RPA2 Module 12

Question 1

Explain the concept of managing retirement assets using a wealth management
approach.

Answer 1

The idea of managing retirement assets using a wealth management approach involves holistic decision making to achieve better overall results for an individual’s total accumulated wealth rather than making retirement plan decisions in isolation.

For example, if a plan participant only makes asset allocation decisions for the assets held in the employer-sponsored retirement plan, he or she may under- or overallocate assets to specific asset classes. If that individual were to examine total investable assets, the targeted asset allocation occurring in the retirement plan is likely to be quite different. Other decisions also can be made using this wealth management approach.

Question 2

What is wealth management?

Answer 2

Wealth management is a process for managing resources that seeks to meet an individual’s needs and achieve his or her objectives by integrating a diverse range of services.

Typically, the process of wealth management utilizes a comprehensive
approach involving investment management, financial planning, retirement
planning, estate planning, tax planning, asset protection, risk management, and cash flow and debt management. As such, retirement planning necessitates being placed in this overall wealth management context.

If conducted effectively and executed successfully, wealth management retirement planning should result in greater asset accumulation, less overall financial risk, reductions in tax liabilities, cost reductions related to the management of resources, and efficiencies in managing cash flow and reducing debt.

Question 3

How does wealth management retirement planning link asset accumulation with distribution planning?

Answer 3

Wealth management retirement planning positions retirement resources so they conform to future planned objectives. Assets are thoughtfully configured to produce retirement income when the distribution phase of retirement commences.

There is thought and planning concerning the transition necessary to strategically move into the distribution phase at retirement. A focus on strategic planning is a hallmark of the wealth management process.

Question 4

Explain the retirement plan features that allow individuals to manage retirement
assets using a wealth management approach.

Answer 4

Various aspects of retirement plan design allow individuals to manage retirement assets using a wealth management approach. Today’s individual participant is, in most cases, more empowered to strategically manage his or her retirement assets.

This trend has been supported by both marketplace forces and governmental policy initiatives. An individual should make the most of this empowerment. This is true both during the accumulation phase and during the distribution phase. Because individuals have the ability to select investments and, in some plans, determine whether their contributions occur on a pre- or after-tax basis, individuals can control both asset allocation and tax status of their accumulating retirement resources.

An individual also can determine what type of retirement savings vehicle to use to accumulate assets.

Question 5

Why do so few individuals use a wealth management context to manage and
integrate their retirement plans within their broader family financial planning?

Answer 5

Although no single definitive answer to this question exists, there are several reasons that readily can be identified why so few individuals use a wealth management context when managing their retirement plans. First, until rather recently, many aspects of private retirement plans were indeed controlled to a much greater extent by employers.

There were few decision factors within an individual’s control. For
most individuals, the only decision available was the type of annuity to select and whether payments would continue to a spouse upon the individual’s death. The opportunity for introducing strategic planning to enhance wealth creation has greatly expanded. Considerably more alternatives and choices are available.

There is also much more complexity in today’s retirement planning arena. The breadth of choices is relatively new when viewed from a historical perspective. With this empowerment, employees also incur risk when they act to integrate their retirement plans with their other assets and financial strategies.

Certain changes in philosophy and the retirement planning paradigm have allowed participants to embark on this more strategic, risk-laden and empowered wealth management activity.

Question 6

Describe how the following forces have served to support a paradigm shift
where individuals are more likely now to use a wealth management approach in managing their retirement assets.

Answer 6

(a) Change in the employer-employee employment contract: The employer employee employment contract has changed over time. In the past, many employers perceived the employer-employee employment contract as a longer term, enduring relationship. Most often in the past, the retirement plan of choice was a defined benefit plan, and the intended result was to continue a percentage of final pay determined by using specific income replacement ratios targeted at the pension plan’s inception. In today’s labor markets, such long-term, enduring employment relationships are far less common.

Consequently, the design and features of retirement plans are very different from the plans that popularized this prior era. Employers have substituted defined contribution plans and leave the future management of plan assets to the individuals who have received plan contributions from their employers.

(b) Change in governmental policy: Changes in governmental and tax policy have allowed employees to exercise greater authority over plan selections. Public policy has moderated to bring more uniformity to plan structures, and increased portability has allowed plan participants to aggregate assets from these multiple plans in an employer-sponsored plan or an individual retirement account (IRA).

Governmental policy has supported a system that allows the individual
participant to play a larger role in controlling his or her personal assets
accumulated from a variety of employers during a career.

(c) Marketplace forces and competition by market participants: Entrance of new participants into various market sectors has brought the introduction of new products and services in the retirement planning area. The presence of insurance companies, mutual funds, trust companies, other asset managers and recordkeepers has meant innovation in the plan offerings for employers and increased competition to provide administrative services to employer-sponsored retirement plans. Employee benefit consultants also have been influential in assisting employers in ensuring plan compliance and innovating plans to capitalize on the latest options and features permitted by law. With many changes in the law requiring compliance, employers found it difficult to stay current with legally required modifications to their plans. As more employee benefit consulting firms and asset managers moved to provide outsourced administrative services to plans, more employers have seen that employee benefit plan administration most often is not an organizational core competency.

This recognition, along with the expertise, high-quality services and cost savings resulting from economies of scale provided by these vendors, have resulted in a movement of plan administration to external vendors.

Providing these specialized administrative services has increased the pace at which innovation has moved into employer-sponsored retirement plans.
(d) Enhancements in technology and recordkeeping services: All the
administrative change affecting retirement plans could not have occurred
without advances in technology. Improved technology and innovations in
recordkeeping services have facilitated this more flexible and portable system.

Question 7

Explain the nature of wealth management and the activities that characterize the wealth management process.

Answer 7

The process of wealth management is, at its very core, a management activity. As with the general management approach utilized in directing the workings of an organizational enterprise, an effective wealth management process is an activity thati nvolves planning, execution, ongoing monitoring, measurement of outcomes, accountability and, at times, creative new approaches.

It also involves team activities, gathering together the expertise of different disciplines, combining the contributions of various specialties, employing project management skills and demonstrating leadership in achieving results. It is as much art as it is science.

However, an important hallmark of a wealth management process is its integrative nature, which ensures that goals and objectives lead to overall wealth enhancement and security

Question 8

What decision elements must be considered when accumulating and distributing wealth to support retirement income needs?

Answer 8

When accumulating and distributing wealth to support retirement income needs, decisions must be made concerning the following issues:

(a) Developing the retirement resource target
(b) Assessing the efficiencies of funding structures
(c) Examining the funding structures in relation to other factors, participant needs or the broader environment
(d) Implementing investment selection, risk management and strategic allocation of resources within the retirement saving structures and monitoring the impact of these decisions on an overall portfolio of wealth
(e) Considering distribution planning and execution
(f) Monitoring excesses or deficiencies relative to retirement income needs
(g) Disposing of excesses or deficiencies when retirement income is no longer needed.

Question 9

Describe the three types of models (and their inherent limitations) used by financial advisors to target retirement resource needs.

Answer 9

Financial advisors attempt to target retirement resource needs using various types of models. These models may be helpful but have limitations. Retirement planning software models may be segmented into the following three model types.

(a) Deterministic models use a set of “fixed” assumptions. The assumptions are determined by the model developer, the model user or some combination of the two. Purely deterministic models do not possess effective means for measuring risk. They can illustrate risks in two ways: (a) The model can be run multiple times illustrating different scenarios, or (b) assumptions can be varied indicating sensitivity to various assumptions (i.e., investment return, mortality, inflation, etc.).

An example of a deterministic model would be one that projects asset
accumulations based on current holdings and an assumed savings rate, given assumptions about investment return and salary increases. This type of model provides a single, expected, future asset accumulation based on the inputs of beginning balance, years to retirement, investment return, ongoing savings amount and salary increases.

(b) Stochastic models do not use fixed assumptions but rather vary assumptions and yield probabilities of success or failure depending on repeated iterations of the model. These models employ statistical techniques to introduce variability into the parameters of the model. Pure stochastic models do not really exist because all of these models need to employ certain fixed assumptions.

Although the models allow for the variation of some assumptions, there are some elements that remain fixed, even though these elements of the environment actually can and do undergo change.

(c) Mixed models use a combination of fixed (deterministic) assumptions and
variable assumptions. These models allow a certain set of assumptions to vary; thus, these types of models attempt to gauge probabilities of success or failure. Monte Carlo techniques are examples of these mixed models. A simulation is an analytical method meant to imitate a real-life system, especially systems that are too mathematically complex or too difficult to reproduce. A Monte Carlo simulation selects variable values randomly, and the model is run multiple times to assess outcomes. For each uncertain variable that can have a range of possible values, the possible values are defined with a probability distribution. The type of distribution selected is based on the conditions that surround this variable

Question 10

What factors are considered in assessing the efficiencies of retirement savings
structures?

Answer 10

In making decisions concerning retirement savings structures, an individual is assessing the tax efficiencies of the retirement savings vehicle, the costs associated with the investment products and the risks of either asset classes or specific investments.

The risks of asset classes should not be assessed in isolation but should
include consideration of other asset classes held, both in retirement savings vehicles and in other savings vehicles outside the retirement plans. These other holdings combined with the assets held within retirement savings plans comprise the individual’s master portfolio.

The master portfolio includes the entire set of of assets held by the individual.

The implicit after-tax return is the compound annual return that an individual needs to earn on a given amount of pretax earnings to achieve a certain after-tax balance at the time of withdrawal. Not only does the type of plan holding the asset determine the implicit after-tax return, but other factors influence this rate of return as well.

Among these factors are the holding period for the asset when held in a taxable account (i.e., short term (less than one year) or long term (one year or more)), type of investment return earned (i.e., dividend, interest payment or capital gain) and the individual’s tax rate that can either decrease or increase over time.

Question 11

Before an individual begins to save within a retirement savings vehicle, how does he or she assess the compatibility of a savings structure with his or her needs?ed as well.

Answer 11

Before beginning to save within a retirement savings vehicle, an individual should assess the compatibility of the savings structure with his or her needs. All of the economic and administrative characteristics of a given structure can ultimately affect the capacity of the assets held within the structure to accumulate wealth.

Particular needs of the account owner can trigger transactions that can incur additional costs or subject the investments to regular taxation or additional penalty taxes. Therefore, the utmost care should be taken in assessing whether a given structure is the appropriate selection for an individual’s personal circumstances. Circumstances in the broader environment should be assessed as well.

Question 12

Discuss the perspective of professional wealth managers when assembling a
retirement investment portfolio design for a client.

Answer 12

Not only has today’s wealth manager been taught that the professionally correct process for portfolio design is the development of a sound and well-diversified investment policy, modern law (Employee Retirement Income Security Act (ERISA), the Restatement of the Law Third, Trusts,* Uniform Prudent Investor Act) mandates adherence to this process.

Because of these underlying investment theories and the nature of the law, many wealth managers implement investment strategies using a prescribed methodology: The investment process wealth managers currently use for
designing and implementing portfolio strategies for their clients has been modeled after investment policy design and implementation strategies developed for large tax-exempt institutional clients. This has led to the design of multi-asset-class/style portfolios, implemented by selecting style-consistent active managers. In selecting an asset class and style universe, wealth managers tend to mimic the universe reflected in the Morningstar style boxes and categories. Although it is unlikely that a wealth manager will use all, or even most, of these class/styles for a single client, a policy will typically include at least six and rarely less than four asset classes/styles.

Although this investment methodology is widely practiced, it is being questioned because of the potentially higher expenses that can accompany it. Using several actively managed portfolios means higher costs associated with active versus passive management as well as costs for the professional wealth manager making investment recommendations at the overall portfolio level. In a low-return environment, the effect of these cumulative investment management expenses can adversely affect portfolio return.

Question 13

Discuss the following universal retirement wealth management principles in
theory and practice. n.

Answer 13

The following guiding principles generally should be considered in managing retirement wealth both during the accumulation phase and throughout the subsequent distribution phase in retirement:

(a) Comprehensive diversification: A comprehensive and holistic approach
generally should be utilized when conducting asset allocation. Individuals
should diversify and look at the entire set of investments along the same
investment time horizon; in addition, asset allocation should use a
comprehensive perspective. Failing to use this comprehensive approach could result in under- or overallocating to specific asset classes. This assumes, however, that all of the assets are being accumulated to support retirement resource needs. This may not be the case. If an individual is earmarking certain assets for college funding, these assets must be accessed within a targeted time period when education expenses become due. Consequently, it would be problematic to use a comprehensive approach since these assets have been segregated with a specific
purpose for their use.

(b) Attainable efficiencies should be sought: When accumulating resources for retirement, an individual can capture certain efficiencies during the
accumulation process. These efficiencies can occur from different sources. For instance, the very nature of retirement savings vehicles confers tax savings through tax deferral. In addition to tax savings, certain retirement savings vehicles offer lower costs to retirement savers. Sometimes these costs are further reduced when individuals achieve a certain asset size within their accounts.

When an individual is starting his or her retirement savings program, vigilance for these savings and the effect of compounding on the individual’s savings can appreciably enhance wealth accumulation.

(c) Duplication of benefits should be eliminated: The functional approach to
employee benefits entails the use of an integrated approach, where employers look for overlap in plan offerings and attempt to eliminate duplication of coverage so as to better utilize limited resources in providing a broad scope of benefit protections addressing the diverse needs of their workforce. As employees have become more empowered in the selection and management of their retirement resources, this same exercise is relevant from an individual perspective. An individual should compare his or her benefit needs and the sources available to address these needs. For instance, an individual may determine that various survivorship needs are applicable because of family circumstances. Some of this need is addressed through social insurance sources.

Specifically, Social Security provides survivor benefits to a worker’s family.
Elimination of redundant or duplicated coverage can be a source of funds for
retirement wealth creation.
(d) Traditional assumptions warrant questioning: Sometimes individual
circumstances warrant deviation from traditional wisdom. For instance, it is
generally preferable to use tax-deferred vehicles to save for retirement. This is
the preferred wealth-creation strategy in most circumstances. However, there
can be situations when deviation from this strategy results in greater wealth
building. An individual with large tax deductions related to such things as
mortgage expense may actually be in a lower marginal tax bracket than he or she will experience in retirement. If the individual were to have access to investment options within a retirement savings plan where asset values are deeply undervalued or discounted, it may be advisable to pay taxes currently. Under these conditions, it may be preferable to purchase these assets as investments through a Roth IRA, Roth 401(k), Roth 403(b) or Roth 457(b).

Question 14

Describe the wealth-building opportunities represented by the following.

Answer 14

(a) Means to diversification: Diversification is an important component in
managing investment risk. Because retirement plan assets need not be accessed until a distant date in the future, diversification need not be continuously maintained throughout the entire period of accumulation. If certain asset classes are thought to be undervalued in the market, a higher weighting can be given to these asset classes, and some degree of portfolio concentration can be tolerated in the short run to enhance longer term rewards.

(b) Dollar cost averaging: Dollar cost averaging is a method of regular, systematic investing in which an individual invests the same dollar value on a periodic basis, usually monthly, in equity investments regardless of whether the valuation of these equities is considered to be undervalued, overvalued or fairly valued. The dollar cost averaging approach is appealing because it avoids some of the emotional pitfalls that individuals can succumb to. Typically, an individual purchases more shares when the market is cheaper and buys fewer shares when the market is more expensive. This method is particularly easy to apply to retirement plan investing because of the regularity of investment that accompanies the payroll cycle. (Although widely recommended, some recent studies suggest some other modified investment approaches may be superior to this traditional investment method.)
(c) Risk transfer at favorable pricing: Given the retirement risks, it is sometimes a preferable risk management strategy to transfer some of these risks. For the individual planning for retirement, this is often accomplished through the purchase of insurance. Risk transfer can occur by using life insurance, health insurance and long-term care insurance. Retirement income risks and investment risks can be transferred by purchasing an annuity or by opting for a retirement distribution in an annuity form. When these products are priced favorably, they should be considered.
(d) Strategic asset positioning: Sometimes the selection of specific assets within certain retirement savings plans can enhance wealth creation. For example, a corporate stock paying a substantial dividend would normally be subject to ordinary income taxation on the dividend. The purchase of this same stock within a self-directed Roth IRA would mean a high tax-free yield if withdrawals in future periods met the stipulations for a qualified distribution.
(e) Preemptive tax planning: Anticipating the tax consequences of strategic actions can result in individuals selecting the optimal alternative. Tax consequences have such important impacts on retirement planning strategies that they should always be considered. This is especially true concerning the distribution of income from retirement savings plans.

(f) Beneficiary planning: The assets held in retirement plans typically represent a substantial component of a decedent’s net worth. Because of the substantive size of retirement accumulations and the importance of these assets for the maintenance of living standards for spouses and other designated beneficiaries, the designation of the beneficiary for these resources should be carefully considered. Retirement plan assets give rise to income in respect of a decedent (IRD). IRD occurs when a deceased person was entitled to items that would have created gross income for federal income tax purposes but that were not includable in the decedent’s gross income for the year of his or her death. IRD items are generally treated as gross income to whoever receives them after the decedent’s death. They do not receive a step-up in basis following the decedent’s
death, as do capital assets at present. Accordingly, these assets can be subject to substantial taxation. Also, because of the ability of assets within these plans to compound on a tax-deferred basis (or on a tax-free basis for Roth plans), these plans can create substantial wealth. Selection of a beneficiary whose life expectancy extends or stretches the period of favorable tax treatment can result in substantial wealth-building possibilities.

(g) Balance between active and passive management: Selecting the investment approach for the assets within retirement savings plans is an important decision.

The merit of active versus passive management has been the subject of
considerable academic research. Selecting an appropriate and effective
investment strategy is a very important strategic consideration with long-term consequences to wealth accumulation. Given the ability to compound
investment earnings within retirement savings vehicles by deferring taxes (or avoiding taxes with Roth accounts), these types of plans become a “highperformance engine” for wealth creation. A cost-effective investment strategy yielding positive and competitive performance will increase wealth.

Question 15

What are some of the key considerations in the development of a retirement plan distribution strategy?

Answer 15

The development of a retirement plan distribution strategy involves at least the following key considerations:

(a) Enumerating possible distribution alternatives and developing a means to evaluate which single distribution option or combination of distribution options meets the individual’s retirement income needs and other objectives
(b) Determining the adequacy of the expected income stream provided by a single or combination of distribution options to meet expected living expenses
(c) Assessing the flexibility and risks related to various distribution methods
(d) Making relevant investment decisions before the initiation of distributions and planning for future investment decisions, if available, with distribution choices

(e) Planning for estate considerations should excess resources exist and
distributions be sought for charities or beneficiaries.

Question 16

Describe the specific types of distribution options available when crafting a
retirement plan distribution strategy.

Answer 16

(a) Annuity payment options: The distinguishing characteristic of an annuity
payment option is the guarantee of lifetime income by the plan or the insurer.

An insurer can guarantee lifetime income because of the law of large numbers and the operational fact that some payments from the annuity contract will be terminated when a plan participant dies. Annuity options are attractive as retirement plan distribution arrangements because the individual opting for this form of payment cannot outlive the income source.
Immediate life annuities convert a single sum of money or an accumulated
balance of plan assets into a series of income payments that continue as long as the contract owner(s) (annuitant, or co-annuitants if there is more than one person receiving guaranteed payments) remain living. A deferred life annuity contractually promises to provide a series of payments in the future.

There are different types of immediate and deferred annuities. A fixed annuity, usually backed by a portfolio of fixed income investments, guarantees a series of fixed payments. Most fixed annuities provide a stable lifetime income once they are established. Some fixed annuities possess both a guaranteed contractual payment and an incremental portion that can vary to some degree.

The nonguaranteed payment from some fixed annuities may change gradually from the initial payment, depending on interest rate movements. A variable annuity provides a periodic lifetime income to annuitants. However, the amount of the annuity payments is not guaranteed. The income provided by a variable annuity varies depending on the performance of the underlying investments in the portfolio

Usually this portfolio consists primarily of equity investments. A variable
annuity may keep pace with inflation over longer time horizons. However, the variability associated with this kind of annuity may be a disadvantage,
particularly in the short run, if poor performance means a downward adjustment in income payments to annuity owners.

(b) Periodic payments: An individual may opt for some form of periodic payment A person may select payments for a fixed dollar amount or for a fixed number of years.

The periodic payment approach would avoid the expenses associated with
annuities that compensate an insurer for assumption of longevity risk.
A disadvantage of fixed periodic payments is that an individual can exhaust his or her asset base at a future time. If this asset base is the sole or primary means for funding living expenses and the period of disbursement elapses before death, the individual could become indigent. However, if the return on the asset base exceeds that which originally was projected, the individual will either be able to aadjust the payment upward or have excess assets to distribute in his or her estate.

(c) Intermittent (nonperiodic) payments: An individual may opt to withdraw
assets from his or her account on an intermittent or irregular basis. Both with periodic payments and the intermittent payments, investment decisions must be made. If the assets held in the retirement savings plan are generating income, as in the case of bonds, the income routinely may be distributed. If the assets in the account are not generating an income stream, or if the income stream is insufficient to meet the individual’s living expenses, decisions must be made concerning the liquidation of assets.

(d) Lump-sum distribution: A qualifying lump-sum distribution is a distribution from a qualified retirement plan of the balance to the credit of an employee afte age 591⁄2 and within one taxable year of the recipient. The distribution must be made on account of the employee’s death, attainment of age 591⁄2 or separation from service. It should be noted that a distribution to the employee in the form of annuity payments after retirement will not prevent the employee’s beneficiary from receiving a qualifying lump-sum distribution. Sometimes an employee holds employer securities in a qualified plan. These securities may offer an opportunity for favorable tax treatment that should be considered. When a qualified plan distributes employer securities as part of a lump-sum distribution to employees or their beneficiaries, the net unrealized appreciation (NUA) on any employer securities included as part of the lump-sum distribution qualifies for special tax treatment.

(e) Lump sum with rollover: Oftentimes, rather than subject a rollover to
immediate taxation, an individual will roll over qualifying plan assets into an
IRA or a single employer-sponsored plan and subsequently take distributions from the account. The rollover can be motivated by favorable investment alternatives available within the IRA, an ability to access funds at a lower expense or the desire simply to consolidate assets through a single retirement savings vehicle to facilitate easier management of the assets. Sometimes this centralization of assets can be motivated by the desire to position assets in a single funding vehicle to simplify estate planning.

(f) Combining various payment options: Individuals often will examine distinct distribution options without giving adequate consideration to the merits of combining various payment options. It often is preferable to combine various payment options to arrive at a distribution strategy that merges the advantages of these distinct options so as to achieve a more integrated solution for providing retirement income.

Question 17

What is a key difference between annuities offered directly through a retirement plan and annuities offered through an insurer outside of a retirement plan?

Answer 17

A key difference exists between annuities offered directly through a retirement plan and annuities offered through an insurer outside of a retirement plan.

This difference involves the mortality table used to compute lifetime income payments. Retirement plan annuities must use unisex mortality tables, where the payments are the same for men and women who have attained the same age.

This has been required ever since the Supreme Court so ruled in the case of Arizona Governing Committee v. Norris in 1983. Annuities sold by insurers outside a retirement plan may use different annuity tables for men and women because the life expectancies of women exceed those of
men

Question 18

Describe important considerations in developing a retirement income strategy.

Answer 18

Developing a retirement income strategy involves several important considerations.

First, an individual must assess retirement income needs and have some idea of the ongoing expenses he or she will incur during retirement. Additionally, an individual should assess his or her risks and the possibility of additional expenses related to the occurrence of these risks. Costs and tax implications of various approaches should be considered.

Apart from the tax consequences, individuals make decisions regarding which income-generating options will supply the resources needed to provide income sufficiency for an extended period of time. For the participant who possesses both a defined benefit (DB) and a defined contribution (DC) plan, the income options selected under the DC plan should be made, supplementing the stream of income that will be generated from the DB plan.

Similarly, the income stream generated by Social Security, which is almost
universally available to workers, should also be considered when deciding on the form and level of resources distributed from the DC plan. Comparisons should be made between the budgeted resource needs of the individual and the extent to which distributions from guaranteed sources will meet the minimum income needs in retirement. For those possessing DC assets only, it is critical that the decision to convert assets into income be well-conceived, considering risks inherent in the
capital markets.

Question 19

Discuss the merits of combining various types of distribution options as
components of a retirement income strategy.

Answer 19

An individual may opt to combine various distribution options as part of a
retirement income strategy. If an individual possesses sufficient resources and has charitable giving or estate-planning objectives in addition to retirement income objectives, it is even more likely that a single distribution option will fail to meet all of the individual’s needs.

Therefore, many individuals evaluate multiple distribution forms as components of their overall retirement income strategy. In addition to blending multiple income distribution forms, the timing when these distributions commence also can be varied. As such, a phased approach can produce income enhancements at select prearranged times or when circumstances dictate additional resource needs.

Question 20

Describe the effect that various income distribution approaches may have in the
following areas.

Answer 20

(a) Reducing taxes: Affecting taxes can be easily demonstrated. For example, suppose an individual decides to move assets from a traditional IRA to a Roth IRA, either because he or she expects tax rates to increase in the future or because he or she wishes to position assets in a tax-free distribution vehicle for the future. Immediate conversion of an entire balance held in a traditional IRA may be very costly from a tax perspective. A full, immediate conversion may cause a significant portion of the accumulation in the traditional IRA to be taxed at a higher marginal tax rate when converted. Full conversion also may cause an individual to lose various tax credits, exemptions and deductions because tax preferences are phased out at higher income levels. An individual who converts
a portion of the traditional IRA to the Roth over a period of years could steer the conversion to occur at lower marginal tax rates and avoid the phaseout of beneficial credits, exemptions and deductions. This same principle of subjecting income to higher marginal tax rates and the loss of tax credits and deductions also applies if an individual holds assets in qualified plans on a tax-deferred basis and also holds balances in a Roth IRA or other Roth-type account such as a Roth 401(k) or a Roth 403(b).

Varying distributions from these retirement savings plans that receive different tax treatments can reduce taxes and increase disposable income.

(b) Reducing risks: Distribution options affect risk retention. Previously, it was shown that annuity distribution options are effective in managing longevity risk.

Other distribution options increase and decrease risks as well. One research paper noted differential impacts on risk depending on the way distributions occur. The paper indicated a spending strategy could involve withdrawals to maintain an individual’s standard of living and another in which withdrawals are a fixed percentage of the value of the account. In the first case, the ultimate risk is insolvency with the account being exhausted, whereas the second alternative risks a sustained and persistent reduced standard of living below what is really necessary. Combining distribution options also can have an impact on risk because of correlations between risks similar to the correlation between individual securities in an overall portfolio. Researchers have shown that the inclusion of an annuity distribution option with other distribution methods can have a beneficial impact on reducing longevity risk and enhancing portfolio withdrawal stability

Question 21

Summarize changes in the law affecting retirement plan distribution options
occurring as a result of passage of the Pension Protection Act (PPA).

Answer 21

PPA made some changes in the law affecting plan distributions and rollovers from various retirement plans.

(a) PPA made changes to the mortality table and interest rate that is used to
compute the minimum value of a lump-sum distribution paid from a DB plan.
The effect of these changes generally was to reduce the value of the lump sum that would be paid under prior law.

(b) In the past, distributions to plan participants from a qualified plan before
severance of employment were problematic. This issue caused difficulties in facilitating phased retirement arrangements for workers nearing retirement. PPA made clear that a qualified plan could provide distributions to an employee who attains the age of 62 even though the employee has not separated from service.

(c) PPA directed the Secretary of the Treasury to change regulations regarding hardship withdrawals from qualified plans, tax-sheltered annuities, nonqualified deferred compensation plans and deferred compensation plans of state and local governments and tax-exempt organizations. With the adjustment in these regulations, distributions for hardships and unforeseen financial emergencies that were previously allowed for conditions affecting spouses and dependents of plan participants were extended to a participant’s beneficiary under the plan.
This provision is especially helpful in situations involving hardship withdrawals for the payment of medical expenses.

(d) PPA waived the 10% early withdrawal penalty tax on qualified public safety employees who separate from service with their employers and take
distributions from government pension plans after having attained the age of 50.

Similarly, the PPA waived the 10% early withdrawal penalty tax to qualified
reservists called to active duty.

(e) PPA allowed rollovers from various types of retirement savings plans to be directly placed into Roth IRAs rather than having to first be moved into a
traditional IRA, as was previously the case.

(f) PPA permitted the rollover of after-tax contributions through a trustee-to trustee transfer from a qualified retirement plan to a DB plan or a 403(b) plan. After-tax rollovers, although previously allowable into DC plans and IRAs, had not been permitted into DB plans or 403(b) plans prior to January 1, 2007.
(g) PPA allowed a nonspouse beneficiary to receive a distribution from an eligible retirement plan previously held by a deceased participant or account owner. Such a distribution must occur through a direct trustee-to-trustee transfer into an IRA created to receive the distribution on behalf of the beneficiary. When such a distribution occurs, the transfer is considered an eligible rollover distribution. The IRA that received the distribution is treated as an inherited account, and the required minimum distribution rules applicable where the participant or account owner dies before the entire interest is distributed apply. The Internal Revenue Service (IRS) issued guidance explaining the rules that dictate how fast money needed to be withdrawn from the IRA. This guidance has substantial implications on the time limit in which tax-deferred (or tax-free for a Roth) compounding occurs, dramatically affecting wealth accumulation within a nonspouse IRA.

Question 22

(a) Describe the basic rule under which retirement plan distributions are generally
taxed, and (b) explain the elements that constitute an employee’s cost basis or
investment in contract for tax purposes.

Answer 22

(a) Broadly speaking, distributions from a qualified plan are taxable in accordance with the annuity rules of Section 72 of the Internal Revenue Code (IRC). Lumpsum distributions made to individuals born before January 1, 1936 may qualify for special income-averaging treatment if certain conditions are met.
(b) It is important to have a clear understanding of the elements that constitute an employee’s cost basis (or investment in contract), if any, since the employee’s cost basis is an important factor in the taxation of distributions under the plan. Briefly, Section 72 of IRC provides that an employee’s cost basis includes the following:

• The aggregate of any amounts the employee contributed on an after-tax basis while employed
• The aggregate of the prior insurance costs the employee has reported as
taxable income, but only for distributions made under that policy. (If the
employee has made contributions and the plan provides that employee
contributions will first be used to pay any cost of insurance, the employee’s
reportable income for any year is the excess, if any, of the insurance cost of
protection over the amount of the employee’s contribution for the year, and
not the full cost of insurance protection.)
• Other contributions made by the employer that already have been taxed to the employee. For example, an employer has maintained a nonqualified plan that later was qualified.
• Loans from the qualified retirement plan to the participant that were treated as taxable distributions.

There also is provision for the inclusion of other items in an employee’s cost basis, such as contributions made by the employer after 1950 but before 1963 while the employee was a resident of a foreign country. For the most part, however, the items listed above will constitute an employee’s cost basis in the typical situation.

Question 23

Summarize (a) the tax on early distributions from a retirement plan and (b) the tax on late distributions from a retirement plan.

Answer 23

(a) Tax Reform Act (TRA) ’86 added an additional 10% tax on any taxable amounts received before age 59½ from a qualified retirement plan. This additional tax on early distributions does not apply in the case of death, disability or termination of employment after age 55. Exceptions also are granted for:

• Distributions that are part of a series of substantially equal periodic payments made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and his or her beneficiary
• Distributions used to pay medical expenses to the extent the expenses are deductible as medical expenses for federal income tax purposes. Also,
distributions from an IRA used to pay health insurance premiums after
separation from employment
• Certain dividend distributions made from an employee stock ownership plan (ESOP)
• Payments to alternate payees pursuant to a qualified domestic relations order (QDRO)
• Distributions from an IRA used to pay qualified education expenses of the
taxpayer or his or her spouse, child or grandchild
• Distributions from an IRA for the purchase of a first home (limited to $10,000)
• Certain other distributions, such as those to pay an IRS tax levy or a timely
corrective distribution from the plan
• The exceptions described earlier in Learning Objective 5.2 as enacted by PPA.

(b) Participants must commence benefit payments by April 1 of the calendar year following the calendar year in which they reach age 70½ after terminating employment. If the participant’s benefit is determined from an individual account, the minimum amount that must be paid each year is determined by dividing the account balance by the applicable life expectancy. The applicable life expectancy is the life expectancy of the employee or the joint life expectancies of the employee and the employee’s designated beneficiary, if any. If the participant’s benefit is determined by the annuity distribution from a defined benefit plan, the annuity must
be paid for in one of the following durations:
(1) the life of the participant,
(2) the lives of the participant and the participant’s designated beneficiary,
(3) a period certain not extending beyond the life expectancy of the participant or the joint life expectancies of the participant and the participant’s designated beneficiary.

The penalty for failure to make a required distribution of (at least) the correct amount is a nondeductible excise tax of 50% of the difference between the minimum required amount and the actual distribution. This tax is imposed on the payee.