RETIREMENT PLANNING

Retirement planning has become among the most important of a person's financial considerations, for several reasons. First, life expectancy has drastically increased. Where workers once had to survive for 5 to 10 years on retirement income, today's citizens can reasonably expect to live for 15 to 19 years after retirement. And because of lengthened life expectancy for men and women, the age at which Social Security can be collected has gradually been raised, meaning Americans will need to work longer before any benefits can be collected.

Inflation is another important factor in planning for retirement. At 6 percent inflation per year, what cost $1,000 in 1999 would cost $4,292 in 2024; or in 2024, $1,000 would have the purchasing power of $233 today. Money must be invested in places it can achieve the growth necessary to support the increased expenses that will be encountered at retirement age. And taxes make it difficult to keep returns on investment from diminishing. An investment that earns 5 percent actually loses money once taxes have been paid on the interest and inflation has been accounted for. At 6 percent inflation, taxpayers in the 28 percent tax bracket need to earn 11.1 percent on investments to realize a 2 percent gain. Because of statistics such as these, tax-deferred investments and retirement plans have become increasingly important to retirement planing.

In the late 20th century Americans were also accused of having a faulty view of how their retirement is likely to be funded. Most Americans between 45 and 64 expected their pensions to cover the majority of expenses after retirement, followed by Social Security and personal savings. For most retirees over the age of 65, however, personal savings is the primary source of income, followed by any money earned post-retirement, and then pension plans. The Social Security Administration estimated that personal savings, including individual retirement accounts (IRAs) and 401(k) plans, would account for 44 percent of retirement income for those retiring between 1994 and 2004. Social Security ranked fourth in total annual income for retired persons, according to the U.S. Department of Health and Human Services. And debate continues over whether Social Security will even be available as retirement income for the youngest members of the current workforce.

GROWTH OF RETIREMENT PLANNING

Retirement is defined by Barron's as "leaving active employment permanently, for the remaining years of life, with income being provided through Social Security, pensions, and savings." Retirement age is the earliest age at which an employee can retire and receive full benefits, and is usually determined by age and length of service at a company. Some individuals choose early retirement, leaving active employment sooner than would normally be the case. This can be done as long as minimum age and service requirements are met, but often results in a proportionate reduction in benefits. Some might choose to defer retirement for some time (without a corresponding increase in benefits, usually), and some companies actually enforce automatic retirement when certain milestones have been reached.

Retirement benefits have been available to employees in the United States for a number of years. Private pension plans in the United States are a result of the Industrial Revolution in the late 1800s, as the industrial base shifted from agriculture to manufacturing. The Social Security Administration was created in the 1930s as a part of Franklin D. Roosevelt's New Deal. Shortly after the creation of Social Security, private pension plans grew, offering tax-deferred retirement income to millions of employees. Additional, subsequently introduced options for tax-deferred savings include the 401(k) plan, introduced in 1981, and IRAs, created in 1974. The insurance industry also began billing certain types of life insurance policies as retirement planning options, selling "whole life" and "variable universal life" policies which offered tax-deferred growth that would also be nontaxable upon withdrawal.

To provide a similar tax-deferred option for the self-employed, the Self-Employed Individuals Retirement Act was enacted in 1962 through the efforts of New York Congressman Eugene J. Keogh. This act established tax-deferred retirement plans—known as Keogh plans—with withdrawals starting between ages 59.5 and 70.5 years. The plan is for the self-employed and those who have income from self-employment on the side (freelancers, moonlighters, etc.).

RETIREMENT PLANNING VEHICLES

SOCIAL SECURITY.

Social Security was conceived as a government-sponsored means of ensuring older U.S. citizens would be able to meet minimum retirement and medical insurance expenses. Employers and employees both contribute equally to the Social Security system throughout an employee's work life. Once the minimum age is reached, most U.S. citizens can begin withdrawing from the Social Security system. In 1998 reduced benefits were available at age 62, and full benefits could begin as early as age 65. The amount paid to each person depended on the amount contributed (earning levels) and whether the recipient was married or single. The amount paid is also adjusted for inflation when payment occurs. The age at which full benefits would be available was increased by a couple of months for each year after 1938 that a person was born. Those born in 1960 or later would not be eligible for full Social Security benefits until they reach 67. (Eligibility for Medicare, however, remained at age 65.)

PENSION PLANS.

Defined-benefit and defined-contribution plans are both common examples of "retirement plans," all of which are considered "pension plans." These can be set up by corporations, labor unions, governments, or other organizations to provide retirement benefits. In defined-benefit plans, employees are entitled to specified payments at retirement, the amount having been determined by the employee's pay level and length of service. Money for these funds is set aside in a group fund, with no separate accounts for individual employees. Defined-benefit plans must conform to minimum funding and insurance requirements as set through the Pension Benefit Guaranty Corporation (established by the Employee Retirement Income Security Act of 1974), which can administer plans and place liens on corporate assets for non-funded pension liabilities. Generally, employees must become "vested" over a period of five years to be eligible for these benefits.

Defined-contribution plans are those in which an employee has his or her own account and both employer and employee contribute to the plan, usually an amount calculated as a percentage of the employee's pay. Contributions and interest earned accumulate in this account either until retirement or until an employee rolls the balance over into a different account with a new employer. Before being paid out, pension funds are usually invested in stock and bond markets. For both plans, maximum contribution rates are set for pretax dollars to avoid retirement plans becoming tax shelters for the most highly paid contributors. In the 1980s and 1990s, defined-benefit plans lost popularity in favor of defined-contribution plans, most commonly 401(k)s and 403(b)s. This is probably due in large part to similar changes in the U.S. corporate climate; more options were made available to employees, along with more control and additional responsibility for making decisions.

Perhaps the most significant difference between defined-benefit and defined-contribution plans is the voluntary nature of the latter. Defined-benefit plans are generally automatic, reserved for union and salaried employees. Defined-contribution plans are fully voluntary plans in which an hourly or salaried employee elects to have a certain percentage of money deducted—before taxes—from the paycheck. Adding to the financial pressure on employers resulting from defined-benefit plans, nondiscrimination rules were enacted in 1996. These rules state that public sponsors must offer the same benefits to all employees regardless of compensation. Many state and local municipalities moved to defined-contribution plans to avoid this new mandate. Also, the voluntary nature of defined-contribution plans makes detractors wonder if ill-informed employees will have less money at retirement than if the defined-benefit plans had been available.

THE 401 (K).

The 401 (k) is a defined-contribution plan introduced in 1981; more than $1 trillion rests in 401(k) plans. The popularity of 401(k) and 403(b) plans is partially attributed to the ease with which such plans can be set up in comparison with defined-benefit plans; employees decide how to invest funds within a given set of options defined by the employer. Employees are allowed to contribute up to $10,000 each year to 401(k) plans, all of which is tax deductible, as are earnings accumulated in the plan. Most plans allow contributors to select which of several offered investment vehicles they would like to place their money in, such as mutual funds, company stock, and government bonds. An additional benefit of these plans is that companies often match voluntary employee contributions, meaning that by participating in company-sponsored 401(k) plans employees already realize significant financial growth.

Contributions to 401(k) plans are subject to penalty if withdrawn before age 59.5, unless the withdrawal is due to death or disability. Loans can be made against these plans, but employees must generally pay themselves back, with interest, and stand to lose—temporarily, until the loan is paid back in full—whatever earnings that money would have made had they left it in the 401(k). If an employee leaves the company, 401(k) balances (once vested) can be rolled over into IRAs or other 401(k) accounts. 403(b) plans work very similarly to 401(k) plans, but are available to educational institutions and other nonprofit organization.

KEOGH (HR-10) AND SEP PLANS.

Keogh plans were designed for self-employed people to save for retirement with the same tax savings as employed workers. Keogh plans offer benefits such as tax-deferred contributions and earnings and income-based contributions, just as standard pension plans do. In order to contribute, the contributing "business" must show a profit and demonstrate that it does not discriminate against other employees. The Keogh plan allows contributors to invest in stocks, bonds, precious coins, annuities, and cash value life insurance, and is available to all fulltime employees of that person's business. Contributors are generally subject to vesting, which occurs after five years of full-time service (partial vesting can occur earlier). Withdrawals are subject to a 10 percent penalty plus income tax if taken before the age of 59.5.

An alternative option to the Keogh plan is the simplified employee pension (SEP) plan, which is easier for small businesses or self-employed individuals to administer. Up to 15 percent of pay can be contributed for each employee, and contributions are tax deductible from pretax profits. Income earned by SEP plans is tax deferred, but the maximum contribution is $22,500 per year, compared to $30,000 for Keogh plans. Any kind of business can open an SEP, and contributors do not have to wait to be vested. SEP plans are subject to the same early withdrawal penalties as Keogh plans, however.

INDIVIDUAL RETIREMENT ACCOUNTS.

Individual retirement accounts (IRAs) were created in 1974 by Congress to encourage retirement savings on the part of individuals. Any person who makes below a certain income level can contribute up to $2,000 tax-free each year to IRAs, with a 6 percent penalty on additional money that is contributed. All earnings, however, are tax deferred. Since IRA contributions are made by the individual, and are not part of a company-sponsored plan, no vesting in required. Also, IRAs can be opened by anyone, even if self-employed. IRA investment options are selected by the person opening the account, and money may be placed in stocks, bonds, or mutual funds.

Except for allowable exemptions (such as death or disability), money invested in IRAs cannot be withdrawn until the contributor reaches the age of 59.5; early withdrawals result in a 10 percent penalty (as well as income tax) on the withdrawal amount. Once withdrawals begin, they are treated as ordinary income and taxed as any other income received. After a person reaches the age of 70.5, contributors must take minimum withdrawals or pay a 50 percent penalty (plus income tax) on the IRA.

In 1998 Congress authorized the Roth IRA, which differs substantially from the traditional IRA. While single people must make less than $40,000 to utilize the advantages of a traditional IRA, the Roth IRA allows contributions by single people making up to $110,000. In addition, money placed in a Roth IRA can be withdrawn anytime after the account has been opened for at least five years or the person is 59.5 years old, and allows for contributions to continue after the age of 70.5. Roth IRA contributions, however, are not tax deductible. Also, if money from a Roth IRA is rolled over into a traditional IRA, the proceeds are taxable.

LIFE INSURANCE.

Many life insurance companies are now billing their policies as retirement planning vehicles as well. While standard term life insurance policies are by far the cheapest option, they offer no financial reward for paying into the policy. But other policies—such as whole life, universal life, and variable universal life—offer options for cash growth, customized investment, and the ability to make cash withdrawals after the policy had been in effect for a specified period. These also pay the face value of the policy in full in case of death. While life insurance premiums are paid with after-tax dollars, investment earnings are not taxed, nor were withdrawals taken upon retirement as of 1999. While not as beneficial to retirement planning as pension plans, to which contributions can be made before taxes (and to which the employer and employees contribute), these policies are another potential tax shelter for people who have already maximized 401 (k) and pension contributions.

INVESTMENT VEHICLES

Once a person selects an IRA, 401(k), pension plan, or an investment-oriented life insurance policy, he or she often faces multiple investment options within the given plan. Most plans categorize the various options as growth funds, growth and income funds, income funds, balanced funds, and capital preservation funds. These categorizes indicate the purpose of that fund and how money within the fund will be invested. For example, growth funds focus completely on capital appreciation and invest in corporate stocks that are expected to realize substantial growth rates. These stocks probably fluctuate more than most, but offer the highest potential to increase investment value and outpace inflation. Because these funds stand to "grow" the most in value, they are termed "growth" funds. Growth and income funds also focus on capital appreciation, but also on generating income. They invest primarily in the stock market, but focus on those stocks that will also pay high dividends. These funds also generate high long-term returns.

Balanced funds try to "balance" the goals of income and capital appreciation by investing in both stocks and bonds. The income portion of the fund is derived from the interest paid on bonds, while appreciation is realized when stock prices rise, further increasing the investment's value. Balanced funds have higher returns than income and capital appreciation funds, but do not generally fluctuate as much as growth funds. Income funds focus more on income than appreciation, investing primarily in debt securities that pay interest, such as government or corporate bonds. While values do fluctuate, income funds often produce decent returns, in part by reinvesting dividends. Finally, capital preservation funds seek to stabilize investments, minimizing the risk of losing money on the principal invested. Capital preservation funds invest in securities that consistently earn returns at current interest rates; investment income is automatically reinvested, compounding the investment's value. These funds usually provide comparatively low returns, but the principal witnesses little or no fluctuation.

How much a person should contribute to different types of funds and investment vehicles varies depending on the individual's age and investment style. In general, younger investors can afford to take more risks (potentially realizing more growth) with their money, since it is not an active source of income. People in their 20s through mid-30s should be seeking maximum growth through investment, and can accept short-term volatility in exchange for long-term growth. More simply put, investors in this age group can afford short-term losses in the stock market in order to realize long-term gains. Most retirement plans advise that people between the ages of 20 and 35 place around 70 percent of their investments in growth funds, maximizing long-term growth. The remaining money can be distributed in growth and income or balanced funds and in income or capital preservation funds.

Once people attain the age of 35 and through their late 40s, investments should become slightly more stabilized and less prone to fluctuation. People in this age group, however, still usually have an increasing income, so the amount invested in growth funds need only be reduced by about 10 percent. That money can then be placed in a capital preservation fund to stabilize some of the principal invested. People in their early 50s through early 60s again need to reduce investment fluctuation, but still want to realize growth in their investments. More emphasis is placed on income and capital preservation as retirement grows nearer. Leaving about 40 percent of invested funds in growth funds should maintain fund growth goals, while investing the other 20 percent in growth and income or balanced funds should help reduce volatility.

Finally, for retired persons, investments need to maximize current income and grow only enough to outpace inflation. Little volatility in investment performance is desired, and income is more important as people are likely not actively earning any income on their own. Only a third of the investment amount needs to be placed in growth funds, while more can be invested in growth and income or balanced funds, income funds, and capital preservation funds.

CALCULATING RETIREMENT NEEDS

Determining how much income will be required at retirement is at best an educated guess. There are, however, several "rules of thumb" and many retirement "calculators" available for planning. Kiplinger's Personal Finance Magazine offers a retirement planning calculator on its Internet web site, as does Money magazine. Many advisors recommend having between 70 and 100 percent of pre-retirement income to live on, while others say a minimum of 80 percent will be necessary to maintain a pre-retirement lifestyle. This depends in part on how each person wants to spend his or her retirement years—homebodies will need less to live on than people who plan to spend the bulk of their time traveling. Other considerations include whether the retiree will remain in his or her own home or move to a new domicile. Most expect that expenses such as mortgages, car payments, and college tuition will be behind them at this point, but it may be necessary to plan for such things as well.

In order to complete most retirement planning calculators, a person needs to know how much income they would like each year after retirement; this number will be adjusted to account for inflation. Additional information required to get a good ballpark estimate includes how many more years of work remain until retirement, how much Social Security benefits are expected annually, marital status, value of current savings and assets, annual pension benefits, and life expectancy. This information is used to calculate the dollar value of assets needed at retirement. All of these together, in combination with information about each person's individual investment style, help illustrate how much that person needs to save by the time they retire, how much they need to save each month to attain that goal, and the best way for them to go about doing so.

Every person in the United States is entitled to Social Security and Medicare benefits. The Social Security Administration provides information on personal earnings and benefit estimates to anyone requesting the information. This can be done by contacting the agency directly via phone, mail, or through its web site. Obtaining accurate figures greatly aids in effectively calculating retirement resources and needs. Another benefit people will need to quantify is their pension. Many companies distribute annual benefits statements describing how much each employee has earned toward their pension at a given point and how much they can expect to receive as income at retirement based on their time invested in the company up to that date.

When planning and investing for retirement, it is important to assess current and future financial goals, i.e., how much money needs to be liquid or available at present, and how much can be invested for future use. This is important because many retirement plans assess penalties for funds withdrawn before the age of 59.5 years. If funds will be needed to purchase a home or meet educational expenses, an appropriate amount of money should remain where it can be readily accessed.