December Cover Story

We’re Not in Kansas Anymore

Factors from higher taxes to  low stock market returns are creating the perfect storm for retirement planning. Help your clients prepare now.

Higher taxes. An aging population. Less wealth due to the stagnation of the stock market over the past decade. And flat—or lower—real estate prices. 

All of these elements have come together to create the perfect storm for retirement planning. And the national anxiety over building a retirement nest egg will only increase as Congress is finally forced to wrestle with the remedies needed to shore up the Social Security system. In the past year, Americans have watched from across the ocean as a number of European countries experienced upheaval and protests as they took measures to perform triage on national retirement programs. In October, France experienced mass protests and demonstrations as the government attempted to implement an increase in the minimum retirement age from 60 to 62.

Under this backdrop, how acute is the problem of adequate retiree income? U.S. households with workers in their peak earning years face an astounding $6.6 tril­lion gap between the money they will need for retirement and the money they will have, according to a new analysis by the Center for Retirement Research at Boston College. According to the findings, about 70 million American households with peo­ple between ages 32 and 64 will be short $6.6 trillion—an average of about $90,000 per household—to live comfortably in retirement. The analysis took into account major sources of retirement income and assets: Social Security, traditional pension plans, defined contribution plans such as 401(k) plans, personal savings and housing values. However, it didn’t factor in health care costs.

Shift from Macro to Micro Saving Strategies

Why does the challenge of saving for retirement seem more daunting than ever? In part, it’s because of a shift in the tools people use to save. With the anticipated changes coming to Social Security, it is more important than ever that people save for retirement through tax-efficient vehicles such as a 401(k) plan or IRAs (including Roth IRA).When those accounts are maxed out, clients should save through tax-deferred savings vehicles such as tax-deferred annuities and life insur­ance. Of course, if a person is covered by their employer’s defined benefit pension plan, that tool provides a meaningful and predictable stream of retirement income. Unfortunately, the cost, complexity and tax rules have chilled the environment for defined benefit plans which were a primary source of retirement income for people who were part of the “Greatest Generation.” In a defined benefit plan, the employer funds a future benefit based on the benefit formula and other factors such as the participant’s age, the plan’s assumed investment return, turnover and other related considerations. Since these plans pay a monthly benefit for the employee’s lifetime, plan sponsors can spread investment and mortality gains or losses (i.e. people living longer or shorter than assumed) over all the participants in the plan, which should approximate the plan’s long-term assumptions. In a sense, a defined benefit plan uses a macro approach in managing the plan and the participants who receive benefits are not affected by investment gains or losses. That makes planning for retirement income much easier to accomplish.

The problem with defined contributions like 401(k) plans is that each participant is taking a micro approach to the plan. As a result, it is hard for employees to determine a current contribution to their 401(k) plan that will generate adequate funds for their desired standard of living in retirement. On an individual basis, each person needs to estimate their future earnings outlook, the long term rate of inflation, their average investment return, the age at which they will retire and how long they will live past retirement. Some of these assumptions can be simplified down to an inflation adjusted rate of return (i.e. 3%) and future salary increases in excess of inflation (i.e. 2%). For example, imagine a person who was age 50 in 2000 developing what appeared to be real­istic assumptions at that time. It would have been very reasonable for a client to assume a long-term 8% annual invest­ment return, an annual increase in home values of 3%, salary increases averaging 4% and retirement at age 65. In actuality, depending on the asset allocation in their retirement plan, for the past 10 years that same client may have averaged 4% in return, seen no home value increase and may have had to take a pay cut two years ago or even have lost their job due to the recession. Most likely, retirement at age 65 is no longer viable.

New Environment, New Plan Structure

Agency principals have most likely seen the value of their agency increase during the first half of the past decade but due to the prolonged soft market, the value has probably stagnated over the past several years. Also, due to the financial crisis of 2008, the rate of bank acquisitions has decreased substantially, affecting demand among buyers and depressing the prices paid for independent agencies. And, with rising capital gains rates scheduled for 2011, the after-tax proceeds realized on the sale of the agency will decrease. Have you revisited your agency’s perpetuation plan or exit strategy?

In short, since most independent insur­ance agencies do not have a defined benefit plan, principals need to take a critical look at the agency’s retirement plan to see if it still accomplishes their objectives. “We’re seeing a definite uptick in agency principals wanting to review their retirement plans from a plan design and investment stand­point,” says Tom Fleck, Big “I” director of retirement consulting and marketing. “Two out of every five independent insurance agencies do not have a retirement plan in the agency. That is unfortunate because retirement plan rules have become more flexible, yet many independent agency principals do not realize that and don’t take advantage of this option.”

Many agency principals and business owners at large are already feeling squeezed by reduced operating margins and might think they don’t have the funds to establish a retirement plan or make changes to exist­ing retirement plans. Studies have shown that employees age 40 or older are most concerned about the age at which they can retire. In fact, the primary reason that employees of small businesses leave to join larger employers is not for higher pay, but for better benefits. Independent agencies in more rural settings may find it difficult to compete with their local governments for people with good technology and commu­nication skills, as they typically have more generous retirement and health insurance benefits. That is all the more reason for agencies to review compensation and pay practices in order to compete for talent. More employers are also turning to volun­tary benefit programs to fill the gap, even if they pay some or none of the costs.

 Get Started Now

Out of the turmoil of the past decade, there is an opportunity for agencies to review their own benefits packages and also assist commercial clients in the same process. While there will continue to be a tension between the desire to sponsor meaningful benefit programs and reining in expenses, successful companies will be able to navi­gate through the rough water—with the help of an independent insurance agent.  

Dave Evans (dave.evans@iiaba.net) is a certified financial planner and an IA contribut­ing editor.

Costs going Up, Cola stays Flat

One important benefit that many retirees count on is the Cost­of-Living-Adjustment (COLA) to monthly Social Security benefits. Over the past decade, the average yearly increase has been in the 3% range, yet for 2010 and now for 2011, due to the low rate of inflation for the factors the government measures, there will not be any increase in Social Security benefits. Yet medical cost inflation— which impacts many retirees—continues to increase. In fact, the amount retirees pay for Medicare Part B premiums has gone up significantly and retirees with higher retirement income now have to pay dramatically more than in the past.

—D.E.

Taxes Head North

Another factor heading into 2011 is that it marks the end of the “Bush tax cuts.” The tax cuts are expiring because the tax legislation was passed in 2001 with less than 60 votes in the Senate and thus was passed using the reconcili­ation process. This legislative legacy ties back to the so-called “Byrd Rule” (named for the late Senator Byrd) which requires a 10-year sunset of any provisions that would increase the deficit beyond 10 years after the reconciliation measure, unless made permanent by Congress. Without action by the Congress and presi­dent, the result is higher tax rates for wages for higher-paid people, and an increase in the tax rate for capital gains and dividends.

--D.E.