Darwin's Finance » Retirement

Is Long-Term Care Insurance Worth It?

Darwin — Sat, 24 Jul 2010 00:19:31 +0000

My mom asked me about long term care insurance recently and I started to mull over the financials to see if it made sense or not. We had some experience with other distant relatives that had to tap the insurance and in one case, they were surprised that they didn’t qualify when they thought they would due to the fine print. First, it’s worthwhile understanding what it’s all about and how it might help you or your loved ones as they age.

What is Long Term Care Insurance?

Long Term Care Insurance is different than your conventional health insurance or life insurance. It’s insurance that’s meant to offset the costs associated with long-term care you may need in the future, typically a consideration for the elderly who anticipate health issues in old age.

Key considerations of Long Term Care Insurance

At a high level, you get what you pay for, right? So, if you’re looking for very generous coverage, you’re going to pay high premiums. The key facet of these programs is that it’s not just getting insurance payouts for “getting sick”, but rather, you’ve got to qualify for a series of activities that you’re unable to perform and then the policy pays for support to perform those duties. For instance, if you can’t perform pre-determined activities like dressing yourself, feeding yourself, etc., the policy would generally cover the cost of either a long term care facility or in-house assistance.

Your health and age matter quite a bit in what kind of rate you’re going to pay. On the applications I reviewed, I noticed they asked about tons of different ailments and whether you were EVER or within the past 10 years, diagnosed with certain ailments. Of course, the older you are, the more likely it is that you’d need to tap the policy as well, so those risks are factored into the premiums.

Unlike what you’ve probably heard in the news about certain malicious health-care practices, the insurance company can’t cancel your policy once you become sick. Once you sign the policy, the actual language of the policy can’t change and you should be able to continually renew for life. For that reason, some advisers advocate that you start a policy early in life. You’ve got to balance that with the costs though.

Example

Let’s say you purchase a policy from a major carrier that has a premium of $3000 per year and provides coverage for up to $250 per day of expenses for up to 6 months, but it only kicks in after a waiting period of 120 days. These are some typical key terms you’d see in a policy. So, let’s say you have an ailment that requires an extensive hospital stay followed by an assisted living facility, but it’s only about 2 months that you’re out of your house, the policy wouldn’t pay out to assist at all since you hadn’t hit the 120 day threshold. This is often a surprise to people who sign up for these policies without reading the fine print. Another catch is that you may have to fail to be able to conduct 3 or 6 or some number of activities as opposed to just one. So, if you can’t dress yourself, but you can feed yourself, use the bathroom and do everything else, the policy may not be activated. Therefore, it’s key early on to really understand what you’re buying.

My Thoughts

Insurance is not an investment. You don’t actually hope that you need it, just like you don’t hope you die to collect on life insurance and you’re not rooting for a wreck to have a “positive ROI” on your auto insurance. It’s a risk mitigation tool. Can you personally weather a catastrophic event in your life from a financial standpoint? If so, then there’s no need to consider it. If not, then you’ve got to consider whether the premiums, the coverage and the likelihood of such an occurrence equate to a prudent use of funds for a policy.

Personally, my wife and I don’t have policies, and probably wouldn’t consider one in the future since the premiums are very much likely to exceed any benefit we’d see (the insurance company’s gotta make a profit, right?) and we have other assets/insurance to help cover such circumstances.

43% of Americans have less than $10k for Retirement, Seriously

Darwin — Wed, 10 Mar 2010 03:39:31 +0000

I was shocked by the results of a recent survey outlining how almost half of Americans have virtually no savings, no retirement, nothing (Employee Benefit Research Institute’s annual Retirement Confidence Survey via CNN) . Now, this excludes the value of real estate and pension promises, which is a major culprit I believe. With the nanny state and bailout nation that’s been fostered stemming from the financial crisis, I’d be surprised if this situation improves in the near term. How did we get here?

I recall a conversation with a family friend who’s nearing retirement. He’s a public school teacher. When talking about savings and retirement, he boasted,

“We’ve never saved a dollar. Not one dollar. Why would we? We don’t have to. I get my full pension when I retire”

So, that’s problematic from a few fronts. First, it is case in point of unionized public sector workers living off the public largess which is simply untenable. My wife’s a teacher by the way, so I don’t have anything against teachers. But for firemen, police, teachers and the seemingly endless litany of other roles that are becoming increasingly dependent on the taxpayer to fund, there’s an expectation of full or near-complete salary pension payments for life. With life expectancy increasing and healthcare becoming ever more expensive, it should be evident that this is not sustainable. Now, I can’t blame workers themselves; I mean they worked a job for 25-30 years, they were made certain promises regarding their pensions, and they planned accordingly.

“But look at Greece”

We aren’t too far off. We already have a few states on the verge of bankruptcy. They need a bailout next, right? And for the US as a whole, when you look at deficits as a % of GDP, the hopeless gap in revenues minus spending and debt service over the next several years and a massive shift from private sector employment to public sector employment (the private sector has to pay for the public sector [govt]), it would not be beyond the realm of possibilities that the US is going to need some “austerity measures” of their own sometime down the road. This may include a reduction in promised pension benefits, a increased retirement age, higher taxes or other measures that shift the calculus of this family friend from “why would I bother saving” to “I’m really screwed and wish I saved some money and didn’t rely on the public teet for my retirement”.

Let’s get off public sector employees though. We’re talking about 43% of working Americans in the survey. I realize there’s a portion of the workforce in the survey that are young workers that perhaps haven’t started saving yet or haven’t yet breached $10,000…but 43% !?! How does that happen? I mean, a mildly liberal emergency funds should start at $10,000 for many families. How do this many people not have either? No savings, no retirement funding and no emergency fund? This many people living paycheck to paycheck just blows my mind.

It’s automatic! Many jobs these days have automatic investment plan participation. Studies have shown that when they’re opt out instead of opt-in, the participation rates are far higher. For workers that perhaps aren’t with a large company with a retirement plan, there’s always been the traditional IRA which comes with a tax break under the threshold and good old cash/stocks in a traditional account.

The only thing I can say is if you’re not saving for retirement, you better start investing today, and if you think a government or corporate pension are going to take care of 100% of your retirement needs, you may want to think again. Pensions can be cut. Benefits can be cut. Taxes can go up. Inflation can take off. While there are ways to hedge energy costs, hedge currency crashes and dodge some bullets, if you don’t have enough money in retirement to begin with, these are minor band-aids for a major malady.

Do You Feel You’re On Track for a Reasonably Comfortable Retirement?

How Does Society Value Additional Time for Your Dying Loved One?

Darwin — Sun, 07 Mar 2010 13:06:42 +0000

There is an excellent article in this week’s BusinessWeek written by the widow of a man who fought a long and courageous battle with cancer. What differentiated this article from other similar accounts is that the article stepped through a very detailed financial account of just how costly it is to sustain a terminal patient at the end of their life when the end is imminent. While she did personalize her account with what a devoted husband and father he was and what a fighter he was, the key message she sent to the millions who read this article is that the US needs to get real about the untenable situation we’re facing with an aging bolus of boomers approaching this same scenario.

The family paid only $9,400 of the $640,000 total bill. So, she asks the question as to whether they would have gone to these lengths if the costs were borne by the family and not a distant pool of healthy participants paying into an insurance pool. While politicians like to paint insurance companies as these draconian profiteering outfits, cases about where they’re shelling out hundreds of thousands of dollars to prolong the life of a terminal patient. When they raise premiums 10% or more each year and America cries foul, nobody’s really digging any deeper than the fact that they are for profit. But these premium increases aren’t all going to the bottom line – the balance sheets and stock prices surely don’t support that notion. No, we have an unhealthy, aging population that demands more and newer more innovative medical treatments – which are costly.

I’ve had this talk about when enough is enough with my wife and as impractical as it sounds (to me at least), she says “you can’t put a price on a day of life. I’d spend every last penny to keep you (me) alive for an extra month”. As romantic as that sounds, it’s just not feasible to spend an infinite amount of money on an ever increasing population of aging Americans. Paying $100K for this regimen of chemo, $100K for a prolonged hospital stay, $50K for this treatment, $25K for that one – it simply isn’t sustainable. It will bankrupt our country and our children. But it’s a conversation no policy makers are having.

Putting aside the controversial aspects of the reform bill like special deals to buy votes, the special Union deal and the lack of tort reform, this issue isn’t really addressed in the bill but eventually America’s going to have to have the conversation. Organizations looking to block the bill and scare voters brought up this “death panel” topic, and while the ghastly name would give anyone pause, I’ve gotta wonder about whether the cliff we’re running toward needs some sort of reasonable cost controls and assumptions in place. i.e. if you’ve failed on this treatment and that treatment, you’re 82 years old and other organs are failing, is it a prudent use of another $200,000 to prolong that life another 2 months? I don’t know. I don’t ever want to have to make a decision on allowing a human life to expire due to money, but someone has to. What is the alternative? Insolvency.

My wife and I have established our living wills and medical directives to insert some logic and reason into the decision making process should something terrible occur. If we’re in a devastating car accident and I’m in a vegetative state for life, rather than depleting our estate so I can rot in a bed braindead for 20 years (this happens quite frequently, and it’s a great cost-center for hospitals), I’d prefer to have the plug pulled. I’d pick my children having money for college over enduring that hell for 20 years any day. But the decisions are rarely that simple. I can tell you now, with young kids and a lot to live for, if I were diagnosed with cancer, I’d be fighting it like hell, and my insurer would likely be shelling out a ton to keep me going. However, if the situation reached the point of hopelessness and we were depleting our family’s future, I don’t know how long I’d keep fighting. I guess you can’t judge that situation until you’re in those shoes, which I’m not.

So, What’s the Solution?

Do we need to have limits on cost of treatment?
Should there be some sort of independent panel that determines the plausibility of continued treatment in hopeless situations?
Do we need families to shoulder more of the burden than insurers and the taxpayer (under government plans)?
Should age, health and possibility of recovery be factored in?
Should everyone get the same treatment regardless of their insurance and financial situation?
What else can be done?

Because to do nothing is to drive our economy right off a cliff.

Can You Put a Value on Extending a Life? Should You?

401K Loan Rules – Taxes, Interest, Pros and Cons

Darwin — Wed, 03 Mar 2010 13:12:24 +0000

401k Loan Rules allow for easy access to retirement funds, but is that a good thing? Many employees are unaware that they can take a loan from their 401k account for basically any personal need with very little hassle. There are clear negative attributes to this route, but some situations may warrant considering this option, depending on the need and other options at your disposal. One major misunderstanding is how the loan works and how it is administered.

How Much Can You Borrow From Your 401K?

Most 401k plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. Many plans allow immediate vesting, but if not, you’ll want to ensure you understand what your vested amount is. You usually have up to five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback. You can basically use the funds for whatever you want. If you adhere to the confines of these rules, you don’t need to pay the 10% early withdrawal distribution penalty since you’re paying it back within the confines of the plan.

Where Does 401K Loan Interest Go?

This is an oft-misunderstood and misrepresented question depending on which site you hit on the internet. Based on personal experience (more on that below), the interest paid actually goes back into your own 401k account – so you’re paying it back to yourself. You are NOT paying to the administrator, to the government or to anyone other than yourself. You might question why there’s an interest rate at all then. It’s basically to deter complete abuse of the provision to borrow money interest-free that was already exempted from income tax when you contributed to your account. Suze Orman and others have also purported that borrowing from your 401K creates some sort of “double-taxation”. While it’s a rather complex consideration of ifs, thens, and competing scenarios, perhaps it’s better stated that the interest is not tax-deductible like other options such as a HELOC, but I don’t agree that the amount borrowed is “double-taxation” by any means. Depending on your frame of reference, one may consider the interest portion as double-taxed because you’re paying back that interest to yourself in a tax-deferred account with after tax money, and then it will be taxed in retirement – But…But – the interest portion is a marginal amount of money compared to the amount borrowed since it is often offered at below market borrowing rates.

So, let’s consider the context. If you borrow $20,000 at 4% and pay if back over a couple years, the total interest is a few hundred dollars. Tax on a few hundred dollars is approaching a measley $100. Is this really worth micro-analyzing if you actually need the $20,000 for something important? It’s less than 1% of the total amount borrowed, so it’s less than a typical annual expense ratio on many funds you’re in, or certainly less than the fees/interest on ANY conventional loan you’ll ever come across.

Where else could you borrow $20,000 for $100 and pick the payback term?

The Case FOR 401k Loans

It’s Your Money! If you need it for an emergency or some compelling reason, you can stop the clock on your retirement funding, withdraw it and pay it back.
The interest rate is usually quite low generally at around 5% or less during the past several years. And you pay the interest back to yourself. The net loss due to the “double taxation” of interest is marginal.
There is no credit check required (see why credit score is critical) and the transaction can usually executed within a week or two. This is much faster than most other loan options.

The Case AGAINST 401k Loans

It’s Too Easy! The ease of which one can withdraw the funds lends itself to bad behavior. If people are already reckless with their personal finances by spending more than they take in by financing a lifestyle with credit card debt, what’s to stop them from drawing down the 401k in similar fashion?
You may miss out on a great market run. While you’re spending that money, it could have been growing your account principal.
If you are unable to pay back the loan, it is considered a premature 401k plan distribution. If you are laid off or leave your job, you may have to pay back the loan in full immediately as well. Otherwise, you will owe federal and state income taxes in addition to the 10% penalty if you are under age 59 1/2.
Sporadically tapping the 401k could seriously impede your retirement goals. Doing this under extremely rare circumstances throughout an entire career is one thing. But taking a loan for each summer vacation and paying it back over the next year is likely to be detrimental to your long term returns.

Why Would You EVER Borrow from your 401k?

There are certain life situations that may warrant tapping your 401k account because the alternative is even less desirable. These circumstances may include being laid off or an unforeseen medical emergency that consumed your emergency funds. If your options are to stop paying the mortgage and face eviction, embrace payday loans, or take a 401k loan, it’s an obvious choice. From another angle, what if a once in a lifetime investment opportunity came along? Example – great real estate investment opportunity or a friend is selling a successful business for health reasons/retirement. If it’s a low risk/high reward opportunity, and you’re confident you could handle the payback over time regardless of what happens to the initial funding, perhaps it’s a worthwhile endeavor.

Disclosure: I Took Out a 401K Loan Myself

In my early 20’s, I took out a 401k loan. I was newly employed and was getting engaged the same year I bought a house a year out of school. I was making pretty good money for my age, as I had one of the highest paying degrees out of school and I employed sound money habits (I drove a piece of junk for years, had no other debt and all I did was work long hours). I knew I could pay the loan back easily but I just hadn’t been working long enough to rebuild a large fund. I had just purchased a home after all. So, in looking at the pros and cons, I decided that rather than either a) propose to my would-be wife with a very meager stone or b) put off getting engaged/married for another year, I opted to fund a diamond I’d be proud to present with partial funding from a 401K loan. While some may scoff at this as a “frivolous” or irresponsible use of 401K funds, I weighed the risks and given the modest amount I borrowed and the outcome, I don’t have any regrets. As expected, I paid it back in a year, paid myself the interest, and as I recall, the market was roughly flat during the period, so I didn’t miss out on a spectacular stock market run.

When To or When NOT To is the Question

With that being said, I don’t think people should take this 401k loan option lightly. Because it’s so easy to do, people are most certainly tempted to tap into those retirement funds for routine spending or frivolous reasons. I mean, is tapping into the 401K any worse than carrying credit card debt? At least with the 401K loan, the interest rate is generally 5% or under and the interest gets paid back directly to you. With credit cards, you can pay upwards of 20% if you’re not in a 0% percent balance transfer. Now, I’m not condoning both/either, but given the lesser of two undesirable sources of temporary income, the 401K loan isn’t looking so bad.

Do You Think It’s EVER Prudent to Take Out a 401K Loan?

Abysmal Survey Results: Americans Don’t Understand Basic Financial Concepts

Darwin — Fri, 13 Nov 2009 11:43:02 +0000

A recent financial literacy survey conducted by Financial Finesse, a finance eduction outfit, revealed some pretty alarming results – downright abysmal in fact. It revealed what most of us probably suspected, but with specific numbers tied to it, the prospects don’t look good with regard to the financial literacy of everyday Americans. According to the survey which was conducted as a 10 year study of US employees across companies in which they service (here):

86% of employees indicated that they have no idea whether or not they are on track to retire comfortably.
53% admit they lack a basic knowledge of stocks, bonds and mutual funds.
43% do not have a handle on their cash flow and spend more than they make each month.
62% have not set up an emergency cash reserve.
23% do not pay their bills on time each month.

You probably glanced through these data and said, “Wow, this survey data looks pretty bad”. However, it’s worthwhile to really consider the implications of each of these poll results. Let’s break these down one by one:

Retirement

With an enormous proportion of Americans having no idea where they stand with respect to retirement, this could very well be the next crisis brewing – the Retirement Crisis. Is it possible that in the next few years, our administration will be passing legislation to bail out retirees that didn’t plan for retirement or were adversely impacted by market moves because they were too heavily invested in stocks? Don’t count it out – retirees are a very mobile and vocal political force given their numbers and influence. And they get to the polls! The internet abounds with calculators and advice on retirement planning. The bottom line is that you need to be realistic about what your spending is going to be in retirement, how far off it is, how much you can reasonably expect to earn on your investments up to and during that time (without taking on exorbitant risk!) and have a healthy buffer to account for the unexpected – like the inevitable tax increases to fund our debt, rising health care expenses, and perhaps be able to leave some family money to your heirs or help with college funding for your progeny.

As evidenced by this case of the 25 vs 35 year old investor and the stark difference in funds at retirement, it should really drive the message home that starting young yields incredible benefits and if you’re not that young anymore, there should be a sense of urgency to start now.

Stocks, Bonds, Mutual Funds

While many investors rely on a financial adviser to handle everything from how much to set aside to asset allocation, many people are too naive to even the most basic premise of asset classes. Aside from the dangers of receiving poor financial advice and not understanding how to benchmark the performance they’re like paying 1-2% per year for, these Americans don’t even know what questions to ask their adviser. While this site is geared toward slightly more sophisticated investment strategies like how stock options work and alternative investments, wikipedia is a great place to start to learn the basics in a user-friendly unbiased fashion.

Spending More Than They Make Each Month

People that form bad money habits often find themselves constrained to a lifetime of debt-ridden misery. It can be a terrible existence of hopelessness and frustration. By forming good money habits early on like putting parts of your finances on autopilot and living within your means, it makes all the difference in the world with regard to what type of life you’re going to lead and provide for your family.

No Emergency Fund

Life is all about the unexpected. And by not planning for the unexpected, one can completely lose a shot at goals and aspirations by not having adequate contingency for things like a car accident, a broken appliance, a costly health situation, etc. While you can only “hedge” so much with an emergency fund, having no emergency fund at all is a surefire way to not realize your life’s financial strategies when you’re living on the margin – because life happens.

Not Paying Bills on Time

This one’s a no-brainer. Some people actually HAVE the money and don’t pay bills on time because they’re either unorganized. This takes a terrible toll on your credit score which is instrumental in determining everything from whether an employer will change their mind on hiring you (viewed as a high theft risk if you have a poor credit score) to what rate you’re going to get on a substantial mortgage for the next 30 years.

Aside from following some basic principles and executing discipline in financial decisions, it’s evident that financial literacy needs to be taught in schools. I can say I learned very little in the way of personal finance and investing in school, even in my undergrad – most of it came from my parents initially, and then through a healthy curiosity and the internet and capped off by an MBA. But today, with so many parents acting like kids themselves when it comes to fiscal responsibility, how can we reasonably expect the next generation of American adults to far any better?

Are you Concerned by This Survey on America’s Financial Literacy? Surprised?

Family Money – Fairness vs. Favoritism in Gifting, Wills and More

Darwin — Mon, 26 Oct 2009 03:01:24 +0000

Family Money is a sensitive topic to cover, but I think it’s critically important from both an estate planning standpoint and from the standpoint of personal relationships with family members. Primarily, when it comes to things like wills, gifting, and financial assistance to family members (usually children) there are a complex array of considerations that many parents either don’t take into account – or ignore. Primarily, the topic comes down to Fairness vs. Favoritism. Let me delve into a couple hypothetical, yet real life examples.

Estate Planning – The Will

The Doctor - A couple in their 60s is looking to update their will now that their children are grown and starting to have children of their own. They have two children. Their First son is a relatively affluent doctor whose wife has a decent income as well. Not only do they pull in a six-figure income, but they have also made wise money moves throughout their marriage. The doctor and his wife have built a sizable net worth through real estate investments and relatively frugal living given their income. They’re viewed as “well-off”.

The Drifter – Enter the second son. He didn’t go to college and never had much in the way of professional ambition. He has drifted around from various music gigs and bartender jobs to seasonal employment while collecting unemployment in the off-season. He pretty much spends what he makes, or more each year. He has no assets in any retirement accounts and often portrays himself as “the victim” to family and friends. He is generally viewed as “poor” and some in the family feel sorry for him, especially when comparing his prospects to his brother’s family.

The Will – The parents have a sizable estate when considering their life savings and real estate. Assuming medical bills later in life don’t eat into their nest egg, they’ll be leaving somewhere in the range of $1.5 Million to their heirs. When considering their sons’ financial situations, they figure that the doctor is in no need of financial assistance and will be just fine no matter what happens. When considering the drifter, they have constant guilt over whether they could have done more to get him on the right track – whether they could have been more involved in his schooling, taken a more active role in his music career, or just loved him enough to give him the self-esteem to be more successful in life.

They decide that the right thing to do is to leave a token $100,000 to the doctor in their will and the remainder – well over $1 Million to the drifter. They feel confident in their decision that they’re doing the right thing by both their sons. They don’t discuss their financial affairs as they’re still in good health and money matters of this nature were never discussed as a routine topic in the family. They don’t consider what this eventuality may do to the relationship between the brothers; they’re pretty much thinking about what they think is “fair”.

Question – Is this fairness? Or is it favoritism?

Gifting

Another fairly affluent couple has two daughters. Each of the daughters had a similar upbringing and pursued similar career paths – they’re both school teachers. Given the current tax laws in their state and the size of their estate, the affluent couple has been gifting to their daughters for several years now. They don’t discuss the gifts openly and usually send a check and card in the mail for each New Year and the unwritten rule is to not publicize or discuss the situation with the others. The sisters don’t talk much now anyway and it would be awkward to do so, so the topic never comes up between the two of them.

Daughter #1 – She married into a relatively healthy financial relationship; her husband’s an attorney and together, they pull in decent money. Their children are into school now, so they’re both working. They live a reasonable lifestyle and have made sound financial decisions, including investing the majority of the gifting money they receive each year. They’ve each been getting $2,500 check every year now for 10 years.

Daughter #2 - She started off as a teacher, but now she’s home with her 4 children, 2 of which are in school. She’s had some tough luck with relationships and is recently divorced – for the second time. Neither of the husbands had adequate income to provide meaningful child support (and alimony is out of the question). She’s now primarily living off meager child support payments when they do come, unemployment and gifting from her parents. The parents are keenly aware of her difficulties and they’ve been gifting her and each of her children $12,000 per year, and in prior years, the maximum amount allowed under tax law. She uses the gifts to the children to help pay for living expenses. In addition, the grandparents pretty much pay for all the clothing and entertainment for the kids and give a lot of cash gifts at holidays outside the purview of the IRS.

Over the years, Daughter #2 and her children have been gifted in excess of $200,000. Daughter #1 and her husband have been gifted approximately $50,000.

Question – Is this fairness? Or is it favoritism?

Tragic Health Expenses

Finally, consider the couple that has two children. The older son is in normal health and in his thirties and they have never gifted him, paid for college or provided any sort of financial assistance outside the expected child-rearing expenses. The younger son is in his twenties now. He has been afflicted with various autoimmune disorders since childhood and has needed virtual constant hospitalizations and treatment. He can’t really take care of himself and between his medical treatments and help with constant caretaking, the parents have pretty much exhausted their retirement savings and expend the majority of their current cashflow on maintaining a dignified life for him since what is provided by government assistance isn’t adequate. The older brother is well aware of the situation, and has lived his entire life watching his brother suffer. He wouldn’t trade his health for anything – including his parents’ money.

I’m not going to ask the question. It’s no longer a question of “Fairness” when it’s life and death and the recipient had no role in their predicament.

As you can see, it’s not always simple. It’s easy to judge the motives and actions of others depending on your vantage point. However, in the first two situations, there will clearly be some animosity when the other sibling finds out just how lopsided their parents’ treatment was. Parents reading this have to ask themselves “Is that the legacy I want to leave? Children jealous and fighting?”.

I’m not writing this post because I have a personal gripe about fairness or favoritism, as my family’s routine affairs and estate planning (including ours to our children) have always been set up with a keen focus on fairness – an even split no matter what. However, I see it routinely with friends and acquaintances and it’s evident that while many families are confronted with difficult circumstances, decisions are often not applied consistently or in a transparent manner.

What Are Your Thoughts and Similar Examples You’ve Experienced or Heard Of?

How Does Deferred Compensation Work?

Darwin — Sat, 27 Jun 2009 01:34:31 +0000

I first heard of a deferred compensation plan a few years ago when one of my old bosses left my company and within a few years, quickly became a high-flyer in the organization, overseeing operations in several countries and managing thousands of employees with a global biopharma. Evidently, many things went right for him, and though he has constantly chided me over the years for not going with him, it was always tempting, but for me, money is only a part of the equation in my work-life balance and I’ve opted to stay put for now. However, I was intrigued and admittedly, somewhat envious, when I learned of the deferred compensation plan he was offered as an executive officer of the company.

What is Deferred Compensation?

Deferred compensation is often referred to as non-qualified deferred comp or the proverbial “golden handcuffs”. Essentially, a deferred compensation plan allows an employee to set aside a portion of their income over a prolonged period of time while it earns interest, while forgoing the tax implications of having such a high compensation structure at the present time. For example, if you were making $500,000 per year with salary and bonus, but only really needed $200,000 to survive, you could probably sock aways $50,000 in the company 401K, set aside $100,000 in deferred compensation each year and with the remaining $350,000 in taxable compensation, tax laws being what they are now, you’d still have well over $200,000 in after-tax income each year, especially considering there’s probably a sizable mortgage interest deduction and other tax savings vehicles involved. For those high compensated executives that don’t actually need to live up to their full income to enjoy a suitable standard of living, deferred compensation plans provide an extra means to stash away funds and earn interest on them without having to worry about the taxes until you’re in a lower tax bracket in retirement (if the administration doesn’t continue to make a push to have virtually all federal taxes shouldered by the top 10% of taxpayers in the country and redistributed to the remaining 90%, which is the direction things are headed now).

Deferred Compensation Tax Considerations

When considering the tax benefits, as mentioned, one also needs to consider what the tax brackets are going to look like in the future. If, due to the significant income you will be taking in retirement, you’ll be in a high tax bracket anyway, the benefits of forgoing the taxes at today’s current rates for a rate that is even higher later may be muted substantially. In effect, it would take several more years under proposed tax laws to realize the benefit of deferred compensation than under the current circumstances.

Risks of Using a Deferred Compensation Plan

There is some risk to leaving your money with your employer in a deferred compensation plan. Because 401K assets are protected for the employees in the event of bankruptcy, employee participation in 401K plans is quite high. The assets are invested in underlying assets in the employees name, and hence, they essentially own those assets and do not face risk of loss due to company solvency (unless of course, you’re holding too much company stock, which is evident from the data I highlighted in “401K Asset Allocation in the US“). Now, with deferred compensation plans, the assets therein are actually treated as though they are an asset of the parent company. Therefore, in a bankruptcy proceeding, it is entirely possible that deferred compensation assets would be treated as an asset subject to creditor purview and you may see your nest egg disappear in one fell swoop. Obviously, a key reason companies draft these plans is to retain employees, so there is often not a lot of flexibility with respect to withdrawing funds on short notice or when departing for a competing firm (which my old boss just did again – so I presume he got a really…really sweet offer to make up for lost funds there). For other circumstances such as death, the employee’s deferred holdings will vest immediately and the assets are available to the estate.

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Any Readers in a Deferred Comp Plan? I’d be interested to hear your experience and additional tips/risks I didn’t touch on here.

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