Retirement Insights

An Emerging Plan Priority: Making Retirement Income L.A.S.T.

An Emerging Plan Priority: Making Retirement Income L.A.S.T.

Forty years since its inception, the 401(k) plan has evolved into the most prevalent employee retirement plan offered in the workplace.1 In that time period, the emphasis has clearly been on wealth accumulation by workers who, with the fading of defined benefit plans, have had to shoulder responsibility for amassing retirement income on their own. The number of Americans age 65 and older will more than double by 2060.With more and more workers retiring, the time has come for plan sponsors and participants to focus on making sustainable retirement income a reality.

BACKGROUND

The 401(k) plan has become the most common employer-sponsored retirement plan type in the United States today, with $6.7 trillion in assets at the close of 2020.3 Participants who are at or nearing retirement hold over sixty percent of 401(k) plan assets. Total retirement assets stood at $35 trillion in 2020.3

 

The Investment Journey

While extremely important, wealth accumulation is only the first phase of a plan participant’s investing journey. Plan participants have long understood and focused on the three critical phases of investing: Accumulate, Protect and Generate Income.

Each phase has its own objective, strategies and tactics that, together, should advance participants towards their overall goal of desired retirement income.

Three phases of participant investing

 

Phase 1:  Accumulate Wealth

A plan participant’s initial investing phase is the longest period during the investing continuum, lasting generally between 40-45 years (ages 21-65) and generally covering 9-10 market cycles. Investment strategies during this phase must address common risks such as not saving enough or for long enough, and not earning a high enough return in relation to the rate of savings.

Phase 2:  Protect Wealth

When the participant is close to achieving his or her funding target, the objective shifts to protecting the wealth that has been accumulated to pay for the desired outcome. Protect wealth is the second and typically the shortest (5-10 years) phase for a plan participant. During this stage, which covers one to three market cycles, the goal is not to lose what has been accumulated, since retirement is just around the corner. Investment strategies must guard against such risks as market corrections, challenging sequences of return, and premature retirement. Although it is the shortest investing stage, Phase 2:  Protect Wealth truly positions a pre-retiree for potential success in Phase 3:  Retirement Income.

Phase 3:  Retirement Income

Securing comfortable life-long income is the goal of Phase 3; the time horizon is unknown, which makes this phase particularly tricky. Investors should plan for a 30-40 year period during which the objective is to receive continuous income generated from their accumulated capital. In order to do that, the investment strategy must protect and grow capital during a number of market cycles (i.e., 8-10).

Shifting to Retirement

As more Baby Boomers retire, the issue of generating retirement income has become pressing. Research by the American College of Financial Services shows that for workers nearing or at retirement, the most important attribute of a retirement savings plan is “To help me understand how much I can safely spend in retirement.” This is in keeping with the new mandate by the Department of Labor (DOL) for plan sponsors to provide lifetime income illustrations at least annually to defined contribution plan participants, reflecting what their account balances would provide as monthly payments.

With their growing concern for employee financial wellness and with encouragement from the DOL, more and more plan sponsors want to offer retirement income options and retiree-focused investment options to retain and service retirees. Among sponsors of large plans, 66 percent prefer to keep their 401(k) plan two-thirds of plan consultants (for both large and small plans) support the adoption of a retirement income tier in defined contribution plans. A majority of plan consultants agrees on the top three actions for retiree retention: 

  1. Adding distribution flexibility;
  2. Including retiree-focused investment options; and
  3. Providing employee education and communication.

 

Where does retirement income come from?

 

On the whole, retirement income comes from seven sources: Social Security, asset income, retirement plans and IRAs, earnings, veteran’s benefits, cash public assistance and “other.” For most individuals, the largest portion of retirement income will come from their retirement plans and IRAs.

Social Security Administration, Improving the Measurement of Retirement Income of the Aged Population, January 2021

 

Social Security Administration, Improving the Measurement of Retirement Income of the Aged Population, January 2021

Location, Allocation, Sequencing and Taxation

Retirees want their retirement savings to LAST, and that depends on Location, Allocation, Sequencing and Taxation.

1. Location refers to the vehicles or “buckets” where retirement assets are kept.

Asset location is a strategy that seeks to minimize overall taxation by housing various retirement savings products in vehicles where withdrawals will receive the most favorable tax treatment. The main bucket options are:

  • Taxable accounts (e.g., personal savings accounts, brokerage accounts);
  • Tax-advantaged vehicles (e.g., traditional IRAs, 401(k) plans); and
  • Tax-free vehicles (e.g., Roth IRAs, Roth 401(k) plans).

The general rule-of-thumb is to put the most tax-advantaged investments in taxable accounts and the least tax-advantaged assets in tax-deferred or tax-free vehicles.

2. Asset allocation involves dividing an investment portfolio among three major asset categories (i.e., stocks, bonds, and cash). The process of determining which mix of assets to hold in a portfolio depends on the individual and his/her current stage of investing. The asset allocation that works best for one person at any given point in life will depend largely on the time horizon or phase of the investing lifecycle (i.e., accumulation, protection or distribution), and the person’s ability to tolerate risk (i.e., the level of comfort an investor has with losing some or all of a portfolio in exchange for greater potential returns). The practice of spreading money among different investments to reduce risk adds up to diversification. By picking the right group of investments, individuals may be able to limit their losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

3. Sequencing comes down to determining the most tax-efficient way to withdraw assets.

At the heart of sequencing is minimizing taxation by pinpointing which assets and accounts (Roth IRAs, 401(k)s, savings, etc.) to distribute and when. Sequencing can have a significant impact on how long an investor’s retirement savings will last and how much a retiree will be able to spend throughout retirement.

While a withdrawal sequence is highly individualized, the following flow is often suggested:

  • Income from Social Security, annuities, work, and other sources;
  • Required minimum distributions and pension payments (i.e., mandatory withdrawals);
  • Income from Social Security, annuities, work, and other sources;
  • Required minimum distributions and pension payments (i.e., mandatory withdrawals);
  • Taxable accounts;
  • Tax-deferred accounts; and
  • Tax-exempt accounts.

    For informational purposes only and is not to be construed as specific tax, legal, or investment advice. You are strongly encouraged to consult with your independent financial advisor, lawyer, accountant or other advisors as to investment, legal, tax and related matters.

    This gives tax-advantaged accounts (4 and 5 above) more time to grow, and helps investors, potentially, increase their after-tax income.

    Keep in mind, too, that the governing plan document and/or treasury regulations for tax-advantaged accounts may specify which order assets are deemed distributed, which can make sequencing extra complicated. For example, a 401(k) plan may specify that withdrawals come out on a pro rata basis from available contribution subaccounts of the participant. Further, if the 401(k) plan has a standard after-tax contribution feature, the plan must distribute pre-1987 after-tax contributions from the after-tax account before post-1986 contributions and earnings.  

    4.  Taxation is giving the government its due share.

    Nothing is sure but death and taxes. The reality is that retirees will pay taxes on most components of their retirement income. Distribution planning is largely a matter of structuring the income stream to minimize the tax implications. For example, benefits from Social Security are taxable for individuals who have modified annual adjusted gross income (MAGI) over $25,000 ($32,000 for married couples), and most distributions from traditional IRAs and qualified retirement plans are considered ordinary taxable income.5

    "The Center for Retirement Research at Boston College concluded from a 2020 study, “Taxes are an important consideration for those who hold ‘meaningful balances’ and should be considered in their financial planning.” The retiree segment referred to are mostly married couples with average combined Social Security benefits of $50,900 annually, 401(k)/IRA balances of $325,400 and financial wealth of $441,400. “Serious tax liabilities arise for these households, [with] tax liabilities of 11 percent, rising to 16 percent for the top five percent and [to] 23 percent for the top one percent.”6]

    And don’t forget about state taxation. Each state adopts its own tax rules and rates. Sometimes they follow the same rules as the federal government, sometimes they do not. A link to each state’s taxing agency can be found here State Tax Agencies.

     

    The following table summarizes general federal taxation rules for distributions based on location.

    Location

    When Distributable

    Federal Taxation of Distributions

    Qualified Plans

    According to the terms of the plan document, potentially subject to an early withdrawal penalty

    Taxed as ordinary income; Net unrealized appreciation in employer securities taxes as long-term capital gains

    Traditional IRAs7

    On demand, potentially subject to an early withdrawal penalty

    Taxed as ordinary income

    Roth IRAs

    On demand, potentially subject to an early withdrawal penalty

    Earnings tax-free if conditions satisfied

    Social Security

    Full retirement age or age 62 with reduced benefits

    Taxed as ordinary income above MAGI threshold

    Stocks, Bonds and Mutual Funds

    On demand

    Long-term capital gains

    Health Savings Accounts

    On demand, primarily for qualified medical expenses

    Tax-free return of contributions and earnings for qualified medical expenses, otherwise

    subject to ordinary income tax and a 20% IRS penalty (unless the owner is age 65, disabled or an amount paid due to death).

    Annuities

    Retirement age, potentially subject to an early withdrawal penalty

    Earnings taxed as ordinary income

    Qualified Dividends

    Dependent on holding period

    Long-term capital gains

    Nonqualified Dividends

    Dependent on holding period

    Ordinary income

    Municipal Bond

    Upon maturity

    Tax-free

    Certificates of Deposit, Savings Accounts, Money Market Accounts

    On demand

    Ordinary income tax on interest payments

    U.S. Savings Bonds

    Upon maturity

    Generally, taxed as ordinary income8

    Source: Internal Revenue Service, https://www.irs.gov/taxtopics/tc400, https://www.irs.gov/pub/irs-pdf/p550.pdf

     

    Conclusion

    For many retirees a large portion—if not the greatest share—of their retirement income will come from their workplace defined contribution retirement plans. With a solid nudge from the DOL and plan participants, plan sponsors and their financial advisors are beginning to embrace more innovative retirement income options and to include information and education in their plans that support income strategies involving asset location, allocation, sequencing and taxation.

    1. 1Plan Sponsor Council of America, 63rd Annual Survey, 2020
      2PRB analysis of data from the U.S. Census Bureau. 
      3Investment Company Institute, https://www.ici.org/research/stats/retirement/ret_20_q4
      4 PIMCO Defined Contribution Consulting Study, June 2020
      5Capital gains tax treatment may apply for certain distributions from qualified retirement plans.
      6Center for Retirement Research at Boston College, "How Much Taxes Will Retirees Owe On Their Retirement Income?" December 2020
      7Includes simplified employee pension and savings incentive match plans for employee IRAS
      8Exceptions apply for interest paid on series EE and I bonds used for certain higher education expenses

    2. For informational purposes only and is not to be construed as specific tax, legal, or investment advice. You are strongly encouraged to consult with your independent financial advisor, lawyer, accountant or other advisors as to investment, legal, tax and related matters.

      The opinions expressed are not necessarily those of the firm. These materials are provided for informational purpose only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistic contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security.

      All investments involve the risk of loss of principal.

      FEF Distributors, LLC (“FEFD”) distributes First Eagle products; it does not provide services to investors. As such, when FEFD presents a strategy or product to an investor, FEFD and its representatives do not determine whether the investment is in the best interests of, or is suitable for, the investor. Investors should exercise their own judgment and/or consult with a financial professional prior to investing in any First Eagle strategy or product.

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