MONEY Social Security

How to Fix Social Security — and What It Will Mean for Your Taxes

As Baby Boomers retire, the Social Security trust fund is getting closer to running out of money, a new study finds.

Last week I explained why I thought it would be a bad idea to close Social Security’s long-term funding gap by simply making all wages — not just those up to the annual ceiling, which this year is $117,000 — subject to payroll taxes, thereby socking it to wealthier workers. That wasn’t a popular opinion among those who feel it only right to raise the levies on the top 1%, or even top 5%.

“When all other sources have been depleted soak the portfolio holders even more disproportionately,” one critic responded via social-media .

Tweets, unfortunately, don’t make great policy arguments. And as Social Security’s doomsday clock keeps ticking, it’s all the more urgent to come up with a balanced reform strategy and act on it. Last week the Congressional Budget Office projected Social Security’s trust funds would be depleted during calendar year 2030—a year earlier than its previous estimate. If this happens, the program could then pay only about three-fourths of its scheduled benefits.

How, then, to close the funding gap? Although I do not want to see the wealthy as the primary bill-payer for Social Security reform, I do think the payroll tax ceiling is set too low. Today that ceiling, which is $117,000 this year, captures about 83% of all wage income, but it used to apply to 90%. The reason for the decline is widening income inequality, as the upper end of the wage scale has soared disproportionately higher.

Raising the ceiling until it once again covers 90% of the nation’s wage income would help, somewhat, to improve Social Security’s finances, the CBO found. The big headline here is that hiking the ceiling to cover 90% of wages would require a huge jump—from a projected $119,400 in 2015 to $241,600. The steep hike is necessary because high-end earners are a relatively small slice of the U.S. population. Even so, raising the payroll tax ceiling, which more than doubles the amount of Social Security payroll taxes paid by wealthier earners, would close only 30% of the system’s projected 75-year actuarial deficit.

You might wonder why we don’t eliminate the ceiling altogether so all wages are subject to payroll taxes. Glad you asked. Eliminating the ceiling would still close only 45% percent of the deficit, according to CBO. Both these projections assume that wealthier people would also see their Social Security benefits increase.

To make a more significant reduction in the deficit, you could limit Social Security benefit increases for the wealthy to only an additional 5% of pre-retirement earnings. In that scenario, along with eliminating the earnings ceiling, we could close nearly two-thirds of the funding gap. Still, as I wrote last week, I think soaking the rich this way is nearly as bad as soaking poorer people. Soaking people is not what Social Security was or should be about. It’s about requiring people to set aside enough money through a mandatory payroll tax to provide them a modest level of retirement security.

For most people the payouts are, indeed, modest. In 2013 a 66-year old who had earned average wages during his or her working life would qualify for lifetime Social Security payments beginning at $19,500 a year. This amounts to 45% of average pre-retirement income. What’s more, most workers file for benefits early, which sharply reduces the level of income replacement.

Yet that’s pretty much how the program was designed, and even these low levels of replacement income have been enough for Social Security to be a spectacular success. Before the program began in the ‘30s, retirees had the highest poverty rate of any age group. Today they have the lowest. (Medicare gets major credit as well.)

Problem is, even as Social Security has worked well, the other parts of the retirement system have fallen apart. The move from defined benefit pensions to 401(k)s and other defined contribution plans has shifted enormous retirement risk from employers to employees, and the numbers show that many aren’t saving enough to meet their goals.

Given the looming retirement shortfall, there has been growing support to expand Social Security benefits, not contract them. That will be tough to do. As the CBO reported last week, under current rules Social Security’s long-term deficits will continue to balloon. Over the next 25 years, program income will amount to 5.2% of the nation’s gross domestic product, while program benefits will account for 6%.

The fundamental problem is the aging of America. As the wave of Baby Boomers moves into retirement, the number of people collecting Social Security is projected to rise by roughly a third from 58 million today to 77 million in 2024—and by nearly 80% to more than 103 million by 2039. By contrast, the work force, defined as people aged 20 to 64, is expected to increase by only 5% by 2024 and just 11% by 2039.

Something’s got to give. Higher taxes, in one form or another, are inevitable.

Philip Moeller is an expert on retirement, aging, and health. He is an award-winning business journalist and a research fellow at the Sloan Center on Aging & Work at Boston College. Reach him at moeller.philip@gmail.com or @PhilMoeller on Twitter.

MONEY retirement planning

Answers to 5 of Twitter’s Most-Asked Questions About Retirement

Following a recent Twitter chat, a retirement expert expands on answers to queries about Roth IRAs, Social Security and more.

The Twitterverse has questions about retirement. What’s the best way for young people to get started saving? Are target-date funds good or bad? Should we expand Social Security to help low-wage workers?

Those are just a few of the great questions I fielded during a retirement Tweet-up convened this week by my colleagues at Reuters. Since my column allows for responses beyond Twitter’s 140-character limit, today I’m expanding on answers to five questions I found especially interesting. You can view the entire chat —which included advice from personal finance gurus from Reuters and Charles Schwab—on Twitter at #ReutersRetire.

Q: What’s the best way for parents to help young adult children save for the long term? How about Roth IRAs?

Roth IRAs are no-brainers for young people. With a traditional IRA, you pay taxes at the end of the line, when you withdraw the money. With a Roth, you invest with after-tax money, and withdrawals (principal and returns) are tax-free in most situations. That’s especially beneficial for young retirement investors, since most people move into higher income-tax brackets as they get older and make more money.

Q: How would you expand Social Security? Any current proposal appealing?

This question was posed during Twitter chatter about the difficulty low-income workers face building retirement saving, and ways to make our retirement system more equitable. Expanding Social Security may fly in the face of conventional wisdom, which argues that rising longevity should dictate reductions in future benefits, not increases. But this is a case where the conventional wisdom is wrong.

An expanded Social Security system is the most logical response to our looming retirement security crisis because of its risk pooling and progressive approach to income distribution. Social Security replaces the highest percentage of pre-retirement income for workers at the low end of the wealth scale.

Several ideas are kicking around Congress. Most would raise revenue by gradually phasing out the cap on wages subject to the payroll tax ($117,000 in 2014) and raising payroll tax rates over a 20-year period. Some advocates also would like to see a surtax on annual incomes over $1 million. On the benefits side, advocates want to increase benefits across the board by 10%, recognize the value of family caregivers by awarding work credits toward Social Security benefits and adopt a more generous annual cost-of-living adjustment formula.

Q: With the myriad questions about retirement, can “live” advisers really be replaced by automated advice and data-driven programs?

Online software-driven services—so-called robo-adviser services – can’t fully replace human advice. But they address a key problem: how to deploy retirement guidance to mass audiences at a low cost. Services like Wealthfront and Betterment interact with clients online using algorithms, with low fee structures—typically 0.25% of assets under management or less.

Another variation on this theme: services that deliver advice through a combination of software and human advice, such as LearnVest. One of the most interesting tech-enabled experiments is Vanguard’s Personal Advisor Services, which provides access to a managed portfolio of Vanguard index funds and exchange-traded funds, along with portfolio management services from a human adviser.

Vanguard charges just 0.3% of assets under management for the service. The service is in test mode with a small group of clients, and only available to clients with $100,000 to invest. The minimum will be reduced when the service expands, and it should be rolled out more broadly over the next 12 to 18 months, a spokeswoman says. Given Vanguard’s huge scale, it’s a venture worth watching.

Q: What’s the final verdict on target-date funds—good or evil?

We don’t have a final verdict yet, but target-date funds (TDFs) are doing more good than evil—though they generate plenty of controversy, confusion and misunderstanding. The general idea is to reduce the risk you’re taking as retirement approaches by cutting your exposure to stocks in favor of fixed-income investments—the “glide path.” But some TDFs glide “to” your retirement date, while others glide “through it.” Experts debate which is better, but you should at least know which type of fund you own.

Many retirement investors misuse TDFs by mixing them with other funds, a recent survey found. These funds are designed as one-stop investment solutions that automatically keep your account balanced; doing otherwise will hurt your returns.

Bottom line? TDFs do more good than harm by automatically keeping millions of retirement portfolios balanced with reasonably good equity-to-fixed-income allocations. And they are the fastest-growing product in the market: Some $618 billion was invested in TDFs at the end of 2013, according to the Investment Company Institute, up from $160 billion in 2008.

Q: Anyone know what the highest Social Security income is for a retiree today versus what’s expected 30 years from now?

This year’s maximum monthly benefit at full retirement age (66) is $2,642. The Social Security Administration doesn’t have projections for future benefit levels, but the answer certainly will depend on how Congress decides to deal with the program’s long-term projected shortfalls. Solutions could include tax increases (discussed above) or higher retirement ages. Boosting the retirement age would mean a lower benefit at age 66.

MONEY early retirement

How to Figure Out Your Real Cost of Living in Retirement

Your retirement savings “number” gets a lot of press. But your expense number is even more important, especially if you retire early.

Many financial advisors say you’ll need some fixed percent of your previous income in retirement—often 80% is considered “reasonable.” But that’s nonsense. What it costs you to live in retirement, or before, is not a function of how much you make! There are millionaires who live like college students, and college students who live like millionaires—for a while anyway, on credit.

Where are you on the lifestyle spectrum? To get serious about retirement planning, you’ve got to have an accurate picture of your monthly living expenses. You need to know your bare minimum or fixed expenses, your average or normal expenses, and your ideal expenses—allowing for some luxuries.

Spending is a personal area, so everyone’s pattern will be different. But on average the first phase of retirement is when you’re likely to spend the most, since you’re finally free to travel, dine out and enjoy other leisure activities. Among older Americans, average annual expenditures peaked at about $61,000 for those in the 45-54 year age range, according to the latest data from the Consumer Expenditures Survey. By ages 55-64, spending dipped to $56,000, and down again to $46,000 between ages 65 to 74. At 75 years and older, average spending was only $34,000, though health care expenses may spike up for many.

We are in our mid-50’s and live a modest but comfortable lifestyle, which currently costs us about $4,500 a month, in addition to housing. We rent a smaller, two-bedroom house (about $1,500 monthly), and share a single gas-efficient car ($370 a month, including gas, insurance and repairs). But we eat well, own some nice things, and have plenty of fun—mostly free or cheap outdoor activities. And our living expenses run about 25% above the national average for our age.

This past year we moved to our ideal retirement location. So we’ve had to spend a bit more than usual due to the relocation. But these have generally been one-time home or personal expenses—not recurring expenses that would inflate our lifestyle forever more.

Health care costs remain a concern, since we are too young for Medicare. Fortunately, I was able to get coverage through my wife’s retirement health plan, thanks to her former career as a public school teacher; we pay $1,100 a month on average for premiums, co-pays, deductibles and the like. That’s one of our larger expenses, but it is manageable, for now. (For more on our spending in early retirement, see my blog here.)

If you’re willing to live in a cheaper area, buy used, and eat simpler, you can probably live on much less than we do. On the other hand, if manicured retirement communities, luxury vehicles, and international travel are your idea of retirement living, you could need quite a bit more. In most surveys of consumer expenses, the biggest items are housing and transportation. So, if you want to optimize your retirement lifestyle, start with your home and vehicle.

Without a complete understanding of how much it costs you to live, your retirement planning can’t get off the ground. The best way to determine your expenses is to actually keep track of them for at least a year, as you approach retirement. You can record expenses using dedicated tools like Quicken on the desktop or Mint on the web, or you can use an electronic spreadsheet or paper journal.

As an engineer, tracking expenses was second nature to me. But what if you aren’t the detail-oriented type? You could estimate your expenses based on those government averages above, but in the long run you’ll need more accuracy to be confident about your own situation.

One approach is to sit down with your checking and credit card statements, and use them to estimate a monthly or annual amount for each important budget category. You can start with this short list: housing, transportation, food, health care, entertainment, and personal expenses. Just don’t forget those less-frequent items such as home and auto repairs, vacations, and property taxes!

Your retirement savings “number” gets a lot of press. But even more important than that is your expense number. Understanding your expenses is a critical stepping stone to building wealth and retiring comfortably. If you still don’t know where your money goes, why not get started today?

Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com. This column appears monthly.

MONEY retirement income

Need Low-Risk Yield? CDs are Back in Fashion

Dollars and cents
Finnbarr Webster / Alamy

Retirees and other people desperate to earn interest can find respectable deals on certificates of deposit.

Getting low-risk yield has been one of the toughest challenges for retirees ever since the financial meltdown of 2008-2009. Interest rates are near zero, and many retirees are nervous about bonds out of fear that rates might jump.

All of which leaves a simple question: How about a good old-fashioned certificate of deposit?

Retirees desperate for yield can find some respectable deals on CDs. The yields may not sound sexy, but there’s no risk to principal and the Federal Deposit Insurance Corporation protects accounts up to $250,000.

There’s nothing new about the higher rates on CDs compared with bonds. Banks, especially those without extensive retail branch networks, have long offered generous rates on CDs, mostly online, as an inexpensive way to attract deposits. It’s also a way for banks to bring in retail clients who can be cross-sold other higher-margin products.

But there’s an especially compelling case to be made for CDs in the current rate environment.

“For retirees, it’s the one corner of the investment world where you can get additional return without additional risk,” says Greg McBride, chief financial analyst for Bankrate.com.

The most aggressive banks will sell you a two-year CD with an annual percentage yield (APY) of 1.25%; compare that with current two-year Treasury rates, now at about 0.48%. Three-year CDs top out at 1.45%, compared with 0.92% on a Treasury of the same duration. If you want to go longer, five-year CDs top out over 2%.

Five or 10 years ago, the high rates came mainly from smaller no-name banks, but that’s not the case now. Some of the more aggressive offers currently come from big names like Synchrony Bank (formerly GE Capital Retail Bank), Barclays and CIT Bank. Bankrate.com lets you search and compare offers.

You could get higher yields on corporate or junk bonds. But they’re risky because the available yield isn’t adequate for the credit risk you need to take, argues Sam Lee, editor of Morningstar’s ETFInvestor newsletter.

“I’d rather be in a five-year CD than a bond fund taking on more duration or credit risk,” Lee says. “If rates do rise, you can lose a whole bunch of money on long-duration bonds — maybe 10 or 20% of your principal.”

The only risk you face locking in a longer CD — five years, for example — is the lost opportunity cost of obtaining a higher rate should rates jump. Lee likes that strategy.

“The interest rate sensitivity is very low, because you can always just get out and reinvest at a higher rate,” he says. “You’ll pay a bit of a penalty, but that is more than offset by the higher rate and value of the FDIC guarantee.”

McBride isn’t convinced rates will jump substantially anytime soon. “The long-awaited rising rate environment has yet to show itself — it might happen next year, or maybe not.”

Still, you should understand CD penalties in case you do need to make a move, because the terms can vary. The most common penalties for early withdrawal on a five-year CD are 6 or 12 months’ worth of interest, says McBride. “The terms can vary widely — some are assessed just on the amount you withdraw, others on the entire investment.”

If you’re worried about opportunity cost, some of the banks offering aggressive CD rates also have attractive savings accounts that let you make a move at any time – although some require a minimum level of deposit to qualify for the best rates. For example, Synchrony will pay you 0.95%. That’s not much less than the 1.1% it pays on a one-year CD – or the 1.2% for a two-year CD, for that matter.

The other option is a step-up CD that boosts your rate if interest rates rise in return for a lower initial rate. But those aren’t easy to find right now, McBride says. “We’ll see those become more prevalent if we get into a rising rate environment.”

No matter how long you go, Lee says, the implication for retirees is clear: Use CDs for the risk-free part of your portfolio and equities for whatever portion where some risk is acceptable.

Equities should help keep your overall portfolio returns substantially above the rate of inflation. The Consumer Price Index is up 2.1% for the 12 months ended in May.

“The U.S. stock market’s expected real [after-inflation] return right now is about 4%,” he says. “The expected inflation-adjusted yield on bonds right now is close to zero.”

MONEY Social Security

Why Taxing the Rich is the Wrong Way to Fix Social Security

ERROL FLYNN as Robin Hood
Errol Flynn, as Robin Hood, leading an early fight against income inequality. WARNER BROS/RGA/Ronald Grant Archive/Mary Evans—Everett Collection

It may feel good to jack up payments by wealthier earners, but Social Security is a safety net, not a tax collector.

How do you categorize the money that comes out of your paycheck to fund Social Security? Do you consider that deduction to be a tax, or a mandatory contribution into a retirement account, or an insurance premium?

For many people, the answer is a tax. That’s what I heard from the majority of readers who responded to my most recent column, “3 Ways to Fix Social Security and Medicare.” It’s an understandable view. After all, the Social Security payroll deduction is commonly referred to as a FICA tax. (FICA is the acronym for Federal Insurance Contributions Act.) And because it’s called a tax, these readers think that Social Security reforms should focus on making wealthier wage earners pay more into the system. Making all wage income subject to payroll taxes would solve between 75% and 80% of the system’s funding shortfall.

I don’t agree with this approach, as I’ll explain. Still, these readers have plenty of company, including some leading critics of Social Security, who argue that payroll taxes are less progressive than the federal income tax. Everyone who works in a job that is covered under Social Security rules pays the same rate: 7.65% of their earned income up to an annual ceiling of $117,000 in 2014; the level is increased annually for inflation. Employers pay another 7.65%. (These totals include 6.2% for Social Security and 1.45% for Medicare.)

The way Social Security’s benefits are designed, at this year’s $117,000 income level, you receive the maximum credit—those earning higher salaries would not qualify for any more benefits. That’s why requiring wealthier people to pay even higher taxes without any additional income would break the implicit bond between your contributions and the benefits you may receive. And the move would certainly undermine support for the program.

Whatever Social Security lacks in progressive taxation it more than makes up for in the benefits it pays out, which are heavily weighted toward lower earners. Here’s how: The program breaks a person’s lifetime earnings history into three dollar segments that are divided by so-called “bend points.” Adjusted annually for inflation, the bend points are $816 and $4,917 in 2014. For the first $816 of your lifetime average monthly Social Security earnings, 90% are credited toward your monthly benefits. Between $816 and $4,917 in earnings, only 32% are applied to benefit entitlements. And for average monthly lifetime earnings above $4,917, only 15% are counted in determining your monthly retirement benefit.

Add it all up, and lower-income retirees wind up with Social Security benefits that make up a much higher portion of their pre-retirement incomes, typically 50% or more, than wealthier households, which may receive less than 20% of income from these benefits.

That payout usually exceeds the amount that lower-income beneficiaries put in, according to research by the Urban Institute, a Washington non-profit. (That’s notwithstanding the mantra of groups pushing to protect and even expand Social Security: “It’s Your Money; You Paid for It.”) The difference between the amount lower-income households pay and the benefits they eventually receive comes out of the pockets of higher-paid workers.

Of course, balancing Social Security by jacking up payments by wealthier earners feels good to many people and may even seem fair. But let’s try a thought experiment. What if Social Security worked like a 401(k) plan—you contributed a percentage of your salary, often matched by an employer contribution, and the account grows tax-deferred until you withdrew it at retirement. If I put $5,000 a year into my 401(k), but you earn more and can put $20,000 into yours, is this unfair? Should some of your contributions be placed instead inside my 401(k) simply because you make more money?

If you think Social Security is different from a 401(k), then you must also be viewing it at least in part as a welfare program that should be taking assets from the top 10% and distributing them to the other 90%. I don’t share this view, but I would support boosting the earnings ceiling by a hefty amount. Payroll taxes used to catch 90% of all wages. After years of lopsided wage gains by wealthier persons, only a little more than 80% of wages is currently subject to payroll taxes. It would be a reasonable move to restore the original level of taxation.

Even so, Social Security’s primary mission is to provide retirement security—a safety net that would help keep aging Americans out of poverty. It was not supposed to be a tax collector. That’s why I think the best way to look at the program is as a form of insurance for longevity, rather than an investment that should give you a better-than-break-even rate of return.

So if you believe that wealthy people should pay higher taxes, change the tax code. Don’t look to Social Security to do this work for you.

The Committee for a Responsible Federal Budget, a Washington non-profit, has a Social Security calculator showing reform options and their impact. If you use this tool, we’d like to hear how you would reform Social Security, so please share your ideas. We’ve all got a stake in this.

Philip Moeller is an expert on retirement, aging and health. He is an award-winning business journalist and a research fellow at the Sloan Center on Aging & Work at Boston College. Reach him at moeller.philip@gmail.com or @PhilMoeller on Twitter.

MONEY retirement income

How You Can Get “Peace of Mind” Income in Retirement

Bucket of Money
Colin Anderson—Getty Images

More investors are using a "bucket strategy" to provide retirement income. But if you do it wrong, you could put your portfolio at risk.

For pre-retirees seeking steady income in retirement, one of the most popular options today is a so-called bucket strategy. And for good reason. Retirees like the security it offers. But bucket strategies can differ widely—some work well, while others, not so much. In fact, one version of this approach could lead you into a retirement trap.

I’ll tell you the best way to use a bucket strategy and how to avoid missteps. But first, here’s how buckets work:

In the simplest form of this strategy, your investments are divided into two portfolios or buckets. The first holds enough fixed-income assets, such as money market funds, CDs and bond funds, to finance the first 10 to 15 years of withdrawals. The second invests the remaining funds in equity assets, typically stock funds and individual equities, which are intended to replenish the first bucket and finance your later retirement years. Sometimes these two buckets are subdivided, so you might have four or more buckets, but the overall strategy and structure remain the same.

Retirees, understandably, value the peace of mind of a bucket strategy. Their first years of retirement income are tucked away in guaranteed or relatively stable assets that aren’t subject to stock market volatility. They also take comfort knowing that poor equity returns in their early years of retirement won’t affect their future income, since there is time for their second bucket to recover.

You should realize that this same peace of mind could be achieved without designating buckets. A retiree who diversified her nest egg into the same fixed income and equity mix, and who likewise began drawing income from the fixed-income portion, would end up with the same result. Interestingly, there is no published research that a bucket strategy increases either the success rate, ending value or sustainable withdrawal amount, assuming the choices for initial allocation, rebalancing and withdrawals are the same. In reality, a portfolio—however organized—can do no more and no less than the sum of its parts, as shown here.

Another reason that buckets are a bit oversold: the major risk that they are designed to protect against—an early bear market—is often exaggerated. Many retirees could make small adjustments to their spending, while keeping their retirement assets in the same investment mix, and do just fine. Both a recent article and some research from last year addressed how overblown this risk can be when evidence-based decision rules about withdrawal amounts and portfolio allocation are used, buckets or no buckets. That said, however, for many retirees, the psychological comfort of a buckets framework is valuable.

About that trap: if you set and forget those buckets, you could put your portfolio at risk. Say a retiring couple has a $500,000 nest egg and wants to withdraw 4%, or $20,000, in the first year, with annual inflation increases. Using a simple two-bucket strategy, they would put 12 years of income, or $240,000 in the first bucket. This would hold fixed-income assets with yields that would match inflation—but no more—to minimize risk. The remaining $260,000 of their portfolio is invested in U.S. and foreign stock funds.

Now let’s assume that they put their plan on autopilot and let things run their course for four years. By 2018 their $240,000 “safe” bucket stands at $173,000, which will last another eight years. And the $260,000 in equities? Consider three possible four-year scenarios:

*Bad start, with -6% annualized returns (worse than both 2000-03 and 2008-11): their second bucket falls to $203,000 and comprises 54% of total assets.

*Low but positive start, with +3% returns: equities are $293,000 or 63% of the total.

*Good start, with +9% returns (the historical average): equities grow to $367,000 or 68% of the total.

The trap? By failing to rebalance regularly, the couple is very likely to see their portfolio’s stock portion soar, which will make it far more volatile—even with a 3% return, stocks grow to 63% of their nest egg in just four years. Clearly, waiting 12 years to replenish your fixed-income assets would be dangerous and foolish.

Of course, rebalancing, which requires you to trim your winning investments and buy more of the laggards, can feel counterintuitive. But what if the bad-start scenario had gained 30% after two years before falling 40% in the next two (-6% annualized return)? Retirees who refilled after Year 2 would have 5% more total assets after the crash. Or imagine the low-positive case that now has markets at all-time highs amid concerns they are overvalued. And what if Year 5 of the good-start began with a 20% correction?

The key to avoiding the trap is to review your portfolio annually, however many buckets you hold. Choose allocation rules and withdrawal policies to guide your responses to what you find. And if markets are severely out of whack, that’s an opportunity to rebalance—either by replenishing the safe bucket to the 12-year income level that was so comforting to begin with or by putting more money in bargain-priced stocks in the second bucket. Then the peace of mind that your retirement income plan provides can truly be well-deserved.

Jonathan Guyton, CFP is a nationally-recognized financial planner and a retirement columnist for the Journal of Financial Planning. A Principal at Cornerstone Wealth Advisors, a fee-only advisory firm in Minneapolis, he can be reached at jon@cornerstonewealthadvisors.com.

MONEY retirement planning

The Amazing Result of Actually Trying to Save Money

Many Americans aren't saving for retirement, but those who are making a real effort are tantalizingly close to hitting their mark.

The retirement savings crisis in America is real. But it is also skewed by vast numbers of people who have saved next to nothing. Looking only at those who are making a serious effort to put something away reveals a more encouraging data set.

Pre-retirees working full-time and who have both a 401(k) plan and an IRA are tantalizingly close to securing sufficient retirement income—and their situation has improved in the past 12 months, a recent study by investment firm BlackRock found. These savers can likely close the gap with a few simple adjustments.

We are all familiar with the doomsday statistics about retirement savings: A third of workers have less than $1,000 in savings and investments that could be used for retirement, and roughly two-thirds have less than $25,000. So large numbers of people will be stuck working longer than they like and counting on Social Security for nearly all their retirement income.

BlackRock weeded out less serious savers by looking only at those with a balance in both a 401(k) plan and an IRA. The typical working 55-year-old meeting this criterion has $264,000 saved and earns $58,000 a year. That level of savings will produce $19,000 a year in guaranteed lifetime income at age 65, based on calculations from the firm’s CoRI index. (This benchmark estimates the amount of annuity income a pre-retiree would be able to purchase at retirement.) Coupled with $21,000 a year from Social Security, this saver is on track to a secure retirement income equal to 69% of final salary.

Most financial planners believe that replacing 70% to 80% of final household income is the mark savers need to hit. So this typical 55-year-old saver is just about there and can close the gap by saving a little more, spending a little less, or working just another year or two. And if market conditions remain favorable, the pre-retiree may get over the hump without changing a thing. A year ago, the typical 55-year-old saver was on track to replace just 64% of final earnings. But the stock market soared, giving savers additional funds to purchase guaranteed lifetime income when they retire.

Of course, what the market gives it can also take back. This is a moving target. But stocks usually rise over a 10-year period, and if interest rates rise over the next 10 years—most believe that will be the case—it will have the effect of boosting replacement income even further because products like immediate annuities will offer a higher return.

The picture is less rosy for older pre-retirees. The typical 60-year-old saver is on track to replace 64% of final earnings and the typical 64-year-old saver is on track to replace just 59% of final earnings. The poorer preparedness of these groups probably stems from their getting a later start saving in 401(k) plans and IRAs, says Chip Castille, head of the BlackRock Retirement Group. The working years of this age group overlapped the transition between defined-benefits plans, which began to disappear, and the rise of defined-contribution plans. They didn’t react right away and missed years of growth.

In general, the retirement readiness picture in the U.S. remains bleak. Even regular savers are falling well short of the more aggressive retirement income replacement goals. But clearly those who have taken action are much better positioned, and with only modest spending adjustments, they can easily hit the lower range of what planners advise.

MONEY Aging

Why Most Seniors Can’t Afford to Pay More for Medicare

Replacing Medicare with vouchers would push costs higher and put older Americans at risk.

Should seniors pay more for Medicare? Republicans think so; they have repeatedly called for replacing the current program with vouchers that would shift cost and risk to seniors.

There’s no doubt this is where Republicans will take us if they capture control of Congress this year, and the White House in 2016. Representative Paul Ryan, the Wisconsin Republican who chairs the House Budget Committee, advocates “premium support” reforms that would give seniors vouchers to buy private Medicare insurance policies in lieu of traditional fee-for-service Medicare.

Under the latest version of Ryan’s budget proposed in April, starting in 2024 seniors could opt to buy premium-supported private plans or stay in traditional Medicare. Ryan has argued that introducing competition will bring down costs over time, and capping the government’s costs does sound like a tempting way to address Medicare’s financial problems.

Medicare’s trustees project total annual spending will jump 78% by 2022, to $1.09 trillion. Much of that increase will be fueled by higher enrollment as the baby boom generation ages.

But premium supports would shift risk to seniors, and could effectively make traditional Medicare much more expensive by siphoning off healthier seniors to private plans. The Congressional Budget Office has estimated that this effect could boost traditional Medicare premiums 50% by 2020 compared with current projections.

Most seniors simply can’t afford to pay more. If you doubt it, check out the new interactive tool launched last month by the Henry J. Kaiser Family Foundation, one of the country’s leading healthcare research groups.

The tool analyzes the income and assets of today’s 52.4 million Medicare beneficiaries, and how their financial picture will change between now and 2030, when 80.9 million people will be covered by the program. It can compare different demographic slices of the Medicare population based on variables such as education, race, gender and marital status—and here you get a stark look at how economic inequality affects the pocketbooks of seniors.

Kaiser’s tool is based on a simulation model developed by the Urban Institute that uses population data to analyze the long-range impact on retirement and aging issues. I encourage you to test-drive the tool, but here are some highlights:

INCOME

Fifty-three percent of Medicare beneficiaries had $25,000 or less in annual income last year; half had savings below $61,400 and less than $67,700 in home equity on a per-person basis.

The income figures reflect the sharp divisions that characterize the wider U.S. population. Just 4% of seniors had income over $100,000 last year; 27% had income below $15,000 (which is just a bit higher than the average annual Social Security benefit).

Healthcare already is one of the largest expenses for seniors, most of whom are on fixed incomes. HealthView Services, which develops software for gauging healthcare costs, recently estimated that a senior retiring this year in high-cost Massachusetts would pay $7,020 in Medicare premiums alone—a number that will jump to $11,536 in 2024. And that figure doesn’t include co-pays and out-of-pocket costs for things Medicare doesn’t cover, such as dental care. It also doesn’t include costs for a catastrophic event.

“Sixty-six thousand in savings is less than the cost of one year in a nursing home,” says Tricia Neuman, senior vice-president at the foundation and director of the foundation’s Medicare policy program. “That tells us that many people on Medicare today don’t have the resources they’d need to pay for a significant health or long-term-care expense if it should arise.”

DEMOGRAPHIC DIVIDES

Neuman says she was especially surprised by the extent of the gaps in income and saving by race, ethnicity and gender. Median 2013 per capita income for white Medicare beneficiaries was $26,400, compared with $16,350 for African Americans and $13,000 for Hispanics.

Men had $25,880 in median income, compared with $21,800 for women. And married couples were better off than singles: Per capita income for married seniors in 2013 was $27,400, compared with $20,250 for divorced people, $21,050 for widows and $14,150 for those who never married.

That’s unlikely to change by 2030. “The model suggests there won’t be phenomenal changes in wealth, or that seniors will be that much more comfortable,” Neuman says.

Neuman says the data also points to continued income inequality and sharp divisions in the status of seniors. In 2030, 5% of Medicare beneficiaries will have income over $111,900, while half will have income below $28,250.

“There will always be a small share of the Medicare population with sufficient wealth and resources to absorb higher costs, but most will not be in that position,” she says. “The assumption that boomers are healthier and wealthier and that we’ll have a much rosier Medicare outlook down the road just isn’t going to happen.”

MONEY 401(k)s

The New 401(k) Income Option That Kicks In When You’re Old

The U.S. Treasury allows savers to buy deferred annuities in their retirement plans. But no need to rush in now.

The U.S. Treasury Department has just given a tax break and its blessings to retirement savers who want to buy long-term deferred annuities in their 401(k) and individual retirement accounts.

The new rule focuses on a particular kind of annuity. These so-called deferred “longevity” plans kick in with guaranteed income when the buyer turns, say, 80 or 85 years old. For example, a 60-year-old man who spent $50,000 on a longevity annuity from New York Life could lock in $17,614 in annual benefits when he turned 80, the company said.

Like most insurance policies and traditional pension plans, these “longevity” plans take advantage of the pooling of many lives. Not everyone will live beyond 80 or 85, so those who do so can collect more income than they would have been able to produce on their own.

That takes the worry of outliving your money off the table. It also lets you take bigger retirement withdrawals in the years between 60 and 80. A saver who put 10% of her nest egg into one of these policies could withdraw as much as 6% of her retirement account in the first year instead of the safer and more traditional amount of 4 percent, estimates Christopher Van Slyke, an Austin, Texas, financial adviser.

A fee-only planner who tends to view many insurance products with some skepticism, Van Slyke likes these longevity plans for those reasons and because they convey a tax break, too: IRA and 401(k) money spent on these policies—up to 25% of the account’s value or $125,000, whichever is less—is exempt from the required minimum distribution rules that force savers over 70 1/2 to make withdrawals that count as taxable income.

The insurance industry loves this new rule, too, so consumers can be excused for taking some time to consider all the costs and angles. Treasury official J. Mark Iwry announced the new rule—declared effective immediately— at an annuities industry conference on Tuesday, and it was a crowd pleaser.

Related: Where are you on the Road to Wealth?

For retirement savers, the math just got harder. Should you buy such a plan? If so, when and how? What should you look for? Here are some considerations.

* You don’t have to rush. The younger you are, the cheaper these annuities are. A 40-year-old male putting down that same $50,000 with New York Life would get $31,414 in monthly benefits—almost twice the payout of the 60-year-old. But there’s a downside to that: Most do not have built-in inflation protection, points out David Hultstrom, a Woodstock, Georgia, financial adviser. So if you’re buying a $1,200-a-month benefit now but not collecting it for 20 years, you’ll be disappointed with its buying power. At a moderate 3% annual inflation rate, in 20 years that $1,200 would cover what $664 buys now.

* There are other reasons to wait. These policies are relatively new, and the Treasury’s rule “will open the floodgates,” Van Slyke says. Expect heightened competition to improve the policies. Furthermore, annuity payouts are always calculated on the basis of current interest rates, which remain near historic lows. A policy bought in a few years, in a (presumably) higher interest-rate environment probably would provide higher levels of income.

* Age 70 might be a good time to jump for those with lots of assets. Those required taxable distributions start the year you turn 70 1/2, so if you’re worried about the tax hit of taking big mandatory distributions, you could pull some money out of the taxable equation by buying one of these policies with it. Your benefits would be taxable as income in the year you receive them.

* Social Security is the best annuity. Before you spend money to buy an annuity, use money you have to defer starting your Social Security benefits as long as possible. Your monthly benefit check will go up by roughly 8% a year for every year after 62 that you defer starting your benefits. Social Security benefits are inflation protected, unlike these annuities.

* Think of your heirs. Money spent to buy an annuity is gone, baby, gone, so you can’t leave it to your kids. Some of these annuities will offer “return of premium” provisions. That means that if you die before you’ve received your purchase price back in monthly checks, your heirs can get the rest back. But that will probably cost you something in the first place. New York Life, for example, shaves almost $4,000 a year of annual payout for the 60-year-old who wants to add that protection to his policy. The heirs would get only cash that has been falling in value for all the years you’ve held the policy, not any income on that cash.

* This won’t solve your long-term care problems. The more money you have tied up in an annuity when you need round-the-clock nursing care, the less you have available to pay for that care. So if you want to use a longevity annuity to give yourself some income in those later years, you should also assure you have the big bad expenses covered. That means setting aside enough other money to pay the $7,000 to $10,000 a month it can cost for full-time nursing care, or buying a long-term care insurance policy you have faith in and can afford.

MONEY Taxes

The Moves to Make Now So You Can Cut Taxes Later

A financial adviser explains that to maximize income, you need the right kinds of investment accounts, not just the right investments.

In my work with financial planning clients, I can see that people understand the merits of having a diversified mix of securities in an investment portfolio. Investment advisers have done a good job of explaining how diversification can improve clients’ risk-adjusted returns.

What can be a little harder for advisers to explain and clients to understand, though, is the value of “tax diversification” — having investments in a mix of accounts with different tax treatments. By having some securities in taxable accounts, others in tax-deferred accounts, and still others in tax-free accounts, people can maintain the flexibility that makes it easier to minimize their taxes in retirement.

The benefits of traditional tax-deferred retirement accounts, such as IRAs and 401(k)s, are easy for participants to see. Contributions reduce people’s current tax bills. And the benefits continue to compound over the course of the investors’ careers, since none of the income is taxable until withdrawals are made.

Yet what clients don’t often grasp is the price they’ll wind up paying for this tax benefit later in life. Distributions from tax-deferred accounts are treated as ordinary income. It can be more expensive to spend money from a traditional IRA than from a taxable account, since dividends and long-term capital gains in taxable accounts are taxed at more favorable rates. And IRS-mandated required minimum distributions from traditional retirement accounts can force a retiree to generate taxable income at times when he or she wouldn’t want to.

So how do you get clients to understand that traditional IRAs and 401(k)s may cost them more than they think? Sometimes it’s a matter of being blunt — saying that the $1 million they see on their account statement isn’t worth $1 million; they may only have $700,000 or less to spend after paying taxes.

Once clients understand that, they also understand the appeal of Roth IRA and Roth 401(k) accounts, since current income and qualified distributions are never taxable. Another advantage: The IRS also does not require distributions from Roth IRAs the way it does for traditional retirement accounts. For many high income taxpayers, $700,000 in a Roth IRA is more valuable than $1 million in a traditional IRA.

But Roth IRAs and 401(k)s aren’t perfect and shouldn’t be a client’s only savings vehicle either. Participants don’t receive any upfront tax benefit. And it’s conceivable that future legislation may decrease or eliminate the benefits of Roth accounts. If the U.S. or certain states shift to a consumption-based tax system, for example, a Roth IRA will have been a poor choice compared to a traditional IRA.

And it’s useful to have money in taxable accounts, too. People need to have enough in these accounts to meet their pre-retirement spending needs. In addition, holding some stock investments in taxable accounts allows people to take advantage of a market downturn by realizing capital losses and securing a tax benefit. You can’t do this with a retirement account.

Given that each type of investment account has advantages and disadvantages, advisers should encourage all their clients to keep at least some assets in each retirement bucket. That way, retirees have the flexibility to choose the source of their spending based on the tax consequences in a particular year.

In a low-income year, retirees may want to pull some money from their traditional IRAs to benefit from that year’s low tax bracket. Depending on the retiree’s income level, some traditional IRA distributions could escape either federal or state income tax entirely. In a high-income year, when investments in a taxable account have a lot of appreciation, it may make sense for the retiree to spend from a Roth account instead.

Since we don’t know what a client’s tax situation will look like each year in the future, diversification of account types is just as prudent as investment diversification.

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Benjamin Sullivan is a manager at Palisades Hudson Financial Group, where he helps the firm’s high-net-worth clients with their personal financial planning, investment and tax planning needs. He is a certified financial planner certificant, an IRS enrolled agent, and a member of the New York chapter of the Financial Planning Association.

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