In 1936, during the midst of the Great Depression, Franklin Roosevelt championed Social Security as part of the New Deal. Prior to that time, workers had no guaranteed retirement benefits and often worked until they died.
Social Security benefits paid a modest monthly amount starting at age 65. Most retirees in 1936 died by the time they were 67 so there was little risk that the Social Security Trust Fund would ever go broke. The plan was based upon a large number of workers contributing a small amount of money to fund current retirees. Since there were more employed contributors than there were retirees, this further guaranteed that the fund would be solvent.
Social Security
There have been some considerable changes made to Social Security since the Roosevelt administration: Medicare was added in 1965 and the monthly benefit increased to a maximum of $2323 for full retirement at age 66 in 2009. The maximum amount that is deducted from an employee's paycheck has escalated to 6.2% of the employee's wages up to $106,800. The employer is required to match the contribution at 6.2%, for a total contribution of 12.4%. Despite all these efforts, there are still concerns that Social Security could be on the verge of bankruptcy or that benefits may be cut drastically. In an effort to stem the tide of red ink, the retirement date has been moved up from 65 to 66 years of age for workers born from 1943-1954;workers who were born after 1960 must wait until they are 67 to reach full retirement age. Workers may still retire at age 62 but their benefits are significantly lower than if they wait until age 70, when current regulations allow for the maximum benefit. To complicate this, the number of workers paying into Social Security has dropped to one contributor for every two retirees. This means that, in the future, a smaller number of workers will be paying for an increasing number of retirees. Since this scenario makes it statistically impossible for Social Security to remain solvent, other forms of retirement savings must be implemented for younger audiologists still in the workforce.
The perennial question posed to the current administration is, "Will Social Security still be around when I retire?" So far, there has been no definitive answer. Some experts suggest that the benefits would have to be reduced, while others support a broad-based tax to make up for future shortfalls. The problem is exacerbated by constant federal borrowing from the Social Security Trust fund. Thus, even current payments are based upon borrowed money. Once again, the future of Social Security remains dim because of so many attempts to take money from the fund for other purposes.
The government estimates that Social Security will begin to run a deficit by 2016 and cannot be sustained after 2037 without reducing benefits by 25%. That gives little comfort to the young audiologist under age 40 who is trying to pay off school loans, build a profitable practice and save for a child's college expenses. When Social Security goes into the red, other federal taxes will be levied to redeem the bonds taken out of the trust fund to pay all benefits promised if changes are not made. This could pose an additional tax burden on current wage earners
Alternative retirement programs have been discussed. However, Social Security remains the largest government program in the world, and takes 23% of the federal budget. Social Security taxes comprise the largest tax that the typical family pays and it is not likely to change in the near future. If Social Security is to survive, either benefits will have to be cut or taxes be raised to pay for them. Until then, audiologists planning for retirement must consider their Social Security as an important source of income. Alternatives that would allow for younger workers to invest privately have been proposed, but those options have yet to materialize.
Non-Government Pensions
While most employees look at pensions as merely a guaranteed retirement benefit, there are other reasons employers offer pensions. The most obvious is the lifetime guarantee of income at the age of retirement. Less obvious is the nature of long term savings that forces workers to save for their retirement. Unlike Social Security, which does not dedicate contributions to each worker's unique account, some types of small company pension plans invest contributions for each employee. Other types, called defined benefits plans, invest in a pool for all employees. An annual statement is usually given to the employee showing how much has been invested and what the retirement benefit would be. These prospective figures are based upon actuarial formulas used to calculate the benefits, depending on the parameters of the plan. This forces the employee to save and also shows how much annual income can be realized for the years after retirement. Another reason for an employer to provide a pension is to retain qualified employees. Additionally, in today's economic climate knowing that a pension awaits is a compelling reason for the employee to stay with the company. Finally, a pension is a form of life insurance, by allowing the employee to designate a portion of the benefit to the spouse in the event that the employee passes away before retirement.
Types of Pension Plans
There are two general types of pension plans available: individual plans such as individual retirement accounts (IRAs) and Roth IRAs, and employer-sponsored retirement plans where employees may or may not be able to make contributions. Except for the Roth IRA, most plans allow for contributions in pre-tax dollars, i.e., the amount paid in is not taxed until redeemed at retirement age.
Employer/Employee Contribution Pension Plans
Many audiologists are employed by the state, public hospitals or public universities. Presently, most states provide a retirement benefit for vested employees who meet certain qualifications. Vesting is the requirement met by longevity and type of service. In most cases, employees must meet a minimum of weekly hours and specified minimum period of time of employment. Generally, workers are not allowed to take retirement benefits until they have reached a certain number of years of employment and a specified age.
While each state, agency or public institution has its own system, most are based upon years of service and an average of the highest three years' income. Becoming vested may or may not require full time employment. Employer sponsored retirement plans are also offered by small businesses.
The Plight of 401(k) Plans
Until the recession began in December 2007, employees with a 401(k) plan - the most common type of pension plan - believed that their investment was safe. The drastic downturn in the market resulted in many 401(k) plans losing up to half their asset value. Although this is likely to reverse itself when the market regains upward momentum, many people who were near retirement had to defer leaving for financial reasons;as the value of their 401(k) plummeted, the amount of retirement cash was reduced significantly. There is no guarantee that a pension plan will retain all of its value in a fluctuating market.
Briefly, a 401(k) plan allows the employee to invest pre-tax dollars, up to a specified limit in securities that will later be paid out as a pension. Since the contributions are pre-tax dollars, the employee defers paying income tax on the proceeds until he or she is retired. At that point, the retiree's income tax bracket would be lower with less of a tax burden. However, 401(k) type plans have been hit hard to the extent that they are no longer the only vehicle in which to invest pension funds.
The high cost of setting up a 401(k) plan for the small employer is a disincentive. The employer may elect to have an employee-only contribution and a matched contribution, whereby the employer matches the employee contribution as a form of profit sharing. If an employee leaves before retirement age, the employer may retain his portion of the contribution. For 401(k) plans, the funds remain in the employee's account even if the employee leaves the company, as long as the employee is vested. It also caps the contribution an employee makes at $14,000. Despite some of the downsides, 401(k) plans remain the most popular form of retirement strategies;however, employees and employers alike must be diligent about where the money is invested to insure that the funds will be protected from drastic changes in the stock market, as we have recently witnessed. A balanced portfolio with stocks, bonds, government securities and other stable investments is the best hedge against a sharp reduction in 401(k) plan value. Since most companies do not have the benefit of a full time investment counselor, employers must rely on the judgment of a plan advisor who is an investor not affiliated with the employer.
Profit Sharing Plans
A profit sharing plan is a defined contribution plan that is not a pension plan or a stock bonus plan. It is usually based on a formula whereby the business owner deposits a fixed amount of the profits between 0% and 25% of the eligible employee's compensation each year. The business owner must stipulate the nature of the profit sharing, who is eligible and other requirements in a written document.
Saving Incentive Match Plan for Employees (SIMPLE)
SIMPLE pension plans are open to small businesses and self-employed individuals having fewer than 100 employees. It is similar to a 401(k) plan, whereby the maximum an employee may contribute is $10,000 a year. This may be matched by the employer up to 3% of the compensation (salary or wages) paid to the employee.
Money Purchase Pension Plans
This is a retirement plan that allows the employer to contribute a fixed annual amount or percentage of salary to an employee's individual retirement account.
Employee Stock Ownership Plan (ESOP)
An ESOP gives the employee company stock that is held until the employee retires. This was a commonly used retirement plan by United Parcel Service when it was a privately held stock company to retain their employees.
Simplified Employee Pension (SEP)
SEPs are popular with small business owners because they are inexpensive to set up and allow the employer to make contributions up to $42,000 annually or 25% of total compensation, whichever is lower. The SEP allows employees to invest in a group of IRAs and control them. The benefit to the employee is that he or she has control over the funds that are paid on their behalf by the employer. All contributions are tax deferred until taken at retirement.
Defined Benefits
The small audiology practice with only a few employees might consider setting up a defined benefits pension plan. This type of plan allows for much larger contributions;however, it is an employer owned plan that precludes employees from making contributions. The benefit is the employee does not have to contribute. For employees on a tight budget, defined benefits allows for savings without any personal financial sacrifice. For the employer who shows a good profit, defined benefits allows for much of the profit to be reinvested in the practice without a tax liability. All contributions are pre-taxed dollars.
By establishing a defined benefits plan, the employer agrees to set aside a certain amount of money each year to be paid to eligible employees upon retirement. A defined benefits plan must meet strict requirements as set by the Internal Revenue Service (IRS) that include: having a written legal plan, selecting a consulting actuary not associated with the practice, selecting an investment manager to invest the contributions, and guaranteeing certain minimum and maximum contributions to meet the plan's financial goals.
The retirement benefit for a defined pension plan is usually set by one of three formulas:
- Flat-benefit: allows for a fixed dollar amount to be paid for each year of employment;
- Career-average: an employee receives an annual benefit, which is a percentage based on each year they are in the plan multiplied by the employee's yearly earnings. When an employee retires, he or she receives an annual benefit equal to the sum of each year's annual benefit, payable until his or her death;
- Final-pay: an employee receives an annual benefit based on the highest average earnings during a specified number of years closest to retirement. This is the type of benefit often used by most government employees such as teachers and police officers, whereby the retirement benefit is paid on the last three (highest income) years of employment. Some private employers have this type of plan as well.
Setting Up a Defined Contribution Plan
A certified public accountant (CPA) is one of the first professionals that should be consulted about setting up a pension plan. There are tax ramifications that both employers and employees should be aware of before contracting with a third party to handle pension funds. Many mutual funds offer defined contribution plans with simplified documents, administration and investment choices. When setting up a defined benefits plan, a consulting actuary - one who determines what financial impact may result from risk or uncertainty - should be retained to establish the appropriate benefit formulas that would allow for recipients to have an adequate pension. Such variables as the age of the employee(s) at the time the plan is established, the plan's retirement date and longevity need to be considered carefully.
A pension is designed to provide a livable income to the retiree in addition to Social Security. Too little contributions can drive the retiree into the poorhouse while too much can hamper a growing audiology practice that needs capital for expansion. The actuary should be able to design a "qualified plan," i.e. a plan that is acceptable to the IRS and assists in locating an investment manager. In most cases, a financial institution or brokerage house acts as the investment manager. The actuary designs the plan and advises the employer about how much to contribute annually to target pre-set goals. This is analogous to how an audiologist targets the best gain and output using real ear measures. Too much cash contributed into the account in one year could result in an IRS penalty if the intention was to avoid paying taxes. The plan should be flexible enough to allow for a lower contribution in lean years and a more generous contribution when economic times are good. Current IRS funding minimums and maximums permit this within reason. This is similar to dollar cost averaging, where funds invested over a long period tend to grow regardless of how much or little is invested at a particular time.
How substantial a benefit should a defined benefits plan promise? That depends on several factors including the age of all qualified employees, the plan's retirement age, the effect of inflation on the economy, and the desired standard of living that the employer and the employees seek upon retirement. A defined benefits plan should be used in conjunction with - not as a replacement for - other retirement income.
Practical Hints
If the employer-audiologist is under age 45, a defined contribution plan - probably a variety of profit-sharing plan with a mutual fund - is the most cost effective. If he or she is over age 45 and desires to save a large amount for retirement with more modest contributions for their employees, a defined benefit plan would be better, based on the variables mentioned above. The latter plan is more expensive to operate but offers bigger cost and tax advantages.
Summary
Audiologists who are planning for retirement should not rely upon Social Security alone to fund their pensions. Employer-audiologists need to look at creative ways that they can provide for themselves and their staff without sacrificing their quality of life. One way to provide for the retirement years and defer paying taxes on income is to set up a qualified pension plan now. With the help of a financial advisor and an actuary, a qualified plan that saves the employer from paying taxes on income while providing for all employee's retirement years in a win-win situation for all parties, especially in an unstable financial climate.
References
American Institute of Certified Public Accountants, Inc. (2009). Types of defined contribution pension plans. Retrieved September 15, 2009, from aicpa.org
Job-Employment-Guide.com (2009). Types of retirement plans. Retrieved September 15, 2009, from www.job-employment-guide.com
Lowtax Network (2009). Types of pension plan. Retrived September 15, 2009, from www.usa-federal-state-individual-tax.com
