By: Neal Stoughton, Professor of Finance, School of Accounting and Finance
Among
the
many
significant
impacts
of
the
recent
crisis
is
the
effect
on
individual
pensions.
Retirees
are
heavily
dependent
on
other
pension
funds
or
savings
as
the
average
social
security
benefit
is
only
$1500
per
month.
Pensions
can
come
in
many
forms
such
as
401(k),
IRA,
Roth
IRA,
defined
benefit,
and
defined
contribution.
We
discuss
important
considerations
facing
individuals
in
view
of
recent
developments
and
changes
in
pension
policy.
Defined Contribution Plans
In
recent
decades
there
has
been
a
gradual
trend
away
from
defined
benefit
toward
defined
contribution
plans.
Defined
benefit
plans
are
at
the
discretion
of
the
employer
and
may
be
threatened
by
underfunding.
By
contrast,
defined
contribution
plans
are
“fully
funded”
by
definition.
But
all
the
risk
is
essentially
borne
by
the
employee
or
retiree.
Optimal
asset
allocation
policies
are
usually
governed
by
a
rule
whereby
the
mix
between
risky
stocks
and
bonds
shifts
towards
bonds
as
the
employee
approaches
retirement.
Due
to
the
market
crash,
it
is
very
likely
that
the
allocation
to
equities
has
declined
already.
Therefore,
many
employees
may
find
they
are
“underweight”
equities.
Do
not
exacerbate
this
by
selling
equities
and
moving
more
funds
into
bonds
or
cash.
First,
lessons
of
financial
history
show
that
there
are
long
run
mean
reversion
tendencies
in
the
stock
market.
Risky
investment
opportunities
are
better
now
than
before
the
crisis.
Second,
long
term
bonds
are
returning
a
nominal
return
near
zero,
which
means
that
even
small
amounts
of
inflation
may
decimate
real
bond
returns
in
the
future.
Especially
if
there
are
more
than
10
years
to
retirement,
if
the
equity/bond
percentage
is
below
the
classical
60/40
split,
a
reallocation
towards
stocks
will
probably
pay
off
handsomely
in
the
long
run.
401(k) Plans
These are a form of defined contribution plans sponsored by the employer, so the above considerations apply. Examine the current value split between equities and bonds (cash) in relation to the 60/40 classical ratio. Keep an eye on the types of funds in your portfolio, however. There has been a big difference in industry impacts in the recent crisis. Some industries, like travel have been very hard hit. Their prices have declined enormously. But because government bailouts come with strings attached, current shareholders may have their stakes diluted by government warrants. This is what happened in the last financial crisis, GM and Chrysler being an example. By contrast many Tech companies are in relatively better shape going forward despite the fact their prices have declined less.
One
important
change
in
regulations
concerns
Required
Minimum
Distributions
(RMDs).
Under
current
law
retirees
do
not
have
to
withdraw
RMDs
until
age
72.
Due
to
the
virus
there
is
a
one-year
moratorium
on
RMDs.
This
means
that
retirees
can
save
on
current
taxes
if
they
do
not
need
the
money
for
consumption
purposes.
But
be
careful.
The
massive
increase
in
federal
deficits
and
Fed
balance
sheet
growth
has
consequences.
Tax
increases
especially
for
wealthy
retirees
are
likely.
You
may
be
trading
off
saving
taxes
now
but
paying
much
more
in
a
few
years
when
that
money
must
be
withdrawn
anyway.
Roth IRA Conversions
An IRA is another example of a defined contribution plan, but one where the individual has more authority over the options for investing. These plans are not employer specific. Now might be a good time to consider a Roth IRA conversion, i.e., paying the tax in 2020 and shifting funds to a non-taxable Roth IRA account. Again, this might be a good idea because of the likelihood of higher future tax rates. Also, Roth IRAs are not subject to RMDs.
The Virus Crisis has forced us all to reexamine our lives. Even if we can stay healthy, we should take this opportunity to reexamine the pension situation as well. In the immortal words of Benjamin Franklin, we should aspire to be healthy, wealthy, and wise.