The Social Security Trust Fund

On Tuesday, the trustees of the Social Security Trust Fund issued their annual report. It’s getting bleak; like our 401(k) statements.

Of all the key projections, the keyest projection of all is the year the retirement Trust Fund is expected to run bone dry. That is now projected to happen in 2037, a full four years earlier than last year’s projection. That’s a big change. And it’s as much a testament to the fragility of long-term projections as it is to the fragility of the Fund.

What happens when the well runs dry? Revenues are then still pouring into the Fund—remember all those FICA taxes you’re paying—but they will be insufficient to pay 100% of promised benefits. In fact, they’re projected to be enough to pay only 76% of promised benefits. Unless, the law is changed, that’s all retirees will get: 76%. Some promise, huh!

Another key date that’s deteriorating is the year the Fund stops growing. Taxes and interest grow the Trust Fund, building up a needed surplus to deal with a substantial projected increase in promised benefits. The Fund is projected to switch from growth to erosion in 2016, one year earlier than last year’s projection.

There’s lots of reasons for this deterioration—greater unemployment, slower growth in wages, low interest income on the Treasury bonds comprising Trust Fund’s assets. But at least the Trust Fund hasn’t been decimated by last year’s poor stock market performance. There ain’t no stocks in the Fund.

Clearly all our political leaders need to agree to resolve the solvency of the Trust Fund. Even if the solution ultimately favored by the majority is not their favorite solution, at least they should agree that some early action is better than inaction. It is manifestly unfair for future retirees to see their “promised” benefits shaved when they (we) have been cheerfully—or at least dutifully—supporting current retirees with our payroll taxes.

What are your favorite solutions to the actuarial shortfall? I've previously bloviated as to my own favorite fix, in January 11's post. I've shown you mine; you show me yours.

Refundable vs. Nonrefundable Saver’s Credit

Yesterday’s post described the Saver’s Credit, a taxpayer-paid matching contribution designed to encourage and assist low income workers to save for their retirement. In a thoughtful comment, David highlighted the purpose of the Saver's Credit, which is to asist low-income workers in saving for their own retirement.

Which leads me to focus on one particular feature of the Saver's Credit: it’s a nonrefundable credit. That’s tax jargon for a credit that is limited to your tax liability. A nonrefundable credit can only operate to reduce your tax liability. If your potential credit is a dollar more than your tax liability, you don’t get that extra dollar.

There’s currently a bill recently introduced into the House of Representatives by Congressman Pomeroy (H.R. 1961) that would turn the Saver’s Credit into a refundable credit. If your potential Saver’s Credit exceeds your tax liability for the year, the taxpayers give you a refund anyway—although “refund” is a poor choice of words, since the dollars would come from other taxpayers.

What is the point of drawing a bright line at your tax liability? Opponents of refundable credits call it welfare, since the refundable part comes from other taxpayers. If you limit the credit to tax liability, it’s easier to characterize it as a tax reduction. (“Welfare,” “tax reduction.” Words are really loaded, aren’t they?) Proponents of refundable credits note the arbitrary nature of the line that’s being drawn at the taxpayer’s tax liability. If she’s engaging in the favored activity that generates the credit, why draw a line at her tax liability? Particularly as the complexity of the Tax Code, with all its other deductions, exemptions and credits, makes that line increasingly arbitrary.

It’s instructive to note what other credits in the Tax Code are refundable. What activities are so favored by Congress that they are willing to have other taxpayers support the activity? The big one is the earned income credit, which constitutes taxpayer help for the working poor. There are also a couple of narrowly targeted credits aimed at farmers with high fuel costs and some unemployed individuals who need help with their health insurance costs. Most other credits—the child tax credit, adoption assistance, dependent care, the list is a long one—are nonrefundable. Congress just hates stepping over that line.

So what do I think? (Actually, nobody really asked me, but I have the floor.) I favor making the Saver’s Credit refundable. In my view, helping low income workers save for their retirement falls into the same category as the earned income credit for the working poor. They’re doing everything society wants and encourages them to do, yet often through no fault of their own they need help making ends meet. They’re exactly the ones the rest of us, through our tax dollars, ought to encourage, assist and support. They're the productive ones, the good guys.

Besides, if you look at the way the Tax Code is structured, you get the definite sense that deductions and credits serve fundamentally different purposes. Deductions are generally aimed at figuring the "right" measure of your ability to pay income tax. Credits, on the other hand, are designed to encourage specific activities; they are not germane to calculating your fair share of the country's overall need for tax revenue.

So what do you think? I’d like to know. Send me an email at TheTwoLeggedStool@gmail.com. Or, better, post a comment.

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)

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.

The Unintended Consequences of 401(k)

In a comment to March 1’s post, Chris from California observed that 401(k) plans have effectively shifted the burden of building up a retirement fund from the employer to the employee. I gotta’ go along with Chris on that one.

I question whether that was the intent of 401(k), but it sure has been the effect. Here’s a little history.

401(k) was added to the Tax Code in 1978. But it had its roots long before that. Over the years, it had become popular for companies to adopt profit sharing plans; they served as a tax-favored environment in which to reward employees with bonuses when the company had a good year. Some companies had wanted to give employees a choice of getting their profit sharing bonuses paid outright to them or saved inside the profit sharing plan. Fearing that only the higher paid employees would opt for the plan contribution—and the rank-and-file employees would all take cash—in the 1950’s and 1960’s the IRS came up a couple of guidelines for when this kind of choice would be allowed. These guidelines were designed to assure that at least some decent percentage of lower-paid employees were getting contributions to the tax-favored plan. In 1978, Congress decided to codify the principles behind these older IRS rulings by enacting 401(k).

401(k) lay there like a lump in the Tax Code for a few years until the IRS finally issued interpretive regulations in 1981. Those regulations included an innocuous-seeming technical feature which would eventually lead to the wholesale adoption of 401(k) plans. The 1981 regulations made it clear that the employee’s choice of cash-or-tax-deferral was not limited to ad hoc bonuses. To run a 401(k) plan, a company did not have to go through the steps of offering the employee a bonus and asking, “Will you take that in cash, sir, or shall I deposit in your tax-sheltered account?” The employee could be allowed to make that choice by electing to reduce his regular weekly wages by some amount, and have that amount added to his 401(k) account. So beginning in 1981, 401(k) plans could be adopted by any company, whether or not they paid bonuses.

It became common for companies to offer a matching contribution of some kind—both to reward employee thrift and to encourage lower-paid employees to participate so the plan would meet the tests imposed by 401(k).

But then, as now, the match was usually modest rather than overwhelming. Perhaps 25% or 50% of your own dollars. Everyone, it turns out, loved 401(k). The employee loved it because, unlike her future benefit under the company’s traditional defined benefit pension plan, the employee could sink her teeth into her 401(k) account. She could watch her account grow with each quarterly statement. You can relate to a growing account with six digits much better than some pie-in-the-sky future monthly benefit with only four. It helped that the effective invention of 401(k) in 1981 coincided with the beginning of the biggest, baddest bull market in history.

And boy did employers love 401(k)! They saw that they could get their employees to pick up 2/3 or 80% of the cost of their own retirement—and even smile about it.

I think profit sharing plans generally, and 401(k) plans in particular, had been thought of—by policy makers and human resources professionals—as adjuncts to the traditional defined benefit pension plans; as a tax-efficient aid for employees to build up the third leg of retirement’s three-legged stool. But over the years, many employers have dropped their traditional pension plans altogether. To soften the blow, they could tell their employees, “We’re not taking away your retirement funding; we’re just putting the dollars into a generous (e.g., two-for-one) matching contribution, rather than a pension plan which few of you appreciate anyway.” But after some time (and forgetfulness) intervened, that two-for-one match gave way to the “industry standard” 50% match. The second leg of the stool was gettin’ kind of wobbly.

That was then. This is now. In current hard times, if you listen carefully you can hear the thudding sound of companies dropping their matching contributions. And their employees—or those who still have jobs anyway—are left to shoulder the retirement funding burden on their own. It remains to be seen whether those companies who have discontinued their matching contributions will reinstitute them once they return to profitability.

I've got two more posts on this subject, and then I'll get back to planning. I promise.

Problems with Real Estate in Tax-Favored Retirement Accounts

In yesterday’s post I mentioned some types of investments that create legal problems when housed in a tax-favored retirement account. Today I focus on everybody’s favorite investment: real estate. Well, maybe not this year’s favorite. Anyway, there is no per se prohibition against real estate in a tax-favored retirement account. But there are so many traps to avoid, it becomes a real practical difficulty. Here’s some.

The Trustee. It can be difficult to find an IRA trustee or custodian willing to hold administratively difficult assets like real estate. What about 401(k) trustees? Forget about it. Not gonna’ happen.

Valuation. Tax rules require that retirement accounts be valued once a year, generally on December 31. Unlike publicly traded stocks, bonds, and mutual funds, it’s difficult to value real estate. You can't just look up the fair market value of a house on the pages of the Wall Street Journal.

Carrying Costs. Real estate tends to have high carrying costs—real estate taxes, maintenance expenses, mortgage payments, and the like. Even if you personally have the funds to afford these payments, you may not be allowed to get the dollars into the retirement account where they’re needed, due to legal restrictions on contributions, as described in February 4’s post.

Distribution. Retirement accounts are subject to required minimum distribution rules, requiring distribution of relatively small amounts each year. But real estate tends to have a relatively high value. You can’t easily distribute it in small dribs and drabs. It’s all or nothing.

Illiquidity. You can end-run the distribution problems described in the last paragraph by having your account sell the real estate, but real estate is illiquid. You can’t just snap your fingers and cause a sale like you can with stocks, bonds, and mutual funds.

Financing. Financing a real estate mortgage in an IRA creates Unrelated Business Taxable Income, requiring the IRA to pay a tax, obtain its own taxpayer ID number and file a tax return—which is all quite burdensome for an account that is usually tax-exempt and burden-free.

Prohibited Transaction Potential. There are oodles of hidden highly-penalized prohibited transactions waiting to bite you unexpectedly when you have real estate in an IRA. Here are some examples:

• Your IRA rents a vacation property to your children? Prohibited transaction!
• You spend a weekend at your IRA’s vacation property? Prohibited transaction!
• Lend your IRA money to pay the real estate tax bill (with or without interest)? Prohibited transaction!
• Personally enter into a contract to buy a property which is then closed by your IRA? Prohibited transaction!
• Co-purchase the real estate 50%-50% between you and your IRA? Prohibited transaction!
• Distribute a fractional interest in the real estate to yourself to meet the IRA’s required minimum distribution obligation? Prohibited transaction!
• Personally guaranty the IRA’s real estate mortgage? Prohibited transaction!
• The list goes on. It's a minefield out there.
  

Bottom line? Better to own your real estate outside your retirement accounts.

The Politics of Roth

This daily blog is usually dedicated to personal retirement planning. But occasionally I feel motivated to digress into public policy. Today is one of those days. It’s not like it’s my birthday or anything. But sometimes it’s just nice to ramble. The weather’s nice. It’s March, so it’s almost spring. Today I’ll digress.

I’ve devoted a number of posts to the pros and cons of saving on a Roth basis instead of a traditional pre-tax basis. I’m trying to help you answer the question, “What’s in my long-term best interest?” But why has Congress offered us all these opportunities? Roth IRA’s. Roth 401(k)’s. Roth conversions. 2010 Roth sale.

Think of it as the stealth triumph of Steve Forbes. Remember him? He lost the Republican primaries in 1996 and 2000. Big time. He campaigned on the misguided platform of a flat tax on all of your compensation income, but excluding any tax on income from your investments. Imagine if his tax policy had carried the day. People wealthy enough not to have to work, who live off their interest, dividends and capital, would not share in the country’s tax burden. I don’t know about the economics of that kind of system, but the politics is just plain nutty.

But that’s what Roth saving is all about. You pay tax when you earn the compensation by not getting a deduction as you would, say, for a pre-tax contribution to your traditional 401(k) plan. And then you never again pay tax on the interest, dividends and capital gains within the Roth account.

So it turns out Steve Forbes has won, but only to some extent. Roth opportunities are limited in amount. A wealthy person can’t just Roth-ificate all his investments; just the part that’s found its way into a tax-favored retirement account. And those parts are limited by law (as described in February 4’s post). But for most Americans, that’s enough. Few of us can afford to save more than the amounts the Tax Code allows us to contribute to our IRA’s, 401(k)’s, and the like. For all but the wealthiest, these accounts can (and do) contain all of our savings. (Well, there’s also our houses, but most capital gain on that is tax-free too.)

How did we get to this point? The Bush administration was, like Forbes, enamored of the concept of excluding capital-based income from taxation. And for a while Bush had the requisite sway with Congress. So he achieved a few steps in that direction: Expansion of Roth opportunities; extremely low tax rates on dividends and capital gains. For years he promoted (unsuccessfully) further expansion of the concept, trying to create Lifetime Savings Accounts, which would have been Roth-like accounts that could be used for any purpose, not just retirement. Bush even feinted toward permanently abolishing all traditional pre-tax retirement accounts (all of them!!!), a recommendation made by his commission to reform the income tax system.

How was Bush so successful with Congress where Forbes fell on his face? It probably didn’t hurt that Roth savings—particularly Roth conversions of large pre-existing traditional IRA’s—generate lots of near-term revenue at the expense of future revenue, a subtle form of inter-generational theft. Roth opportunities help Congress pretend it’s balancing the budget by only looking at 10-year projections, while the real revenue losses don’t hit until many years down the road when the growing army of Roth retirees stop sharing in the tax cost of running the show.

Well, that ramble was fun. Tomorrow I’ll go back to my usual posture: “To hell with the next generation. What’s in it for me?”