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Retirement Focus - Retirement 101

By Gary D. Halbert
March 20, 2007


1.   Gary’s Introduction

2.   Retirement Plans Basics

3.   The Various Types of Retirement Plans

4.   This Month’s Retirement Tidbit

5.   Gary’s Conclusions


In my February 20 E-Letter, I announced that Mike Posey will be writing a monthly Retirement Focus issue that will feature various aspects of retirement planning.  I am very pleased to say that my announcement met with very favorable responses from readers.  It seems that Mike and I had correctly determined that retirement issues are on the forefront of many of my readers’ minds.

One issue that was mentioned in several of the readers’ responses was a desire to learn more about both pre-retirement and post-retirement financial issues.  It seems that much of the space given to retirement topics in the financial media tends to be dedicated to pre-retirement issues, with less emphasis on post-retirement planning.  Though we did not specifically note this in the February 20 E-Letter, Mike will be addressing both pre- and post-retirement issues in his monthly writings.

In this first regular issue of the new Retirement Focus feature of the Forecasts & Trends E-Letter, Mike will provide a background for future issues by discussing the various types of retirement plans and how they work.  This will give you a glossary of sorts to refer back to when the various types of plans are discussed in future Retirement Focus issues.  So, with that as an introduction, I’ll turn it over to Mike.

Retirement-Speak 101
            By Mike Posey

If you have ever been around a group of computer programmers or technicians, you know how they can tend to speak their own language.  They sometimes use so many acronyms and other tech jargon that a listener who is not very familiar with computer hardware and software may feel like these tech jocks are from a different country (dare I say “different planet?”).  Unfortunately, the same thing can happen in relation to retirement plans.

I have noticed that some retirement planning professionals and even the financial media often toss around retirement terms while not always defining exactly what they are, or at best providing only a very limited definition.  To be most effective in planning for your own retirement, I think that you need to be familiar with the different types of plans and arrangements, and the basic characteristics of each.  At the very least, you need to know how plans covering you and/or your spouse work.    

In this week’s Retirement Focus, I’m going to set the groundwork for future issues by defining the various types of plans you are most likely to encounter, and providing a short description of how each works.  I wish I could say that what follows will be the most interesting piece of writing you’ve ever read, but I know that it will probably not live up to that billing. 

It will, however, provide a general overview of various types of retirement plans available to employers.  I recommend that once you have read over this information, that you either print it out or put it in an e-mail folder for future reference.  You might also want to share it with your children, grandchildren or anyone else you know who may be covered by a retirement plan.

I should also note that, due to space restrictions, I will just be able to hit the high points of the various types of retirement plans.  Plus, I will only cover the types of plans you are most likely to encounter, and not discuss very specialized plans that have limited appeal to employers.  If you are covered by a plan that does not seem to fit any of the categories discussed below, feel free to send me an e-mail and I will try to answer any questions you might have individually.

Defined Benefit Retirement Plans

As a general rule, there are really only two basic types of retirement plans:  defined benefit plans and defined contribution plans.  All of the various types of plans discussed below will fall under one of these umbrellas.  Each type of plan has its own set of rules and requirements to meet as dictated by legislation, the IRS and Department of Labor.  Conforming to these rules, while sometimes onerous and expensive, results in the plan being “qualified.”  In other words, contributions made to the plan are deductible by the employer, are not included in the participants' current compensation, and are allowed to grow tax-deferred until withdrawn, which is usually upon retirement, death or disability.        

I’ll cover defined benefit plans first because they have been getting a lot of press over the past year or so.  I noted in our February 20 issue that one of the major focal points of the Pension Protection Act of 2006 was to make the funding of defined benefit plans more secure.  That being the case, let’s talk about how these plans work.

A defined benefit plan is one that does exactly as its name implies – it defines a promised benefit to be paid to a participant upon retirement, usually in terms of a monthly income.  The methods of calculating the promised monthly benefits to be paid under a defined benefit plan vary widely.  Formulas may include a number of different factors, offering employers a great deal of flexibility in tailoring the plan to suit employee demographics.

Once the amount of the future monthly benefit is known, a math wizard known as an actuary determines the amount of funding required over the working lifetime of the employee to fully fund the benefit.  This is where the complexity comes in.  The actuary must use a set of assumptions to come up with the cost of future benefits, and then back into a yearly contribution.

Defined benefit plans have the following additional features:

1.         The power of compound interest makes the cost of funding a young employee’s benefit very small when compared to funding benefits for older workers.  Thus, these plans often work best in large corporations where there is a good mix of employee ages and compensation levels. 

2.         Defined benefit plans can also be beneficial in smaller companies where the owners and key employees are older and have less time to accumulate benefits.  Since the only limit on employer contributions is the actuarially calculated cost necessary to fund benefits, such a company could make a large, deductible contribution with most of that going to the benefit of the older owners and key employees.

3.         Defined benefit plans usually pay out their benefits as a monthly income to the participant, as well as to a surviving spouse upon the participant’s death.  While cash-outs are allowed under certain circumstances, the amount of any lump-sum payment must be actuarially determined using rigid guidelines to insure the cash payment is “actuarially equivalent” to the monthly benefit that would otherwise be payable to the participant.

4.         These plans provide employees with a promise of a future benefit that must be funded each year, with the employer taking all of the investment risk.  If investment returns are lower than those assumed by the actuary when calculating contributions, more money must be contributed by the employer to fund promised benefits.

5.         The maximum benefit allowed under a defined benefit plan is set by placing a cap on the amount of benefit that can be provided.  Adjusted for inflation annually, the 2007 maximum annual benefit is $180,000.

6.         Investment of fund assets is usually handled by trustees of the plan, often with the help of institutional money managers.  Participants have little or no say as to how the money is invested for their benefit.

7.         A defined benefit plan is the only type of retirement plan with benefits guaranteed by the Pension Benefit Guaranty Corporation (PBGC), a federal corporation created by the Employee Retirement Income Security Act of 1974 (ERISA).  Employers are required to pay premiums for each covered employee to guarantee a portion of their benefits.  Unfortunately, the PBGC does not guarantee the full amount of the promised benefit, so if an employer experiences financial problems or turns to bankruptcy, employees could see their promised benefit reduced.

Even with all of their advantages, defined benefit plans are on the decrease.  As I discussed in the February 20th issue, some employers have abused the actuarial assumption and funding rules for defined benefit plans, so the Pension Protection Act was passed to help shore up these benefits.  As a result, I expect to see far fewer defined benefit plans in the future.

Defined Contribution Plans

As noted above, the other major type of retirement plan is the defined contribution plan.  In a defined contribution plan, the amount of contribution going into a participant’s account is defined by a formula, and there is no guarantee as to what benefit may be paid upon retirement. 

The amount of contribution for each participant varies based on the type of plan chosen, but there is generally no need for actuarial mathematics.  Most contribution formulas are a simple percentage of salary or a pro-rata share of an employer contribution.  The important distinction is that the employees take all of the investment risk, and their eventual benefit is whatever the contributions accumulate to over time.  Defined contribution plans have a number of other features that are unlike the defined benefit plans discussed above.  These differences include:

1.         Where defined benefit plans tend to benefit older, higher paid workers, defined contribution plans tend to favor younger employees who have many years for compound interest to work in their favor.  Of course, the actual accumulated value at retirement will depend upon the actual investment returns experienced over the working lifetime of the employee.

2.         In some types of defined contribution plans, participants may direct the investment of their own accounts rather than having trustees or institutional money managers handle the job.  Of course, that can be good or bad, depending upon the participant’s investment elections.

3.         Defined contribution plans can be used by companies of virtually any size.  The various types of defined contribution plans, discussed in more detail below, offer a great deal of flexibility to employers wanting to provide retirement benefits to employees.

4.         The maximum contribution allowable in a defined contribution plan is generally 100% of compensation, up to an overall annual maximum of $45,000 in 2007.  However, lower limits may apply to certain types of contributions or within certain types of plans.  I’ll discuss this in greater detail later on. 

5.         Many defined contribution plan account balances are paid out in cash at retirement rather than being paid out as a regular monthly income.  This allows participants to transfer retirement distributions into Rollover IRAs and manage their retirement funds accordingly.  However, some plans also have monthly income options based on the value of the participant’s account.

6.         Employers tend to like defined contribution plans because they offer a high degree of flexibility and the amount of contribution can be pre-determined.  In some plans, the employer can even have an option of whether to contribute from year to year, or even have employees share in funding the plan.  They can also be less expensive to establish and administer.

7.         Benefits under defined contribution plans are also not guaranteed by the PBGC or any other state or local agency or corporation. 

Perhaps the greatest advantage of defined contribution plans is the wide variety of plans available to both employers and individuals.  Below, I have listed the major types of defined contribution retirement plans, and their major characteristics:

Money Purchase Pension Plan – This type of plan is also known as a “pension” because the employer makes a promise to contribute a set amount of salary each year to a participant’s account.  For example, if a plan calls for 5% of compensation to be contributed to the plan, the employer must fund this level of contribution each year, even if the business does not turn a profit.  Assets are usually invested by trustees without participant involvement, much like defined benefit plans.  With the growth of 401(k) plans that offer more contribution flexibility, money purchase pension plans have fallen out of favor and are now relatively rare.

Traditional Profit-Sharing Plan – These plans offer the greatest degree of employer flexibility.  As the name implies, this type of plan was originally set up to allow an employer the option of contributing a portion of its annual profits to a plan for employees.  More recent changes dropped the requirement for contributions to come from profits, so that even an employer who has a bad year can still make profit sharing contributions.  Another way profit sharing plans differ from money purchase plans is that contributions are not allocated as a set percentage of compensation, but rather as pro-rata allocation, usually based on salary.

401(k) Plan – 401(k) plans are the most popular form of retirement plan in the US today.  Most 401(k) Plans are traditional profit sharing plans with an added provision allowing for the participants to contribute money through automatic deductions on a tax-favored basis.  Salary deferrals are limited to 100% of pay up to $15,500 in 2007, but participants age 50 or over can contributed an extra $5,000 "catch-up" contribution.  Another benefit of the 401(k) plan is that it allows participants to direct the investment of their accounts.  This puts the employee in control of the money he or she puts into the plan.

While employer contributions are not required under a 401(k) Plan, many provide a matching contribution, which is in addition to the $15,500 limitation discussed above.  Matching contributions often increase employee participation as it provides an automatic return on money saved.  The employer may also make a regular profit-sharing contribution that is allocated pro-rata to each participant based on salary.  Contributions from all sources cannot exceed the defined contribution maximum annual addition limit of $45,000.

Employee Stock Ownership Plan (ESOP) – An ESOP is a qualified defined contribution plan where participants are allocated employer stock rather than cash contributions.  In some cases, ESOPs are used to transfer ownership of a corporation to the employees over time.  This concentration in employer stock can be good if the employer is doing well, but can be very harmful if the employer’s fortunes turn south.  The recent Enron debacle is a good example of how lack of diversification can be harmful to retirement plan participants.

403(b) Plans - These plans, also known as “tax-sheltered annuities,” may only be maintained by schools, churches, charitable organizations and other similar non-profit entities.  They operate like 401(k) plans in that they allow an employee to defer a portion of his or her salary on a tax-favored basis.  However, 403(b) plans were around long before 401(k) plans were invented.

The original contribution rules for 403(b) plans were rather complex, but beginning in 2002, 403(b) plan contributions are essentially the same as under a 401(k) plan.  Thus, employees may contribute up to 100% of their compensation, subject to an overall maximum of $15,500 in 2007, and employees age 50 or over may contribute an extra $5,000.  In the early years, employer matching of 403(b) was fairly rare, but it has become more common in recent years.  Some differences still remain between 401(k) and 403(b) plans, but they are too involved to get into in this brief discussion.

Self-Employed (Keogh) Plan - Retirement plans for self-employed individuals used to be very different from those of their corporate counterparts.  Called "Keogh" or "HR-10" plans after the legislation that created them in 1962, these arrangements were governed by an entirely different set of rules and limitations.  Fortunately, numerous law changes over the years have created a high degree of parity between self-employed and corporate retirement plans, though the term "Keogh" is often still used to designate a plan maintained by a self-employed individual.

Today, self-employed individuals may now maintain virtually any type of defined benefit or defined contribution plan, though plans covering the self-employed still have some minor differences.  The biggest issue in regard to Keogh plans is that many were set up long ago under the previous rules, and have never been updated to comply with recent law changes.  If you have an old self-employed Keogh or HR-10 plan, you may want to contact a retirement plan administrator in your area to see if your plan needs to be brought up to date.

Simplified Plans For Small Employers

While an employer may choose among any of the above types of plans, the establishment and ongoing administrative costs are often greater than a small employer can pay.  Defined benefit plans are expensive to establish and maintain due to the actuarial calculations required.  401(k) plans can be expensive for an employer to maintain because of the highly flexible nature of these plans.  The result is that many small employers cannot afford to establish and administer a plan, even if the employees make virtually all of the contributions.

The solution to this problem can be found in a scaled-down 401(k) known as the “SIMPLE 401(k)” and two IRA-based programs (Simplified Employee Pension, or SEP, and SIMPLE IRA) that greatly simplify the process of establishing and maintaining a retirement plan.  While these plans are generally restricted to employers with less than 100 employees and offer little in the way of flexibility, they do allow many employers to provide retirement benefits for themselves and their employees that they may not have otherwise been able to do so.

Hybrid And Combination Plans

There are some retirement plans that contain features of both defined benefit and defined contribution plans.  The plans listed below offer employers additional flexibility in providing benefits to employees.

Target Benefit Plans - As the name implies, Target Benefit plans are designed to fund a specified monthly income at retirement, much like a defined benefit plan.  The monthly benefit is determined by a formula, and an actuarial calculation is made to compute an annual contribution sufficient to fund the benefit, but that's where the similarity with a defined benefit plan ends.

Once the annual contributions required to fund the benefit are calculated, the plan acts like a defined contribution plan, in that the eventual benefits provided depend upon the earnings on contributions.  Thus, the monthly benefits are not guaranteed, but if investment returns vary from the assumed rate of return, the employee might end up with more (or less) benefit than under the defined benefit plan.  Target benefit plans tend to favor older workers who have less time to fund benefits, and are relatively rare.

Cash Balance Plans - There has been a lot of press lately about cash balance plans because a number of large companies have proposed converting their defined benefit plans to this type of arrangement.  A cash balance plan is a form of defined benefit plan, but it does not guarantee a future monthly retirement benefit.  Instead, a cash balance plan works somewhat like a money purchase pension plan on the front end.  A "credit" equal to a specified percentage of compensation is established, along with an "interest credit" which may be fixed or vary based on a specified index such as the one-year T-Bill rate.

With the contribution level, rate of return and years to retirement known, a calculation is made to determine the promised account balance at retirement.  Since the cash balance plan is a true defined benefit plan, the cash balance at retirement is guaranteed by the PBGC.  At retirement, the cash balance may be taken in a lump sum, or used to fund a monthly retirement benefit.  Cash balance plans tend to favor younger workers who have more time for compound interest to work in their favor.

As you can see, employers and individuals have a wide array of available plans from which to choose.  Each plan has slightly different characteristics and contribution levels that aid in effective retirement planning within a corporate or family budget.  Some employers will even have two or more retirement plans to provide a greater variety of benefits to their employees.

Unfortunately, it’s not always easy for employees to tell exactly what type of plan their employer maintains.  I have seen a number of plans simply called the XYZ Corporation Employee Retirement Plan. This could be virtually any kind of employer plan.

The key to understanding your own retirement plan lies in the Summary Plan Description, a brief overview of your retirement plan that employers are required to give you when you become a participant.  Armed with the information above, you should be able to go through your summary plan description and determine exactly what type of plan you have, and how you can best use it to maximize your retirement planning.

Retirement Tidbit – Transferring Your Tax Refund Directly To Your IRA

For the most part, investors are aware that the IRS will allow you to claim an IRA deduction on your 1040 that you have not yet made, as long as you use your refund to fund it prior to the tax filing deadline (usually April 15th).  This allows individuals to fund an IRA contribution for the prior tax year that they may not have otherwise been able to make.

Last May, the IRS announced that it was going to make it even easier to have a tax refund contributed to an IRA.  Form 8888 gives taxpayers the ability to designate up to three accounts to automatically receive portions of a tax refund.  Previously, only one account could be specified so if the tax refund was greater than the allowable contribution limit, a personal account would have to be designated.

With this new rule, you can now file electronically and have all or part of your refund sent to your IRA account with a bank, mutual fund, brokerage firm or other financial institution. If you want to take advantage of this feature, keep the following important tips in mind:

1.         Your refund can be deposited directly to your traditional IRA, Roth IRA or SEP IRA.  It cannot, however, be used to fund a SIMPLE IRA.  Be sure to document the correct account and routing numbers, as these must be placed on Form 8888.

2.         The receiving IRA must already be established and it’s important to make sure the IRA sponsor will allow direct deposits.  A married couple, filing jointly, may establish an IRA in each spouse’s name and then have direct deposits made into each of these accounts. 

3.         You must tell your IRA custodian to which tax year the direct deposit will apply.  If you do not designate the direct deposit to be for the 2006 tax year, your IRA custodian will likely assume it is for 2007.  This will create a problem when no traditional IRA contribution is reported for the prior tax year to support your 2006 deduction.

4.         You need to be sure that the direct deposit will be made to your account by April 17th, this year’s tax filing deadline.  Keep in mind that it usually takes a couple of weeks for refunds to be processed, even on returns filed electronically.  If you miss the deadline, you will have to file an amended 2006 return without the IRA contribution deduction.

5.         In addition to an IRA, direct deposits may be made to a Health Savings Account (HSA), Archer Medical Savings Account (MSA), or a Coverdell Education Savings Account (ESA). 

If you have any interest in using the Form 8888 to fund your IRA, it is very important that you file your return as soon as possible so that your refund will be processed and deposited into the account before April 17th.

That’s it for me today, Gary.

            By Gary Halbert

Thanks, Mike.

This week’s E-Letter showcases the variety of retirement plans available to both individuals and business owners.  However, it’s pretty easy to see that this variety also brings with it quite a bit of complexity.

I liked Mike’s comparison of retirement plan jargon to that of the computer industry.  The reason I find this to be interesting is that I know that we have a number of clients who do not participate in the “information age” because they are unfamiliar with computers or are intimidated by their complexity.

This, in turn, makes me wonder how many employers and employees don’t understand all of the specialized terms used in relation to retirement planning, and just never offer or participate in these plans.  I have seen studies that document how many people are eligible for 401(k) plans, but never participate.  These statistics were a big reason the Pension Protection Act of 2006 contained a provision that allowed employers to automatically enroll employees into their 401(k) plans, and even select default investments.

The big difference in Mike’s comparison is that if someone never embraces computer technology, all they may lose is the access to a better way to communicate and access information.  However, failure to participate in retirement planning will very likely have a negative effect on the retirement security of those who choose not to contribute.

This is one of the main reasons I wanted to incorporate this Retirement Focus feature in my Forecasts & Trends E-Letter.  If Mike and I can help to blaze a path for you to follow through the maze of retirement plans and investments, then you are more likely to have some gold in your golden years.

Very best regards,

Gary D. Halbert


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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