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- Chapter 12
Retirement Planning
1
- Chapter Goals
Recognize the importance of planning for retirement.
Evaluate retirement savings structures.
Weigh the advantages and disadvantages of
pensions as compared with personal savings
vehicles.
Summarize the retirement planning process.
Identify and describe the risks that can affect
retirement planning.
Contrast pre- and postretirement alternatives when
shortfalls in capital needs become apparent.
2
- Overview
The retirement planning process:
– Familiarize yourself with retirement issues.
– Develop goals.
– Become knowledgeable about retirement structures.
– Asses types of retirement assets and alternative structures.
– Analyze retirement risks.
– Decide on retirement investment policy.
– Calculate retirement needs.
– Finalize plan and implement.
– Review and update.
3
- Familiarize Yourself with Retirement
Issues
The concerns of retired people are assigned a
relatively high priority by the working population and
the government.
Per capita spending by the government on the
elderly substantially exceeds that for the rest of the
population.
The average age of retirement has declined from 67
in 1950 to 62 in 2000.
4
- Familiarize Yourself with Retirement
Issues, cont.
Labor force participation rate (percent)
Age Men Women
1960 2000 1960 2000
40-44 95.4 92.1 45.3 78.7
45-49 94.5 90.1 47.4 79.1
50-54 92.0 86.8 45.9 74.1
55-59 87.7 77.1 49.7 61.2
60-64 77.8 54.8 29.4 40.1
65 and older 30.6 17.5 10.4 9.4
Labor participation rate of
population 16 years and older 80.4 74.7 35.7 60.2
Source: Richard Johnson, “Why the ‘Average Age of Retirement’ is a Misleading Measure
5 of Labor Supply,” Monthly Labor Review 124, no.12 (December 2001), 38-40.
- Familiarize Yourself with Retirement
Issues, cont.
The quality of life of the elderly has risen absolutely
and probably relative to the average worker.
The elderly are expected to rise from 15 percent of
the population in 2000 to 20 percent in 2030.
This greater concentration of retired people is
projected to create a shortfall in Social Security
pension resources.
Medical costs are rising at a faster pace than overall
inflation, which adversely affects the elderly on fixed
cost pensions and government funding to assist in
6 medical cost reimbursement.
- Develop Goals
What do you want retirement to look like? Will your
overall living costs go up or down? When do you
want it to happen?
Most wish to retire sooner than later. However, a
significant number view retirement as something you
do when you are unable to continue working.
In planning, many people select an early retirement
or financial independence date that can provide them
with the option of retirement at that time and also
better accommodate a forced retirement due to
7
health or company layoffs.
- Pensions
Retirement structures: Financial frameworks such as
pensions, annuities, and Social Security that are
established specifically for retirement.
Pensions: Savings structures into which money is
deposited to generate income for retirees. Include
both private and government pensions.
Private pensions:
– Used to be largely limited to fixed monthly retirement sums
set by companies.
– Sometimes heavily weighted toward highly compensated
workers and those who had worked for a company for many
8 years.
- Pensions, cont.
Vesting: The point at which an employee is entitled
to a stated amount of nonrevocable benefits from an
employer.
The U.S. government has mandated that plans be
nondiscriminatory by being open to all workers.
Maximum periods before full vesting were reduced
sharply and generally are no more than six years.
The Employee Retirement Income Security Act
requires that employers act as fiduciaries managing
investment assets in the employee’s best interests.
The Pension Benefit Guarantee Corporation,
guarantees pension assets or income when
companies go bankrupt.
9
- Qualified Plans
Qualified plans: Pension structures that comply with
established government regulations.
– They allow you to place pretax (untaxed) dollars into the
plan.
– This allows you to place a greater sum in the plan, which
results in higher earnings.
– All dividends and capital gains generated while in the
pension plan are tax deferred as well.
– All amounts you withdraw are treated as taxable income
and are taxed at ordinary income rates.
The qualified pension’s combination of pretax dollars
deposited and tax-free compounding is what makes
it such an appealing way of saving.
10
- Qualified Plans, cont.
Two principal types of qualified plans:
Defined contribution plans: Place an amount of money
in the pension regularly. Often portable when you
change jobs or retire.
Defined benefit plans: Provide a stated stream of
income, often a level amount, throughout retirement.
The normal pension by a company or a union offering
yearly income is a defined benefit plan.
Social Security can be considered one as well.
It is the emphasis on end of working period time and/or
salary for calculating benefits in contrast to beginning
of working period contributions that distinguishes
11 defined benefit from defined contribution plans.
- Nonqualified Plans
Nonqualified plans: Pension plans that may be used
for retirement but whose deposits are generally not
eligible to receive a tax deduction.
While deposits are in the plan, investment income
and capital gains are not taxed.
Withdrawals are taxed only on appreciation in asset
values. The original amounts placed in the plan are
not assessed by governmental authorities since they
were taxed prior to their deposit.
The taxable portion of withdrawals is subject to
ordinary income rates.
Two common examples are tax-deferred
compensation and tax-deferred annuities.
12
- Tax-Deferred Compensation
Tax-deferred compensation: Monies that employees
have earned that is not paid out by their employers
until some future time.
In the interim the sums grow tax-deferred.
The amounts may be paid out at a stated date, at
retirement, or over a period of years.
Since tax-deferred compensation is an exception to
the nonqualified pensions after-tax rule, a
requirement of these plans is that the employee be
subject to risk; if the employer goes bankrupt, the
employee becomes a general creditor of the
company.
13
- Tax-Deferred Annuities
Tax-deferred annuities: Savings vehicles that allow
for retirement or other purposes; after-tax deposits
grow tax-free until monies are withdrawn.
Withdrawals are taxed only to the extent of income
and gains on original deposits.
If not withdrawn by death, all gains over original cost
are subject to tax at ordinary income rates.
Tax-deferred annuities can be separated into fixed
and variable types.
– Fixed annuities: Provide an interest rate that is established
by the issuer and often changes annually.
– Variable annuities: Offer a range of investment choices to
be selected by the purchaser, often in stock and bond
14 mutual funds.
- Tax-Deferred Annuities, cont.
Most annuities also have a redemption charge for
liquidation or transfer prior to a fixed period of 5 to 10
years with a declining rate as the period the annuity
is held increases.
Withdrawals of a fixed percentage annually are not
subject to this redemption change.
Annuitizing converts a lump-sum asset accumulated
into the payment of a fixed flow of income per year
based on life expectancy.
15
- Tax-Deferred Annuities, cont.
Advantages Advantages of Competing Explanation or Additional
of Annuity Instrument Information
Fixed Annuities Tax deferral Safety of U.S. government Comparison of returns
Versus CD agency guarantee varies
Fixed Annuities Tax deferral Flexibility in shifting. Comparison of returns
Versus Taxable Lack of Annuity has redemption charge varies
Bond fluctuation for a number of years
in principal
Fixed Annuities Higher Taxfree return1 Highest return often
Versus pretax depends on length of
Municipal Bond return holding period; very long
periods often favor
annuities
Variable Tax deferral Favorable capital gains rates on Death benefit is guarantee
Annuities Guaranteed equity fund, appreciation and of return of original
Versus Mutual death dividends. Higher total expense principal or, in some cases,
Funds benefit ratios and a redemption charge a higher interim amount.
for annuities. Most variable annuities
Limitation on investment choice have total charges of 0.75
16 for annuities.
percent to 2.0 percent.
1
If you buy muni in the state you reside in.
- Social Security
Social Security:
– Principally provides monies to retirees and their spouses.
– Extends benefits to surviving spouses and the family’s
minor children when a wage earner dies before retirement.
– Gives benefits to those who are permanently disabled.
The Social Security system is a blend of two goals.
– To provide retirement payments to individuals based on
their contributions.
– To redistribute income so that all workers may retire at a
minimum standard of living.
Advantages: Overhead costs at less than 1 percent
of payouts and its form of forced savings.
Disadvantages: Discourages savings and work and
17 provides a low rate of return on investment.
- Social Security, cont.
Social Security is a mandatory system that is funded
by a payroll tax on both employers and employees.
Each pays a tax of 6.2 percent on a maximum of
$84,900 in 2002 and a Medicare tax of 1.45 percent
with no maximum.
In order to be eligible to receive full retirement
benefits you must have completed 40 quarters
equivalent to 10 years of work.
Benefits are linked to the amount of contributions.
Spouses receive the greater of their own work
contribution or 50 percent of that of the sole or other
wage earner. If the wage earner passes away first,
the surviving spouse payout is raised to 100 percent.
18
- Social Security, cont.
Your date of birth determines the percentage you
receive for earliest retirement at age 62.
It ranges from 70 percent to 80 percent, depending
on the date you were born, and rises proportionately
the longer you wait until retiring.
If you wait until after your normal retirement age to
start taking payments, they will rise by 4.5 percent to
8 percent a year until you are age 70.
There is no incentive to delay payments beyond age
70.
In addition, no further payroll taxes are taken out of
wages at age 70 and beyond.
19
- Social Security, cont.
Birth Year Year Worker Attains Age Normal Retirement Age
62
1938 2000 65 + 2 months
1939 2001 65 + 4 months
1940 2002 65 + 6 months
1941 2003 65 + 8 months
1942 2004 65 + 10 months
1943 2005 66
….. ……
1954 2016
1955 2017 66 + 2 months
1956 2018 66 + 4 months
1957 2019 66 + 6 months
1958 2020 66 + 8 months Source: Tax Partners and
Professionals of Ernst &
1959 2021 66 + 10 months Young LLP. The Ernst &
Young Tax Guide.
1960 2022 67
Hoboken, NJ: John Wiley &
20 1961 and thereafter 2023 and thereafter 67 Sons, 2004.
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