Magic 'Cull'

Participant education meetings have long touted the “magic” of compounding; that apparent miracle of finance whereby income earned on investments becomes part of an account balance, and earns more income that in turn adds to the account balance, which earns more income, and so on. The net result, of course, is that at the end of a savings career, you wind up with a lot more money than you ever thought possible.

The funny thing is, I’ve known about this magic for so long, I had almost forgotten how impressive the results could be. Or had, until Russell Investments published a short paper with a long title— “The 10/30/60 Rule: Where Do Defined Contribution (DC) Plan Benefits Come From? It’s Not Where You Think.” This paper wasn’t about compounding per se—if it had been, I doubt that I would have taken the time to read it. In fact, now that I’ve brought up the subject of compounding, you may have already gone on to other things—but stick around.

We all know that compounding is a good thing—something that works on our behalf even when we aren’t doing anything. Sort of like having a good metabolism that keeps your portfolio in fighting trim without requiring any physical exertion (I still remember those days fondly). As a consequence, we tend to take it for granted.

“Post” Script

However, the point of the Russell paper wasn’t the magic of compounding. It was a message about the importance of investment—particularly investment after retirement. How important? Well, important enough that a reasonably simplistic spreadsheet included in the paper showed that nearly 60% of one’s total retirement distribution can come from investment returns attained after retirement (age 65 in the example). How much comes from individual contributions? Well, in the Russell example, a relatively miniscule 10%, and the rest from pre-retirement earnings—about 30%.

Now, to get there, you have to embrace several assumptions—and the paper’s authors are clear on that point. They assumed a 7.8% annual rate of return and applied it consistently over the period in consideration (each year’s contributions were half-weighted). Granted, some might argue that 7.8% is a tad “optimistic,” certainly when one considers that return applied over a 64-year period without interruption (1). However, they also assume a 4.75% annual increase in the contribution. That assumption is doubtless expected to account both for wage increases and deferral growth—but still seems wildly optimistic in a 40-year savings “career.” However, if that is optimistic, then it only serves to accentuate the point of the Russell paper—that investment returns play a significant role in account accumulations (more on that in a minute). The paper’s authors also factor in distributions—again, in a consistent stream—that increase by 3% each year, designed to draw the account balance to $0.00 at age 90.

What that means for the baseline scenario presented is that, if you start by saving $1,000 when you are 25, by the time you get to 65 (under the assumptions noted above), you will have an account balance of nearly $470,000, of which only about $113,000 would have come from contributions. However, the real “magic” is that, by the time the sample participant exhausts his account at age 90 (2), he would have been able to withdraw more than $1.1 million. In other words, even after money starts being drawn from the account—and even after contributions are no longer made—those post-retirement years add nearly $700,000 to that account balance at retirement.

We all know that in the “real” world, nothing moves in a consistently positive direction. Investment returns are generally unpredictable, if not downright volatile; contributions (even “escalated” designs) tend to plateau at some point; and account balances are depleted, for a time anyway, by things like loans and withdrawals. However, the message—that your investments keep working for you even after you quit working—is timeless, and one well worth keeping in mind, IMHO, as we work toward a financially secure retirement.

- Nevin E. Adams, JD

(1)The paper’s authors examined a couple of different investment return scenarios—one where the annual return is 5% and another where it moved from 7.8% to 5% post-retirement. They did not, however, factor in any negative returns.

(2)The paper’s authors acknowledge that 90 is “slightly beyond the average life expectancy,” but explain its usage as a reflection of the need to “build in a margin against the uncertainty introduced by longevity into retirement planning.” However, if death is assumed to occur at age 85, rather than 90, the authors note that the 10/30/60 rule shifts to only 12/36/52.

Conspiracy Theorist

I spent some of my precious three-day weekend perusing Teresa Ghilarducci’s When I’m Sixty-Four, an intriguing title for a book about pensions–or, as the subtitle suggests, “The Plot against Pensions and the Plan to Save Them.”

To her credit, Ghilarducci, an economics professor at Notre Dame, actually offers a serious proposal to provide a more secure retirement income stream for Americans, certainly for lower-income individuals. It is unfortunate, IMHO, that she devotes but a single chapter of the 300-page book to exploring the “plan to save them,” leaving the bulk to “the plot.” A “plot” that includes the complicity and outright scheming of employers, advisers, providers, and even the federal government (well, at least the Bush Administration).

The plan? Well, she gets there by imposing a mandatory 5% FICA-like withholding (yes, in addition to the current one) into a “Guaranteed Retirement Account (GRA),” imposing mandatory annuitization of those benefits (no lump sums, and no ability to pass that “account” along to heirs, though she would allow you to accept a reduced benefit for the ability to include a beneficiary in an annuity stream), doing away with the current tax benefits associated with 401(k)s, and replacing that with a $600 refundable tax credit that would be indexed for inflation.

The “Plot”

As for the “plot,” in Ghilarducci’s view, employers offer defined contribution plans instead of traditional pension plans not because they are preferred by workers (in fact, she rather seems to doubt that) or because they are less impactful to the balance sheet (particularly these days), but simply because they are less expensive (there have, of course, been studies that refute that notion). She decries the 401(k)’s disproportionate benefit to upper-income workers–which apparently results from the reality that they are more likely to actually participate in such programs than are lower-income workers. The Pension Protection Act’s tightened reporting strictures on pensions were, in Ghilarducci’s view, at best an overreaction to a non-existent funding crisis and, at worst, an overt move by politicians who so desperately wanted to promote an individual account system over defined benefits that they effectively legislated it out of existence. Oh–and if you’ve been worried about Social Security funding, you can breath a bit easier. Apparently, the actuaries are notoriously pessimistic, according to Ghilarducci.

In Ghilarucci’s world, the current travails of the nation’s retirement system are not due to the lack of a coherent national policy, the aberration of a voluntary savings system inadvertently converted into THE retirement savings device, or the challenges that a pay-as-you-go Social Security design naturally experiences as it tries to pay for more people going than paying. Instead, it all seems to be the result of some form of Machiavellian plot–and one that, IMHO, is a perspective of someone who has perhaps not spent much time with plan sponsors who agonize over the very issues she seems to think they proactively set in motion.

She doesn’t seem to think that we need a different or additional system simply because the current approach isn’t working for everyone–rather, she seems to see the malicious and deliberate hand of employers in undermining the system (and, it seems, in championing the concept of working in retirement. “Working ‘retirees’ help manufacture healthy profits,” she says).

The Plan

Little wonder, then, that her solution relegates employers to the role of payroll withholder (she makes an allowance for employer-sponsored defined benefit plans that contribute 5% of payroll each year), while–like many who see government as a necessary part of the solution–advocating what amounts to higher taxes for all, willingly embraces a broad redistribution of wealth, and puts the management of said funds in the hands of the federal government.

Ghilarducci is remarkably sanguine, IMHO, about the funded status of Social Security and pension plans generally (though, as I have said in this column before, I think too much was made over the effects of the so-called “perfect storm”). She “solves” the apparent tax “inequities” of the voluntary savings system by imposing a new FICA-like withholding on everyone. However, 5% withholding alone wouldn’t be enough to do the trick––and that’s where the pooling comes in, and where, like Social Security today, if you die early, your “account” is simply assimilated into the broader pool. The financial risks attendant with the program’s guarantee? “Borne by the government, not by the worker,” she explains–as though the government has a funding system independent of those workers.

I think most Americans would find the Ghilarducci proposal problematic. People who can save for retirement today but don’t ostensibly have reasons (or excuses) that would be impeded by the 5% mandatory tax. Those who currently have and appreciate the tax benefits of their 401(k) would surely hate to see that disappear (one wonders what would eventually happen to those workplace retirement plans and/or company matches if such a universal system were in place). While Ghilarducci takes pains to distinguish the GRA from Social Security, those distinctions will be invisible to most workers, and with good reason. Moreover, once the federal government gets its hands on that money, it’s hard to imagine that Congress won’t find other ways to spend it (one need look no further than how the original purpose and withholding rates of Social Security have morphed to today’s design to appreciate the potential).

We do need solutions beyond what is available today, IMHO–and Ghilarducci’s proposal will, and should, certainly contribute to the discussion. However, I think that discussion would be better served with less emphasis on the alleged conspiracies—and more on the theories that will truly make a difference.

- Nevin E. Adams, JD

You can check out a paper that was a precursor to the book HERE

The Rest of the Story

Last week, AARP published a report on how economic worries are impacting Americans.

The report, aptly titled “The Economic Slowdown’s Impact on Middle-Aged and Older Americans", "revealed” what seems obvious to most—that a large majority of Americans think the economy is in trouble (even though most respondents’ personal lives seem largely unaffected) and that, as a result, some are making adjustments in lifestyle (things like vacations and eating out), saving, investing, and retirement plans.

In fact, the headlines—including ours—tended to focus on the fact that more than one out of four (27%) workers age 45-64 say they postponed plans to retire, and nearly as many reported they are prematurely taking money out of their 401(k)s and other investments (see “Delayed Retirement, Early Withdrawals Result from Economic Downturn”). Another interesting data point was that 27% said that recent stock market losses had led them to start putting less in their retirement accounts.

That anyone is cutting back on savings is disconcerting, of course, since, by and large, people seem not to be saving enough as it is. But, “buried” in the survey data was another interesting data point: Nearly as many—25%—said that because of losses (or despite them) in the stock market, they were actually putting MORE of their income in retirement accounts.

The real point in all of this, of course, may be that—while they are concerned about the economy (though even in this survey, most Americans haven’t been impacted directly)—most haven’t made any significant changes to their retirement preparation habits. According to the poll, 77% haven’t changed their minds about retirement timing; nearly half were saving exactly the same amount before the market turmoil as now. In fact, if you take that latter group, and add in the group that has stepped up their savings, the headline could—and perhaps should—have been “Americans Cut Back on Eating Out—But Still Saving.”

As noted above, that wasn’t the focus of the coverage—not even ours. Discerning motivations is a tricky business, particularly when those motivations are as varied as the individuals covering these surveys (or the editors looking over their shoulders). It is, perhaps, natural to assume that a slowing economy would inexorably lead to a reduction in savings—and, in fairness, those cutbacks were highlighted in the press release that accompanied the survey’s release. And, lest we forget, there was absolutely nothing misleading in acknowledging the reality that a significant minority had, in fact, cut back on their retirement savings.

There’s an old journalistic maxim that says “if it bleeds, it leads.” It’s the reason why the teaser for the nightly news is about murder, a horrific fire, or a natural disaster—and you can’t just blame that on the news producers. They may not be giving us what we “want” when they do so—but they are, in fact, giving us what we tune in to hear about. Crudely put, it’s the kind of thing that sells papers (or Web clicks).

Still, we owe it to ourselves—and those we support—to look for “the rest of the story.”

- Nevin E. Adams, JD

One More Thing To Do

Last week, the Connecticut legislature didn’t get around to voting on a bill that would have effectively set up a state-sponsored 401(k) plan for small businesses (see CT State 401(k) Plan Proposal Dies as Session Ends). Proponents—which included AARP—claimed that the legislation would save businesses with fewer than 100 workers a lot of money, basically by allowing them to pool their plan investments—a pool large enough to provide the negotiating power that small businesses generally lack on their own (workers would have individual accounts and be able to choose from various investment options, while employers could contribute a percentage or set up a program to which employees would contribute).

Opponents—which included the Connecticut Business and Industry Association (CBIA), the Connecticut Bankers Association, the Insurance Association of Connecticut, the American Society of Pension Professionals and Actuaries (ASPPA), the Council of Independent 401(k) Recordkeepers (CIKR), and the Small Business Council of America (SBCA)—refuted that cost-saving claim. Cost-effective alternatives exist already, they said, in the form of SIMPLE IRAs. Moreover, they were doubtful that the projected cost savings would actually occur under the new design. And, of course, they also were concerned about the “competition” resulting from such a program for their members.

In comments submitted on behalf of ASPPA, CIKR, and the SBCA, Michael Callahan, founder of Southington, Connecticut-based third-party administrator Pentec, Inc., said, “If an employer doesn’t want to set up a retirement plan, it is generally either because the employer is not educated about available options, or the employer does not want to commit to making contributions for employees each year.”

Now, one can hardly argue that small business owners are, as a rule, intimately familiar with their retirement plan options, and surely there are any number of them who are not comfortable committing to making contributions every year. But, IMHO, neither of those is a major impediment to adoption of these programs by small businesses.

Fees Matter

And, despite the assertions of those opposed to the Connecticut proposal, I do think fees are an important issue, though perhaps not a central concern. These days, it’s not unusual for even moderate-size plans to be able to pay no explicit fees, courtesy of revenue-sharing offsets. However, smaller programs—particularly start-ups—are confronted with different realities; frequently forced to embrace proprietary fund solutions, and fund solutions of higher-priced mutual fund share classes, in addition to explicit administrative charges. However, for the very most part (explicit fees are always a complication), these “extra” charges, while real, are drawn from the participant investment accounts, not the employer’s purse (business owners frequently overlook the fact that theirs is the largest balance—and thus the largest “contributor”).

There are other noteworthy impediments: A fear of getting sued by participants looms larger every day (even though the plaintiff’s bar seems focused on more lucrative targets), not to mention concerns about the time and energy associated with keeping up with these programs. Indeed, IMHO, one of the biggest impediments to small-business adoption of these programs was noted in Callahan’s comments arguing against the proposal. “The ERISA rules, and Internal Revenue Code non-discrimination requirements, are designed to protect rank and file workers. These rules are important—they are also complicated and time consuming.”

While it was cited as a reason to oppose the legislation, that admonition applies with even greater force when it comes to what is required of employers to administer these programs on an ongoing basis.

Those rules and restrictions are, of course, in place for good and valid reasons, and many were put in place to deal with specific, real-world abuses. But the fact remains that offering a qualified retirement plan benefit is neither simple, nor easy—and until it can be, we probably shouldn’t wonder why so many choose not to take on that responsibility.

That’s not to say the Connecticut legislation dealt with any of that, though I’m guessing that it might well have made it easier for small businesses to choose a program, and perhaps one that charged participant accounts less than they would pay outside that model (they may well have paid more in taxes, of course). We often fret about the shortcomings of a system where only three-quarters (or less) of those eligible to participate in a 401(k) do so, and we rightfully worry about the adequacy of the deferral rates of those who do save.

However, the sad fact is that only about half of working Americans today even have the option of participating in a workplace savings plan—and most of the job creation in this nation’s economy comes from small businesses. We need to be creative in order to help make it easier for small businesses to embrace these programs and give those they employ a chance to save for retirement.

It takes a lot of courage, time, and energy to start and run a small business, after all. What small business owners generally aren’t looking for - is one more thing to do.

- Nevin E. Adams, JD

Their Own Devices

There’s been a lot of talk about tax policy of late.

It’s an election year, after all—and while most of the rhetoric revolves around targeting only “the wealthiest Americans,” it’s hard to shake a sense that the impact will be less than precisely targeted.

There’s talk of raising the tax rate on capital gains and dividends, for example—as though only the rich invest in stocks and mutual funds. A prominent presidential candidate talks openly about the fairness of increasing the amount of income subject to FICA withholding, and while it certainly sounds “fair,” that could represent a pretty big tax increase for some decidedly unwealthy families (worse, unless the benefit calculations are adjusted—and it would certainly be most unfair to do so—the move won’t even help the Social Security deficit; we’ll just pay out more in benefits to the people from whom we have now taken more FICA).

Another prominent presidential candidate wants to sever the tie between employment and health insurance, and if he is successful, many in the working middle class who currently enjoy that workplace coverage could find some or all of that benefit taxed—and probably shouldn’t hold their breath waiting for a salary boost to compensate for the loss (even more could simply find themselves with the “opportunity” to shop for insurance on their own). Others have resurrected the notion of imposing a “windfall profits” tax on Big Oil—as though we don’t all know who will actually wind up paying for it (note to politicians: It’s been tried before…it didn’t work).

Complicate Ed

Unfortunately, our economic lives are going to get more complicated in the coming months. We’re not technically in a recession, but regardless of such technicalities, many feel—and are hunkering down—as though we are. Ultimately, of course, perception is reality in such matters—and none of the current U.S. presidential candidates has any real interest in convincing us otherwise.

What that means, of course, is that between now and the election, we’re going to have a lot to fret about. Concerns about the rising cost of—well, just about everything—and anxiety about how the markets (and our 401(k) accounts) respond to that uncertainty will almost certainly continue to be the order of the day. In the months ahead, it’s likely to be harder than ever to keep participants focused on, and committed to, their retirement savings. Frankly, even the well-intentioned coverage and focus on 401(k) plan fees (and not all of it qualifies as “well-intentioned”) serves to undermine participant confidence in these programs.

As a solution, the Democratic candidates are touting payroll deduction plans for retirement savings (Senator Clinton’s are voluntary, Senator Obama would make them opt-out for participants) with government matches of up to $1,000. These solutions, of course, relegate the employer to nothing more than a payroll agent in the transaction (Senator McCain has yet to address the issue).

Doubtless, the ease of payroll deduction will spur some takers (certainly Obama’s opt-out version), but one can’t help but wonder how well-served workers, left to their own devices, will be in the retail IRA market, certainly compared with the structure, guidance, and institutional pricing afforded most employer-sponsored plans. It is a shame, perhaps a tragedy, IMHO, that the candidates have yet to consider the opportunity to provide real incentives for employers to “suit up” as a fiduciary for these programs.

But if there is a tragedy greater than the fact that only about three in four eligible actually participate in a workplace retirement savings plan, IMHO, it is that roughly half of working Americans don’t even have the opportunity.

- Nevin E. Adams, JD