Saturday, September 08, 2007

The Upcoming Retirement Crisis

This blog will depart from state politics (although it could affect state policy in years to come) and discuss an issue no Federal or State politician wishes to even talk about--the upcoming retirement crisis. But it is coming. I do over six hundred tax returns a year and see very few employees putting into their retirement plans. In fact, I see quite a few of them take their money out of retirement plans and spend it. Take it from this CPA, it is coming.

Years ago, back in the 1950s, 1960s and 1970s, the only pension plans were defined benefit plans. The company would set aside monies to fund future retirement benefits for their employees. Since the vesting period for a pension was ten years, there was little turnover. The employee didn't have to put in a penny of his own money for retirement. When he hit retirement age, he would get his benefit based on his years of service. For example, for every year you served with a company, you would get a 1 1/2% pension accrual. If you served forty years with a company, you would get 60% of the average of your last five years of salaries. Add that pension to Social Security, throw in some investments and you could have a comfortable retirement. Major industries and almost all government entities had defined benefit plans.

But in 1978, IRC 401(k) was passed by Congress. It was a little bitty sentence, but it would have major implications. A financial person wrote a letter to the IRS seeing if he could form a deferred compensation plan where you could put away for retirement, but payroll taxes would still have to be paid. The idea was to use this as a supplement to the defined pension plans. This would even assure workers of having a better retirement.

But things went awry. The defined contribution plan was born. True, they were always there through the Keogh (a self-employed retirement plan, which I use), but not for the average Jane and Joe in the workplace. For the next thirty years, employers except for government and the biggest employers covered by union contracts did away with the defined benefit plan.

The dynamics of retirement planning changed. Employers no longer had to offer ANY retirement plan. If you wanted retirement income, you could put in $1500 (the amount in 1975)in an IRA a year (It is now $5000.). But if you didn't, you were just out of luck. The burden for retirement planning switched from the employer to the employee. So how much retirement income would you have if you didn't put into an IRA or your employer didn't have a retirement plan, you were out of luck. You would have bupkis (nothing). And if you didn't have any money saved up, you'd be subsisting only on Social Security. Great future.

But most places do have a 401(k) plan. You can put up to 25% of your earned income on your job into a 401(k) up to $15500 (for 2007). (Yes, I know about the top-heavy rules, but let's keep this simple.) Plus, you can still contribute to a Roth or a non-deductible IRA of $4000 a year (which I do).

So based on the above, let's take the situation of two workers. John Smith starts out earning $48000 at a CPA firm in the metro area (By the way, that is about the starting salary for an accountant fresh out of college.). He decides to put in the maximum of $12000 a year. His company is required to contribute 4%, or $1920 (Some of you pension experts can correct me on this.) to John's 401(k). Just for argument's sake, let's say John works there for 42 years and NEVER gets a raise (Obviously, that isn't realistic.). Let us also assume the rate of return is 5.5% a year (which is not unrealistic). By the time he retires, he will have $2,145,078.46 in his 401(k). Assuming he takes out only 6% a year, he'll be yanking out $128704.71 a year. That's not bad bucks. And remember, this is the lowest amount he'll be putting in.

But now let's look at Susan Jones. She works in a clerical job earning $20000 a year. There is no way she can put any money into her 401(k). Rent, car note, food, utilities and taxes leave her with very little. To rent a decent apartment in Rankin County costs $600-$800 a month. Her employer does offer a 401(k) plan, so her employer is required to contribute 3%, or $600. Let's say she works there for 45 years. Lets also use the same amount of 5.5% a year. When she retires, she will have $110,471.50 in her 401(k). Assuming she takes out 6% a year, she'll be yanking out $6628.29 a year. She'll be eating a lot of red beans and rice.

Look at the disparity: $2,145,078.46 versus $110,471.50. That is 19.4175 times the disparity between the least and the greatest amounts. Unfortunately, I see more of the latter than the former. I see a very large number of people taking out premature distributions and spending it on cars and even boats. When they retire, they only have Social Security. If you think Social Security is going to get you through your final years, think again. Indeed, MOST of the retirees today state Social Security is their main source of retirement income.

I agree with the pension bill passed this year that allows employers to mandatory yanking out 3% out of an employee's check to put in a 401(k) plan. In Susan Jones' instance, she would put in $600 a year of her own money and her employer would be forced to match it with 4%, or $800. That would be $1400 a year. When she retires, she would have $257766.83 in her retirement account and she could take out $15466.01 a year. (However, the employee does have the right to forbid the employer to take the 3% out of her check.)

The overwhelming number of small businesses do not have any kind of retirement plans. Bupkis, baby. That is where you are going to have the retirement crisis. How are they going to live? Social Security won't suffice. The employees don't have much choice other than to contribute to an IRA. Most employees don't.

President Bush had the right idea to set up Personal Savings Accounts to replace the retirement portion of Social Security(which is 5.3% for the employee and 5.3% for the employer, a total of 10.6%) (I calculated I would get three times the benefit under Bush's plan than under Social Security. In fact, I'm not even counting on Social Security for my retirement and don't even factor it in my retirement calculations.). Except for the very poor, has shown PSAs would benefit almost all workers.

I know the argument. If there was a severe downturn in the financial markets, the PSAs would diminish in value. What the government could do is pay the retiree the difference in what his PSA pays out versus what he would get under normal Social Security calculations. This would protect retirees from the vagaries of the downturns (like the ones in 1969-1970, 1973-1974, 1981-1982, October 1987, 2000-2002.).

But this is only theory. Right now, the Baby Boomers are starting to retire. In 2008, the first of the Baby Boomers will start drawing Social Security. The retirement crisis will soon be coming upon us during the next ten years and accelerating. In the past, the defined benefit plans would give us a strong retiree middle class. But the future may show a small wealthy retiree class, a weak retiree middle class and a large impoverished retiree class.

Government will not be able to solve the problem unless it decides to jack up taxes. And that will cause a massive taxpayers' revolt. The free market can solve the problem, but I've seen very few good ideas out there other than Bush's PSA accounts. But his plan was--and is--dead in the water.

Maybe some politician out there has a good solution. If he (or she) does, I'd like to know about it. The retirement crisis is going to hit us soon and we need some solutions.

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