Six Ways People Leave Money on the Table

May 22, 2014

Most people associate financial planning with investment management, when in fact investment planning is only a small piece of the financial planning process. We actually believe that the investment management is the portion where the presence of a financial advisor adds the least amount of value. Nowadays, there is plenty of information and platforms for consumers to build a properly diversified portfolio, according to their age and risk profile, without professional help. The financial advisor may play an instrumental role in determining the right allocation of fixed income and equities, and at times can direct the investments to platforms that may not otherwise be available, such as institutional platforms. However, this is traditionally the main function associated with the financial planner profession, when in fact it encompasses a lot more.

In our experience, we make a more profound and quantifiable impact on our clients’ finances through an active management of their general financial plan and the decisions involved in this process, rather than just the selection of the mutual funds they should invest in. Below are some examples of these important decisions that our clients face during their accumulation and retirement phases.

1. Social Security Strategies:
Normally, people assume that they should start their benefits as soon as they can if they are already retired, but this decision is a lot more complex than it seems and there are important strategies that allow you to maximize your benefits.

For every year that you delay Social Security, your monthly benefit increases by approximately 8%. This increase is called delayed retirement credit. For a single person, generally speaking, it is worth delaying payments if the person ends up living to at least 85 years old. On the other hand, someone who lives until age 80 would be better off taking benefits at age 62. Of course, no one knows how long they will live but it is important to make a thorough analysis considering each one’s personal circumstances. It is also important to look at the other sources of income to determine what portion of the benefits will be taxable and how this situation is likely to change throughout the life of the individual.

When it comes to married couples, we find more significant planning opportunities, using some often unknown strategies. One of them is called “file and suspend”. Let’s suppose both spouses turn 66, which is the current full retirement age, roughly at the same time. Let’s assume the husband had a career and the wife stayed at home, and his full retirement age benefit is $2,000. When he turns 66, he can file for social security benefits and immediately suspend receipt of those benefits. This allows his wife to start collecting spousal benefits of approximately $1,000 as she turns 66, half of his benefit, while he accrues delayed retirement credits. At age 70, he can then start his own benefit and would be entitled to his maximum benefit, approximately $2,640/month. Most importantly, if he predeceases her, she’ll then receive his maximum benefit of $2,640 during her remaining years.

On this same example, let’s suppose the wife also worked. She can still choose to collect the $1,000 of spousal benefits between ages 66-70 and accrue delayed retirement credits on her benefits as well. When she turns 70, she then starts collecting her own benefits, now 32% higher for life.

These are just a couple of examples showing how families may miss some significant opportunities to maximize their retirement income.

2. Choosing the Right Retirement Plan
Maximizing Social Security payments is very important, but we also know that most likely those payments will not be enough to support many retirees’ lifestyles, which calls for the need to start saving early and diligently.

Making retirement contributions that are tax-deductible allow you to pay less taxes on the year when you earned the money and delaying those taxes until distributions are taken during retirement, when presumably you will be in a lower tax bracket.

For those who are employees of companies offering 401(k) plans, the obvious answer is to contribute as much into the plan as their cash flow allows, preferably the maximum of $17,500/year – without forgetting that people 50 and older are entitled to shelter additional $5,500/year.

If your employer doesn’t offer a 401(k), or you were just hired are not yet eligible to contribute, why not make a contribution to a Traditional IRA on the year that you were not covered by an employer plan?

When it comes to self- employed individuals and business owners, there are quite a few different options. SEP IRAs allow you to contribute about 20% of your self-employed income, up to $52,000, with very little administrative costs. Setting up your own 401k, also called Indi(k), coupled with a profit sharing, also allows you to contribute up to $52k, even if it represents up to 100% of your income, but will entail slightly higher costs. On the other hand, for those making $50,000/year or less, a SIMPLE IRA might be the best option, allowing deferrals of $12,000/year, again at insignificant administrative costs.

For the high-income earners with few or no employees, a defined benefit plan can really maximize retirement savings and tax deferrals, allowing contributions of up to $210,000. Those plans are more elaborate and have higher administrative costs, but they are a great tax planning resource for the high-income earners.

By proactively analyzing all these options, our clients can maximize their tax savings. In some cases, it may be acceptable to contribute to more than one plan – for instance, someone who has a side business can direct part of that income to a SEP IRA without jeopardizing their ability to contribute to their company’s 401(k). The analysis needs to be done every time circumstances change, if their business becomes more or less profitable, if they are adding employees, switching jobs, etc.

3. Pension Maximization
For our clients that worked in the government sector or in companies that offer a pension plan, there are also important decisions to be made. These employers often offer different options of pension benefits, the most common being the option of adding a spousal benefit.

For instance, one might be entitled to $1,000/month during his/her life alone, or could opt to take a lesser value, say $700, payable through the life of the employee or the spouse, whichever is longer. It is sensible to take care of one’s spouse, but at times this can be accomplished in a more cost effective manner.

If the employee beneficiary of the pension is healthy enough to apply for life insurance, we could use the difference in pension payments, those $300/mo from our example, to fund a life insurance policy on the employee’s life, which would then support the spouse upon his/her death.

If the employee ends up outliving the spouse, then the life insurance will assist the children or other heirs – in which case taking a lower pension payment would have turned out to be a poor choice.

4. Health Insurance Analysis
As we all know, due to the implementation of the Affordable Care Act (“ACA”), now everyone can purchase their own health insurance regardless of pre-existing conditions. Many people already had coverage through their employers, and may think the ACA is of no consequence to them.

However, they may be overlooking better options for their dependents coverage. Many times, employers subsidize the health insurance premium of their employees, but deduct the full amount of the dependent coverage off their paychecks. In many instances, the group coverage may be more expensive than what these dependents would pay for their own individual plan. In addition, at times, employers offer fewer choices of plans, which may be more comprehensive than what each person really needs.

Considering that pre-existing conditions no longer matter, we encourage people to take a close look at their paycheck deductions for health insurance premium, since they are usually a significant household expense. Unfortunately, open enrollment is closed for 2014, but voluntary changes of health insurance can take place again at the end of this year for 2015. We anticipate that the next open enrollment period will start on November 15, 2014.

5. Distributions During Retirement Years
For those clients that are retired, or taking regular distributions from their investment accounts for any reason, it is crucial to plan these distributions carefully.

Balancing distributions from taxable accounts – IRAs, 401ks – with distributions from non-qualified accounts, can make a substantial difference. As an example, we use a financial planning software that automatically attempts to find the most favorable tax distribution on the first year it is taken. According to this logic, one would recommend exhausting the non-qualified accounts first, and then tapping into IRAs and retirement plans later, thus delaying the taxable distributions. We learned that once we override the software default setting and manually adjust distributions to a more “balanced” mix, trying to keep taxes at a lower level throughout the life of the individual, the projections show a much better performance.

This happens because we are in a progressive tax system, and “overburdening” some years with higher taxable income will result in more dollars paid to the IRS. A common strategy that we recommend is to withdraw as much taxable income as you can to fill your current tax bracket, trying not to incur any income in the higher bracket. In addition, we need to take into consideration the fact that the client will need to take Required Minimum Distributions from IRA accounts after age 70 ½.

6. Use of Annuities when Appropriate
Purchasing an annuity can be very effective to mitigate risk of a retiree out living his/her assets. This risk becomes greater in circumstances when the market performs poorly in early years of retirement. It is a concept called sequence of returns. We can look at past returns as an attempt to estimate the average long term annual return of an investment portfolio, but it is impossible to estimate or predict returns for any given year. If an individual experiences extreme negative performance – such as we saw in 2008 – early in his/her retirement years, it would have a more drastic effect on the portfolio than if that performance was experienced after a few good years of positive performance.

Annuities can provide a predictable income guaranteed by the paying ability of the insurance company throughout the life of the individual. They can be a very good tool for a part of the portfolio of those whose projections show them on the cusp of running out of money. They can also be appropriate for those who are more risk averse and wouldn’t otherwise feel comfortable investing in a growth-oriented portfolio. It works like a “longevity insurance”.

However, annuities come at a higher cost than regular investment portfolios and have a substantial impact on liquidity due to high surrender charges during the first 7-12 years of the contract. Usually, we would not recommend it for those with plenty of assets and willing to ride market fluctuations.

Evidently, none of the above described strategies involve a cookie-cutter simple recommendation, and the role of the financial advisor is to understand every client’s situation and present the appropriate options. Even though the answers are not always obvious, our general belief is that these are some of the decisions which are likely to have a great impact on someone’s retirement savings, more so than the hypothetical discussion over choice of an active managed fund or an index fund, or the choice of a fund manager over another.