the surviving spouse, your spouse’s death can be a non-event. At least in retirement plan world if not in real life.

More about death tomorrow. Then with that as background, I can describe the RMD rules as applied to the non-spouse beneficiary after the death of the retirement account owner.

The Many Facets of Risk, Reward and Uncertainty

In discussing annuities in yesterday’s post, I referred to its risk/reward matrix. Huh? What’s that?

When you invest your assets in something, you expect to be rewarded with some amount of return. And you take on risks of different sorts: the uncertainty of returns; fluctuations in value; default; etc. But rather than thinking about what specifically can go wrong with a given investment, think instead of the many facets of risk and uncertainty generally. You can picture all those different facets as creating a risk/reward matrix for any investment, where the magnitude of each facet differs for each type of investment. Focusing on these facets can help you determine how much of each type of risk you can afford.

Here’s a summary of some of the many facets of risk and uncertainty. I’m sure it’s not complete, and I invite you to post a comment or send me an email to round out the list.

A. Volatility of Returns. Sometimes an investment gives good return; sometimes negative returns. How much can you expect the return to fluctuate over the long run? (By long run, I mean your particular time horizon, between now and when you’ll need to spend the money.)
a. What’s the highest annualized return you might reasonably expect over the long run?
b. What’s the worst loss (negative return) you might expect?
c. What’s the spread; the difference between the two?
d. What’s the likely spread; eliminating the outliers, say, the 10% best and 5% worst returns?
e. What’s the standard deviation? On second thought, forget standard deviation! That’s a statistical measure that is meaningful when, say, playing craps in Las Vegas, but it serves no useful place in the turbulent, non-Gaussian world of investments. Relying on standard deviation and other inapposite arithmetic is what got our banks into the economic mess we’re currently paying them to rectify.

B. Win/Loss Percentage. What percentage of the time will an investment succeed in the long run, and what percentage will it fail?
a. To retain its nominal value?
b. To retain its real, i.e., inflation-adjusted, value?
c. To outperform a relatively risk-free investment alternative?
d. To achieve a realistic goal that’s important to you?

C. Return/Likelihood Matrix. What is the likelihood of this investment achieving each and every different percentage of return (or loss) over the long run? Nobody really knows this, but we all act as if we do. We can’t help ourselves. We feel we must assign probabilities based on past performance, even though past performance is an imperfect guide to the future.

D. Expected Return. Over the long run, what is the “average” expected return? It’s funny, but we want to know the average, even though that’s a number that’s not likely to repeat itself in the particular future we embark on today.
a. What’s the past median return?
b. What’s the past geometric average?
c. What’s the past arithmetic average?
d. What do the experts prognosticate for the particular future we are about to embark on?

E. Competing Investments. In the long run, how well has an investment performed against competing investments? After all, all your investments will be performing in a single specific economic environment, which may be good or bad.
a. How often was it the best performer?
b. And how much better was it?
c. How often was it the worst?
d. And just how much worse was it?
e. How much better or worse did an investment perform as you dial up or down your percentage allocation to that investment?

F. Interim Volatility. How scary will the ride be as your particular future plays itself out? For example, stocks might snap back to their historical average returns, but it sure has been sickening to watch them fall by 50% while we wait for that to happen. Sickening enough, perhaps, to cause you to sell at their low point. So even ephemeral losses matter if you react to them.
a. What percentage of the periods (years, months, days) has an investment lost value?
b. What range of interim losses has an investment experienced?
c. What range of ephemeral gains has it experienced?

So it turns out we use the word “risk” to encompass many different things. Nothing’s easy.

More About Annuities, Risk and Reward

In yesterday’s post, I used Mr./Ms. Anonymous’s comment as an excuse to spout off about investment risk. What can one say about the risk of the insurer who issues your annuity becoming insolvent?

There are too many facets of risk to easily compare the risk-reward matrix presented by an annuity to the risk-reward matrix presented by other investment options.

But you can at least make a start by looking at the reward side of the matrix. Ask yourself this: How much more of an income can an annuity provide than you can expect from a well-diversified pot of assets? In the paper by Almeida and Fornia cited in March 9’s post, the authors attempted to quantify the reward side by noting that money contributed to a pension plan (which is similar to an annuity) might be expected to provide an employee with a 46% greater income in the long run. In their book, Coming Up Short: The Challenge of 401(k) Plans, Alicia H. Munnell and Annika Sunden cite a study which reached a similar conclusion: dollars committed to an annuity might be expected to buy you a 45% greater income than the stream of payments you can fashion for yourself out of a well-invested savings bucket. (Munnell and Sunden are (or were) with Boston College’s Center for Retirement Research, a great source of retirement wisdom and perspective. Its website is here: http://crr.bc.edu/.)

46% and 45%. These are big numbers. In fact, they seem a bit on the high side, but nonetheless there is clearly some meaningful retirement income premium provided by an annuity, a pretty good reward for the particular risks you incur in relying on the solvency of the insurer.

So why doesn’t everybody buy annuities? Nobody knows. In fact, academics have even given that question a name: The Annuity Puzzle. Here are a couple of reasons:

First, a pure annuity leaves nothing for your kids after the death of you and your spouse; whereas taking distributions from your savings buckets will necessarily leave your kids an inheritance. Why? Because you’ll be too cautious in your distributions to ever let your savings buckets run dry. So that forbearance, which contributes to such a measly retirement distribution to you, also contributes to an inheritance for your kids. Think of it as a by-product of your retirement spending plan; an unintentional inheritance. If like many, you’re struggling to provide yourself a decent retirement, you might ascribe no value to that inheritance, and focus instead on strictly what you can expect to spend during your lifetime. (After all, those rotten kids, they never write, they never call.)

Second, you would never use 100% of your savings buckets to buy annuities. Why? Because while the primary purpose of your savings buckets is to provide a source of lifestyle spending during your retirement, they also serve an important secondary purpose: to provide a pot of assets in case of an unexpected emergency. But if you commit them all to annuities, your access to that capital would be cut off, or at least severely impeded.

Third, you give up too much control. Who wants to lose the ability to invest all their assets, and to spend them at the rate she sees fit?

Fourth, most annuities don’t protect against inflation. So they in effect provide a shrinking annual payment when expressed in real inflation-adjusted dollars. Some insurers, however, offer an annuity which increases with inflation—an alternative which should be seriously considered.

Fifth, annuities are expensive and opaque. It’s hard to know what their embedded costs are, or if the insurance company is giving you a fair shake.

Notwithstanding these downsides, and the risk of the insurer’s default, depending on your circumstances, it may be wise to invest a portion of your savings buckets in an annuity. How big a portion? Here is one way to adress the question from two different perspectives. First, figure out your personal poverty level—how much income does it take to meet your bare bones living expenses—subtract what you expect from Social Security and your employers’ pensions, and ask how much it takes to annuitize the balance. Second, project what percentage of your savings buckets you will be investing in fixed income during your retirement. Consider an inflation-adjusted annuity for the lesser of the two amounts.

Then invest the rest of your assets wisely.

A Digression About Risk

I was planning to say a bit more about Required Minimum Distributions and Spigot Planning, but I will get back to that shortly. Today I want to respond to Anonymous’s comment to March 10’s post about annuities and how they can be used to create a Do-It-Yourself Pension. Anonymous astutely points out that annuities do not come without risk.

All an annuity is, at bottom, is the bare promise of an insurance company to pay you $X per month for the rest of your life. But if the insurance company goes belly up, what’s that promise worth? All states have back-up funds to rescue annuitants tied to a failed insurer. But only up to a stated maximum, which varies from state to state. And for the balance of your annuity? Well, you’ll get just pennies on the dollar, as would a creditor in any other bankruptcy.

So if you buy an annuity, of course you should—and will—check out how the insurer is rated by the rating agencies. Hah!! What good is that? In his comment, Anonymous pointed out that Executive Life was highly rated before it had to be taken over by the state of California. And we are all aware of the black eye the rating agencies gave themselves in the ongoing sub-prime mortgage fiasco. So annuities carry risk.

And so does every other investment available to you.

Let me repeat. Every investment in every one of your savings buckets carries risk. No exceptions. None.

Your challenge, which, unlike those Mission Impossible guys, you have no choice but to accept, is to moderate that risk as best you can by diversifying among different types of assets; and to be sure you are compensated with adequate potential reward for each risk you take on. Not so easy. But you have no choice.

Let’s look at some investment alternatives. Anonymous mentions a few.

Broad–Based Equity Index Mutual Funds. Good idea. But of course even well-diversified equity index funds will lose money when the stock market goes down. Consider that the S&P 500 (total return), a ubiquitous broad-based index, fell 50% from its peak on October 9, 2007 to yesterday's close. Is that risk of loss reason to avoid such funds? No. Because over the long run, the stock market has adequately rewarded investors, on average 9.62% per year from 1926 through the end of 2007. That's he geometric average, not the arithmetic average. The challenge—and it’s an intractable one—is to figure just how much of this particular risk you can stand, given your financial resources and your projected needs.

Bonds. Bonds are a fine fixed income investment, with less of the vertiginous ups and downs of the stock market. But they too carry risks, most notably (i) the possibility of default by the bond’s issuer, and (ii) loss of value if interest rates go up. Again, how much of these particular risks can you stand? And is the potential reward worth it?

Certificates of Deposit. Since CD’s are insured by the U.S. (at least up to a $100,000 maximum; $250,000 for just this year), they avoid the risk of default. But they don’t avoid the risk of loss of value if interest rates rise. And because they don’t carry default risk, they offer only low returns. Which creates its own risk of failing to keep up with inflation.

Treasury Inflation-Protected Securities (TIPS). These are great because they grow in face value with cost-of-living adjustments, and are issued by the U.S. government, so they have a lot of the risk bases covered. But they therefore carry a low real yield, and so create their own risk of failing to provide sufficient return to meet your lifestyle needs. And even these marvelous instruments fluctuate in value with the turbulent forces of the marketplace—millions of buyers and sellers with their diverse needs and opinions causing the TIPS’ value to go up or down for no discernable reason.

The larger point here is that there are lots of types of risk, so it’s difficult to compare one investment to another. Is the risk of default by an annuity insurer bigger or smaller than the risk of the stock market dropping? They’re apples and oranges. And there are too many facets of risk to make a simple comparison.

You can’t eliminate risk. It’s a fact of life. The best you can do is diversify it, so that not too many disasters occur simultaneously. And be sure you are adequately rewarded for the risks you’re forced to take.

To be continued.

Roth IRA's vs. Required Minimum Distributions

In the last couple of posts, I have talked about traditional tax-favored retirement accounts and how the Required Minimum Distribution rules dictate the gradual expiration of their valuable tax-exemption. But Roth IRA’s are different. Required Minimum Distributions don’t have to begin until after your death; or, more accurately, after the death of you and your spouse. So with Roth IRA’s, the end of tax-exemption is dictated by your need for spending money rather than any RMD rules, at least during your lifetime.

This suggests another opportunity for Spigot Planning—the clever choice of which savings bucket you tap first to meet your living expenses.

As an example, consider Jerry and George from yesterday’s post; but let's change the situation. They each still have $1,000,000, but now it’s split equally between a Roth IRA and a taxable investment account. George holds to his naïve approach of taking his spending proportionately between his two accounts. Jerry—clever fellow—first depletes his taxable investment account before tapping into his Roth IRA, thus preserving the Roth IRA’s tax exemption for as long as feasible. Using reasonable assumptions, George projects that he will be able to spend $56,584, increased each year for inflation, before depleting his wealth at age 100. Jerry projects he will be able to spend $59,231 per year, a 4.7% increase. Nice work, Jerry!

Notice how much more meaningful the benefit from Spigot Planning compared to yesterday’s example. That’s because Roth IRA’s have no lifetime Required Minimum Distributions, so there’s more opportunity to benefit from delaying distributions from your tax-favored retirement account.

More to come on Spigot Planning.

The Dynamics of Required Minimum Distributions

Yesterday, I summarized the rules for figuring your Required Minimum Distributions (RMD's) from traditional tax-favored retirement accounts. Today I will point out how you can use them to your advantage.

The first thing to notice about the RMD rules is that, all things being equal, if you take distributions from your IRA strictly based on the minimum required amount, you will receive a stream of increasing distributions. There are two reasons for this.

The first reason is that while the divisors that determine your required distributions are grounded in your life expectancy, they do not shrink by one each year as your real life does. The actuarial profession gives you a bonus for surviving a year. Say “thank you” to nice Mr. Actuary. So the divisors shrink by about 0.9 each year. (Actually, the divisors have been determined by the IRS based on the joint life expectancy of you and a hypothetical person who is ten years younger than you. You don’t really need to remember that. It’s just a fun fact to know and tell.) Here are the first four divisors to give you a feel for how this works:

Age 70, Divisor 27.4
Age 71, Divisor 26.5
Age 72, Divisor 25.6
Age 73, Divisor 24.7
Etc.

The second reason your RMD's tend to grow each year is that the rule for determining your required distributions has been formulated without regard to the expectation that your account will grow with investment earnings. So investment earnings—assuming we start getting them again—will make your next year’s RMD bigger than this year’s.

While your RMD’s tend to grow—and the expectation is that they grow faster than inflation—your real life living expenses might be expected to only grow with inflation. So you might be tempted to take greater retirement account distributions than the RMD rules dictate. Remember, the rules only dictate a required minimum; you are always free to take more.

Not so fast, Kowalski. If you also have an ordinary taxable investment account, all things being equal, you may realize a long-term tax saving by taking only the minimum required amount from your tax-favored retirement account, and spending a correspondingly greater amount from your investment account. I’m not talking about giving Future You a greater spending allowance than Present You; just playing with which Savings Bucket your allowance comes from. In February 12’s post I called that Spigot Planning—opening and closing the spigots on your various Savings Buckets.

Here’s an example. Jerry and George are two friends who are identical in every way—same age (age 70), same savings, same investment approach, everything. Both have two accounts—a $500,000 traditional IRA and a $500,000 taxable investment account; so each has $1,000,000 in the aggregate. But there’s one difference. George chooses to take his retirement spending proportionately from each of his accounts, while Jerry initially takes only his Required Minimum Distribution from his IRA (at least until he’s exhausted his investment account). Applying reasonable assumptions, George projects that his $1,000,000 will provide him with annual after-tax spending of $47,388 (increased by inflation each year) before depleting his wealth at age 100. While Jerry projects annual after-tax spending of $47,546. Just by engaging in a bit of Spigot Planning, and taking advantage of the back-loading allowed by the RMD rules, Jerry can increase his spending by 0.33%.

Hey. Why not? Little things add up. More on this tomorrow.

Required Minimum Distributions

In prior posts I have extolled the benefits of the tax exemption of tax-favored retirement accounts. But all good things must end, and so must tax-exemption.

For many people, the end of tax exemption is determined by their need for cash from their retirement accounts to meet their living expenses. To spend it, you’ve gotta’ take it out of the plan. But some have other resources to live on, in which case the end of tax exemption can be determined by the Required Minimum Distribution rules. In today’s post, I will briefly describe those rules as they apply during your lifetime. (Post-death Required Minimum Distribution rules will be described in a later post.)

At the outset it’s important to recognize that Roth IRA’s are not subject to Required Minimum Distributions during your lifetime—a significant benefit which will be explored in a later post. Roth 401(k) accounts are theoretically subject to lifetime Required Minimum Distribution rules, but you can easily get around them by taking a lump sum distribution from your Roth 401(k) account, and rolling it over to a Roth IRA, which is not. So the rules described today are effectively limited to traditional tax-favored retirement accounts.

Another thing. Congress suspended Required Minimum Distributions for 2009 in light of people’s unusual market losses, so you don’t need to take a distribution this year if you don’t want.

Generally, you must begin taking retirement account distributions the year you reach age 70-1/2. (There’s that half-birthday thing again. Who came up with that?) However, in the case of an employer plan, such as a 401(k) plan, you can further delay the start of distributions until you actually retire from the sponsoring employer. Unless you own 5% or more of the employer, in which case, 70-1/2 is it.

You can also delay your first year’s distribution and take it early the second year—by April 1. But that particular delay is only allowed for the first year’s Required Minimum Distribution. So if you take advantage of it you’ll be forced to double up on distributions in the second year.

So how much must you distribute once you’ve reached the magic year? A few years ago the rules were criminally complex, but the IRS stepped up and simplified them greatly. The usual rule (with one exception to be described below) is simply this: Divide the value of your account (as of January 1; actually, the prior December 31 will do) by the Applicable Distribution Period, based on the age you will attain during the year. The Applicable Distribution Period can be found in a table the IRS has created, which is printed as an appendix in IRS Publication 590. It's called Table III, Uniform Lifetime Table.

As I said, there is one possible exception to the above procedure: If you are married to a much younger spouse and you have named your spouse as your death beneficiary under the plan. Then you may skip the Uniform Table and use your and your spouse’s joint life expectancy, which can also be found in an appendix in IRS Publication 590. This generally gives you a higher divisor, and therefore a lower Required Minimum Distribution, if your spouse is 10 or more years younger than you. Yet another reason to marry a young’un.

To make it even simpler, the institution that serves as custodian of your IRA is required to inform you of the amount of your Required Minimum Distribution each year.

If you have more than one traditional IRA, you are permitted to aggregate your Required Minimum Distributions and take them from whichever IRA you please. But you can’t do that with employer plans. Each employer plan must separately meet its Required Minimum Distribution obligation.

So those are the rules. That's how tax exemption ends, not in a lump sum, but in an annual dribble. In another post I will discuss how you can use them to your advantage.

Do-It-Yourself Pension Plan

In my last two posts, I ranted a bit about how employers have generally shifted both the cost and the investment risk of our retirement security onto our puny shoulders. (At least we have Social Security. I think.) No matter what I say, employers are not likely to reverse course and take back those burdens. So what can we do about it? Here’s my modest proposal.

• Your employer should tinker with its 401(k) plan to add an additional investment option: an annuity.
• Every paycheck, a portion of your elective deferral (and matching contribution, if your employer provides one) would go toward the purchase of an annuity for your (and your spouse’s) lifetime. You would choose the percentage: 25%, 0%, 100%, whatever.
• The annuity would be funded by a reputable insurance company selected by your employer (just as employers now select the mutual funds or other institutions that constitute your 401(k) options). AIG, say.
• The annuity would start at the plan’s stated retirement age, something like age 65, but you could decide when you get close to retirement exactly what age to begin.
• Generally, it would be a pure fixed annuity. Not a variable annuity based on the performance of the stock market. We already have plenty of market-linked investment options.
• Only three variations would be offered. (i) the starting age; (ii) your spouse’s survivor percentage, if any; and (iii) with or without an annual cost-of-living adjustment. These choices would all be made when you’re ready to begin retirement.
• Your annuity would be portable. If you leave your employer, the 401(k) plan will distribute the insurance company annuity policy to you.
• The amount of annuity that each dollar of your contribution buys will, naturally, vary depending on your age when you make the contribution. The younger you are, the greater the future income your dollar buys. And your future income will also vary with current annuity market conditions, notably interest rates and longevity expectations. But each year you work you would be adding a little slice to your future retirement income.

Variations of the Do-It-Yourself Pension now exist; but not, to my knowledge, the whole package. For example, it is not uncommon for 401(k) plans to offer you the opportunity to convert your account balance to an annuity when you are about to retire. But then the size of your retirement income depends on when you retire. Retire on October 9, 2007? The market’s high, and you’ll be able to buy yourself a comfortable income. Retire on March 10, 2009? The market—and your 401(k) account—has tanked, and therefore so will the annuity you can purchase.

Some insurers offer a 401(k) option that’s close to the Do-It-Yourself Pension, but not quite there. You can accumulate credits with the insurance company during your working years, but the insurer won’t lock in an annuity amount until you’re at retirement. That means your ultimate pension income depends on where the ups and downs of the annuity market have landed on the date you retire. It would better if you could average into the annuity market gradually over your entire working life.

But why should these Do-It-Yourself Pensions be restricted to 401(k) participants? The next logical extension would be for the insurance companies to offer them to every working person through their IRA’s.

The Do-It-Yourself Pension requires the cooperation of employers, the insurance industry, and a government agency or two (but no new legislation, I believe). There’s actually an insurance industry association called the Institutional Retirement Income Research Council whose goal is to pave the way for Do-It-Yourself Pensions, or something like them.

If anyone out there knows of an insurance product that already meets all these criteria, please leave a comment or send me an email.

Enough of my opinions. Tomorrow I get back to individual planning.

Defined Contribution vs. Defined Benefit

In yesterday’s post, inspired by Chris from California’s comment to March 1’s post, I burdened you with my observations of how 401(k) plans have been the (perhaps) unintended vehicle for companies to shift the burden of paying for retirement onto the shoulders of the employees. Today I’d like to talk about the burden of investment risk.

All financial markets are risky. Even the smartest investors can forget that sometimes, especially after a long run of favorable returns. But anyone who forgot about risk was certainly reminded—ever so gently—by the crushing losses of the last year. For the wise investor, risk is (or ought to be) accompanied by reward: higher returns averaged over time for taking on the risks of the markets’ ups and downs.

In defined contribution plans—epitomized by 401(k) plans—the risks and rewards are borne (and enjoyed) by the employee as his account goes down and up. In defined benefit plans—you know, the ones that promise traditional monthly pensions (maybe your dad had one, or perhaps you read about them in the history books)—the employer bears the risks and rewards of investment performance. As the big collective pot drops in value, the company is required to contribute more; and as the pot enjoys favorable investment experience, the company is required to contribute less to meet its pension promises.

So who is in the better position to deal with the volatility (nay, turbulence) of the financial markets? The employer and its defined benefit plan, or the employee and her defined contribution plan account? To ask the question is to answer it. It sure as shootin’ ain’t the employee! That’s the whole raison d’etre for this blog! As an individual, how much should I salt away? How should I invest it? How much should I spend? If these questions weren’t so intractable, this blog would have no reason to exist. (Wouldn’t that be tragic.)

These are all very difficult questions for individuals, not because we’re stupid, but because we’re individuals. We're limited to live but one financial life, unable to benefit from averages.

But what about the employer and the defined benefit plan? That kind of collective pot of assets can act like a reservoir, with the employer filling it up when bad times cause it to run low; and slowing down its funding in good times. A community reservoir is much better at collecting water for everybody, than a bunch of individual cisterns. When was the last time you saw a cistern? I think it was the Middle Ages.

In a crystalline, brilliantly concise paper on the subject (“A Better Bang for the Buck”), Beth Almeida (of the National Institute on Retirement Security) and William B. Fornia describe how dollars spent by a company in funding a defined benefit plan go further than the same dollars spent funding a defined contribution plan, e.g., as matching contributions in a 401(k) plan.

There are three reasons for this:
Longevity Pooling. You have to save more because you don’t know how long you and your spouse will live. You have to plan for the worst. (Or is it the best?) But a company’s actuary can tell you how long the average employee, among thousands, will live. The company can fund for the average lifetime rather than an extra-long possible lifetime. You don’t have that luxury.
Asset Allocation. Your asset allocation should get more conservative as you grow older, because you can ill afford the volatility of too much stock in your 401(k). But a company pension plan, being a large reservoir for employees of all ages, can better afford to weather the downs of bear markets in order to benefit from the ups of bull markets. It can afford a less conservative asset allocation based on the average age of all pension plan participants. And it can afford to venture a few dollars in riskier (but more rewarding) illiquid alternative investments, which are foreclosed to your measly 401(k) account.
Efficient Investor. With economies of scale, an employer plan can pay for good investment advice at a lower cost than you can. They can get it wholesale. You can’t.

Almeida and Fornia actually take a stab at quantifying these three factors, and conclude that on average it costs 46% less for a company to deliver a dollar of an employee’s retirement income through a defined benefit plan compared to a defined contribution plan. Keep that in mind if you’re a human resources manager about to design your company’s retirement program.

It's an informative paper, but back to reality. The traditional pension plan is probably not poised for a comeback. Maybe your employer doesn’t want to pay the cost of your retirement, and maybe it doesn’t want to take on the investment risks of your retirement. So what can you do? That’s for tomorrow’s post.