Friday, November 20, 2009

The Roth of Con(versions)

Tax Increase Protection and Reconciliation Act of 2005 (TIPRA)

TIPRA has a forward-looking provision regarding Roth conversions. It repealed the MAGI limit of $100,000 for 2010 and beyond on conversions. The contribution limits remain intact.
TIPRA also provided for a special tax treatment of Roth Conversions made in 2010. Unless a taxpayer elects otherwise, income from the conversion is taxed over a two-year period, beginning in 2011. So, if a taxpayer converts $100,000 of Traditional IRA money to a Roth IRA in 2010, he will add $50,000 to his tax return for the 2011 tax year, and $50,000 to his tax return for the 2012 tax year. If the taxpayer elects, he may add the entire $100,000 to his tax return for the 2010 tax year.

Cents and Sensibilities

The feasibility of a Roth Conversion depends on tax rates at the time of conversion, tax rates at the time of distribution, availability of funds to pay the taxes, expectations of portfolio growth, and likelihood of passing the account to non-spouse beneficiaries. Many of these factors are unknown; a decision needs to be made based on reasonable expectations. By evaluating the following questions, a Traditional IRA owner can to determine what the practical approach is:
  1. Will tax brackets rise after 2010?
  2. Will tax brackets remain above current rates for an extended period of time?
  3. Do you expect the account balance to increase meaningfully during 2010?
  4. Do you have non-retirement funds that you can use to pay the tax liability upon conversion?
  5. Will the Roth IRA likely survive both you and your spouse?; also,
  6. Will Congress initiate new taxes in 2010 that will be retroactive?
  7. Will a conversion trigger Alternative Minimum Tax or other surtaxes, or will it accelerate the phase-out of deductions and exemptions?
The more confident the taxpayer is that the answers to questions 1-5 are "Yes" and the answers to questions 6 and 7 are "No," the more confident he can be that a conversion early in 2010 would be practicable. The taxpayer should also consult his tax advisor before committing to any conversion.

To Bifurcate or Not To Bifurcate, That Is the Question

Assuming we convert to a Roth IRA in 2010, we have a choice of when to pay taxes. For conversions that occur in 2010 only, the taxpayer may pay the tax liability by April 15th, 2011, or they can add one-half of the converted amount to the tax return they file by April 15th, 2012 and the other half on the tax return they file by April 15th, 2013.
At first blush, you would think that we want to defer taxes until later. However, we are making the conversion in the first place to take advantage of the known lower tax rates currently in effect. Things are not as they seem—it is, as if, something is rotten in Denmark (or D.C.).
First off, converting to a Roth IRA becomes more advantageous if tax rates rise. Whether we pay the tax from the IRA or not, we are in essence betting that taxes will go up. Taxes are at historically low levels. Many political and economic pundits say that ballooning deficits will put pressure on the Government to raise taxes.
Secondly, the current tax law expires on December 31, 2010. Unless Congress acts, tax rates will return to 2006 levels on January 1, 2011. Tax brackets shift from the current 10%, 15%, 25%, 28%, 33%, and 35% rates to 15%, 28%, 31%, 36%, and 39.6%. Taxes on capital gains and dividends will rise, and certain credits will cease or be reduced.
Barring the unknown of Congressional action, we know the tax structure will be higher in 2011 and 2012 than it is in 2010. Unless a taxpayer knows that his taxable income will be significantly lower in the latter years, it makes sense that he pay taxes on the conversion in 2010. (As a broad supposition, if many taxpayers convert great amounts of IRA dollars and choose to pay the tax with their 2010 returns, it may ease the pressure on Congress to raise taxes in 2011 or 2012 beyond the de facto increases in place.)

Diversify, Diversify, Diversify

Investment advisors recommend that we diversify across asset classes to reduce purchasing power risk. They recommend we diversify within asset classes to reduce systematic risk. They recommend we diversify among banks and insurance companies to reduce unsystematic risk. We now have an opportunity to diversify among taxable, tax deferred and tax favored ownership to reduce income tax risk.
We know that mechanisms are in place to change taxes in the future, as they have changed over the past 100 years. Tax deferred assets such as qualified plans and IRAs are exposed to future tax risk. Taxable assets are exposed to both current tax risk and future tax risk. Roth IRAs (and their similar ownership forms such as 529 plans) are exposed to current tax risk, but avoid future tax risk—barring an outlying event such as a retroactive tax law change. As our assets accumulate in tax deferred ownership, we become over-weighted in future tax risk. Roth IRA conversions allow us to diversify this risk, just as we attempt to diversify to reduce the other risks.

What Good Hath Roth?

On May 24, 1844, Samuel P. Morse officially opened the Baltimore – Washington telegraph service by sending the message "What hath God wrought?" The telegraph led to the telephone. The telephone led to the cell phone. Following the trail of the cell phone leads to my teen-age daughter. I too lament, "What hath God wrought?"
Moving from the meta-physical and inter-personal to the financial, we can ask: "What good is a Roth IRA?" I admit that, when Roth IRAs were introduced, I thought they were a ploy to get people to pay taxes sooner rather than later. Looking more closely at the provisions and the mechanics of this ownership form has convinced me that Roth IRAs have a place in most people's retirement portfolio.


Roth IRAs were created by the "Taxpayer Relief Act of 1997." Under the Act, an individual may establish an IRA under which all distributions are free from federal income taxation if certain conditions are met. There is no income tax or penalty tax on distributions if the Roth IRA has been in existence for five years and the owner would qualify for a penalty-free withdrawal from a Traditional IRA—the owner attaining age 59 ½ being the most common qualification. After the five year period, contributions can be withdrawn income tax and penalty tax free even if the owner is younger than 59 ½. If a distribution is made from a Roth IRA without meeting the requirements, there is a 10% penalty tax on it plus income tax is owed on any portion that wasn't previously taxed.
One feature of a Roth IRA is that it is not subject to the Required Minimum Distribution rules as long as it's owned by the Contributor or spouse. Non-spouse beneficiaries may maintain the Roth IRA in its tax-free state, subject to a new 5-year hold and Required Minimum Distributions. A non-spousal beneficiary has to take the balance of the account within 5 years, or start lifetime payments before the end of the calendar year following the year of the contributor's death. Generally, there are no IRD issues involved. Additionally, since they bypass probate, Roth IRAs can be an efficient way of passing assets to heirs.
There is a catch to Roth IRA contributions. A married couple cannot make a contribution to a Roth IRA if their Modified Adjusted Gross Income (MAGI) is over $176,000 ($120,000 if single). A conversion of a Traditional IRA to a Roth IRA is prohibited if the taxpayer's MAGI is over $100,000 (married or single). (This limit to conversions is removed as of 1/1/2010 by TIPRA. See "The Roth of Con(versions).")

Pay Now or Pay Later?

Whether it is financially advantageous to convert to a Roth IRA or not is based on tax rates at the time of conversion and at the time of withdrawal. For comparison purposes, let us assume that a 50-year old has $100,000 in a Traditional IRA and is in the 35% marginal tax bracket. He will withdraw all of the funds in 20 years. If he converts to a Roth IRA, he will owe $35,000 in taxes, which he has available in a taxable account. Let us further assume that all accounts earn 6% annually, although the taxable account pays tax on its growth annually. He can either keep the $100,000 in the Traditional IRA and pay taxes on withdrawal, plus have $35,000 grow at an after tax rate; or, he can convert the $100,000 to a Roth IRA and pay the $35,000 in taxes now. On the day after he converts the funds he is either in a much lower (15%), lower (28%), same (35%), higher (42%), or much higher (55%) tax bracket. The table below shows the after-tax outcome of these five scenarios.

Roth IRA
After-tax Traditional IRA + Taxable Fund
Much lower tax rate
$272,607 + $94,650 = $367,257
Lower tax rate
$230,914 + $81,549 = $312,463
Same tax rate
$208,464 + $75,228 = $283,692
Higher tax rate
$186,014 + $69,374 = $255,388
Much higher tax rate
$144,321 + $59,632 = $203,953

For the Traditional IRA + Taxable Fund to equal or exceed the value of Roth IRA, the marginal tax bracket must drop 9% or more immediately after the conversion.
Now, let us assume that the 50-year old wants to consider a Roth conversion, but doesn't have funds to pay taxes with, other than the IRA. He will owe ordinary income taxes plus a 10% penalty tax on funds withdrawn to pay taxes. This time, we assume tax rates change some time before withdrawing everything from the Traditional IRA in 20 years. Using the assumptions above, we have the following outcomes:

Roth IRA - Taxes
After-tax Traditional IRA
Much lower tax rate
Lower tax rate
Same tax rate
Higher tax rate
Much higher tax rate

Even with the 10% penalty tax, it does not take much of a tax increase to make the Roth IRA worth more. A tax increase of 4% or more makes the Roth IRA beneficial, even if taxes are withdrawn from it.
The conclusion we can draw from this analysis is that: (1) if a Traditional IRA participant has outside funds to cover the taxes, a Roth IRA Conversion is advantageous as long as tax rates do not drop more than 9% immediately after conversion; (2) if a Traditional IRA partyicipant pays for the conversion from the Traditional IRA and incurs the 10% penalty tax, the Roth IRA Conversion is still beneficial if taxes rise 4% or more by the withdrawal date. These conclusions do not necessarily apply to new contributions—we are analyzing Roth Conversions only.

Take Backs; or, A Question of Character

We have looked at a number of "what-if's." Here is another "what-if": What if an IRA owner converts an IRA early in the year and the value goes down after that. For example, on January 2nd the owner converts a $100,000 IRA to a Roth IRA. On December 1 the Roth IRA is worth $60,000. The owner would have a tax liability on $100,000 but would get no benefit from 40% of that liability (the tax paid on the value that disappeared). Fortunately, you can "take-back" a Roth Conversion as long as it is done by the filing deadline. This process is called re-characterization. The IRA custodian will have forms that provide the proper information to perform a re-characterization acceptable to the IRS.
Let us follow the mechanics of conversion and re-characterization. The owner converts a Traditional IRA to a Roth IRA in January, 2010. (The earlier in the year that you convert the IRA, the more time you will have to take advantage of any tax planning.) On April 1, 2011, he compares the Roth IRA's value to its conversion value. If the Roth IRA is higher, he pays tax on the lower conversion amount when he files his taxes. If the Roth IRA is lower, the owner re-characterizes it back into a Traditional IRA and cancels the tax liability. Re-characterizations take two weeks or more, so the owner wants to allow time to act before he has to file, although a taxpayer can also file for an extension to file as late as October 15th.
If the owner re-characterizes the IRA, the money is back in a Traditional IRA but he wants it in a Roth IRA. The tax law says that re-characterized money can be re-converted by the later of the start of a new tax year or 30 days. The owner initially converted the IRA in the 2010 tax year. The money was re-characterized by April 15, 2011 for the 2010 tax year. Since he is past the end of the tax year, he waits 30 days and converts the Traditional IRA to a Roth IRA on May 15, 2011. The owner will pay taxes on the IRA's value when he files his taxes for 2011. Since the value is lower than when he initially converted the IRA, he will owe less tax on the conversion.
Setting aside the politics of deciding when we want to give the Government money to use or waste, Roth IRAs are an advantageous ownership form for most persons' retirement. They are an excellent estate planning tool: the owner is not forced to dissipate a Roth IRA through Required Minimum Distributions; Roth IRAs pass outside of probate as long as the estate is not the beneficiary; and, they can maintain their tax-free status for the heirs. Congress has made provisions that make converting a Traditional IRA to a Roth IRA especially advantageous in 2010. See the article "The Roth of Con(versions)".

Thursday, November 19, 2009

Goldman Sachs, Buffett to help small businesses

Goldman Sachs teams with Warren Buffett on $500 million effort to help small businesses
Yahoo! Finance
  • On 10:57 pm EST, Tuesday November 17, 2009
NEW YORK (AP) -- Goldman Sachs Group Inc. is teaming with billionaire investor Warren Buffett to invest $500 million to provide thousands of small business owners across America with college scholarships and boost their access to capital.
AP - FILE - In this March 27, 2009, file photo, Goldman Sachs Chief Executive Officer Lloyd Blankfein leaves the ...AP - FILE - In this March 27, 2009, file photo, Goldman Sachs Chief Executive Officer Lloyd Blankfein ...
The move comes as the company has been criticized for setting aside billions for employee paychecks despite the continuing weak economy.
Goldman's philanthropic effort, called "10,000 Small Businesses," includes a $200 million contribution to community colleges, universities and other institutions to give grants to small business owners to further their education.
The New York-based bank also will invest $300 million through a combination of lending and charitable support. Goldman said the money will be funneled through community development financial institutions to boost lending and technical assistance available to small businesses in underserved communities.
In addition, Goldman Sachs executives, in partnership with national and local business organizations, will aid small businesses with advice, technical assistance and professional networking opportunities.
An advisory council co-chaired by Goldman Sachs CEO Lloyd Blankfein will oversee the program. Legendary investor and Goldman's largest shareholder, Warren Buffett, and Harvard Business School Professor Michael Porter will serve as co-chairs as well. …
10,000 Small Businesses, which has been in development for nearly a year, is a five-year program modeled on the Goldman Sachs 10,000 Women initiative, which creates partnerships between academic institutions and non-profits to provide business and management education to women around the world.
Other Council members include George Boggs, president and CEO of the American Association of Community Colleges, Glenn Hubbard, dean of Columbia Business School and Marc H. Morial, president and CEO of the National Urban League, among others.
The first community college to participate will be LaGuardia Community College in New York City's Queens borough, which houses a Small Business Development Center. The first community development financial institution to receive financing from Goldman Sachs will be New York-based Seedco Financial Services Inc., with loans to underserved businesses in the New York area expected to begin early next year.

Wednesday, November 18, 2009

Obama Tax Credit May Cause Millions to Owe More Taxes

Financial Planning magazine


November 17, 2009

The Making Work Pay Credit, a tax credit that was a signature part of President Obama’s economic stimulus package in February, could lead to more than 15.4 million people owing additional taxes, according to a new government report.

… The credit is advanced to taxpayers by their employers through reduced withholding, resulting in an increase in take-home pay.

The Treasury Department’s Inspector General for Tax Administration said in a new report that the implementation of the tax credit creates the possibility that millions of taxpayers may be advanced more of the credit through reduced withholding than they are entitled to receive. When filing their tax returns for 2009 and 2010, such taxpayers may ultimately owe additional taxes.  Some also may be subject to estimated tax penalties.

The MWPC was implemented using new income tax withholding tables. However, the changes to the withholding tables did not take into consideration the dependents who receive wages; single taxpayers with more than one job; and joint filers where one or both spouses have more than one job or both spouses work. Other groups potentially affected include: individuals who file a return with an Individual Taxpayer Identification Number; those who receive pension payments; and Social Security recipients who receive wages. …

“While implementing a credit through reduced withholding is an effective way to provide economic stimulus evenly throughout the year, it is difficult to account for everyone’s circumstances,” said TIGTA Inspector General J. Russell George in a statement. “More than 10 percent of all taxpayers who file individual tax returns for 2009 could owe additional taxes because their withholdings were reduced by more than the Making Work Pay Credit. If corrective actions are not taken, this problem will continue to plague taxpayers in 2010.”

TIGTA recommended that the IRS increase media coverage, consider ways of advertising other than the media already being used, and target communications to taxpayers who may be adversely affected as a result of the MWPC. TIGTA also recommended that the IRS use the withholding tables that were in effect before the enactment of the Recovery Act for pension payments in order to prevent pensioners from being negatively affected by the MWPC.

The IRS agreed with TIGTA’s first recommendation and plans to take corrective action. However, the IRS did not agree with the second recommendation, claiming that it would be burdensome and costly.

Monday, November 16, 2009

Retirement income – the axiomatic case for annuities

J.P. Morgan Compensation and Benefit Strategies

Nov 12, 2009

… In this article we lay out the axiomatic case for annuities as the investment instrument for providing retirement income. Summarizing: where, over any particular period, the objectives are to maximize lifetime income without risking the possibility that you will outlive your assets, an annuity (vs. self insurance alternatives) will always provide the greatest income. …

Longevity risk – the unpleasant choices for those blessed with long life

… Longevity "risk" … is the risk of being old and poor. Not, say, age 70 and poor … . Instead, we're talking about being, say, 85 or 90 and poor. … [Poor] because the individual lived longer than he or she expected. The retirement savings have been spent, and the individual now has nothing.

What are the choices?

We are going to consider three different general strategies for dealing with longevity risk:

  • "ignoring" it, that is, depending on someone else (family, Social Security, state welfare systems) to finance it;

  • self-insuring;

  • or buying an annuity.

Ignoring longevity risk

If an individual is old and doesn't have any assets, one (or more) of three things happen. Either he or she: (1) moves in with his or her children or other family; (2) lives off of Social Security; and/or (3) lives on some combination of state welfare programs (e.g., a state-provided nursing home). Let's consider each of these alternatives in turn.

1. Living with family. The retiree may have a large and strong family, with a tradition, for instance, of grandparents living with parents and children. … [He] or she is also likely to have a positive motive in favor of preserving retirement assets for a legacy. If the individual does not have family members he or she can realistically live with, then alternative 1 is not a solution to longevity risk.

2. Living off Social Security. … In 2009 [the maximum] benefit is about $2,300 per month. If the individual lives in a low cost-of-living community and is prepared to get by on "very little," then alternative 2 may work.

3. State welfare. Finally, some states and municipalities have quite livable publicly funded "old age" homes. … At least at this time, in this country, there is still a safety net.

Realistically, if the individual is going to ignore longevity risk, i.e., not insure (either with an insurance company or self-insure) against outliving personal retirement resources, he or she is probably counting on some combination of alternatives (2) and (3) and perhaps, depending on family circumstances, alternative (1). …

What is self-insurance?

… Let's assume that you are primarily concerned about the risk of living to age 95. If you live past 95, then somebody is just going to have to take you in. … In that case, self-insuring simply means spending your resources at a rate that (more or less) insures that you will have income through age 95. …

… For purposes of this article we're going to assume that the typical individual, at 65, assumes that he or she is going to live into his or her 80s and is prepared to consider, at least, self-insuring for that period – say, 20 years. So that the individual will spend his or her resources at such a rate that they will last at least until age 85.

What is an annuity?

As we use the term in this article, an "annuity" is a guarantee by some other entity (e.g., a pension plan or an insurance company) of a specific income "for life," that is, with payments beginning on some date and continuing until you die.

Rate of return

… For purposes of this article we're going to assume the same investment return (generally 5% per year) for all purposes: whether you're ignoring longevity risk, self-insuring or buying an annuity. …

… This is not the place to discuss alternative return strategies. Suffice it to say, identical alternative return strategies can be pursued either via self-insurance or an annuity vehicle, that is, in a variable annuity. Thus, the return strategy itself should not affect the relative efficiency of self-insurance and annuities. As a general matter, our conclusions hold whatever rate of return you assume, provided it is the same for whatever longevity risk strategy you pursue.

Comparing alternatives

Let's now quantify the financial alternatives available for mitigating longevity risk – self-insurance vs. annuity.

Let's assume you have $1 million, are age 65 and in average good health. … Let's consider four alternatives: (1) you self-insure for the period age 65 to 85 and disregard longevity risk thereafter; (2) you self-insure through age 95; (3) you self-insure for the period age 65 to 85 and buy an annuity for the period after age 85; or (4) you buy an annuity beginning at age 65 (the number provided here is for a DB plan, not a retail annuity).

The following table summarizes the results for each alternative.

Alternative--Income per month

Self-insurance age 65 to 85--$6,512

Self-insurance age 65 to 95--$5,279

Self-insurance age 65 to 85 + annuity 85-death--$6,091

Immediate annuity beginning at age 65 DB plan--$6,945

Explaining these results

…Self-insurance age 65 to 85 – means you spend all your money, at a rate of $6,512 per month, to age 85. If you live past that age, someone else has to pay your living expenses.

Self-insurance age 65 to 95 – means you spend all your money, at a rate of $5,279 per month, to age 95. As discussed, this is more or less the equivalent of fully self-insuring longevity risk, that is, survival past age 95 can be realistically ignored.

Self-insurance age 65 to 85 + annuity 85-death – means you take some of your $1 million (about 6-7% to be precise) and buy, at age 65, an annuity that is payable for life beginning at age 85. This annuity is relatively cheap, because it doesn't pay anything unless you at least survive to age 85. You then take what's left over and spend it, at a rate of $6,091 per month, to age 85.

Immediate annuity beginning at age 65 – means just a regular old garden variety life annuity. As indicated, our immediate annuity number is based on what you would get out of a DB pension plan using current "standard" actuarial assumptions. Insurance company and regulatory overhead will add costs to annuities and bring the annuity income number down somewhat.

Tax effects

In our analysis we have generally disregarded tax effects. And, assuming our $1 million starts out in a qualified plan or IRA, taxation under self-insurance or an annuity will be, for the most part, identical. We say, "for the most part," because we have ignored two elements of the tax code that, in fact, further skew results in favor of annuities.

First, money held in a qualified plan or IRA, unless it's rolled into an annuity, must be distributed at a specific minimum rate (with a lot of oversimplifications, over the participant's life expectancy). At a stretch, those minimum distribution rules would permit a distribution over 20 years, i.e., allowing self-insurance over the period age 65 to 85. They would generally not permit distribution … under an age 95 self-insurance strategy, some tax-advantaged money would have to be distributed early and held in a taxable account.

Second, the after-tax rate of return on a taxable account (e.g., a garden variety bank or brokerage account) will be lower than the after-tax rate of return on a retail annuity. That's because the "inside build-up" on retail annuities is untaxed. …

When you put these two rules together, the annuity approach enjoys a tax advantage vis a vis self-insurance. Nevertheless, we regard that advantage as relatively marginal and have not taken it into account in our analysis.

Why are annuities such a better choice?

…Given those two objectives, maximizing retirement income and minimizing the chance of outliving your savings, annuities are the most efficient investment because – all other things being equal – they share the risk of outliving savings within the annuity pool. …

*     *     *

… Reviewing it, you would think that everyone would buy one. But the fact is, very few individuals do. Consider – only 2% of the income of current retirees comes from private annuities. (Increasing Annuitization in 401(k) Plans with Automatic Trial Income; Gale, Iwry, John and Walker; 2008.)…

Compromised longevity

The foregoing, "axiomatic" case for annuities holds for someone in average good health. Clearly, if you realistically expect not to live to an average life expectancy – that is, your longevity risk is, for some reason, compromised – then you should generally not buy an annuity. …

Solvency risk

If you take the annuity approach, then a third party will be paying you an income for life. Generally that third party is either an insurance company or an employer-sponsored pension plan. Both insurance companies and (corporate) pension plans are subject to solvency rules – requiring them to fund benefits at certain minimum levels. Moreover, many states provide insolvency funds for insurance companies that go "bankrupt," and the Pension Benefit Guaranty Corporation generally insures corporate pension benefits up to certain minimum levels.

…Suffice it to say, if you are taking an annuity option, you will want to evaluate the possibility that, under some circumstances, the third party annuity provider might not be able to make payments.

Explanations focusing on aspects participant behavior

Concerns about compromised longevity and carrier insolvency risk cannot, however, explain the overwhelming rejection of annuities by participants. …

In recent years, the field of “behavioral economics” has provided insights as to why individuals do not always act in accordance with “rational” principles. … While we recognize the fruitfulness of this perspective, we are resistant to the idea that low uptake on annuities is simply a result of irrational decision-making. …

Individuals view early death as "losing" in an annuity system

If you look at the actuarial tables, over 15% of a typical age 65 annuity cohort will die in the first ten years. They will "lose" – by dying early – a significant portion of the value of their benefit. We put "lose" in quotes because the axiomatic argument does not regard this as a loss. The participant is dead and so does not need any more income. And the participant could have had no fixed legacy intention with respect to the "lost" money – if (as was in fact more likely) he or she had lived to a normal life expectancy, there would have been no money "left over" to leave to heirs and beneficiaries.

Our guess, however, is that people don't think like that. …[Human] beings are reluctant to take a substantial risk that money they worked hard for will simply go to strangers, even after they're dead. … Humans retain, and act on, a proprietary view of their money, even after their (anticipated) death. …

Annuities limit flexibility

Simply, if money is "locked up" in an annuity, there is no (or, at least, less) money available for emergencies or, for that matter, for something special.

Individuals place a lower value on life after 85

… More nuanced: a 65 year old does not regard the financial challenge presented by living past 85 as a particularly high priority. Perhaps an analog to this is the reluctance of young people (say, individuals in their 20s) to buy health insurance. In both cases, the likelihood of catastrophe – a health catastrophe for a young person or a longevity catastrophe for an old person – is small enough that the individual feels comfortable ignoring it. (This argument reflects the behavioral economics notion of “hyperbolic discounting.”)…

This is a publication of J.P. Morgan Compensation and Benefit Strategies. J.P. Morgan Compensation and Benefit Strategies is a part of JPMorgan Chase & Co. If you have any comments or questions, please contact your J.P. Morgan Consultant or Insight Editorial.

This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. J.P. Morgan Compensation and Benefit Strategies is wholly owned by J.P. Morgan Retirement Plan Services LLC, an affiliate of JPMorgan Chase & Co.

IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.


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Thursday, November 12, 2009

Leading the Horse to Water

 Legislation may nudge plan sponsors to reconsider annuities—but what about participants?

Judy Ward


Illustration By Marco Wagner


The market's recent plunge likely frightened more Americans into a willingness to consider putting at least some of their 401(k) assets in a retirement-income product at retirement. Now, Congress may give them a nudge to go ahead with it.

Support for tax advantages for annuities, previously proposed in 2005 by Rep. Earl Pomeroy (D-North Dakota), seems low this year… However, several other ideas appear to have potential traction, and they speak to the logistical and psychological reasons that many see at the heart of 401(k) participants' continued aversion to retirement-income products—the overall inertia, concerns about the complexity and cost of choosing an annuity on the open market, the fear of losing money to unstable financial institutions, and the impression that a series of small payments made over time has less value than one big lump-sum payment.

"As we bring more people into the system, we will need to address the longevity risk," says David Certner, AARP's Director of Legislative Policy in Washington, pointing to the Obama Administration's auto-IRA push. "Having a better-functioning annuities market would be very helpful."

Three Possible Solutions

These three possibilities seem the most discussed currently:

Auto-enrollment in annuities: Nonprofit public-policy researcher The Brookings Institution has proposed a "test drive" that would automatically enroll defined contribution participants in an annuity for two years after they retire. …

A government mandate to purchase annuities "would be a step in the wrong direction," [William Gale, a Brookings Vice President and Director of the Retirement Security Project] stresses. An annuity does not work best for everyone, he says, and, even when it does work well, a bunch of variables mean no one annuity setup is right for everyone. "It is very important that these things remain voluntary," he says. If people get the wrong annuity, he says, they "have made a big, permanent mistake."…

From an employer perspective, sources agree, auto-enrollment succeeds in giving many more participants access to a retirement-income vehicle. With opt-out rates low for automatic enrollment in 401(k) plans, "it is not likely that they will opt out" of auto-enrollment in an annuity, says Robyn Credico, Arlington, Virginia-based National Director, Defined Contribution Consulting, at Watson Wyatt Worldwide. …

The concept has its challenges, though. "The problem is the pricing," says Dallas Salisbury, President and CEO of the Employee Benefit Research Institute (EBRI) in Washington. "You could do it—but it would be a very expensive option, because any annuity that can be terminated at the end of two years becomes very expensive to underwrite." …

Edward Ferrigno, Vice President, Washington Affairs, at the Profit Sharing/401k Council of America, also worries about any sort of annuity mandate. "We … fully support … a tremendous amount of innovation [by annuity­ providers], he says, but it would kill that innovation if they mandated something. "For insurance companies, that is a jackpot: 'We have your money, and you cannot get it back.'"

A federal guarantee: Some believe that automatic enrollment in annuities makes little sense without setting up a federal-guarantee structure for annuities, similar to the Federal Deposit Insurance Corp. (FDIC) guarantee of bank deposits. …

On the other hand, "One thing employers might be ­concerned about is that the whole arrangement would be ­subject to future changes by Congress," says Jan Jacobson, Senior Counsel, Retirement Policy, at the Washington-based American Benefits Council, "and it would be a fairly expensive proposition." Adds Salisbury, "Given the current fiscal situation, even if people said it was a good idea, it would take a long time to do."

Channeling employer contributions: Brookings' Gale also talks about using legislation to funnel employer contributions to an annuity. "It would be a default," he says. "[The idea is that] the employer has to offer it, but it is voluntary for the individual."…

Ferrigno does not favor the idea at all. "We would fight that to the death," he says, again mentioning a dislike of plan-design mandates. "If there was a demand for ­annuity products in a plan, they would be there.” …

"There is a lot of interest. The Administration is in favor of it, and I think Congress gets it," Gale says. "…The sea change coming is going to be to think of a 401(k) not as an asset-accumulation device, but a retirement-income-provision device."

Jacobson also sees interest in annuities in Washington, but does not expect a stand-alone bill. … U.S. Rep. George Miller (D-California), Chairman of the House Education and Labor Committee, was said at press time to be "in the middle of drafting a retirement bill that might or might not include annuities," Salisbury says. "Everything at the moment is dominated by the health-care discussion. The probability of that [retirement] bill getting enacted this year is probably zero," he predicts. "The question becomes, does it become a priority in 2010 and 2011, assuming they get health care done this year?"…

Judy Ward

Legislation provides incentives for annuitizing distributions

Bipartisan legislation has been introduced to give workers a new incentive to annuitize, rather than spend, their retirement savings. U.S. Representatives Earl Pomeroy (D-North Dakota) and Ginny Brown-Waite (R-Florida) have introduced The Retirement Security Needs Lifetime Pay Act, H.R. 2748, which would encourage workers to annuitize some of their retirement savings by providing a 50% tax exclusion for up to $10,000 of lifetime annuity payments annually.

Other Provisions

The bill also will exclude from taxes 25% of lifetime income payments from individual retirement accounts (IRAs), qualified plans, and similar employer-sponsored retirement savings plans other than defined benefit plans. …

"For years, the federal government has recognized its duty to assist American families in building a retirement nest egg," Pomeroy said in a press release. "Saving and investing for the long term is extremely important, especially in these challenging times. A greater retirement challenge lies ahead: managing assets to make sure that your retirement savings last a lifetime. The Retirement Security Needs Lifetime Pay Act will provide families with incentives to plan for a secure lifelong retirement."

Alison Cooke

Monday, November 9, 2009

Total Benefits:Pay for (Patient) Performance


Illustration By Olaf Hajek

Behavioral economics plays a big role in the success of wellness programs

"People are constantly making trade-­offs between immediate gratification and delayed benefits," says Kevin Volpp, Associate Professor of Medicine and Health Care Management at the University of Pennsylvania's Wharton School. Employers could get better results in their wellness programs if they focused more on the immediate gratification, say Volpp and a team of academics currently researching the role of behavioral economics in these programs.

Volpp and Wharton School Professor of Health Care Management Mark Pauly call this approach "P4P4P": pay for performance for patients. Too often, they say, employers' wellness programs have had major incentive-related design flaws that hampered results. … Rather, people's psychological motivations should become a key part of wellness-program design, Pauly, Volpp, and their collabor­ators say, "Our human nature is a combination of rationality and irrationality. It is best to design a program that uses both approaches," Pauly says. "The rational thing is to be conscious of your mortality and doing something about it, … In some ways, life is too short to be rational all the time."

… "We have 25 years of research on the use of behavioral economics on the retirement-planning side, and we are now starting on the health side," says Paul Fronstin, Director of the Health Research and Education Program at the Employee Benefit Research Institute (EBRI) based in Washington. "What employers have learned is that they have not provided the right incentive" in wellness programs. …

What works differs based on the desired behavior change and the particular employees involved. "The whole challenge of the psychology is, what is the trigger point?" says Chris Mathews, a Vice President at The Segal Co. in Washington. Employers know their populations' trigger points better than wellness providers, he says….

Sources point to these ideas for employers to consider when designing a program:

 Money often motivates people to participate. … While the Wharton research has not yet determined if it is the best motivator for wellness adherence, Pauly says, "Our visceral feeling is that cash is preferred to income-in-kind." Offer employees $250 off their annual health-insurance premiums for participating, and "many people will not even notice that" … Volpp says. "But if they get a check for $250, that will be very noticeable," he says. …

A reward should materialize soon. … A reward has to be paid close to the behavior an employer wants to encourage, Pauly says. … As [Barry Hall, a Boston-based Principal at Buck Consultants, LLC] says, "There is what we call a 'present bias': People put more value on things that are right in front of them today than things that are off in the future."

 Consider making it competitive. Create some type of competitive atmosphere to get people engaged, Robbins suggests. So, a company with multiple sites might have a weight-loss or exercise competition amongst them, he says. …

 Ultimately, motivation has to become internal. Incentives do help drive near-term participation "but, when you take them away, most people rebound to their old behavior," says Kathy Harte, East Region Leader of the Hewitt Associates, LLC's Health & Clinical Consulting practice. … For something to become a long-term lifestyle change, the motivation has to shift from an external factor, such as a material reward, to an intrinsic motivation, [Hall] says. Employers can help by creating a "culture of health" in their organizations, he says.

"What has worked is a multiprong approach," Harte says. That means things like senior management leading a lunchtime walking program, middle management supporting employees who need to take a wellness day to get preventive care, and peer-level wellness "champions" who talk informally with co-workers about their success, she says. It also includes subtle messages such as whether staff meetings feature cookies or fruit as a snack, Hall says. "A lot of social things are going on [in those ­meetings]," he adds. "Is it cool to eat fruit?"

Judy Ward

Best of both worlds? Combined pension/401k plan

The Associated Press via Google Hosted News

By DAVID PITT (AP) – November 7, 2009

DES MOINES, Iowa — Over the last year it's become abundantly clear that the stock market can devastate even seemingly healthy retirement accounts. …

The vulnerabilities of the 401(k) plan have cast doubt on whether a voluntary savings plan is the best way for workers to prepare for retirement. There are some possible alternatives coming, however, that might just catch on. One that may become available in January offers a guaranteed pension-like retirement benefit alongside a 401(k).

It's called the DB(k) and it was created in the tax code in 2006. The law allows companies with fewer than 500 workers to start the hybrid plan after Jan. 1, 2010 … 

Here are some questions and answers that explain details of the DB(k):

Q: What are the basic features of the DB(k)?

A: There are two components to the plan:

Companies will be required to establish a pension fund sufficient to pay a worker in retirement up to 20 percent of that individual's average annual pay received during the last few years of work. After three years with a company, a new employee's benefits will be vested. … Their balance in this account would be paid out at retirement in monthly checks like a traditional pension plan. …

Alongside that benefit, the company will automatically take 4 percent of a worker's pay and put it in a 401(k) plan. The company must match 50 percent of that amount, which would be immediately vested. At retirement, the worker could withdraw additional funds from their 401(k) account to supplement the pension payments. Workers can opt out of their contribution or chose to set aside less.

Q: What's the reason for creating a hybrid pension/401(k) plan?

A: … More companies are dropping pension plans and workers with a 401(k) often do not save enough, leaving U.S. workers woefully unprepared financially for retirement. A recent study by The Center for Retirement Research at Boston College concluded that 51 percent of households likely will not have enough money in retirement to maintain their lifestyle, up from 44 percent in 2007.

The DB(k) idea allows companies to provide the benefits of a combined plan without onerous paperwork, regulatory requirements and costs that would come with operating the two plans separately, said Chris Mayer, a Principal Financial Group vice president. Workers get a more secure retirement with the guaranteed pension alongside their own savings.

Q: What types of companies would want to offer a DB(k) and why?

A: Companies must have at least two employees and cannot have more than 500 workers to implement a DB(k) plan. These plans are most likely to be offered by companies looking for professional workers in competitive fields — those who feel they need to offer this enhanced retirement plan to attract the best in their field or keep workers from going to a competitor, said Jan Jacobson, a spokeswoman for the American Benefits Council. …

Employers must completely fund the pension and provide matching contributions in the 401(k) plan. As a result, those adopting this plan need adequate cash to pay the cost, which Principal Financial's Mayer estimates to be about 6 to 8 percent of payroll. … [Companies] currently managing both a pension and a 401(k) might consider the new plans to reduce costs and paperwork.

Q: How soon are we likely to see DB(k) plans launched?

A: The DB(k) is authorized by the Pension Protection Act of 2006, which authorizes companies to begin offering the plans starting on Jan. 1. However, the Internal Revenue Service and the U.S. Treasury only recently began developing rules for the plans, so adoption may be delayed until later next year. …

Q: How can I find out more?

A: … If you want to do further research, you can find information by searching "DB(k) plan." The government frequently refers to the plans as "eligible combined plans" in its documents. You may also find some information under the IRS designation 414(x), which is the section of the tax code relating to the retirement accounts. The IRS details the plan in a document at:

Many details about the practical operations of DB(k) plans will not be known until the IRS and Treasury officials complete and publish the final rules, which could affect the number of interested companies.

Copyright © 2009 The Associated Press. All rights reserved.

Monday, November 2, 2009

What Sponsors and Advisors Should Know About Retirement Plans

October 28.2009
According to a 2007 U.S. Labor Dept. survey, 68% of small business owners feel unprepared for retirement and just 42% maintain a retirement plan. Here are four frequently overlooked tips about retirement plans for plan sponsors and their advisors.
  1. Understand the "controlled group" opportunity. If you or your spouse own and/or control several businesses, the IRS may require you to treat all of your businesses as one for certain retirement plan purposes. The controlled-group rules can affect retirement plan selection and operation and could mean higher deductible contributions.
  2. Determine your contribution budget. … For example, if your goal is to contribute more than $49,000, you will need to consider a defined benefit plan; a lesser figure can be served by such options as a simplified employee pension (SEP), savings incentive match plan for employees (SIMPLE) IRA, or 401(k)/profit sharing plan.
  3. Shop around. Fees for establishing and maintaining plans vary enormously. … [You]can …evaluate how much you are paying for such things as plan investments and record keeping. In fact, it is your fiduciary duty to do so.
  4. Keep good records. … Having an investment policy statement and documenting your activities for reviewing and evaluating your plan investments are good ways to start.
John Carl
Retirement Learning Center
Brainerd, Minn.

Fiduciary Liability Insurance vs. ERISA Fidelity Bonds – What’s the Difference?

Reish & Reicher
This article addresses an issue that every plan sponsor should consider whether they have ever been sued or not. We’re talking about the issue of insurance, and more particularly, the distinction between fidelity bonds and fiduciary liability insurance.
The issue is important because some confusion exists among retirement plan sponsors about their insurance needs. … Among other things, they learn that a bond is required by the Employee Retirement Income Security Act (“ERISA”). …
Under the bond requirement statute (ERISA §412), every fiduciary of an employee benefit plan and every person who “handles funds or other property of such a plan” is required to be bonded. The amount of the bond is 10 percent of the amount of the plan’s assets as of the beginning of each plan’s fiscal year. Unless the plan holds company stock, the maximum amount of the bond is $500,000. The statute requires the bond to “… provide protection to the plan against loss by reason of acts of fraud or dishonesty on the part of the plan official, directly or through connivance with others.” (Emphasis added.)
… For example, assume a plan has $7 million in assets as of the beginning of its fiscal year. Its bond amount is set at the statutory maximum of $500,000. The company’s CFO is a member of the plan’s administrative committee along with its CEO and COO. …
Over a period of months, the CFO writes checks for “consulting fees” to a dummy corporation. The dummy corporation in turn routes the plan’s money back to the CFO. The embezzlement is never detected until the CFO resigns. In that instance, the bond required by the statute may provide protection to the plan up to the maximum amount of the bond – $500,000.
Let’s assume, however, that the former CFO absconded with a total of $1.5 million. Even after the bond company pays the total amount of its liability under the bond, the plan is still out $1 million. Not surprisingly, the participants are upset and question why the other members of the administrative committee – the CEO and the COO – failed to prevent the loss from occurring. … [Neither] the CEO nor the COO was complicit with the CFO. Rather, they were simply ignorant of what the CFO was doing. In other words, one might argue that the plan lost money for two reasons: (1) the CFO’s theft and (2) the innocent breach of fiduciary duty by the CEO and COO. The former is covered by the bond. The latter is not.
These facts are skimpy and we couldn’t say – without knowing more – whether the CEO and COO would ultimately be liable for a breach of fiduciary duty. That issue is secondary, however, to how the fiduciaries will pay the cost of defending themselves against the claim. The answer may be fiduciary liability insurance. …
Several companies offer fiduciary liability insurance designed to cover claims and losses arising out of claimed breaches of fiduciary duty. … The plan itself can purchase liability insurance for its fiduciaries as long as the policy allows the insurer to seek recourse against the fiduciary if the fiduciary is determined to have breached his duty to the plan. Otherwise, the employer or the fiduciary himself can purchase insurance. …
There are several issues to think about in considering fiduciary liability insurance. Among them: the annual premium cost; the amount of coverage needed; the amount of any deductible; whether the deductible is charged any time a claim is made or only if there is a settlement or judgment, and; whether the limits of liability under the policy are reduced by attorneys fees and costs incurred in defending against a claim.
Fiduciaries are personally liable for losses incurred by a plan due to their breach. Although it isn’t required by ERISA – as is a bond – every fiduciary of an ERISA plan should seriously consider obtaining fiduciary liability insurance.

Any tax advice contained in this communication (including any attachments) is neither intended nor written to be used, and cannot be used, to avoid penalties under the Internal Revenue Code or to promote, market or recommend to anyone a transaction or matter addressed herein.

© 2009 Reish & Reicher, A Professional Corporation. All rights reserved. THE ERISA CONTROVERSY REPORT is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish & Reicher does not warrant and is not responsible for errors or omissions in the content of this report.

Defined Benefit 401ks set to make their debut
Posted by gailperry in on 10/29/2009 - 12:19
Small business owners have plenty of options to choose from when it comes to a qualified retirement plan for the company. It can range from a Savings Incentive Match Plan for Employees (SIMPLE) to a Simplified Employee Pension (SEP) to a 401(k). But now there’s a new kid on the block.

Strategy: Consider the defined benefit 401(k) plan (called the “DB/401(k)” for short) for small business clients. This hybrid plan combines some of the advantages of a traditional pension plan with a regular 401(k).
…The authority for this new plan, which becomes available on Jan. 1, 2010, was buried deep within the massive Pension Protection Act of 2006. But interest in DB/401(k)s is expected to heat up during the coming year. …
It is available for the 2010 plan year to employers with at least two employees and no more than 500 employees.
The DB/401(k) combines a defined benefit plan based on final average pay with a safe-harbor 401(k). Two requirements:
1. The defined benefit part of the plan must provide a benefit equal to 1% of the final average pay times years of service up to a maximum of 20% of final pay. …
2. The 401(k) part of the plan requires automatic enrollment with an employee deferral of 4% of compensation. …

  Advisory: If these requirements are met, the company has to file only one document for the plan and one Form 5500, Annual Return/Report of Employee Benefit Plan, each year. Best of all, employers don’t have to undergo the rigorous testing procedures for 401(k)s. Simply make the allowable contributions, file the paperwork and you’re set.
Requirements for automatic-enrollment 401(k)s

Elective Deferrals By Employees     
Automatic deferral must equal between 3% and 10% of compensation with:
• At least 3% in the first year of participation
• At least 4% in the second year of participation
• At least 5% in the third year of participation
• At least 6%, but not more than 10%, in any subsequent year of participation
Employer Contributions
100% vesting after no more than two years under either of the following two options:

Option 1: Matching contributions for nonhighly compensated employees (non-HCEs)* must equal 100% of elective deferrals up to 1% of compensation + 50% of elective deferrals of more than 1% up to 6% of compensation.

Option 2: Automatic employer contribution must equal 3% of compensation.
*Matching contribution rate for highly compensated employees (HCEs) can’t exceed matching contribution rate for automatically enrolled non-HCEs.
Reprinted with permission from The Tax Strategist, October 2009. For continuing advice on this and numerous other tax strategies, go to Receive 2 FREE Bonus reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013. …