A few weeks ago Congress passed and the President signed a comprehensive budget bill that will last through the rest of Obama's Presidency. The good news is the end of brinksmanship for the next two years. So no more market swoons when the debt ceiling nears and an agreement between the parties seems impossible. For at least the rest of fiscal year 2016 (which runs from this October 1st to next October 1st) and all of fiscal year 2017 the federal budget is in place. That also means no more worker furloughs, no more closed National Parks, and as mentioned but most important, no default of our national debt. This agreement changed some things, tried to fix some problems and actually cut some expenses as unlikely as that may sound. Now the bad news; In doing so they have made at least two changes to retirement programs that might affect you - there could be more but like most laws there are a lot of pages to go through so it may take a few more weeks to figure it out.
As for the first change, if you are still working and the company you work for has a pension plan, that plan is probably backed up by the Pension Benefit Guarantee Corporation (PBGC) which will pay you at least some of your benefits should the pension fund run dry. The PBGC was set up by the government but is supposed to be funded by insurance premiums paid by the companies that sponsor the covered pension funds. The cost of that insurance in 2015 was $57 per covered person - starting in 2016 it will rise over the next three years to $78 per worker. While $21 doesn't seem like a lot of money it's just another expense of having a pension plan vs. having a 401K or other defined Contribution plan where the assets available at retirement are the employees' responsibility not the employer's. Along with this small change that is designed to cover the $60 Billion short-fall in the PBGC are other new guidelines that will help insure that pension plans can meet their obligations. While this is sensible on the surface, the government doesn't want to bail out plans that haven't been properly managed; in reality the average pension plan has less than 82%* of the funding it is supposed to have to meet its future obligations. So on top of the slight increase in insurance premiums, there will be bigger tax penalties on plans that are underfunded - making them that much more unaffordable. In a nutshell, these provisions save the government money by decreasing the liability the government has for failed pensions - but it also will accelerate the already quick transition from pension plans to defined benefit plans. Further, many of these provisions that only applied to corporate pensions have now been extended to union pensions as well - so those union shop pensions that seemed so safe even as corporate pensions went away may be on the wane as well.
The next change affects many more of you as it has to do with Social Security. The File and Suspend strategy for spousal Social Security benefits will be going away - although it seems this will not affect those already employing this strategy. But what is this provision? The easiest way to tell you is by giving you an example. Max and June are married and 65 years old. June is still working but Max is retired. As a spouse, Max is allowed to collect his Social Security or � of June's Social Security - but he can only choose the second option if June has filed for benefits. Let's say that at age 65 Max's monthly benefit would be $900, but � of June's benefit is $1,000. June doesn't want to collect right now because as she's still working and younger than the full retirement age of 66 anything she gets in Social Security payments is subject to the so called "give back" rule. But June can file for Social Security and then suspend her payments - that way she doesn't pay the penalty for earning too much and her benefit keeps growing until she's 70 - but at the same time Max can still get the $1,000 a month of spousal benefit allowing Max's own benefit to keep growing. Then at full retirement age June can start collecting her benefit at the maximum amount and Max can shift at age 70 from the Spousal benefit of $1,000 / Mo. to his own benefit which would have grown to $1,200 / Mo. (For simplicity I'm ignoring possible cost of living adjustments.). In this way Max and June have gotten $6,000 more dollars from Social Security between Max's age 65 and 70, and then $54,000 more from age 70 to Max's life expectancy. You can see why this provision is being eliminated, it manipulates the system to get you more income then you were supposed to get. By getting rid of the file and suspend option Social Security will pay out less money (estimated at $10 Billion per year) and be solvent for a longer period of time - but if you based your plans on getting that extra $60,000 over the course of your retirement, then things just changed dramatically.
I point these two instances out to make a larger point - the performance of your investments is only one small piece of retirement planning. If a couple with $500,000 in retirement savings was planning to use the file and suspend strategy as part of their retirement plan, with one swipe of the pen they lost more than if the market value of those investments went down by 10%. These outside issues, and adjusting your plans to account for them, can have far greater impact on your retirement lifestyle than if you slightly beat or slightly trailed a market index in the last year. For another example, let's say you're a couple in the 25% tax bracket - meaning you make about $75,000 a year of taxable income and you have a $250,000 taxable investment account that spins off almost all its income as short-term capital gains and non-qualified dividends and interest. If that account earns 8% and spins off that $20,000 of income in the way mentioned - you will pay taxes on that income at your 25% Federal Tax Bracket - so you'll pay $5,000 in taxes leaving you with $15,000 of after-tax earnings. Let's say that account was instead invested such that it spins off qualified dividends and long-term capital gains - but it only earns 7.2%. So you earn $18,000, but you only owe 15% in Federal taxes on those types of income, or $2,700. So after taxes you've earned $15,300 on your account - a couple hundred dollars more than the account that had a higher gross return.
Let's go back to the first change I mentioned that was incorporated into this new budget deal -the PBGC insurance increase. If you have access to a pension in retirement that allows you to take a big lump sum rollover in lieu of your monthly pension benefit -what should you do? The monthly pension payments are nice, but with most pensions vastly underfunded and the tax penalties and insurance premiums to keep those pensions viable making them even more expensive - what are the odds your union or company will be able to pay those pension benefits for the next 20 or 30 years? Most pension funding is also based upon an assumed rate of return into the future - so a pension that is only 80% funded may base that number on earning 7% a year on the pension fund; what happens if they only earn 6% or 5%? Should you take the upfront lump sum and pass on the seemingly more stable monthly income? Especially knowing if the PBGC gets involved there is a maximum monthly amount they will insure based on your age and other factors - maybe less than your pension is supposed to pay? Isn't this decision just as, if not vastly more, important than which large company investments you pick in your portfolio? Aren't these the decisions that really define what our retirement is going to look like?
We manage money for our clients and we think we do a pretty good job. But even the best portfolios can trail their index for a few months or even a few years. What we get paid for is not just that portfolio - helping you make the right decisions with these other aspects of your retirement - the legal, tax and administrative stuff that in most cases impacts your retirement success more than the investments themselves. If you choose the wrong pension option, get penalized for not calculating your required IRA distribution correctly, take Social Security at the wrong time, pay tens of thousands out of pocket to a nursing home because you didn't know you had other options - those are the things that will financially ruin your retirement - and those are the things we get paid to make sure you don't do. If you are reading this newsletter and are not a client of ours or if you are a client and know other people who think they're getting a deal because they pay very little for their money management - ask yourself or them what they are actually paying for. Because if it comes with no advice, if they find themselves making these legal and tax and administrative mistakes - then that's the true cost of their money management. Maybe it's an extra 5% or 10% in taxes every year, maybe it's not getting six months of Social Security payments because they didn't understand when they could file, maybe it's $40,000 in nursing home costs that MassHealth would have paid if they understood the system better. Or maybe it's something as simple an knowing how much you can withdraw from your investments each month, while still accounting for future inflation, and not run out of money before you run out of time.
I am sure these changes in the budget plan -and others that we'll figure out as the exact provisions become public - will affect many of you. We'll be there to let you know about these changes, and if necessary help you work though them. Please see the article below for another administrative change that is a real positive and will help our children and grandchildren get started in retirement savings.
*Pension "fix" by Congress Could Backfire; John W. Schoen, CNBC.com
- Nov. 3, 2015.