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With the recent turmoil in the financial markets and the full extent of losses for private investors still to be determined, we can at least thank our lucky stars for one thing: The Bush administration’s failed efforts to privatize the Social Security system kept that money out of the hands of Wall Street. That’s not to suggest anyone should expect a monthly Social Security check to provide for all their retirement income needs, but it does raise a few good questions: Are you planning for retirement? What are the risks now? Should I have a fallback plan?
Whether you’re just beginning to explore the subject of retirement accounts, or already contributing to one, we’d like to give you a brief overview. This is not meant as financial advice or even an in-depth study of the subject. But it may spark your interest to conduct your own research or to consult with a professional for guidance on which retirement plan is best for you.
Employer-Sponsored Retirement Accounts Traditional “defined-benefit” pension plans for employees were once the mainstay of large corporations. In such plans, companies set aside money earned from sales so that, at retirement, employees who qualified received a benefit based on a percentage of their final salary. Over time, contributing to these plans proved very costly, especially for employers with a growing population of retired workers.
As a result, many companies have phased out these costly plans, opting instead for defined contribution plans, like 401(k)s. For example in 2006, all General Motors employees who had been on board since January 1, 2001 were switched to a 401(k) plan, saving the company nearly $420 million in 2007. Citigroup and Fidelity Investments, the Boston-based money manager, followed suit.
Today, 84% of U.S. employees are enrolled in 401(k) or similar plans. The relatively new Pension Protection Act makes it even easier for companies to enroll employees in these plans, because it allows for automatic enrollment and eases the legal burdens companies face.
Simply put, after an employee enrolls in a company-sponsored plan, money is deducted from his or her paycheck and placed directly into a retirement account maintained in the employee’s name. There are various plan structures, but they operate in similar ways, and are generally named for the section of the U.S. Tax Code that applies:
• 401(k) plans—private companies
• 457 plans—public and non-profit sectors
• 403(b) plans—education and non-profit sectors
Most 401(k) plans provide for employees to voluntarily contribute a percentage of their gross pay, typically a maximum of six percent. As an incentive for employees to participate, many companies make matching contributions, often as much as 50% of the employee amount. Do the math: If an employer matches 50% of what you contribute, that represents a 50% return on your investment, right off the bat. That’s certainly attractive compared to what you’d earn in a bank savings account.
It gets even better. Payroll deductions contributed to a plan are not taxed, and neither is the investment income earned in your account. That money accumulates in your plan, gets reinvested year after year, and is not taxed at all until you retire (unless you take money out early).
Amounts employees contribute to a 401(k) plan belong to the employee. Employer matching contributions typically “vest” over a period of time, so that after three to five years of service, the entire account balance belongs to the employee. The balance in your account is “portable,” meaning that when you leave one employer and join another, you can transfer your account to your new employer’s plan, if they have one.
Asset Allocation and Self-Direction The majority of 401(k) plans invest in mutual funds and allow employees to decide how their money is to be allocated among a variety of those funds. For example, you can decide to invest, say, 30% in bond funds, 50% in growth stock funds, and 20% in money market funds. And, you can change that allocation whenever you want.
The allocation percentage you choose should suit your personal situation, tolerance for risk, and how close you are to retirement. In general, the closer to retirement age, the more concern there is over preservation of principal (reduced risk) compared to a high rate of return.
Individual Retirement Accounts Many employees opt to roll their 401(k) plan balances into an Individual Retirement Account (IRA) when they leave an employer. IRAs are accounts with tax advantages to help you save for retirement. There are two types of IRAs:
• Traditional IRAs allow you to contribute a portion of your income without having to pay taxes on that amount until you withdraw it. Thus, the money you put into the IRA lowers your taxable income and the value grows tax-free while it's in the IRA account.
• Roth IRAs have slightly different tax advantages, plus there are restrictions on who can open a Roth IRA. The most attractive part of Roth IRAs is that your money is withdrawn without paying federal taxes.
The tax-free contributions you can make to a 401(k) are much larger than those allowed under an IRA, so you can accumulate more money, at a faster rate. That’s especially true if your employer matches your contribution. In addition, 401(k) plans generally have lower service fees. And, thanks to the Pension Protection Act, the benefits remain intact for spouses who outlive the primary beneficiary, unlike previous rules that required the surviving spouse to cash out when the retiree died.
The bottom line is, generally you are further ahead contributing to a 401(k) if you have the opportunity to do so, compared to an IRA — especially if you are some years away from retirement. As you get closer to retirement, consider using both a 401(k) and an IRA. In both cases, you can make larger “catch-up” contributions after age 55. Continued on next tab ... How Much Should You Invest? Here are a couple of points to remember when deciding how much you should invest:
• If you invest 10% of your pretax income starting with your very first job, and if you diligently stick to that plan, the balance mounts over time, you could conceivably accumulate enough savings for your retirement.
• Increase your contributions over time. As your level of earning increases commit to adding some extra cash to your retirement account.
This assumes that you will continue to add to your savings through age 62 and beyond, and that your investments earn at least five percent annually.
Try to take advantage of tax-deferred savings vehicles whenever possible. Over time, savings that grow tax-deferred offer the potential to create a significantly larger nest egg than those held in taxable accounts.
Safety Concerns Investors are more than a little skittish in the wake of the government bailout of Fannie Mae and Freddie Mac, the two government-sponsored home loan banks, the demise of IndyMac, Lehman Brothers, and the eleventh-hour support for AIG.
It’s tough to know when the next shoe will drop. For example, the Federal Deposit Insurance Corporation (FDIC) reports that 117 banks are on its "problem" list, with more likely to fail. That is a significant worry because many banks offer IRA and Roth retirement accounts to customers, and provide investment services to corporate customers with employee retirement plans.
There is growing and legitimate concern about the safety of the money investors have accumulated in retirement accounts. Most everyone remembers the heartbreaking stories about employees at Enron whose 401(k) balances were wiped out when the company collapsed. Less well known is the fact that many employees at Marsh & McLennan, the big insurance broker, lost 50% of the value of company stock in their 401(k) when the company was sued for fraud and self-dealing by then attorney general Elliot Spitzer.
Federal Safeguards in Place Three key factors determine how safe retirement accounts are: the type of account, who manages the account, and how large it is.
The FDIC insures standard bank accounts for up to $100,000. Traditional IRAs or Roth IRAs held in an FDIC-insured bank are covered by insurance up to $250,000.
If your FDIC-insured retirement account exceeds $250,000, or if you’re worried about the bank's financial stability, you might consider moving a portion of the money to some other financial institution—but not without doing a little homework first. The FDIC does not release banks rankings until they’re in trouble, but services like www.thestreet.com offer a free ratings screener.
Another form of protection is offered by the Securities Investor Protection Corporation (SIPC), an organization funded by securities broker-dealers. If your retirement account is housed at a SIPC-member brokerage house, you will be protected. In the event that the brokerage firm fails, the SIPC insures customers' cash, stock and most other securities.
In addition to SIPC, you may have more even more coverage if your account has "excess SIPC" insurance offered by Customer Asset Protection Company (CAPCO), an insurance company created in 2003 for this purpose.
Be aware, though, that your 401(k) plan account balance doesn’t have the benefit of automatic insurance protection. The federal Employee Retirement Income Security Act (ERISA) obligates companies to manage retirement plans prudently, but that doesn’t protect you against losses due to economic turmoil. Even in the Enron case mentioned earlier, the employees who lost everything had invested in a 401(k) consisting only of Enron’s own stock. The only recourse for Enron employees was to file a lawsuit that’s yet to be resolved, and likely to drag on for years.
The Big Picture In the overall scheme of things, there is probably minimal long-term risk to your retirement savings account. It is certainly not time to panic and start putting your money under the mattress. To be on the safe side, and to gain some peace of mind, consider taking these steps:
• Request information from your employer and the fund money managers about the status of your account and how your money is being invested now.
• Consider changing the asset allocation in any self-directed retirement account
(401(k) or IRA) to shift the allocation toward more conservative investments for the time being.
Better still, speak to a professional financial adviser and lay out a comprehensive plan for retirement, based on well-thought-out goals and objectives. It is a sad fact that most people spend more time every year deciding where to go on vacation than they do setting realistic and achievable financial goals.
© 2008 Jose D. Roncal |
