creation of a state social security & retirement supplemental...
TRANSCRIPT
©Copyright Christopher St. John 2009
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Creation of a State Social Security & Retirement Supplemental Plan
By
Christopher St. JohnCFP®, ChFC©, CASL™, CDFA™, EA
April 24, 2009
©Copyright Christopher St. John 2009
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Introduction
During an extremely poor economic time, similar to the one now, our nation tends
to focus on short term or immediate fixes and forgets about the long term, especially as it
relates to finances. Short-term solutions are indeed critical to our financial survival, but
we Americans, specifically those younger than the baby boomer generation, must not lose
focus on our country’s long-term goals. And with the current economic crisis upon us,
we must take steps now to ensure our financial future.
The younger generations of our country face a serious threat to their future
retirement. Social Security is a major source of income for current retirees, and in the
near future the fund is projected to take in less money than it can pay out. Future
recipients face the real prospect of not receiving the Social Security income they have
been told they are entitled. They will instead receive far less than the projected amount
shown on their annual benefit statement. This loss of Social Security funds alone, since it
represents such a large percentage of retiree’s income, will create serious problems for
future generations of retirees.
Along with the shortfall in Social Security income benefits, the shift from Defined
Benefit Pension plans to Defined Contribution plans by companies will add to the
problem of Americans lacking future retirement income. Companies are taking less
responsibility for retirement income while transferring more of it to the individual
employee. Therefore individuals must adequately fund, through savings and good
investments or the individual will not have enough to live on when they retire.
To help prevent this shortfall in future retirement income it is necessary to
implement a system that will allow individuals to make up for some of their “losses.”
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South Carolina should create a State Social Security and Retirement Supplemental Plan
(SSSRSP). This plan will allow individuals to save and invest money tax-free, for
potential growth, and also receive the funds tax-free following retirement. This
privatized retirement system will not negatively affect the current Social Security fund
and could potentially prolong the life of the Social Security Trust fund.
This paper will discuss the background of the Federal Social Security system and
the problems the system is facing. It will detail trends in the retirement plan industry and
the problems associated with these trends while also discussing the income and savings
habits of Americans and what this means for their future. A solution to this potential
crisis will then be presented.
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Background of Social Security
The Old Age and Survivors Insurance Program (a.k.a. Social Security) was passed
by the United States Congress in 1935. This act was put in place to provide workers aged
65 and older retirement income benefits.
In the late 1800’s and early 1900’s, rural Americans, enticed by higher incomes
from industrial employment, left family farms and small towns for big, bustling cities.
This was a monumental shift in the American lifestyle. Despite being raised in spacious,
self-sustaining, agricultural environments, the new urban-dwellers adapted well to the
tight confines of the cities. They found good paying jobs to support their families. The
income allowed them to acquire food and shelter, two necessities that previously would
have been grown or built with their own hands in the country.
During the 1920’s America was in an expansion mode and it seemed like it would
continue nonstop, as companies expanded through the use of debt, and individual
investors wanting to cash in on the growth sought instant wealth through the use of
margin accounts. This growth, however, was strictly on paper. On October 29th 1929,
this overextended period of growth and debt-use came to a screeching halt. Over the next
3 months the stock market lost 40% of its value and banks were suddenly unwilling to
lend money to businesses or individuals. Since banks would not lend money to
companies to purchase goods or pay employees, layoffs began. Fearful of losing their
jobs, individuals were reluctant to buy unnecessary goods, which helped trigger an
economic spiral downturn. Soon banks were being squeezed, as businesses defaulted on
loans because they could not be profitable with stingy consumers. This led to a massive
number of bank failures throughout the nation. The trickle-down effect eventually
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pushed America into a depression over the coming years. The Gross National Product
declined from $105 Billion in 1929 to $55 Billion in 1932 and unemployment swelled
beyond 25% (SSA. Historical Background).
During the crisis, a variety of ideas emerged on how best to resolve the problem
and provide relief to hurting Americans. Examples include Huey Long and Francis
Townsend who drafted two completely different proposals. Long, Governor of Louisiana
in 1928 and later a Senator in 1930 recommended a program entitled “Share Our
Wealth”. This program ensured that every family received a guaranteed, annual income
of $5,000 by the Federal Government for basic necessities. Along with the guaranteed
income, Long wanted to “Socialize” the rest of the country’s money by limiting private
fortunes to a maximum of $50 million, legacies of $5 million and a maximum of $1
million of income per year( SSA. Historical Background).
Francis Townsend’s proposal entailed a guaranteed government pension of $200
per month to every American over the age of 60. The program was to be funded by
revenue from a 2% national sales tax. Eligibility required an individual to be retired,
have a “criminal free” past and the money had to be spent within 30 days of being
received (SSA. Historical Background).
On June 8th 1934, President Roosevelt announced his intention to create a Social
Security program. He formed a committee which was instructed to study the current
economic problem and report its findings and recommendations back to him. In January
1935, the committee gave its report to the President who subsequently presented the
findings to Congress for approval. In July of that same year a bill was passed. On
August 14th 1935 The Social Security Act was signed into law by President Roosevelt
(SSA. Historical Background).
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There were two major sections in the Act: Title I, which supported temporary
state welfare programs for the aged that would ultimately fade away; and Title II (now
commonly known as Social Security), which supported paying retirement benefits to a
family’s primary worker when they reached the age of 65 (SSA. Historical Background).
This was such a drastic change for Americans that the program needed to be
explained to the people, so the Social Security Board was formed. The SSB’s primary
duty was to explain the details of the new program to the public, including employers and
employees. Employers needed to understand how to account for withholding amounts
based on earnings; employees needed to know when they were eligible and how they
could get benefits. A key feature of this process was assigning Social Security numbers
to individuals. This was an enormous but crucial task, as the numbers helped identify
and keep track of eligible beneficiaries.
Initial benefits distributed from 1937 to 1940 were handed out in annual, lump-
sum payments. The sole purpose of this was to provide some benefit to those Americans
who had contributed to the Trust Fund but due to their age would not participate long
enough to be vested for any monthly benefits. The average lump sum benefit during this
period was $58.06 (with the smallest payment being $.05) (SSA. Historical Background).
Amendments to this program have continued over the years. In 1939 a survivor
and dependent benefit was added to help those who relied on the income of the insured.
If the insured died, dependents and survivors, previously ineligible, would now be
eligible for benefits based on the benefits of the insured’s. In the 1950’s, Social Security
coverage was broadened to cover not just a limited number of jobs, but rather most of
them in the economy. In 1956 a disability benefit was added to help those who were
eligible for Social Security benefits at their full retirement age but became disabled
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before they were age-eligible. In 1965 Medicare was created which would now provide
federal health insurance for those of age. This program was later changed in 1972 to
assist people under age 65 who were disabled. In 1972 a Cost of Living Adjustment
(COLA) was added to the Social Security program to help protect benefits against rising
inflationary costs. In 1972 a Supplemental Security Income (SSI) was added which
provides a national uniform floor of income protection for the aged, blind, and disabled.
SSI provides monthly payments which are supplemented by individual states based on
regional standards of need. SSI is a program that is funded from general Federal
revenues, not from Social Security taxes (SSA Why Social Security).
The major accomplishments of the Social Security program in its first three years:
More than 39 million people had signed up for Social Security retirement accounts; more
than 25 million workers had been covered by unemployment compensation. Close to 1.7
million people were already receiving monthly cash disbursements. Over $47 million
had been paid to support dependent children by the Federal Government. More than
39,000 needy blind persons were receiving monthly cash disbursements (The Wisconsin
Connection).
Current key statistics:
In 2006, 40.5 million beneficiaries received benefits from the Social
Security program, which is projected to increase to 43.8 million in 2010
and to 78.9 million in 2040 and to 96.6 million in 2080 (EBRI FACTS
The Basics of Social Security)
Current assumptions OASDI trust fund expenses are expected to exceed
income from taxes in 2017 and expected to exceed income from taxes and
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interest in 2027, and the Trust fund is expected to be exhausted by 2041
(EBRI FACTS The Basics of Social Security).
Under a low cost assumption the OASDI expenses are expected to exceed
income from taxes in 2022. However, the fund is expected to remain
solvent throughout the next 75 years (EBRI FACTS The Basics of Social
Security).
Under a high cost assumption the OASDI expenses are expected to exceed
income from taxes by 2014 and will be exhausted by 2031(EBRI FACTS
The Basics of Social Security).
As the number of retired workers continues to grow, the ratio of people
receiving benefits to the number of workers paying into the Social
Security Trust Fund is projected to fall from 3.3 to 1 in 2007 to 2.7 to 1 in
2017 and will fall to 2.1 to 1 in 2034 (Facts and Figures about Social
Security 2008).
In 1962 Social Security benefits represented 30% of total aggregate
income (which included gov’t pensions, private pensions, asset income,
earnings, misc, and Social Security income). By 2006 that percentage had
jumped to 37% (Facts and Figures about Social Security 2008).
The Social Security Trust fund obtains its income from three sources. The first
and most significant is the collection of taxes. Employees and employers each
currently pay 6.2% of an employee’s income up to $106,800 (in 2009) while self
employed persons pay 12.4% out of their earnings. The second source of income
for the trust fund is the interest it earns. The trust fund is invested in non-tradable
government bonds which earns a comparable interest rate to tradable government
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bonds. The third source of income for the trust fund is from the taxes it collects
on the social security benefits that are paid out to beneficiaries (EPI Facts at a
Glance). In 2007 the OASDI Trust fund had income of $785 billion of which
$656 billion was from contributions, $19 billion from taxation of benefits, and
$110 billion from interest earned. The Trust fund had expenditures of $595
billion of which $585 was in the form of benefits (SSA News Release).
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Retirement Plans
There are a number of retirement plans used jointly by employers and employees
today. Most of these fall within two broader plans: The Defined Benefit Pension Plan
and The Defined Contribution Plan. Although the ultimate goal of these two plans is the
same—to provide the employee with income when they retire—there are fundamental
differences as it relates to contributions, distributions, risk, and responsibility, that effect
employers and employees.
In a Defined Benefit Pension Plan, the employer is primarily responsible for
retirement benefits. Through Defined Benefit Pensions employers usually provide a
monthly payment to an employee following his or her retirement. The monthly amount is
calculated by a set formula. There are several formulas often used by employers,
including the Flat-benefit, Career-benefit, and Final-pay formulas.
The Flat-benefit formula calculates benefits by multiplying the employee’s salary
at retirement by the total number of years worked, and then multiplying that by the
accrual rate. The final amount can either be paid to the employee in monthly installments
or one lump-sum amount (the latter places the responsibility of retirement income on the
employee) (Wikipedia).
A little more flexible, the Career-average formula can determine benefits two
ways. First, the benefits can be based on average compensation by reviewing the
employee’s entire work history; second, benefits can be based on a percentage of each
year’s salary. For example, the company would take one percent of the each year’s
salary (Daniels).
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The last, but most widely used, is the Final-average pay formula, which
determines retirement income by averaging the final years (usually the last 5) of the
employee’s income (Wikipedia).
A Defined Benefit Pension plan is either “funded or unfunded”. A funded plan
has specific assets put aside by employers that are invested for future benefits. Since
investments are not guaranteed and returns fluctuate, regular reviews and valuation of the
plan and the plan’s assets are required. Unfunded plans, like our Social Security Program
and most Defined Pension Plans in the United States and European countries, have no
assets set aside for future benefits but rather work through a “pay as you go” system.
This means there is no reserve set aside for future promised benefits (Wikipedia).
There are many disadvantages for employers and employees associated with
Defined Benefit Pension plans. Occasionally employees are subjected to “age bias,” an
unwritten “rule” that states they have to remain with the same employer for a lengthy
period of time before any “real” benefits accrue, as the present value of the employee’s
benefit grows more slowly during the earlier years when salaries are usually much
smaller. Portability is a problem employees encounter also, since they are typically
prohibited from moving their retirement funds if they leave a company. Another
criticism of Defined Benefit Plans is that the future lifestyles of employees are basically
dictated by companies as a result of the income directly provided by the pension plans
(Wikipedia).
There are some distinct positives for employees, however, such as knowing
exactly what their future retirement income will be, and that the responsibility of saving
for retirement belongs to the company. Also, pension plans can be constructed so they
can be transferred to a spouse in the event of a pensioner’s death (although this option
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generally results in a lower monthly payment passed on). Finally, if a company was
unable to pay the retirement benefits, or was to go out of business, the employee’s
pension plan would be covered by the Pension Benefit Guarantee Corporation (PBGC).
One significant issue associated with a Defined Pension Plan from an employee’s
perspective is the fear that a company will be unable to pay the future benefits or will go
bankrupt. If that was to happen the pension fund will then be turned over to the PBGC.
Despite the security the PBGC provides, the retirement amount paid out by it is lower
than what the employee would have received from the company. If the employee has not
put other money away to make up for this potential shortfall, then their financial future
may be compromised.
The Pension Benefit Guaranty Corporation (PBGC) is a federally created program
designed to protect Defined Benefit Pension plans albeit at a lower amount. The PBGC
was initially created by the Employee Retirement Income Security Act of 1974 (ERISA).
The PBGC receives operating income from insurance premiums set by Congress which
are paid by the Defined Benefit Pension plan sponsors, investment income, and any
potential recovery from companies who were formally responsible for the plan.
(PBGC.gov)
The PBGC insures two types of pension plans: single-employer plans and the
multiemployer plan. If the PBGC takes over a pension plan from a company, the PBGC
will pay monthly retirement benefits up to a guaranteed maximum amount. The
maximum guaranteed monthly amount of benefits is based mainly on one’s age on the
plan termination date. As shown on the table on the following page, based on their age
what ones maximum guaranteed monthly income amount would be.
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PBGC Maximum Monthly Guarantees for 2008
Age 2008 Straight-Life Annuity 2008 Joint and 50% Survivor Annuity
65 $4,312.50 $3,881.25
64 $4,010.63 $3,609.57
63 $3,708.75 $3,337.88
62 $3,406.88 $3,066.19
61 $3,105.00 $2,794.50
60 $2,803.13 $2,522.82
59 $2,630.63 $2,367.57
58 $2,458.13 $2,212.32
57 $2,285.63 $2,057.07
56 $2,113.13 $1,901.82
55 $1,940.63 $1,746.57
54 $1,854.38 $1,668.94
53 $1,768.13 $1,591.32
52 $1,681.88 $1,513.69
51 $1,595.63 $1,436.07
50 $1,509.38 $1,358.44
49 $1,423.13 $1,280.82
48 $1,336.88 $1,203.19
47 $1,250.63 $1,125.57
46 $1,164.38 $1,047.94
45 $1,078.13 $970.32
(PBGC.gov maximum monthly amount)
If an employer decides to end a pension plan they must do so by going through a
process called a “planned termination”. There are two types of plan terminations:
Standard Termination and Distressed Termination. A Standard Termination takes place
only after the plan sponsor demonstrates to the PBGC that they have enough assets to pay
all benefits owed to participants. The plan must then either purchase an annuity to
guarantee these payments or pay a lump-sum payment that will cover the entire benefit.
A Distressed Termination is a termination of the pension plan when it is under-funded
and the employer is in financial distress. To accomplish this, the sponsor must show the
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bankruptcy court or the PBGC that it will not be able to remain in business unless the
plan is terminated (PBGC.gov termination).
Under certain circumstances the PBGC may decide to initiate the ending of a
pension plan. This is done to protect both the PBGC as well as the participants in the
pension plan (PBGC.gov termination).
For employers, providing predictable retirement income is beneficial in a couple
of ways. It relieves the employee of the stress associated with saving for retirement and
allows them to focus on their work, which employers hope will result in better
productivity. It also helps the employer assess and budget the necessary monetary funds
for the pension plan. The biggest drawback of a Defined Benefit Plan for an employer is
the cost, as they bear the burden of securing an income stream of retirement benefits to
employees.
Defined Contribution Plans rely on monies paid annually or periodically into an
employee’s individual retirement account. Limited contributions are made by the
employee, employer, or both and invested in a variety of different investments such
things as mutual funds to help the account grow. The amount of an employee’s
retirement benefit is determined by the amount of contributions as well as the
performance of the investments within the plan. Many types of defined contribution
plans currently exist, such as Savings or Thrift plans, Profit-sharing plans, Money
Purchase plans, Employee Stock Ownership plans, or 401k plans.
A Savings or Thrift plan sets up an account for each participating individual. The
individual then makes contributions, usually on an after-tax basis, to that account. The
employer can choose to match the contribution partially, fully, or not at all.
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Individual accounts are also used in Profit-Sharing plans. Employer contributions
are generally based on company profits from the previous year, and although companies
are not required to make an annual contribution, most do; some contribute even if they
fail to make a profit in the previous year. The contribution is usually a predetermined
amount that is divided among employees in proportion to their salaries. Profit-sharing
plans can motivate employees seeking more for retirement and help a company improve
productivity and profit margins.
A Money-purchase plan is yet another individual retirement account for the
employee. However, unlike profit-sharing plans, where the employer is not obligated to
make an annual contribution to the account, it is mandatory in money-purchase plans—
unless the company has no income to do so. Contributions are set amounts and allocated
to individual accounts based on a proportionate percentage relative to an employee’s
salary.
Employee Stock Ownership plans (ESOP) offer the worker a “stake” in the
business, given that employer contributions made to an individual’s retirement account
are reinvested in company stock. Contributions are made on a proportionate percentage
of salary method and do not have to be made on a yearly basis. Similar to profit-sharing
plans, employees are encouraged to do their jobs well because their retirement is directly
related to the company’s productivity.
The most commonly used Defined Contribution Plan is the 401k. It allows
employees to defer part of their salary into individual accounts through an after-tax
contribution or a pre-tax contribution. The investment earnings within the account
accumulate tax free until they are withdrawn. 401k participants have the option of
investing in various mutual funds within the plan for diversification and potential growth.
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Employers can also make a contribution to the individual plan. They usually match the
employee’s contribution up to a certain percent. The Roth 401k, a slight variation of the
Traditional 401k, was introduced in 2006. The Roth lets the employee make after-tax
contributions and allows the earnings to grow on a tax-free basis and when distributions
are taken they are tax free. The employer is not obligated to offer the plan or contribute
to it. If the employer does contribute, however, it will be a on a tax-deferred basis.
During the last 30 years, employers have moved away from offering Defined
Benefit plans and have gravitated toward Defined Contribution plans. This change is
primarily due to the employer’s desire to save money by shifting management fees from
the company to the employee. Along with this added cost, the employee has also been
delegated responsibility for their future retirement, releasing the company from the
obligation of providing steady income following retirement. Even though employers are
saving money on administrative costs, they may not necessarily pass those savings on and
contribute as much to the Defined Contribution plan as they would have in a Defined
Benefit plan (Daniels).
Looking at a graph of companies that offered Defined Benefit plans, Defined
Contribution plans, or a combination of both, we can see the shift in usage. Thirty years
ago 62% of companies had only Defined Benefit Pension Plans while 16% had Defined
Contribution Plans. Ten years later, by a slim margin, Defined Contribution Plans were
used more often than Defined Benefit Plans, 36% to 33%. By 2005 a complete reversal
has taken place, with Defined Contribution plans representing 63% and Defined Benefit
plans representing just 10% (Fast Facts from EBRI June 2007).
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.(Fast Facts from EBRI June 2007).
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In 1997, Defined Contribution plans had $1.85 Trillion in assets compared to 1.78
Trillion for Defined Benefit plans.
(Fast Facts EBRI Feb 2006)
Age is a factor when it comes to participation in retirement plans. According to
the EBRI, when a company does offer a 401k plan roughly 20 percent of eligible
employees do not enroll. These employees tend to have lower incomes, usually because
they are young (Powell).
Older employees tend to participate more often than younger ones. This is
consistent even when comparing younger and older workers with similar earnings.
Employees in the age group 21 – 24, who are full-time, full-year, wage and salaried
employees, have a 29.3 percent participation rate in their company’s retirement plan. If
you include all workers in this age group from both the public and private sectors, the
rate drops to 19.5 percent. However, among employees aged 55 – 64 these percentages
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jump to 60.1 percent and 49.0 percent respectively. The table below shows a gradual
increase in the percentage of participation relative to the age of the employee.
(Fast Facts EBRI Jan 2008)
The average 401k account balance for a participating employee in their 20’s in
2004 was $31,844, while the average for those in their 40’s was $100,106, and those in
their 60’s was $136,400. (Fast Facts EBRI Oct 2005). There is a considerable difference
in the account balance of someone in their 20’s and someone in their 40’s. Even though
there is an increase in the average 401k balance of workers in their 60’s compared to
those in their 40’s, one might expect the increase to be much higher since older workers
tend to contribute more and have a longer time period to do so. But employees in their
60’s may have eased up on their contributions or even taken withdrawals as they
approach retirement. The average 401k account balance for all participants at the end of
2004 was $56,878, which was up from $51,569 in 2003 (Fast Facts EBRI Oct 2005).
Asset allocation has a significant role in determining an account balance. At the
end of 2004 the average 401k asset allocation for someone in their 20’s was as follows:
52 percent invested equity funds; 13 percent invested balanced funds; 12.6 percent
invested company stock; and 20.1 percent invested fixed income funds. For someone in
their 60’s the allocation was: 37 percent invested in equity funds; 9.5 percent invested in
balanced funds; 12.6 percent invested in company stock; and 38.1 percent invested in
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fixed income funds. (Fast Facts EBRI Oct 2005). After reviewing these two
allocations, we find older employee, with the exception of company stock, is invested
more conservatively than the younger.
From 1999 through 2006, the average account balance for 401k plans increased
from $67,760 to $121,202 (EBRI Issue Brief August 2007). Even though 2000-2002
were terrible years for equity performance, the graph below suggests that 401k
participants continued to invest in their plans, as the account values in those years
remained relatively stable and then later grew.
(Fast Facts EBRI Oct 2005).
Figure 7 shows, the next table (below) breaks down the previous table by age
group which shows that not only did the younger participants have smaller account
balance but they also had the greatest return over the eight year period. (Fast Facts EBRI
Oct 2005). Because younger participants did not have much invested and continued to
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invest when the stock market had negative returns for 2000 – 2002, they were poised for
the greatest potential growth.
(Fast Facts EBRI Oct 2005).
This growth can be attributed to the specific asset allocation of the participants.
Equity funds dominate the allocations (Fast Facts EBRI Oct 2005). More exposure to
equity funds—especially when the stock market is growing by double-digits—produces
better portfolio performance.
((Fast Facts EBRI Oct 2005).
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As you can see in the table below, younger 401k participants have a much greater
exposure to equity funds then older participants, making there allocation more aggressive
which can lead to higher returns in good times and higher losses in bad times. (EBRI
Issue Brief August 2007).
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Retirement Info
As Americans age, their sources, abilities and desire to earn income tend to
change at the same time. Younger American’s income sources tend to be from earnings,
where older American’s income sources tend to be from pensions, assets, and social
security. As can be seen in the table below, the sources of income for different age
groups for individuals change dramatically from ages 55 – 64 to 65+ for the amount of
income derived from earnings and the amount of income from Social Security. This
would only seem natural as most people are retiring or thinking about retiring during this
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time frame.
(Purcell).
In the table below, the sources of income are shown however, this table is not
based on individuals and their earnings sources but rather entire households. The trend is
basically the same as it is with individual earning sources especially the changes from the
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age group of 55 – 64 and 65+ with respect to the drop in earnings and the increase in the
social security.
(Purcell)
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In the pie chart below, the sources of individual income for the “top quartile”
(income of more than $32,160) of people over age 65 are broken down by percentage.
As you can see, Social Security represents 18.5 percent of their total income while
Earnings and Pensions represent 58.1 percent of total income.
(Purcell).
In the pie charts below for the “second quartile”, incomes of individuals (incomes
between $17,382 - $32,160) you can see that Social Security now represents 54.1 percent
of total income, while earnings and pensions have decreased percentage wise to represent
33.9 percent of income for this category. As you can see, as the total individual incomes
decrease, there is a major shift in where the income sources are derived. In this case,
individuals rely on Social Security for more then half of their income.
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(Purcell).
In the following two pie charts for the “third and fourth quartiles” for individual
income sources (3rd quartile $10,722 - $17,382 and 4th quartile less then $10,722) the
trend continues. For both the “third and fourth quartiles” Social Security represents over
80 percent of income for individuals.
(Purcell).
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(Purcell).
Changing from individual income sources to household income sources, the
percentages for reliance on Social Security are a little different; however, the trend is still
the same. The lower the amount of household income, the bigger the percentage Social
Security is for the total income source. As can be seen in the four piece charts below the
breakdown for household income sources for the four different quartiles of total income.
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(Purcell).
(Purcell).
(Purcell).
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(Purcell).
In the table below, you can see how vital Social Security is for many Americans.
The table shows what percentage of income for an individual that is made up of Social
Security, and what percent of Social Security recipients that represents. For example,
Social Security makes up 100 percent of income for 28 percent individuals receiving it.
(Purcell).
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The following table details the same information as the table above Social
Security is shown as a percentage of “household” income, rather then to individual
income.
(Purcell).
American’s savings and investments are being utilized more and more for
retirement income sources especially since Defined Benefit Pension plans are
disappearing. In the table below you can see that Americans aged 25 and older have less
than $25,000 in savings and investments (not including their primary residence or defined
benefit retirement plan).
(EBRI Fast Facts April 2006)
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When looking at what Americans think they are going to need as far as additional
assets for retirement, 30 percent believe that they will need less then $250,000. The table
below further breaks down what Americans thinks they are going to need for assets to
supplement or provide their future retirement income.
(EBRI Fast Facts April 2006)
The information above detailing what Americans believe they are going to need
for assets to supplement or provide their future retirement income is further broken down
in the table below by household income. Those believing they will need less then
$250,000 in assets makeup the largest percentage – 26 percent. That 26 percent is then
broken down further by income ranges: those with less then $35,000 in household income
represent 43 percent of the 26 percent, those with incomes between $35,000 - $74,000
represent 28 percent of the 26 percent, and those with incomes above $75,000 represent
13 percent of the 26 percent. This table’s information basically shows that the more
income households earn the more assets they believe they are going to need to either
supplement or provide their future retirement income.
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(EBRI Fast Facts April 2007)
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Solution
American workers, younger ones especially, are saving less than ever before and
inadequately preparing for retirement. This lack of saving, combined with the possibility
of the federal social security program paying less then expected (or worse going broke)
could have devastating consequences. Action must be taken now to minimize the impact
this future retirement problem could have on future retirees, taxpayers and Americans in
general. Creating a State Social Security and Retirement Supplemental Program
(SSSRSP) will boost savings and future retirement income while helping avoid a looming
financial crisis.
Unlike the Federal Social Security program, which is a credit based system,
contributions made into an SSSRSP will be cash oriented. A cash contribution system
would be more transparent and allow participants to view the actual savings they will be
entitled to withdraw in the future. This will be far more appealing to employees, as it is
not just a promise of payment from the state government.
Start up costs for the SSSRSP program would include (but not be limited to): the
designing of the software, purchase of hardware, publicity, consultation fees, hiring of
new employees, leasing of space, compliance regulations, and any other miscellaneous
costs. Ongoing costs would include (but not limited to): rent or leasing costs, salaries,
compliance, consultation fees, upkeep of software and hardware, accounting expenses,
oversight of Index funds, and any other miscellaneous costs. This program should be
internet based, using a paperless statement system and limiting the number of phone calls
participants could make to the home office regarding the SSSRSP. Going paperless will
save on printing costs and completely eliminate mailing costs. Limiting the number of
phone calls per participant will require fewer employees staffing the home office and
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save on salaries. The biggest savings will come as a result of investing contributions in
Index Exchange Traded Funds, as opposed to mutual funds. The typical mutual fund
expense ratio (that is the amount to “run” the fund) averages around 1.5 percent, whereas
the typical S&P 500 Exchange Traded Fund averages .18 percent.
Since employees have a poor record of taking advantage of retirement programs,
participation in this program will be mandatory for anyone under age 55 that has earned
income in the state of South Carolina. Participation for everyone aged 55 and older will
be optional.
Funding the SSSRSP will be done through a “payroll tax withholding system”.
Employers will be required to withhold 5 % of the gross income of each paycheck an
employee receives. Employers will then submit this amount to the SSSRSP the exact
same way they pay payroll tax to the government. To keep costs down for employers,
this amount should be paid on a monthly basis (as opposed to weekly) to the SSSRSP.
The state government along with the SSSRSP will be responsible for overseeing this
process. This will be an additional accounting cost for employers. However, if the
payment to the SSSRSP is done similarly to the payroll tax system the costs should be
minimal. This is not a replacement of the Social Security tax currently taken out of
employee checks; this will be a separate, additional amount removed.
Participants will be allowed to make additional contributions on top of the
mandated 5 %, but no more than a combined total of 8 %. Allowing an unlimited
percentage to be contributed could unintentionally turn the SSSRSP into a “tax shelter”
for the wealthy. Once a year participants will be able to adjust the percentage of their
contributions. All employees wanting to make adjustments should be required to do so
within a window time frame to make it easier for employers.
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An employee who chooses to increase their contribution percentage will be given
a “matching” incentive from the Federal Government. This “matching” incentive will
not be free taxpayer money but rather a cash deposit into the individual’s SSSRSP. In
exchange for the cash deposit, the individuals would relinquish some of their future
Federal Social Security benefits.
According to my Social Security statement, currently I am expected to receive 78
cents for every dollar of scheduled benefits from the Federal Social Security program. If
I were to give up 28 cents and only receive 50 cents for every dollar of scheduled
benefits, the Federal Government would make a cash deposit into my SSSRSP of a
certain percentage or dollars. Individuals would still be required to pay Federal Social
Security tax, though, so current beneficiaries would not be affected. The amount or
percentage of this cash deposit from the federal government will be contingent upon the
voluntary contributions made by participants.
For example, someone age 31 making $30,000 in salary per year is scheduled to
receive $1,121 monthly in Federal Social Security benefits at age 66. Under the
SSSRSP, this person will be required to contribute 5% of their salary ($1500) every year.
Along with this mandatory percentage, they’ll have the option of contributing an
additional 1%, 2%, or 3%. The potential match from the federal government will depend
upon these additional percentages—the higher the percentage, the greater the cash deposit
from the federal government. Coinciding with the increased percentages and potentially
larger cash deposits, however, the individual will see a reduction in their future Federal
Social Security dollars. Suppose our 31 year-old participant voluntarily contributes an
extra 1% on top of the mandatory 5%. The individual would be adding another $300. At
the same time, the federal government would “match” this contribution with a deposit of
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$120, which would be deducted from the individual’s future Social Security benefits.
This particular participant, by contributing an additional 1%, would concede $1,620 per
year in future Social Security benefits. The scale below details the correlation between
the percent of voluntary contributions, federal cash deposits, and surrendered Social
Security benefits based on the 31 year-old with a yearly salary of $30,000.
Gross Salary $ 30,000.00
Mandatory Contribution
5% Mandatory $ 1,500.00
Voluntary ContributionTotal Participant
Contribution
1% Voluntary $ 300.00 $1,800.00
2% Voluntary $ 600.00 $2,100.00
3% Voluntary $ 900.00 $2,400.00
Potential Match from Federal Government Total Contribution (Mandatory, Voluntary,
Match)Based on VC % monthly amount yearly amount
1% $ 10.00 $ 120.00 $1,920.00
2% $ 17.00 $ 204.00 $2,304.00
3% $ 25.00 $ 300.00 $2,700.00
Future Federal Social Security Benefit
$ 1,121.00
Amount of Future Federal Social Security Benefits Given up Yearly Amount
$ 135.00 (1%) $ 1620.00
$ 150.00 (2%) $ 1,800.00
$ 175.00 (3%) $ 2100.00
Continuing on with our participant, the life expectancy at age 66 is 20.2 years and
the February applicable federal rate (AFR) rate (110%) is 3.26%. The calculations in the
table point out the savings to the Social Security system as well as the “matching” value
of some of the future benefits given up by the participant. By voluntarily contributing
1%, the participant will lose $135 of future monthly Social Security benefits. The
Federal Government will use $10 of that money to match (with cash) the individual’s
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SSSRSP. Still, in this case, the Social Security system will save $21,944, and the future
value of the “match” from the Federal Government will be $7,632.28.
Calculations based on VC of 1%
Future Savings of Future Benefits Given up (age 66) ($21,944.00)
(if give up 135 then govt gives back 10 to match into SSSRSP)
FV of Matching Amount by Gov't (at Feb AFR rate) ($7,632.28)
Calculations based on VC of 2%
Future Savings of Future Benefits Given up (age 66) ($23,348.42)
(if give up 150 then govt gives back 17 to match into SSSRSP)
FV of Matching Amount by Gov't (at Feb AFR rate) ($12,974.88)
Calculations based on VC of 3%
Future Savings of Future Benefits Given up (age 66) ($26,332.80)
(if give up 175 then govt gives back 25 to match into SSSRSP)
FV of Matching Amount by Gov't (at Feb AFR rate) ($19,080.70)
The SSSRSP approach benefits both individuals as well as the Social Security
system. The savings by the Federal Social Security system will allow it to live longer.
Since individuals will continue paying into the Federal Social Security Trust Fund,
current beneficiaries would not be affected. Although it will not be as much as currently
projected, SSSRSP participants will still receive future Social Security income. They
will be less reliant on it and have more control over their future retirement income which
has the potential for greater growth.
A participant in the SSSRSP will be allowed to start withdrawing income from
their plan once they reach age 66. Distributions from the SSSRSP will be automatically
deposited into checking accounts on a monthly basis. The amount of distribution should
be 4% of the account balance which will be recalculated on a yearly basis. There will be
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neither state nor federal tax on the withdrawals from the SSSRSP. A special 1099 tax
form will be sent (via email) to all participants taking withdrawals which they will have
for tax reporting purposes, even though these distributions will be non-taxable.
If a participant passes away before all funds are withdrawn, these funds will not
revert to the state. ALL remaining funds will be passed on to a beneficiary. The funds
will be placed in a separate account and the beneficiary will be able to “stretch” the
account and take distributions based on their own life expectancy in a way that closely
resembles how a non-spouse inherited IRA operates. If this “second” beneficiary dies
before all the funds are withdrawn, then the remainder of the account will pass on to
another beneficiary. However, this “third” beneficiary will have to withdraw the funds
based on the previous beneficiary’s life expectancy. For example, someone has a balance
of $100,000 in their SSSRSP and passes away leaving the remaining balance to their 50
year-old beneficiary. That beneficiary must now start taking withdrawals from that fund
(which is separate from their own SSSRSP) based on their own life expectancy. That
beneficiary takes withdrawals from this account for five years but passes away at the age
of 55. They have named a new beneficiary of this inherited SSSRSP. The new
beneficiary then takes over this SSSRSP, which will be placed into a separate account
again, and they must immediately start taking withdrawals based on the previous
beneficiary’s life expectancy, not their own. The use of this “stretch” method will at
some point completely drain accounts and eliminate the prospect of legacies.
Investment options for contributions will consist of two Exchange Traded Funds
(i.e. Index funds) and one money market fund. Investing in mutual funds or individual
stocks, which is more expensive to do, will be prohibited and thus save on overall costs.
The two Exchange Traded funds will be an index fund of the S&P 500 and a Treasury
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Inflation Protected Bond Index fund (TIPS). Furthermore, to reduce risk, the SSSRSP
will have an equal allocation among the asset classes. This means 1/3 of the SSSRSP
will be invested in the S&P 500 index, another 1/3 in the TIPS index, and the final 1/3 in
a money market fund. A bearish or bullish market could alter this 1/3 allocation,
therefore a participant’s SSSRSP will be rebalanced either quarterly, semi-annually, or
annually so that it reasonably maintains its 1/3 allocation format. The participant will
decide when (quarterly, semi-annually, or annually) the rebalance will occur upon
registration for their SSSRSP.
Any growth, dividends, or interest earned inside a participant’s SSSRSP will be
non-taxable to the participant, mirroring the Roth IRA and all the benefits that come
along with it. The SSSRSP will not be allowed, however, to “roll over” or move to
another firm. These plans will stay intact in the state they are “housed.” This will help
reduce on the potential for fraud by dishonest financial advisors or insurance agents.
The following tables possess “sample portfolios” for the period beginning January
1, 2000 and ending December 31, 2008. The use of these dates is crucial because there
was severe volatility in the equity markets during this period. Choosing a timeline to
evaluate a portfolio’s performance is important since the market data can make a
portfolio appear productive when in fact that may not be true. During the selected time
frame there were tremendous swings to the upside and downside in the equity and bond
markets. In early 2000, the equity markets peaked and then subsequently dropped
dramatically causing significant losses for most equity investors. Recovery did not begin
until early in 2003 when, from this point until late in 2007, equity investments rebounded
and had tremendous growth. Thereafter, investors saw another dramatic decline in equity
values.
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The second series of tables and graphs shows that an allocation following the 1/3
format (1/3 Money Market; 1/3 TIPS; 1/3 S&P 500) used during this volatile period
would not only have outperformed the Benchmark index, but done so with overall lower
risk as measured by the standard deviation. Four portfolios beginning with the exact
same 1/3 allocation shown below will illustrate.
Rebalanced Quarterly:
The portfolio balanced quarterly had a positive annualized return of 2.6% and a
standard deviation of 5.43 while the Benchmark (S&P 500) returned a negative 3.06%
with a 15.20 standard deviation.
The graphs below analyze both the Sample Portfolio and the Benchmarks
annualized returns and standard deviations for one year, three year, five year, and 10 year
time frames. The longer the time frame, the higher the annualized rate of returns and the
smaller the standard deviation decreases.
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The graphs below show the return of the Sample Portfolio and the Benchmark
Index as measured by annualized returns and standard deviations. The Sample Portfolio
during this time frame is not only less risky then the Benchmark Index, but also has a
better annualized rate of return as well.
The graphs below show the cumulative returns for both the Sample Portfolio and
the Benchmark Index. As the graph shows the Sample Portfolio not only has a better rate
of return, but is also less volatile.
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The graphs below break down of each asset class inside the Sample Portfolio by:
the annualized returns, annualized standard deviations, and cumulative returns.
Rebalanced Semi Annually:
As you can see by the tables below, the annualized return for the sample portfolio
is 2.74 percent, where the annualized return for the Benchmark (which is the S&P 500)
was -3.08 percent. The standard deviation for the Sample Portfolio during this time
frame was 5.39 while the Benchmark’s standard deviation was 15.20.
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Rebalance Annually
As you can see by the tables below, the annualized return for the sample portfolio
is 2.94 percent where the annualized return for the Benchmark (which is the S&P 500)
was -3.08 percent. The standard deviation for the Sample Portfolio during this time
frame was 5.25, while the Benchmark’s standard deviation was 15.20.
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No Rebalancing:
As you can see by the tables below the annualized return for the sample portfolio
is 3.13 percent, where the annualized return for the Benchmark (which is the S&P 500)
was -3.08 percent. The standard deviation for the Sample Portfolio during this time
frame was 4.89, while the Benchmark’s standard deviation was 15.20.
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Each Sample Portfolio performed better in both categories of risk and return,
compared to the Benchmark Index. The Sample Portfolios performed a little different
from each other due to the frequency of rebalancing observable in the table and graphs
below. The portfolio with no rebalancing actually performed the best of the four Sample
Portfolios, however this portfolio is now completely out of balance from it’s original
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investment allocation, which is not what we want to happen in the SSSRSP. When
comparing the other three Sample Portfolios’ standard deviations, annualized returns, and
cumulative returns, rebalancing on an annual basis performed the best. This could be due
to the time frame of this Sample Portfolio, and it should be noted that in some instances
rebalancing on a quarterly basis may perform the best of the three.
Sample
Portfolios
Annualized Standard
Deviation
Annualized
ReturnCumulative Return
Quarterly 5.43 2.68 26.64
Semi-Annual 5.39 2.74 27.25
Annual 5.25 2.94 29.5
No-Rebalance 4.89 3.13 31.62
Annualized Standard Deviation
4.6
4.7
4.8
4.9
5
5.1
5.2
5.3
5.4
5.5
Quarterly Semi-Annual Annual No-Rebalance
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Annualized Return
2.4
2.5
2.6
2.7
2.8
2.9
3
3.1
3.2
Quarterly Semi-Annual Annual No-Rebalance
Cumulative Return
24
25
26
27
28
29
30
31
32
Quarterly Semi-Annual Annual No-Rebalance
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Conclusion
A potentially catastrophic lack of future retirement income is on the horizon and
action to avoid this problem must begin now. Our political leaders have consistently
acknowledged that something needs to be done to protect retirees and future retirees as
well as keeping our current Social Security system from becoming insolvent. Yet
whenever a possible solution is brought forward, our leaders fail to act appropriately and
engage in “politics,” killing the idea before it’s properly examined.
The creation of the SSSRSP may not be a cure-all; however it is a start in the right
direction. By utilizing such benefits as tax-free growth, tax-free withdrawals, employing
the use of investment vehicles such as Exchange Traded Funds, using a strictly
technology based platform, and potentially receiving a “matching” benefit from the
Federal Government, this plan will be extremely beneficial to participants by not only
keeping internal costs low but by increasing their future retirement income.
This proposal leaves room for further discussion and research. It does not cover
the impact the SSSRSP might have on South Carolina’s economy according to
population, tax revenue, business growth and employment. It also does not mention
disability situations or certain tax issues. These are all items that should be addressed as
they may make this proposal even more attractive to the state of South Carolina.
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Works Cited
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Employee Benefit Research Institute. US Retirement Trends Over the Past Quarter-Century. 21 June. 2007. http://www.ebri.org/pdf/fastfact062107.pdf
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Employee Benefit Research Institute. Workers Estimate the Amount They Will Need in Retirement. 26 April. 2007. http://www.ebri.org/pdf/fastfact042607.pdf
Purcell, Patrick. Congressional Research Service. CRS Report for Congress. Income and Poverty Among Older Americans in 2007. 3 October. 2008. http://assets.opencrs.com/rpts/RL32697_20081003.pdf