Appendix: Additional STRS Retirement Topics by Joanne Benjamin

Transcription

1 Appendix: Additional STRS Retirement Topics by Joanne Benjamin I. 403(b) Plans for Teachers A 403(b) plan, sometimes referred to as a tax-sheltered annuity or TSA, is a tax-deferred retirement (savings) plan for public school teachers, as well as employees of some other government and non-profit organizations. Teachers enroll with their school district/employer and agree to have a certain portion of their salary invested into a 403(b) plan. The 403 (b) contributions are not taxed and the investment grows income-tax free until it is withdrawn during retirement, when it is taxed as ordinary income. Simply put, it is the educator s version of the popular private sector 401(k) retirement plans, although, there s seldom an employer match component. 403(b) accounts for teachers are commonly of three types: 1. Annuities. Teachers frequently choose fixed annuity investments because they guarantee to pay out a fixed monthly amount (or lump sum) at retirement. Variable annuities have mutual fund-like components whose performance isn t guaranteed, but they may have greater risks and, and therefore, greater potential for capital gains or losses. Annuity plans have traditionally been the most popular with California teachers, although they are sometimes have high administrative costs and investment fees. School districts often offer a choice of annuity products from several insurance companies such as TIAA- CREF and Lincoln National. 2. Mutual funds under IRC 403(b)(7). These are typically offered thorough a major mutual fund firm (e.g., Dreyfus, Fidelity Investments, Vanguard, etc.). School districts offering a mutual fund option for 403 (b)(7) accounts typically have a relatively small number of choices (e.g., 5 to 50 funds) from a single firm. Investment choices usually include, but are not limited to, relatively safe index, bond, and target date funds. 3. Self-directed investments. These are offered thorough the major brokerage/investment firms (e.g., Fidelity Investments, Charles Schwab, etc.) but unlike #2, the employee manages the portfolio, and is responsible for choosing and trading the particular mutual funds, stocks, bonds, etc. Since the universe of investment choices is huge, there is a possibility that the employee may choose high risk or less suitable investments. On the other hand, a knowledgeable investor may profit greatly from actively managing his/her own retirement account. Investment and management fees are a function of the investment vehicles chosen (i.e., the same as you would experience with your personal account with the same broker.) California school districts often don t offer a self-directed option, however, they may work with you to establish one (the teacher may have to do the leg work, and set up account with brokerage firm.) Further, when you leave Joanne Benjamin Page 1 June 1, 2012

2 Notes: employment in your school district, or when you retire, you can roll your 403b plans to a self-directed IRA. Beneficiaries Just like with STRS, IRA accounts, and life insurance policies, you name a beneficiary for your 403 (b) plan. Your beneficiary then inherits your account when you die. Borrowing Some 403 (b) programs allow you to borrow (e.g., withdraw ) up to 50% of the funds from your account before retiring. The amount will be subject to federal and state income tax and you must begin paying the loan immediately, with the interest rate and payment terms determined by the plan. If you fail to repay the loan, the IRS will charge you 10% early distribution penalty. How to get started o Contact the benefits administrator for your school district to understand the programs available to you and determine how much you can afford to invest each month (Note: since your contribution is tax exempt, your taxable income and taxes will be less, so you might be able to invest a little more than initially thought). o Research the programs available to you and select the appropriate company and specific investment(s). o Sign up. This usually entails filing a salary reduction agreement (a real misnomer your take home pay is being reduced, but your salary isn t), and lots of forms with the investment or insurance company, including selection of beneficiaries. Resources o California STRS 403b website This website provides specific program and contact information for your school district. o University of Wisconsin 403 (b) Frequently Asked Questions Although centric to a particular university, this document provides lots of general information and guidance on 403 (b) programs o IRS All the nitty gritty, but, like most IRS publications, it can be tedious to read. II. Purchasing Additional STRS Service Credit 1. What are the benefits of purchasing service credit? a. Increased pension due to greater years of service time. The retirement formula, set by law, multiplies three elements: Joanne Benjamin Page 2 June 1, 2012

3 Your years of service credit. A percentage based on your age at retirement. Your final compensation. b. Increased pension due to higher age factor. If you retire with 30 or more years of service credit, 0.2 percent will be added to the age factor, up to a maximum combined age factor and career factor of 2.4 percent. Thus if you have 30 or more years of service, or your purchase of additional service time moves you into the 30 year zone, your age factor may be higher. c. Increased pension due to more higher final compensation. If you retire with 25 or more years of qualified service credit, the highest 12 consecutive months of your average earnable compensation during a school year will be used in your retirement benefit calculation, rather than the average of your last 36 months. Thus if your purchase of additional service time moves you into the 25 year zone, your final compensation may be higher (assumes final 12 months earnings are greater than average of last 36 months.) 2. What types of Service Credit Can be Purchased? a. Redeposit: If you withdrew your retirement contributions, you can redeposit and regain the service credit you withdrew. A redeposit allows you to restore the service credit you lost by your earlier refund. To receive the same amount of service credit you had when you took the refund, you must pay the interest that the refunded amount would have earned had the funds remained in your CalSTRS account. The longer the elapsed time between your refund and redeposit, the higher the redeposit amount will be. Some matters to consider: The cost to redeposit depends on how much service credit you wish to purchase and, because interest must be paid, the length of time between the refund and the request to redeposit the funds. Because most members end up making a redeposit close to retirement, the time gap between the refund and the redeposit is often large. This gap can make the redeposit costly. You can purchase a portion, rather than all, of the service credit represented by any refund you received. If you took multiple refunds, the cost will be a weighted average of the total of all refunds plus interest. To estimate the cost to redeposit refunds, visit CalSTRS.com/calculators. b. Permissive Service Credit: You may purchase service credit for performing certain other, non-calstrs activities. Examples include: substitute service, maternity or paternity leave, Fulbright Leave, Child Care Center, Native American School, School for the deaf and blind, Job Corps or Peace Corps, certain active U.S. military service, out-of-state, Foreign School Service, and University. Check the STRS Handbook for specific descriptions of what and does Joanne Benjamin Page 3 June 1, 2012

4 not apply. You may not, however, purchase credit for service performed at summer school prior to July 1, 2002, or, for which you have received, or are eligible to receive, credit in the CalSTRS Cash Balance Benefit Program or another California public retirement system. The cost to purchase permissive and nonqualified service credit depends on your highest annual earnable compensation in the last three years of CalSTRS-covered employment, the amount of service credit being purchased, and the current permissive service credit contribution rate for your age (see table in CalSTRS handbook under permissive service credit). To accurately calculate the cost for this purchase, CalSTRS must verify current or past service performance in certain other California public retirement systems. The salaries for this service will be used if they are higher than your highest CalSTRS salary. If you are not currently working in CalSTRS covered employment, additional regular interest will be added to the cost of this purchase. c. Nonqualified Service Credit: If you have at least five years of CalSTRS service credit, you may purchase up to five years of nonqualified service credit, also known as air time. Nonqualified service is not connected to any prior employment. Nonqualified service credit cannot be used to qualify for the career factor or the 25-year threshold for one-year final compensation. However, nonqualified service credit can be used for the 30-year service credit requirement to qualify for service retirement between the ages of 50 and 55. Note that the Governor has proposed eliminating the purchase of nonqualified service credit as part of his larger pension reform plan. Stay informed at CalSTRSBenefits.us. The cost to purchase nonqualified service credit or air time is based on many factors and too complicated to discuss here. Read the CalSTRS handbook and then apply to receive a billing statement/estimate 3. How Do I Determine If Purchasing Additional Service Credit Is A Good Deal? When making a decision whether or not to purchase service credit, you need to compare the purchase price with the potential boost in your retirement benefit. a. First, calculate the cost to purchase the service credit. This can be done conveniently online at CalSTRS.com/calculators, or manually by multiplying the amount of service credit you want to purchase by the current contribution rate for your age group (see table in STRS handbook). Then multiply that amount by your highest annual earnable compensation in the last three years of CalSTRS-covered employment. Joanne Benjamin Page 4 June 1, 2012

5 b. Next, estimate the monthly increase you would receive with the extra service credit. Use the Retirement Benefits Calculator at CalSTRS.com/calculators to estimate your monthly payment with and without the extra service credit. c. Decide if the cost is worth the benefit. Since this is most likely a very significant retirement and investment decision, you should probably seek the advice of an accountant, financial advisor, or other professional. Nevertheless, there are several techniques you can perform yourself at least get a feel for the answer, or double check the advice of your professional: Simple method -- calculate how many years it will take to recover your cost (i.e., analogous to techniques may folks use to determine if refinancing a home mortgage is worthwhile.) Simply divide the cost from step a, above, by the increased monthly benefit from step c and multiply the result by 12. If the payback period plus your current age is considerably less than your life expectancy, then the purchase is probably a good deal. However, if it exceeds your life expectancy, then purchase is probably not recommended. But what if the result is in the middle? In this case you need a more sophisticated analysis, as shown below. Annuity method compare prices for an immediate fixed annuity that provides monthly payments equal to the increased pension benefit. If the annuity cost is greater (more expensive) than the purchase cost, then purchasing from CalSTRS is recommended. (And, if the annuity price is less than CalSTRS, purchase the annuity instead.) Notes: o Because immediate annuity prices reflects payments beginning immediately (or within a month or two of purchase) this method is recommended only if you re very close to retiring. o An immediate annuity is a simple financial instrument that should not be confused with the more complex annuity products available in 403 (b) programs. Purchasing an immediate annuity is like buying a monthly pension check. You pay an annuity provider (usually an insurance company) a lump sum in exchange for a guaranteed income stream that begins immediately. The purchase price changes frequently and reflects your age, gender, place of residence, plus current financial market conditions and interest rates. Immediate annuities are also available with spouse survivor benefit and inflation protection options. o See for a useful annuity calculator. Joanne Benjamin Page 5 June 1, 2012

6 Complex method calculate the net present value of the increased pension benefit and compare it with the purchase cost. If the NPV of the benefit exceeds its cost, then purchase is advisable. Although this calculation is straightforward to perform with computer spreadsheets (e.g., Excel) or programmable calculators, it challenging to determine the proper inputs. For example, the NPV calculation needs to consider: o Life expectancy how many months or years of additional benefit should be used? o Inflation if you expect moderate (or high) inflation during retirement, then the increased benefit amount used in your calculation should be increased by 2% each year (i.e., STRS COLA). If you expect low inflation, then adjust accordingly. o Opportunity cost What s the average expected rate of return (i.e., interest rate) you would expect to earn if you conservatively invested the purchase cost? For example, you could purchase a bank CD, a corporate or municipal bond, or an index stock fund. (Note that the CALSTRS board assumes its large investment portfolio will grow at a 7%+ rate, while many personal financial advisors recommend a rate of 2%-6% for small clients.) 4. How is a Purchase of Service Credit made? a. Submit application form to CalSTRS (forms found on mycalstrs website) b. CalSTRS processes your application, determines your eligibility and sends you a billing statement. c. Select your payment choice and return your billing statement by the due date. Failure to respond by this date may result in a higher cost to purchase your service credit or denial, if you have already retired. Note that CalSTRS accepts a variety of payment methods including lump sum payment, rollover from other retirement plan (e,g, IRA, 403(b), 401(k), etc.), or monthly payment by mail or payroll deduction (however, you must complete all payments before retiring). III. Term Life Insurance As Another Way To Protect Your Beneficiaries Many STRS retirees select a beneficiary option to provide lifetime pension benefits to their spouse or other beneficiary in the event of their death. However, a beneficiary option results in a reduced pension benefit (compared to the member only benefit) for the retiree. An alternative is for the retiree to select the member only benefit, and then use the difference in the pension amounts to fund a term life insurance policy for the beneficiary. Joanne Benjamin Page 6 June 1, 2012

7 Disclaimer: This alternative is not directly equivalent to the STRS Beneficiary Option and it has its own advantages and disadvantages which need to be considered carefully by the retiree. Also, it certainly isn t always financially competitive as term life insurance rates change frequently due to interest rates, actuarial tables, and competitive factors. Definition: Term life insurance is simple life insurance that provides guaranteed benefits for a fixed period of time for a fixed annual premium. It is the least expensive form of life insurance and should not be confused with the more popular (but expensive) whole life policies that combine an investment component in addition with straightforward life insurance. Premiums for term life vary considerably based on the insured s age, health, lifestyle, occupation, and location of residence. The Concept: The retiree chooses the STRS member only benefit, and uses term life insurance to protect his/her spouse in the event of retiree s death. The difference between the member only pension amount and the beneficiary option pension amount can be used to pay for the term life insurance policy. For example, a 60 year old male in good health that s enjoys a well behaved lifestyle (e.g., no drugs, smoking, sky diving, etc.) might be able to obtain a $250,000, 20 year term life policy for $200 per month. This means that if the insured dies anytime between age 60 and 80, his spouse or other beneficiary will receive a lump sum $250,000 payment that is tax free. The $250,000 can be invested and drawn down for monthly living expenses, or else used to purchase an annuity. At current prices, $250,000 could be used to purchase an annuity that would provide a lifetime monthly income stream of the following amounts dependent on the age of the beneficiary at the time of the retiree s death: Age of Beneficiary at Time of Retiree s Death Lifetime Monthly Amount $1,200 $1,470 $2,160 Variation: Because the total amount of life insurance needed by a beneficiary generally declines with age and life expectancy (e.g., a spouse with a life expectancy of 79 would need less of an insurance benefit at age 75 than at age 60), multiple term life insurance policies can be structured to reflect this need. For example, instead of purchasing a single $250K, 20 year policy, the retiree might opt instead for three policies a $150K -20 year policy, a $50K 10-year policy, and a $50K 5 year policy. This would provide a death benefit of $250K for the first 10 years, $200K for next five years, and $150K for the final five years. This technique would be less expensive than a single $250K 20 year policy. Advantages of the term life insurance alternative compared to the STRS beneficiary option: Joanne Benjamin Page 7 June 1, 2012

8 1. The retiree and spouse/beneficiary may enjoy a higher standard of living while both are alive. This can happen in two ways: a. If adequate term life insurance can be secured for less than the difference between the two pension amounts, then the savings can be enjoyed as retirement income. b. If during retirement, the retiree s financial situation improves to the point where term life insurance unnecessary. then the policy can be cancelled, and the savings enjoyed as retirement income. 2. If the spouse/beneficiary predeceases the retiree, then the term life insurance can be cancelled, and the retiree will enjoy a higher standard of living 3. If the retiree dies, then the lump sum life insurance payment is tax free to the spouse/beneficiary. Risks of the term life insurance alternative compared to the STRS beneficiary option: These apply to the situation where the retiree dies and spouse/beneficiary receives the lump sum life insurance payment. 1. The retiree may live longer than the time period of the life insurance policy. (e.g., retiree and spouse both age 60 at time of retirement and purchase 20 year term life insurance policy. Retiree dies at age 81 after insurance has expired. Therefore, spouse receives nothing.) 2. The life insurance benefit may prove to be inadequate at the time of the retiree s death. (e.g., a $250K policy thought to be sufficient at time of retirement could be inadequate ten years later due to high inflation.) 3. The life insurance company may become financially insolvent, and unable to pay the death benefit. Conclusion: The term life insurance alternative is definitely not suitable for everyone. However, it should be understood and studied by all retirees considering the STRS beneficiary option. At a minimum, the analysis can tell you whether or not the STRS beneficiary option is a good deal. And, if term life insurance is more consistent with your needs, then if might save you money. Because of the complexity, multitude of factors involved, and the volatility of term life insurance rates, retirees are advised to seek the help of an account, financial advisor, or other professional to fully pursue this alternative. Joanne Benjamin Page 8 June 1, 2012