Live Long and Prosper

On Monday, October 27, 2014, the Society of Actuaries issued new estimates of life expectancies in the U.S. A 65 year old female has a life expectancy of 88.8 years, an increase of 2.4 years from the 2000 age projection. Males age 65 have a life expectancy of 86.6 years, an increase of 2 years from the 2000 projections. The good news—we’re living longer; the bad news—we’re living longer.


This increase in life expectancy has financial planning implications. Many defined benefit pension plans are currently underfunded. The Society of Actuaries predicts that the underfunded status of these plans could increase between 4 and 8% because of the increased life span. Defined contribution plans—such as 401(k) and 403(b) plans which shift retirement benefits to the employee’s successful management of funds invested—will require a greater time period of income coverage. Such increased coverage should come from increased savings, more aggressive investment management, delayed retirement, reduced spending in retirement, or some combination of all the preceding.


Syndicated columnist Scott Burns provided additional statistics with planning implications. He quoted data from a 2012 study by the Census Bureau that showed what the average group of 65 year olds could expect by age 80:


          Thirty eight (38) percent will have passed away.


          Thirty four (34) percent will have some form of severe disability.


          Nine (9) percent will have some disability.


          Eighteen (18) percent will have no form of disability.  (There is some rounding error in totals.)


The first three categories may require special financial planning problems. Given their relative likelihood, planning now may be a prudent course of action.


We at Paragon Financial Advisors can help our clients as they plan for their “golden years.” Please call us with questions. We do not sell any products (i.e. insurance, etc.) but we will help clients analyze those options available to them.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Monthly Pension or Lump Sum Benefit?

More and more retiring employees are facing the question of whether to take their retirement benefits as a lump sum payment or a life-time monthly payment. The “correct” decision obviously lies with the individual’s particular circumstances (health of retiree and spouse, other financial assets, fund needs, etc.). There are compelling reasons for both scenarios in today’s interest rate environment. Monthly pensions usually come from employer sponsored defined benefit plans. Such pensions are “guaranteed” by the employer as long as the employee (and/or possibly another beneficiary) is alive. Following death, all benefits cease. The lump sum option represents a current payment of all future retirement benefits offered by the employer; the employer’s obligation ceases with the lump sum payment.

Monthly pension amounts are usually based on formulas established by the benefit plan. Common conditions include length of employee service with the company and the highest annual earnings of the employee for a specified number of years. This type of plan is just what the name implies: a defined benefit. The employer is guaranteeing the retiree an income for the rest of the retiree’s life. Therefore, the employer is responsible for providing contributions into the retirement plan that will sustain anticipated benefits for all employees and retirees of the company over their lifetimes. The employer also bears the investment risk for plan assets. If the plan assists earn more than projected, less money can be contributed to the plan. If the plan assets earn less than projected, the employer must increase contributions to the plan.

Each choice offers advantages and disadvantages which we will discuss below.

Monthly Pension

When a retiree elects the monthly pension option, there are several payment offerings available. The amounts differ depending on the actuarial assumptions involved. The retiring employee may select a single life payment (for the life time of the retiree only), a joint and survivor payment (where monthly payments continue as long as the retiree or a designated beneficiary is alive), or an option for payment over a certain time period (which guarantees payment for life time but also for a minimum specified period). The obvious benefit is a steady source of monthly income. However, inflation may erode the value of monthly payments depending on the cost of living adjustments (if any) to the monthly benefit. In addition, the retiree is depending on the strength of the plan to maintain payments over a retirement lifetime.

Lump Sum Payment

With a lump sum payment, all retiree benefits are given to the retiring employee at retirement. The retiree is now responsible for investing the benefit payment in such a way that the monthly income checks are duplicated. The length of time such payments continue is purely dependent on how successfully the investments perform. The investment risk has been shifted from the employer pension plan to the retiree. In exchange for that risk, the retiree gains a significant opportunity. While payments stop at death for monthly pensions, retirees with a lump sum option may have assets remaining which they can pass to heirs of their choice.

Lump sum payments are based on an assumed earning rate over the retiree’s lifetime. The higher the assumed earning rate, the lower the amount that needs to be distributed as a lump sum payment. Conversely, the lower the assumed earning rate, the greater the amount that needs to be distributed as a lump sum. Today’s low interest rates favor larger lump sum payments.

Why are employers offering the lump sum option?

The primary reason for a lump sum option is the shifting of responsibility for future benefits from the employer to the retiree. Many retirement plans today are underfunded; i.e. the plan does not have enough assets to meet the expected liabilities of current and future retirees. The lump sum payment removes any further obligation from the employer.

Employers also pay an annual premium to the Pension Benefit Guaranty Corporation for each employee covered by the plan. This premium is made to guarantee that the retiree will receive some (not necessarily all) retirement benefits if the employer’s plan fails. The current premium (for 2014) is $49 per employee; it is rising to $64 per employee in 2016. That increase will likely continue as the premium payments are tied to inflation in the future. Reducing the employees covered by a plan also helps reduce overall plan expenses.

What to Do?

As mentioned earlier, this retirement election is critical to a successful retirement. We at Paragon Financial Advisors will assist in analyzing the benefits available under retirement plan options to ensure that the choice matches the best interest of the retiree. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

IRA Changes

Individual Retirement Accounts (IRAs) have been a popular savings vehicle for a long time (since 1974). They became more popular with the Economic Recovery Tax Act of 1981. Contributions made into an IRA were usually tax deductible (depending on your income level) and grew tax deferred until money was taken from the IRA. There were contribution limits (the smaller of 15% of taxable income or $1500 in 1974 and $5500 today for those under age 50). There are also penalties if the money was withdrawn before age 59 ½. No taxes were due on the earnings until payments were taken from the IRA; that payment was then taxed as ordinary income. There was also a “required minimum distribution” (RMD) at age 70 ½. Failure to withdraw your RMD was subject to a 50% penalty plus ordinary income tax on the amount that should have been withdrawn.


Since contributions were limited, one would think that IRA accounts have modest account values. However, rollovers from corporate benefit plans have been allowed. Such rollovers did not result in a taxable distribution from the benefit plan to the employee, and the rolled amounts could continue to grow tax deferred. The net result is that significant amounts (trillions) of dollars are now contained in IRAs. There have been some recent changes in IRA laws which warrant planning consideration. We discuss some of those below.


Asset Protection

In many states, IRAs were protected assets; i.e. they were not subject to attachment by creditors as long as the IRA was established under the Employee Retirement Income Security Act (ERISA). Such plans had an anti-alienation provision which prevents an employer or plan administrator from releasing benefits to a creditor. In July, 2014, the Supreme Court of the United States ruled that “inherited” IRAs were not protected from creditors. An IRA passed to a non-spousal heir was not protected because the non-spousal owner: 1) could not add to the account, 2)had immediate access to the entire account without penalty, and 3) was required to take annual distributions from the IRA regardless of age. There are still state considerations which may come into play, but the case does show that IRA creditor protection is worthy of planning.

Exemption from Required Minimum Distributions

As previously mentioned, IRAs are subject to a required minimum distribution at age 70 ½. However, there is an exception to that rule. An exemption is given to funds put into a deferred annuity. The IRA owner can purchase an annuity and defer the start of benefit payout until age 80. The purchase amount is limited to the smaller of 25% of the IRA or $125,000. That annuity is excluded in the calculation of the annual RMD amount. The basic intent was to allow the individual to provide guaranteed income protection later in life from the IRA holdings. While such a plan provides protection from minimum distribution requirements, the economic advisability warrants another complete analysis.

Temporary Withdrawals

Currently an IRA owner is allowed to withdraw from an IRA with no tax implications if the total amount withdrawn is replaced into the IRA within 60 days. Such a withdrawal is allowed once every 12 months and can be done from each IRA account. For example, an individual with two IRA accounts could do two such withdrawals and replacements every 12 months with no income tax consequences. That rule will change beginning in January, 2015. After that date, an IRA owner can make only one temporary withdrawal within 12 months from IRA accounts—regardless the number of accounts.

We, at Paragon Financial Advisors, assist our clients in management of their IRAs. If you have questions or concerns about your particular situation, please call us.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Paragon Perspectives

Retirement brings many changes. The old adage of “twice as much spouse and half as much money” is humorous; other aspects of retirement are not. In this issue, we discuss some of the planning issues that retirement brings. We also look at what may lie ahead for rising interest rates.


The first article discusses longevity. No one knows how long they will live, but prudent planning says “run out of time before you run out of money.” There are some things that we can do to plan for an extended life span. Three are discussed in the first article.


The second article explores financial issues surrounding the  death of the first spouse. In many households, one spouse is the primary financial manager. If that spouse dies first, the remaining spouse may be faced with financial decisions at an obviously stressful time. What can be done to remove some of the financial stress? That is the topic of discussion in article two.


Finally, how long can these low interest rates last? No one knows for sure—even the Federal Reserve Board of Governors. However, there are some historical items that might give a clue. The third article shows the historical difference between the rate of inflation and the 10 year U.S. Treasury bond. Looking at the current “spread rate” might provide some indication of what lies ahead.


Sincerely,


Wm. Jene Tebeaux CFP® CFA® CAIA®



If you did not receive a copy of this quarter's newsletter please email info@paragon-adv.com to request a copy. 

School "Daze"

It’s that time of year again—students are moving into the dorms at colleges and universities all over the country. Traffic is increasing, restaurants are crowded, and all the other “problems” associated with students starting a new school year are at the forefront. It’s a new world for freshmen students; confusing and sometimes stressful. That stress is not limited to students, however. Parents are looking at rising education costs and looking for ways to pay for college expense. A frequent source of that funding comes from college savings accounts (such as 529 plans) and from extended family (grandparents). Those sources are our topic of discussion here.


The 529 college savings plans are sponsored by states and the funds in those plans are managed by large mutual fund companies (Vanguard, Fidelity, American Funds, etc.). After tax contributions placed into the accounts grow tax free as long as the funds withdrawn are used to pay for qualified college expenses (room, board, tuition, mandatory fees, books and equipment, etc.). Historically, parents have been the ones setting up 529 plans for children; the owner of the account is the person setting up the plan. However, with rising college costs and more affluence in the retiring baby boom generation, grandparents are funding 529 plans. That’s a great benefit for easing the financial burden on parents of college students. It can come with some hidden implications that should be addressed.


College personnel award financial aid to students based on the income and assets that students and their parents claim on the students Free Application for Federal Student Aid (FAFSA) form. Contributions from parents are not counted as student income for FAFSA purposes. That is true even when the funds come from a 529 plan owned by the parent. However, when funds come from other people (such as 529 plans owned by grandparents), the funds are counted as student income. Therefore, payments from a grandparent owned 529 plans could jeopardize the student’s eligibility for other forms of financial aid. Limitations (or loss) of grants, subsidized federal loans (on which the student is not charged interest while still in school), or work study programs funded by the government or college might come into play. The loss of such benefits could be significant. Prudent planning dictates consideration of such a loss in the total cost of a student’s education.


Are there ways for grandparents to fund college expenses and still get the tax free growth on the funds? Perhaps. The grandparents could possibly transfer ownership of the 529 plan to the parents prior to any withdrawal for college expenses. Some plans don’t allow a transfer of ownership and may count the transfer as a distribution (earnings are then subject to taxes and a penalty because the distribution was not used for allowable college expense). Another possible alternative would be to wait until the student’s last year in school before using 529 funds. The student (not attending graduate school) would not be filing another FAFSA for the following year; hence no income considerations. Care should be taken here though as some colleges require additional information that requires listing all accounts benefiting the student which are owned by other than the parents.


While students are facing the academic world (many for the first time), planning for college expenses should be done in advance. We, at Paragon Financial Advisors, will be happy to review the plans our clients have put in place. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Investing Beyond Stocks and Bonds

When you think of “investing”, what comes to mind? Did you think of the US stock market? You might have thought about bonds or other fixed income securities. What about real estate, commodities or other alternative investments? Although less common, they can provide significant benefits when combined with stocks and bonds. How can these investments benefit you? The answer lies in their correlation, or relatedness to other investments. Alternative investments typically have lower correlations with stocks and bonds; they often “zig” when others “zag”. These alternative investments increase the overall diversification of the portfolio, thus reducing risk (i.e., think fewer eggs in a single investment basket). Below are some examples of alternative investments and the importance of their inclusion within a portfolio.

Commodities

Inflation, or the general rise in prices, typically reduces company profits due to an increase in costs (e.g., cost to borrow money, cost of input materials, and cost of transportation). Commodities typically increase in value when interest rates are steady or rising. They may provide the investor a way to benefit when stocks are not performing well. Gold, and other commodities, typically have very low and often negative correlations with stocks. Commodities can also provide significant income from the production and transportation of oil and gas.

Other Investments

Due to the finite and absolute necessity characteristics of real estate, investors can benefit in a number of ways. Investors seeking income may find Real Estate Investment Trusts attractive due to their high yields. Others may prefer investments that benefit from the long-term appreciation of property values. Foreign investments provide exposure to markets less correlated to the United States; other economies sometimes expand when the US economy contracts. Access to frontier and emerging markets allow investors to benefit from faster growing economies and increased consumption from an expanding middle class. Very small companies often provide niche services or goods, frequently sheltering them from adverse events that affect larger companies.

Commodities and other alternative investments reduce risk by increasing exposure to a diverse set of asset classes. They frequently outperform when US stocks and bonds fumble. Although they are typically a small portion of a portfolio, the benefits of inclusion may be significant. In a diversified portfolio, alternative investments should lessen the volatility of the entire portfolio. Despite the correlation benefits, investors must realize that the individual alternative investment may have greater risk than traditional investments.

Have you reviewed your alternative investments lately? We at Paragon Financial Advisors look beyond the realm of US stocks and bonds, seeking investment opportunities across the globe. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

The Value of a Job

I had a discussion with a friend today about the value of a job. Not the value of a job as a younger person, but the value of a job as a “phased in” retirement. Many baby boomers are facing the question “When should I retire?” Our discussion focused on some options available.

 

My friend is a professional and has the ability to continue working on a part time basis if he so chooses (earning approximately $75,000 per year). He is 65 years old and his marginal tax bracket is approximately 40%. His estimated social security benefit at full retirement age (age 66) is approximately $2400 per month.

 

Our discussion prompted some thoughts which I share here. Note that these thoughts are purely from a financial planning standpoint; they do not address the personal satisfaction questions of continued working vs. time use in retirement.

 

Social Security Benefits

 

Age 62

 

My friend has several choices concerning his social security benefit. He could have chosen to receive his social security benefit at age 62. He did not choose that option for several reasons:

1. At age 62, his monthly benefit would have been reduced by 25% (approximately 6% per year for each year of age before his age 66 full retirement age giving him only a monthly benefit of $1,800). That reduction in benefit is generally permanent and would continue for his life span.
2. If he continued to work, his social security monthly benefit would be reduced $1 for each $2 he earned in excess of $15,480 (this amount is applicable for 2014 –it changes annually)
3. He was not ready to quit working at that age.

Age 66

At age 66, my friend can choose to receive his full retirement age benefit of $2400 per month. He can continue to work with no reduction in social security benefit regardless of the amount he earns. He has another option at age 66. He can “file and suspend” his benefits which would allow his spouse to collect spousal benefits without affecting his or her future benefits. With a file and suspend election, he would file for his age 66 benefit but choose not to begin receiving his benefit payment. His spouse could begin drawing ½ of his benefit ($1200 per month) without affecting her social security benefits. The suspension of his benefit would allow his monthly benefit amount to increase as outlined in “Age 70” below.

Age 70

My friend can delay receiving his social security benefit until age 70; if he does, his monthly benefit will increase by 8% per year (or a total of 32%) for each year from age 66 to age 70. His monthly benefit at age 70 would then be $3,168. Note that his spouse could have been drawing spousal benefits for that four years or until she began drawing her own benefit.

Note: This social security discussion is a generalized one; you should discuss your particular circumstances with the Social Security Administration before making any decisions.

Investment Implication

There are consequences on my friend’s investment portfolio that should also be considered. His continued earnings of $75,000 per year for 4 years (age 66-70) are money that would not be withdrawn from his IRA. Since required minimum distributions (RMD) don’t start until age 70 ½, that amount could continue to grow tax deferred until he needed it or was required to withdraw for RMD purposes. At a conservative rate of return (the current 30 year US Treasury rate of 3.5%), the future value of not withdrawing for those 4 years is approximately $316,000. That is, his retirement portfolio will be about $316,000 more at age 70 if he continued working until that time.

What to Do?

Retirement is an individual decision that is dependent on many things (health circumstances, life style choices, economic factors, etc.).

We, at Paragon Financial Advisors, assist our clients in evaluating options available to them.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.