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Chapter 29
Tools & Techniques of Financial Planning
Retirement Planning is the process of insuring that there are sufficient financial resources to provide a desired lifestyle in the retirement years. It consists of several tasks:
Determining retirement financial needs. Analyzing current resources to provide for retirement needs. Working with retirement plan distributions and seeing that your client follows certain rules in a timely manner.
For more detailed information on retirement planning, see the Tools & Techniques of Employee Benefit and Retirement Planning.
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Some of the factors you and your clients need to understand to successfully plan for wealth accumulation and retirement include the following:
The magnitude of the financial requirements facing retirees during retirement. The impact of inflation on retirement. The effect that financial well-being has on the quality of life. The planning alternatives that are available for the purpose of developing a plan that leads to financial self-sufficiency.
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Even at what may appear to be low levels, ongoing inflation during the retirement years will erode the purchasing power of the retirees income.
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Recently, the long-term viability of the Social Security system has come into question, and employer pensions are becoming more rare, leaving the persons savings the one leg left.
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Not designed to replace all pre-retirement income. Best only replace about one-half.
Integration with Social Security reduces that to 20-25%. Based on entire career, not the final working years. Do not provide protection against pre-retirement inflation.
Profit-sharing plans do not assure that a contribution will be made each year. Defined benefit pension plans are being replaced by 401(k) plans that put savings and investment burden on the employee. Many employers are terminating all pension and profit sharing plans.
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Most defined contribution plans do not guarantee an income for life. The responsibility for managing resources becomes the employees. There are no cost-of-living increases the employee gets a lump-sum and must do the best he or she can. Many people are ill-equipped to manage a portfolio by inclination or education.
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Social Security is meant to be a safety net. However, it does not come anywhere near replacing pre-retirement income. Many observers question whether Social Security will be able to meet the demands for benefits after the year 2020.
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Biggest threat to economic independence in retirement is inflation. As prices go up year by year, the retiree has to draw down more money to have the same amount of purchasing power. Even if Social Security keeps pace with inflation, at 4% inflation, in about 10 years, the combination of pension and Social Security will have only about 75% of the purchasing power that it had in the first year.
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No one can accurately project future inflation rates. Over the period from December 1950 to December 1992 inclusive, the average compound increase in prices was 4.2%. Since 1992, however, it has been under 3% compounded. Many people may be comfortable with projecting a 3%-4% annual increase for long-term estimates of inflation. Others who are more cautious and conservative in their approach may want to choose a higher long-term inflation assumption.
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Predicting how long a person will live is not easy. If ones relatives have lived well into their 80s, then genetically there could be an expectation that one will also have a long life-span. Others, whose relatives died young, may not expect to live that long. One of the biggest fears of retired persons is outliving their money. Even knowing the average life expectancy, since the probability of a person living beyond the average life expectancy for someone their age is greater than 50%, it is clearly imprudent to base predictions on average life expectancy.
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Consider John and Judy, age 65 and age 62. The median age of death, where a person has exactly a 50/50 chance of surviving that long or longer, for them as single persons is 15.7 and 22 years, respectively. However, half the people will survive beyond their median ages of death, so it would be unwise to use the median ages of death. According to the survival probabilities, John has a 25% chance of surviving almost 22 years to age 86.9 and a 10% chance of surviving almost 27 years to age 91.8. Judy has a 25% chance of surviving almost 28 years to age 90.9 and a 10% chance of surviving about 34 years to age 96.2. How much risk can you take that you will run out of income?
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Longevity trends have averaged 2% - 6% increase every 10 years for the past five decades. This means that using todays tables for computing retirement needs for people decades away from retirement age could severely understate the need. In addition, financial planning clients tend to be better educated, be in better health and be more affluent than average, all factors leading to greater longevity. Never forget that average life expectancy tables mean that there is at least a 50-50 chance that the person will live longer than the average age.
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Overestimating the length of retirement is less serious than underestimating it. No one is going to complain about being better off in retirement than expected, but the fear of running out of money is constant and can be debilitating for the retiree. The monitoring of the financial plan over the years will keep the retirement plan on track.
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An employee in an ERISA plan must be provided with annual benefit statements, a summary plan description, appropriate tax forms and access to a plan administrator. The benefit statement must show the accrued benefits and vesting status. It may show projected Social Security benefits, family death benefits, and value of any contributions the employee has made to the plan.
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Benefit consists of accumulated account balance. Balance includes contributions by the employer, contributions by the employee and investment earnings, plus in some cases, forfeitures by nonvested employees who have left the plan. Value may go down if investment return is negative.
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Simplified employee pension plans (also called SEPs). Salary-reduction simplified employee pension plans (also called SARSEPs). Stock bonus plans. Thrift plans. Savings plans. Target benefit plans. Cash balance plans. SIMPLE IRAs. SIMPLE 401(k) plans.
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A defined benefit plan defines the benefit the employee will receive at retirement, usually based on earnings and years of service. The benefit may be based on the final salary and the number of years worked for the employer. In these plans, the accrued benefit is the current value of the funds the employee has earned to date that will be used to buy the pension benefit. When reading the annual benefit statement:
Note whether the benefit is the current or projected benefit. Are benefits stated in current or future dollars?
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To receive a benefit, the plan participant may have to be in the plan for a specified number of years. This waiting period is called the vesting period and benefits that the employee will receive even if he leaves the company are vested. There are two kinds of vesting schedules:
Cliff vesting: The employee is not vested at all until a certain date, then is 100% vested. Graded vesting: A certain percentage of the employees accrued benefit is vested per year over a period of years. Five year vesting is very common.
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The summary plan description gives more detail and may include explanations of:
Early retirement provisions. Normal retirement age. Deferred retirement provisions. Payout options available at retirement. Potential pitfalls. Claims procedures. In addition, the Summary Plan Description will usually explain how benefits are computed.
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In addition to the annual benefit statement and summary plan description, employees will also be supplied with a variety of retirement-related federal tax forms. Chief among these is Form 1099R. This form is sent whenever a person receives a lumpsum distribution from the retirement plan or whenever a person is receiving annuity payments or periodic payments.
Plan Administrator
In addition to all the written information employees receive about their plans, they also have access to a plan administrator, benefits adviser, or human-resources representative. In some cases, the same person may wear all three hats; in others, a team of experts is available to advise employees.
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Any wealth accumulation plan assumes a continuation of the ability to earn money and that assets, once acquired, will stay intact. One of the major tasks of retirement planning is to assure that risks in the clients life do not derail their retirement plans. Loss of earning power through death or disability or loss of assets through property damage or malfeasance can destroy the best-laid plans. Insurance is the method of handling risk most often used for retirement planning.
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Some risks will be retained because the premium cost to use insurance is great compared to the risk involved. Insurance is the best value when the risk is unlikely (meaning a low premium) but the risk could be devastating to the insured. For example, it is highly unlikely that the average homeowner is going to face a negligence suit for millions of dollars. However, if he or she did, it would be crushing. So an umbrella policy for $2 million, which is typically only about $250 per year, would be a great buy.
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Life insurance protects a family against the loss of income or increased expenses due to the death of the insured. The amount of life insurance needed is the remaining amount in the projected wealth accumulation plan.
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A client has a greater chance of suffering a disability than of dying, yet the impact on the wealth accumulation plan might even be worse with the medical expenses needed to treat the disability. Disability income insurance can replace the income from a job or keep a business afloat during the disability of the client. Since an elimination period of 90 days or more will cost much less than a shorter period, the financial planner must assure that the client keeps an emergency fund of 3 to 6 months living expenses.
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Medical costs have spiraled up much faster than have other costs in the economy. An unexpected illness or accident could cost hundreds of thousands of dollars in medical bills. Although most medical insurance is obtained through the employer, self-employed clients will need assistance in obtaining medical insurance at a reasonable price. The most reasonably priced medical insurance is the HMO, however, there are a number of other variations of medical insurance. Employees rarely have much choice: Selfemployed can make the decision of what kind of insurance they want. Choosing a high-deductible plan can provide insurance against devastating loss with a lower premium cost.
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Some participants just want the highest income possible in retirement, and do not want to think about taxes. The planner must consider:
1. 2. 3. 4. the direct income tax on the lump sum or periodic distribution. penalty taxes. estate taxes. generation skipping transfer taxes.
A qualified plan distribution may be subject to federal, state, and local taxes, in whole or in part. This section will focus only on the federal tax treatment. Federal tax is usually higher than state or local and many states exempt retirement distributions.
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While the bulk of most retirement plan distributions will be taxed as ordinary income, some will include a tax-free return of the employees own money. If an annuity is taken, payments will be proportionally taxable and tax-free according to the ratio of the employees cost basis in the plan. An exception for after-tax contributions made prior to 1987 for certain plans is that those will be treated as non-taxable until the entire pre-1987 contribution has been recovered.
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The first step is to determine the participants cost basis in the plan benefit. The participants cost basis can include:
1. The total after-tax contributions made by the employee to a contributory plan. 2. The total cost of life insurance reported as taxable income by the participant if the plan distribution is received under the same contract that provided the life insurance protection. 3. Any employer contributions previously taxed to the employee for example, where a nonqualified plan later becomes qualified. 4. Certain employer contributions attributable to foreign services performed before 1963. 5. Amounts paid by the employee in repayment of loans that were treated as distributions.
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The annuity rules of IRC Section 72 apply to periodic plan distributions made over more than one taxable year of the employee in a systematic liquidation of the participants benefit. Amounts distributed are taxable in the year received, except for a proportionate recovery of the cost basis. The method used for recovery of the cost basis depends on the participants annuity starting date.
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If the annuity starting date is after December 31, 1997 and the annuity is payable over two or more lives, the excludable portion of each monthly payment is determined by dividing the employees cost basis by the number of payments shown in the table below:
If the combined ages Of the annuitants are: Not more than 110 More than 110 but not more than 120 More than 120 but not more than 130 More than 130 but not more than 140 More than 140
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If (a) the annuity starting date was after November 18, 1996 and before January 1, 1998 and the annuity is payable over two or more lives, or (b) the annuity starting date is after November 18, 1996 and the annuity is payable over one life, the excludable portion of each monthly payment is determined by dividing the employees cost basis by the number of payments shown in the table below:
Age Not more than 55 More than 55 but not more than 60 More than 60 but not more than 65 More than 65 but not more than 70 More than 70
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A lump sum distribution may be desirable for retirement planning purposes, but the distribution may be large enough to push most of it into the highest tax bracket. In determining the tax on a lump sum distribution, the first step is to calculate the taxable amount of the distribution. The taxable amount consists of (a) the total value of the distribution less (b) after-tax contributions and other items constituting the employees cost basis. If employer securities are included in the distribution, the net unrealized appreciation of the stock is generally subtracted from the value of a lump sum distribution.
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In general, the income tax treatment that applies to death benefits paid to beneficiaries is very similar to that of lifetime benefits payable to participants; however, more favorable treatment applies to spouse beneficiaries than to other beneficiaries. Either the annuity rules or the lump sum special tax provisions may be available to the beneficiary receiving a death benefit. However, an additional income tax benefit is available, in that if the death benefit is payable under a life insurance contract held by the qualified plan, the pure insurance amount of the death benefit (Total life insurance benefit Cash Value) is excludable from income taxation.
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