Charting the Course: Planning for Life after College
It has frequently been said that the end of college is not an end at all, but is rather the beginning of life’s journey. Because life is a journey rather than a race, it is important to make some plans ahead of time so the path is known and the destination understood to the extent possible in advance. When most people set out on a journey to destinations unknown, they usually secure a map ahead of time to avoid getting lost. Likewise, a map of an individual’s life journey can help a person stay on course and avoid the pitfalls that await the unwary along life’s roads; however, in some cases, there is no real adventure on a trip without straying slightly from the path to see what is down the “road less traveled.” At any rate, with such a life’s map in hand, the journey through life will be more predictable and progress easier to chart.
Statement of the Problem
Growing old and retiring is a phenomenon of growing importance in economic life. As a result of the establishment of social security in 1935, the increase of private pensions after World War II, and the general rise in living standards since the Great Depression, an extended period of retirement has come to be regarded as a normal end to a successful career. Furthermore, as the result of innovations in healthcare technology and medicine, longevity has been increasing, and retirement ages have been declining. As a result, retired people represent a growing proportion of the population. When the baby boom generation begins retiring in 2005, this proportion will also rise at a sharper rate. “Faced with the prospect of changes to retirement plan provisions, many workers will probably prefer lower early retirement benefits rather than pushing back the age at which retirement can commence” (Rappaport & Schieber, 1993, p. 148). Consequently, trends in retirement have raised important questions about the financial soundness of some of the main institutions that provide income to retirees and their families such social security, other public and private pension plans, and Medicare (Aaron & Burtless, 1984). Therefore, identifying effective means of ensuring for a sound retirement early on just makes good business sense today.
Purpose of Study
The purpose of this study is to develop a comprehensive and viable financial plan for a graduating college student that will grow and change with him as he passes through the different stages of life. The key points addressed in this financial planning regimen include, goal setting, saving, debt management, insurance needs, career planning, retirement planning, and how they are impacted as the student moves from single to married to family to retired.
Importance of Study
The demographic composition of the United States is changing in fundamental ways. Beyond the ethnic shifts taking place in the country, there are going to be a lot more people retiring in the years to come than ever before. The graduates of today are faced with a dual burden of inheriting this growing retired segment of workers, while trying to provide for their own personal well-being and that of their families. In order to achieve a satisfactory standard of living as life progresses in this changing environment, younger workers are going to have to hit the ground running.
Scope of Study
This study will examine the factors involved in financial planning regimen for college graduates today in general, with a focus on the research in particular.
Rationale of Study
It is widely recognized that early planning is an important part of the retirement planning process. According to McKinney (2003), “A well planned estate allows you to decide how your property will be administered during your lifetime and distributed after your death.” Today, many Americans are affluent at midlife and are naturally looking forward to a comfortable retirement. These lucky individuals already enjoy sizable pensions, investments and an accumulation of assets like homes, second homes and other valuable property. “They need not worry about outliving their assets and may be more concerned about protecting their wealth through tax-saving strategies, estate planning and setting up trusts for their heirs” (Genovese, 1997, p. 13). Those adults who have not begun to plan, though, may learn the hard way about what is involved in the process when they are forced to assist their aging parents with financial and estate decisions. “While many older adults have well-organized financial affairs, other adult children find parents’ plans and records in disarray. They may get ‘on the job’ experience as they try to untangle their parents’ affairs after a health or financial crisis” (Genovese, 1997, p. 13). While practical experience may be the best teacher, the importance of saving for retirement is reinforced for many people today who are alarmed by their first experience with the costs of home care, retirement community living or nursing home care. Genovese reports that a private nursing home costs $40,000 per year or more, depending on the part of the country and the type of facility. Another factor that can shock first-time estate planners comes from the realization that their parents may outlive their resources or face spending down their assets to qualify for Medicaid when they enter a nursing home.
Definition of Key Terms
Career. For the purposes of this study, the term “career” will refer to employment in an occupation that will ultimately lead to retirement along a predictable career path in a profession of the individual’s choosing. For those who fail to make the distinction between life’s “calling” and a “career,” the results can be disappointing or even disastrous. According to McGee (2003), people who do not pursue employment in an occupation they will enjoy are going to pay for it the rest of their working lives. By defining career success in terms that also embrace such nebulous issues as personal satisfaction and self-worth, the type of lifestyle demanded by the occupation, and what benefits can reasonably be expected to be associated from pursuing such a career path, the individual will be in a better position emotionally and psychologically — and perhaps even financially — when the journey is over.
Goals. A “goal” as discussed in this study is “the object of an action; it is what a person attempts to accomplish. Goals include such efforts as, “. . . attempts to sell more products, to improve customer service satisfaction, and to decrease absenteeism in a department by 5%” (Ivancevich, 1995, p. 219).
Professional. According to Black’s Law Dictionary (1990), a professional is “one who is engaged in one of the learned professions or in an occupation requiring a high level of training and proficiency” (p. 1210).
Overview of Study
This chapter introduced the issues involved in preparing for graduation from college and making plans for life’s journey. A statement of the problem, the purpose and the importance of the study were followed by a discussion of the study’s scope and rationale. Definitions of key terms were also provided. Chapter Two will provide a review of the related peer-reviewed literature, and Chapter Three describes the study’s methodology, a description of the study approach as well as the data-gathering method and database of study used. Chapter Four reviews the analysis of the data developed during the research process, and Chapter Five provides a summary of the research, conclusions and recommendations.
Chapter 2: Review of Related Literature
In 1978, Locke presented the now-classic paper, “The Ubiquity of the Technique of Goal Setting in Theories of and Approaches to Employee Motivation,” and ever since there has been a growing interest in applying the goal-setting technique to a variety of settings. Locke’s view of an individual’s conscious goals and intentions were that they were “the primary determinants of behavior” (p. 36); in other words, a universal characteristic of intentional behavior was that it “tends to keep going until it reaches completion.” As a result, when a person starts something such as a new job or project, that person will keep striving toward completion until the goal is achieved.
A study was conducted early on to determine whether goals change work efficiency without affecting the associated physiological cost (Wilmore, 1970). To this end, Wilmore conducted a series of experiments to determine whether goals enhanced the accomplishment of a physical task and found that “. . . goals should be behind every performance if maximum performance parameters are to be stimulated” (p. 37). The results of Wilmore’s experiments indicated that “physical performances without set goals will not produce the best form of physical response. As has been demonstrated by champion athletes, every task of training and competitions must be oriented to some particular explicit goal that will focus the athlete on functioning with the greatest efficiency in performance. A physical activity at training without a goal-orientation is a wasted opportunity for improvement” (1970, p. 38).
Therefore, goal-setting appears to be an essential component in the effective application of physical effort. In organizational settings, at least, the following issues have been identified as constraints to the effectiveness of the goal-setting technique; many of these apply to the individual goal-setting process as it applies to career planning as well:
Goal setting is rather complex and difficult to sustain.
Goal setting works well for simple jobs — clerks, typists, loggers, and technicians — but not for complete jobs. Goal setting with jobs in which goals are not easily measured (e.g., teaching, nursing, engineering, accounting) has posed some problems.
Goal setting encourages game playing. Setting low goals to look good later is one game played by subordinates who do not want to be caught short. Managers play the game of setting an initial goal that is generally not achievable and then finding out how subordinates react.
Goal setting is used as another check on employees. It is a control device to monitor performance.
Goal accomplishment can become an obsession. In some situations, goal setters have become so obsessed with achieving their goals that they neglect other important areas of their jobs.
The positive effects of goal setting are sometimes only temporary (Ivancevich, 1995).
Goal setting seems easy, and a lot of people assume that they have the intuition and inherent skills to set and use goals to accomplish organizational goals; however, it has also been shown that training in specific goal-setting skills can be very effective. Therefore, the career planner should seek to establish goals according to goal specificity, goal difficulty and goal intensity as these factors apply to accomplishment of these goals (Locke, 1978). Locke defines these components of the goal-setting process as follows:
Goal Specificity is the degree of quantitative precision (clarity) of the goal.
Goal Difficulty is the degree of proficiency or the level of performance sought.
Goal Intensity pertains to the process of setting the goal or of determining how to reach it (1978).
Goal Commitment. According to Ivancevich, “To date, goal intensity has not been widely studied, although a related concept, goal commitment, has been considered in some studies. Goal commitment is the amount of effort used to achieve a goal” (1995, p. 111).
For a recent college graduate in search of an effective planning technique, goal setting provides a method that is responsive to individual needs as well as those of the organization involved. Goal-setting also provides some solid echniques for accomplishing goals. “Research has shown that specific goals lead to higher output than do vague goals such as ‘Do your best'” (Locke, 1978, p. 38). Clearly, the results of goal setting as a motivational tool are overwhelmingly positive. The studies by Locke and others have shown time and again that setting specific goals has led to better performance than do value goals. In fact, in 99 out of 100 studies reviewed by Locke and others, specific goals provided better results (1978).
According to Needles and Powers (1998), in order for people to succeed in accomplishing their goals, they must be able to control their expenses and provide for savings. There are a number of approaches available for the young, middle-aged and older saver today that may be applicable depending on individual needs and circumstances. These alternatives are discussed further below.
Traditional IRA. According to Springstead and Wilson (2000), a traditional Individual Retirement Account (IRA) is a personal savings account that offers tax advantages to set aside funds for retirement. “Annual contributions of up to $2,000 are fully tax-deductible for workers not covered under employer-sponsored pensions, for single workers with earnings under $32,000, and for married workers filing jointly with earnings under $52,000” (p. 34). In addition, workers may make nondeductible or partially deductible contributions.
Investment earnings for all contributions accumulate tax-free and are not taxed until funds are distributed. The Taxpayer Relief Act of 1997 created Roth IRAs, which differ from traditional IRAs in that contributions are made with after-tax dollars but distributions are tax-free.
Roth IRA. According to Beech (1997), there are a number of options available when considering retirement plans, the new retirement plan option called Savings Incentive Match Plan for Employees (SIMPLE). A survey by Fidelity Investments, the nation’s largest mutual fund company and a leading provider of financial services, found that fully 80% of small business owners believed it was important to help employees save for retirement, but only 35% of them currently offered an employer-sponsored retirement plan. “Some business owners don’t make this offer because they are overwhelmed by the choices, the expense of employer contributions and the time it takes to implement and administer these plans” (Beech, 1997, p. 28). In the 1970s, Congress first started allowing taxpayers to contribute to individual retirement accounts (IRAs); thereafter, IRAs became highly popular in the 1980’s (Bledsoe, 1998). According to Daryanani, tax year 1998 was the first year a Roth IRA could be established. At that time, approximately $21 billion was placed into mutual funds via Roth IRAs. Since that time, the Internal Revenue Service has issued additional guidance that has affected the playing field for those interested in pursuing a Roth IRA as opposed to alternative financial vehicles, such as traditional IRAs, simplified employee pensions (SEPs), savings incentive match plans for employees (SIMPLEs), and Keogh plans, as well as Sec. 401(k) plans, all of which are available and offer tax deductibility to qualified taxpayers (Moore, 2001).
By March 2003, the Roth IRA had been in placed for five years. Appleby suggests that this is a significant milestone for the Roth IRA as 2003 was the first year a “qualified distribution” could occur from any Roth IRA. The Tax Payer Relief Act of 1997 created the Roth IRA, which was made effective for the tax years beginning 1998. According to Sabelhaus, the Taxpayer Relief Act of 1997 changed policy towards Individual Retirement Accounts (IRAs) in a number of ways. For example, income limits for eligibility for traditional deductible IRAs were increased, a new “backloaded” (this is the Roth) IRA was introduced, and education expenses and first-time home purchases were added to the list of allowable reasons for withdrawing funds from IRAs before retirement without penalty. Since 1997, additional modifications to IRA law have been suggested, including more reasons for non-penalized withdrawals and changing minimum distribution requirements for taxpayers older than 70-1/2 (Sabelhaus, 2000).
Prior to 1998, taxpayers who wanted to fund an IRA could make either a deductible or non-deductible contribution to a Traditional IRA. Distributions from Traditional IRAs are generally treated as ordinary income and may be subjected to income tax as well as an additional early withdrawal penalty if the withdrawal occurs while the IRA owner is under the age of 59-1/2 years old. The Roth IRA, on the other hand, allows “qualified distributions” to be free from tax and penalties. Given that 2003 is the first year that a qualified distribution from a Roth IRA can occur, we will review the tax treatment of Roth IRA distributions (Appleby, 2003).
Individual Benefits and Disadvantages. From Steig’s viewpoint, workers should choose a Roth IRA over a traditional IRA if they meet the following criteria:
The individual has 10 or more years until retirement. The reason is that there are penalties on withdrawals from Roth IRAs unless the individual has had the IRA for 5 years and is over the age of 59-1/2 years.
The individual and spouse have a combined income of less than $150,000, or the individual is single and making less than $95,000. The reason is that if an individual earns more, he or she may benefit more from the tax-deductible contributions of a traditional IRA.
The individual anticipates being in the same or a higher tax bracket when he or she retires. The reason here is that a traditional IRA has income limits on deductions; therefore, if the individual expects to earn more money as he or she gets older, the Roth IRA might be a superior alternative.
However, a Roth IRA has some strict rules that should be taken into consideration as well:
No earnings, no contribution- — contributions are limited to earned income or $3,000, whichever is less;
Earn too much and you are locked out of the game (a problem for many adults);
Subject to a few exceptions, withdrawals taken prior to the owner reaching 59-1/2 years are hit with a 10% penalty.
The positive side to this for taxpayers is that although contributions to a Roth IRA are not deductible, withdrawals are tax-free (after age 59-1/2 years); however, there is another tax-advantaged way to prefund a taxpayer’s child’s education that is superior to a Roth IRA. The alternative is called a Tax-free Education/Retirement Plan (tax-free E/R plan). According to Blackman, the reasons a tax-free E/R plan is better than a Roth IRA are two-fold:
1) earnings do not count (whether an individual has zero earnings or earns millions); and
2) withdrawals are always tax-free no matter when taken (and they can be used for any purpose such as a college education, to buy a home or for retirement).
Further, individuals can start a tax-free E/R plan at any age and annual contributions (these are actually premiums for a specially designed life insurance policy) to the Plan have no limit (Blackman, 2003). There have been some recent developments in the administration of Roth IRAs that will moderately affect future financial planning efforts.
In their article, “Countdown to Savings,” Mary Beth Franklin and Alison Stevenson of Kiplinger’s Personal Finance advise that the basic limit for a Roth IRA is now $3,000; however, taxpayers age 50 years and older are able to save $3,500. If an individual is not covered by a company retirement plan, all of the contributions to a traditional IRA are deductible. (These authorities also point out that a write-off is available to taxpayers who are covered by company plans and whose income is less than $34,000 on an individual return and below $54,000 on a joint return; however, it is phased out as income rises above those levels) (Franklin & Stevenson, 2002).
If a taxpayer elects the Roth variety, he or she will receive no up-front tax deduction; however, the individual’s earnings will be tax-free in retirement. The right to contribute to a Roth is gradually phased out as income levels rise between $95,000 and $110,000 on a single return and between $150,000 and $160,000 on a joint return; as a result, the sooner taxpayers make these deductions, the sooner their earnings will be protected from the IRS (Franklin & Stevenson, 2002). According to Donald Jay Korn, the economic conditions today represent a good time to convert from a traditional IRA to a Roth IRA (2002).
Notwithstanding the opportunities available for frugal investors, saving for any type of retirement alternative can be an enormous challenge for some people, and particularly younger workers who will likely be earning lower wages; further complicating things for younger people is the fact that there are high costs associated with raising young children. For these younger workers, there was a new incentive added recently in the form of a tax credit for savers who contribute to a company plan or IRA. This incentive credit ranges from 10% to 50% of what is deposited (up to $2,000 a year, and depending on income and filing status. For instance, Franklin and Stevenson use the example of a married couple with an adjusted gross income of $30,000 or less will get a 50% credit (2002).
The credit is reduced to 20% when AGI is between $30,000 and $32,500 and to 10% when income is $32,500 to $50,000. Single taxpayers have the sliding scale cut in half; e.g., the credit is 50% if income is $15,000 or less, 20% if income is $15,000 to $16,250 and 10% if it is between $16,250 and $25,000 (Franklin & Stevenson 2002). The net advantage to the taxpayer in this case is pronounced. For example, in the case of a married couple with an AGI of $34,000, one of whom puts $2,000 into a company retirement plan while the other contributes $2,000 to a traditional IRA. The $4,000 in contributions reduces the couple’s AGI to $30,000, saving $600 in taxes and thereby qualifying them for the 50% credit, saving another $2,000 (Franklin & Stevenson, 2002).
In reality, though, the couple will not realize the complete $2,600 in savings because they will not owe that much in tax (the maximum tax on $30,000 of AGI on a joint return in 2002 will be $1,819), and Congress says the new credit can do no more than eliminate a tax bill. Nevertheless, this approach allows the couple to save $4,000 for retirement at an out-of-pocket cost of less than $2,200; however, the saver’s incentive credit is not available to those under age 18 years, full-time students and anyone who is claimed as a dependent on another person’s return (Franklin & Stevenson 2002).
Other changes in the tax code that became effective in 2002 also made it practical for a business that employs only the owner (or only the owner and his or her spouse) to have a 401(k) plan that allows participants to save up to $40,000 a year on a tax-deferred basis. Table 2 below summarizes the current tax treatment of Roth IRA distributions:
Table 2. Roth IRA — Tax Treatment of Distributions
Regular participant Contributions
Tax free and penalty Free
Tax free and penalty Free
Income tax and early withdrawal penalty are never applied to distributed assets for which no deduction was allowed when the assets were contributed to the IRA
Tax free and penalty Free
Tax free but penalty may apply
These are already taxed when converted.
Penalty is waived if any one of the exceptions apply.
Tax free and penalty Free
Tax free and penalty Free
Income tax and penalty is never applied to distributed assets for which no deduction was allowed when the assets were initially contributed the IRA
Tax free and penalty Free
Taxes apply and penalty may apply
Penalty is waived if any one of the exceptions apply [Source: Appleby, 2003.]
If an IRA holder completes multiple Roth conversions, the 5-year period for each Roth conversion is determined separately for each conversion.
For determining “qualified distributions,” there is only one 5-year period. This never starts over.
If an excess contribution is made to a Roth IRA and removed later, this contribution cannot be used to determine the 5-year period for qualified distributions (Appleby, 2003).
The types and levels of insurance coverage will clearly change over the course of an individual’s life; a single person, for instance, riding the bus to work and living in an apartment will have drastically different insurance needs than the head of large household with two mortgages, several vehicles (and maybe a boat), as well as numerous dependents. In addition, there are several types of insurance coverage available today that might be appropriate even for younger workers since the earlier this type of coverage is secured, the more benefits will be realized in the future. These various types of coverage are discussed further below.
Renter’s Insurance. The new college graduate may not be able to, or be reluctant to, secure a mortgage until later on when income levels can reasonably be expected to increase. Many renters either do not carry or simply do not know that there is renter’s insurance to protect their personal belongings. While a landlord may have insurance to cover the building, this type of insurance will not cover an individual’s destroyed belongings. That applies to co-op or condo owners as well. Just like homeowner’s insurance, renter’s insurance also covers liability. If a renter elects to be covered for about $40,000 worth of coverage for your possessions and $300,000 in liability, you should expect to spend about $150 a year.
Renters have the same choice as homeowners do between replacement cost and cash-value coverage; in addition, if they own jewelry or antiques that will nott be fully covered, such renters should consider getting an endorsement policy as well (Washington, 1998). According to Marjolijn Bijlefeld and Sharon K. Zoumbaris (2000), consumers can save several hundred dollars a year on homeowner insurance and up to $50 a year on renter insurance by purchasing insurance from a low-price, licensed insurer.
These authors provide the following tips for consumers in search of homeowner’s or renter’s insurance policies:
Ask your state insurance department for a publication showing typical prices charged by different licensed companies. Then call at least four of the lowest priced insurers to learn what they would charge you. If such a publication is not available, it is even more important to call at least four insurers for price quotes.
When buying homeowner’s insurance, make certain you purchase enough coverage to replace the house and its contents. “Replacement” on the house means rebuilding to its current condition (Bijlefeld & Zoumbaris, 2000).
Make certain your new policy is in effect before dropping your old one.
Unemployment Insurance. As the term implies, unemployment insurance is a type of social insurance that is designed to compensate certain categories of workers for unemployment that is involuntary and short-term in nature. Unemployment insurance programs were primarily created to provide financial assistance to workers who were laid-off during a period deemed long enough to enable them to find another job or be rehired at their original job. Today, in most countries, workers who have been permanently disabled or who have been unemployed for a long period of time are not covered by unemployment insurance but are usually covered by other plans. Unemployment insurance benefits vary from one legal jurisdiction to another. In most countries the benefits are related to earnings; a few countries pay a flat rate to all beneficiaries; benefits are generally paid only for a limited period of time though.
The funding for unemployment insurance also varies from nation to nation. Employers or employees may be taxed specifically for unemployment insurance, or funding may come out of general government revenues.
While other provisions vary, in all states, a worker must have good cause for voluntarily leaving a job in order to avoid disqualification. “In many states, good cause is restricted to that connected with work, or else it must be attributable to the employer. The States do not report on the number or proportion of job leavers who receive unemployment insurance for good cause, but the proportion is small” (Stengle & Wandner, 1997, p. 15).
Over the past few years, in any given month, approximately one-third of the unemployed workers who are counted as part of the total unemployed by the Current Population Survey (CPS) have filed for regular unemployment benefits. These individuals are termed the “insured unemployed.” The percentage of the total unemployed who file for or collecting unemployment insurance is generally known as the recipiency rate. There are alternative forms of recipiency rates that involve different measures of the total unemployed and the insured unemployed and with different meanings and divergent policy connotations (Stengle & Wandner, 1997).
Health Insurance. According to William A. Glaser (1991), understanding health insurance in the United States is not as simple as it is elsewhere. “Every developed country except the United States has extensive organized methods of paying for health care. Most have statutory health insurance systems in which the private insurance funds gain many new members throughout the population, administer money collected by requirement from subscribers and employers, and pay the health care providers — all according to laws” (Glaser, 1992, p. 3). Some countries have national health services, a system in which government owns, manages, and fully finances health care for all citizens. In fact, many Americans believe that the only alternative to their private and unorganized system is full governmental domination; however, reality of the situation with health insurance is very different, and understanding what type of health insurance is right for you and your family is not difficult if you do some homework. The bottom-line, though, is that health insurance is a method of enabling people to pay doctors and other healthcare providers. Different paths can be designed between the step where consumers pay insurance premiums and the step where the healthcare providers collect money for their work.
Generally speaking, health insurance is simply a system for the advance financing of medical expenses by means of contributions or taxes paid into a common fund to pay for all or part of health services specified in an insurance policy or law. The key components in health insurance are:
advance payment of premiums or taxes, pooling of funds, and eligibility for benefits on the basis of contributions or employment without an income or assets test (Health Insurance, 2004).
Health insurance may apply to a limited or comprehensive range of medical services; such insurance may also provide for full or partial payment of the costs of specific services. The benefits paid by the various types of insurance may be comprised of the right to certain medical services or reimbursement of the insured for specified medical costs and may sometimes include income benefits for working time lost owing to sickness or maternity leave.
A private, or voluntary, health insurance system is one that is organized and administered by an insurance company or other private agency, with the provisions specified in a contract. Private health insurance is generally financed on a group basis, but most plans also provide for individual policies. In addition, private group health insurance plans are normally financed by groups of employees whose payments may be further subsidized by their employer, with the money going into a special fund. The most prevalent form of health insurance is designed to cover hospital costs; another type is major medical expense protection which provides coverage against large medical costs but avoids the financial and administrative burdens involved in insuring small costs.
If a health insurance system is financed by compulsory contributions mandated by law or by taxes and the system’s provisions are specified by legal statute, it is a known as a government (or social), health insurance plan. This type of medical insurance plan traces its origins to 1883, when the government of Germany initiated a plan based on contributions by employers and employees in particular industries. In the United States, Medicare (medical insurance for the elderly) and Medicaid (medical insurance for the poor) are examples of government health-insurance programs. The distinction between public and private programs is not always this clear, though, because some governments subsidize private insurance programs.
However, socialized medicine and government medical-care programs are quite different. In these insurance systems (which are normally financed from general tax revenues), doctors are employed, either directly or indirectly, by a government agency, and hospitals and other health facilities are owned or operated by the government. The National Health Service in the United Kingdom and the hospitals operated by the Department of Veterans’ Affairs in the United States are examples of such systems (Health Insurance, 2004).
According to Michael Bucci and Robert Grant (1995), Bureau of Labor and Statistics (BLS) data show that one-third of employees who were offered health care plans in 1992-93 had a variety of plan of types from which to choose. Increasingly, more employees are able to select from a variety of health care plans, due to the growing prevalence of preferred provider organizations (PPO’s) and health maintenance organizations (HMO’s) offered by employers during the past two decades.
New data from the Bureau of Labor Statistics also indicate that fully two-fifths of full-time workers in private industry were offered a choice of health plans; in addition, more than one-half of full-time private establishment employees were offered a PPO or HMO plan, and nearly one-third of those who were offered health insurance could choose from more than one type of plan (Bucci & Grant, 1995). According to these researchers, fee-for-service health insurance plans were the most common type of plan offered by private establishments, with slightly fewer than one-half offering such plans. PPO’s and HMO’s were offered by an approximately equal number of establishments, with one-tenth offering each. More than nine-tenths of establishments offering health care offered only one type of plan, with a fee-for-service plan being the most common plan type offered by itself. Further, 72% of establishments offered only fee-for-service type plans, 13% offered only PPO’s, and 8% offered HMO’s. “When establishments offered more than one type of plan, the most common combination was a fee-for-service plan in conjunction with an HMO, offered by 4% of establishments” (Bucci & Grant, 1995, p. 38).
These new data suggest that despite the availability of choices among health care plans, employees frequently choose traditional fee-for-service arrangements. It is also apparent that larger establishments are more likely than smaller ones to offer choices of health care plans and alternative health care arrangements. Therefore, while the percent of establishments offering choices and alternatives is small, such features are available to a sizable proportion of employees (Bucci & Grant, 1995).
Dental Insurance. Dental insurance is ordinarily sold through a group plan and sponsored by an employer. This type of insurance covers such dental services as fillings, crowns, extractions, bridgework, and dentures. The majority of dental policies contain relatively low annual limits of coverage (such as $2,500), as well as deductibles and coinsurance provisions. Further, some policies limit benefits to a percentage of the cost of services (Greene, 2004).
Long-Term Care Insurance (LTCI). The eventuality that a household head could become unable to work can be financially devastating for many households if it is not somehow provided for by the family in advance. Even though it is probable that any Social Security disability benefit would likely be less than anticipated spending needs, the possibility of becoming sufficiently disabled to be unable to work appears distant enough for most people to avoid planning for it; however, in June 1999, there were fully 4,783,000 workers were receiving Social Security disability payments (Social Security Administration, 1999).
Additionally, other workers were receiving disability payments from state and local government systems as well as from private companies. Consequently, the total number of workers qualifying as disabled and not able to work was over five million. “Insurance industry statistics show that the odds of suffering a debilitating injury or illness are far greater than dying during one’s working years” (Marino, 2000, p. 14).
Nevertheless, more workers are likely to have life insurance than disability insurance (about 70% versus 40%, according to the Health Industry Association of America) (Marino, 2000). Given the number of individuals who are receiving some level of disability benefits, financial planners must have a method that provides a reasonable estimate of disability insurance needs. Discussion of disability insurance in textbooks has been quite limited compared to coverage of life insurance; for example, Garman and Forgue (2000) have just over four pages (pp. 323-327) covering disability insurance, compared to a 34-page chapter on life insurance, even though a much higher proportion of working age households actually need to consider disability insurance than need to consider life insurance. A senior level financial planning course at Ohio State university requires that students being preparing comprehensive financial plans for an actual client household. An important aspect of this planning process is to complete a risk management profile for the household.
The methodology for calculating the need for private disability insurance plan has some similarities to methods used in to estimate life insurance needs; however, a major difference exists in that disability insurance is priced and sold as a monthly benefit. Because the amount needed is not a lump sum amounts, individuals cannot simply take the present value of monthly needs and subtract the present value of resources.
In this regard, Gutter and Hanna (2000) provide a detailed account of a method to determine the ability of the client to financially cope with the loss of income that stems from one household head becoming unable to work. According to Gutter and Hanna (2000), the first step in the analysis is to determine the monthly spending in the event of disability.
Based on a sample of 89 non-retired clients with appropriate information reviewed by the authors, almost half (48%) had some need for additional disability insurance. Of this 48%, the average amount of monthly coverage required by a disability insurance plan was $1,181; the minimum amount was $37, and the maximum was $3,565. “Clients with low gaps were not seen as needing to take action but clients with significant gaps were advised to reconsider disability spending issues and/or look into the possibility of purchasing private disability insurance. The results of the needs analysis suggests the importance of stressing disability insurance estimation” (Gutter & Hanna, 2000, p. 220).
In his analysis of the long-term insurance needs for workers today, Clapp (2003), reports that “long-term care insurance (LTCI) is an emotionally charged but increasingly important insurance product that addresses the inevitabilities of infirmity and aging — a topic many individuals and families have difficulty coping with” (p. 40). The general premise of Clapp’s essay is that well-informed choices made today will mean peace of mind and more control of resources and circumstances later. “The need to consider long-term care plans and long-term care insurance (LTCI) long before retirement is increasingly evident. The growing number of seniors in the United States face sobering threats to their financial survival, with potentially staggering medical costs and a greater-than-40% risk of serious incapacity” (Clapp, p. 41).
LTCI coverage has improved since its introduction a quarter of a century ago, making policies increasingly difficult to analyze, compare, and buy or sell. In the current market environment, LTCI providers are reevaluating this coverage’s potential and profitability, offering better coverage while tightening underwriting and increasing premium prices. Companies that offer LTCI are consolidating, resulting in a few large, financially stronger companies that will probably have stronger positions in individual and group markets (Clapp, 2003).
In the 1970s and 1980s, most insurers covered only licensed nursing-home care. Starting in the 1990s, nursing-home care and homecare coverage became integrated. In conformity with the nursing-home reimbursement model, the home-care coverage of most LTCI policies covers caregivers provided by licensed home-care agencies or independently hired certified home aides. Meanwhile, LTCI coverage added new features, generally integrated into policies at no cost or priced separately as a rider. At the end of 2002, LIMRA International, an association that provides research, consulting, and other services to insurance and financial services companies, reported that there are 5.3 million individual and group LTCI policies and $6.9 billion of premiums in force, up 13% and 15%, respectively, over 2001.
While LTCI’s expected long-term growth is less assured now than in the 1990s, the growth outlook remains favorable, given that such policies have become even more valuable components of retirement plans. Younger people that can afford a higher level of coverage should consider slightly higher premiums as long as they remain eligible for LTCI (Clapp, 2003).
The effectiveness and affordability of LTCI has been influenced by a number of recent trends:
The bearish stock market, sluggish economy, threats of terrorism, war, declining interest rates, and unemployment have all affected the retirement income and savings of elders as well as the assets and profitability of insurance companies offering LTCI.
The priority that prospective buyers can afford to give the purchase of a suitable LTCI policy — reflecting choices of carrier quality and level of coverage — requires difficult decisions about appropriate coverage.
Healthcare costs, including Medicare, Medicaid, and prescriptions, have been growing at more than twice the rate of the Consumer Price Index (CPI). Attempts to contain costs have failed. With an aging population, federal and state governments will likely have to share an increasing percentage of health costs.
Today, 7 million seniors require long-term care services. About 5.5 million of them are at home, and 1.5 million are in nursing homes. About 7 million more people, disabled but not yet 60, also require long-term care services, often for many years.
The shortage of care providers in hospitals, nursing homes, senior housing, and elders’ own homes is increasing. With the caregiver population aging, underpaid, and shrinking in size, this shortage will increase significantly. Providers will have to pay caregivers higher wages to attract and keep them.
The low occupancy and high costs of assisted-living facilities, built mostly in the 1990s well in excess of demand, have led to numerous industry bankruptcies.
With about half of the nursing home industry’s revenues coming from Medicaid, that program’s problems place the industry at risk. The industry’s other revenue and cost problems include declining occupancy, pressure for wage increases, and demands for better service, which implies increasing staff levels.
In the late 1980s, life insurance companies’ disability income (DI) policy claims increased from prior years by about 30%, as did the duration of claims. Insurance companies have tightened underwriting and reduced offerings of noncancelable price-guaranteed policies, as well as increased prices. With DI own-occupation coverage, certain specialized professions eligible for a claim benefit, such as doctors, qualify more easily than those in other job classifications for disability claims as a result of inability to perform their responsibilities. Because insurance companies remember bankruptcies resulting from the costs of DI claims, they are reluctant to improve LTCI coverage. Companies incorrectly compare these two different types of policies, forgetting that the LTCI benefit triggers and the duration of these claims at older ages are much shorter than DI claims at younger ages.
Costs and Benefits. The costs of long-term custodial caregivers vary with care arrangements and location. The costs of the four main types of long-term care are assumed to grow 5% annually, from 2003, doubling by 2018, and doubling again by 2033, indicating the levels of annual LTCI coverage that should be adequate; nevertheless, Clapp emphasizes that the shortage of caregivers, custodial caregiver costs are also expected to increase at this same 5% annual rate. “Therefore, care costs may exceed $500,000 for a few years of care. LTCI offers good value and may be the best way to finance LTC costs” (Clapp, 2003, p. 43).
The principal types of home-care coverage, rated by Clapp from least to most flexible, are as follows:
Caregivers must be hired from a licensed home care agency.
Licensed agency caregivers or certified home-health aides may be employed.
In an indemnity policy, minimal daily service must be provided by licensed or certified persons, and the remaining funds may be paid to the insured.
The insured may hire a private caregiver.
In a cash benefit policy, the insured may use the benefits for any purpose, including supplementing inadequate disability income coverage; sharing funds with an informal family care person, a disabled spouse, another person in a congregate lifestyle; or paying for other expenditures, such as a CCRC.
Home-care coverage and related features have been gradually improved in LTCI policies by offering limited care management consultation; care training for caregivers and family members; respite care for an insured to relieve a caregiver; reimbursement of adult day-care programs; homemaker services; and even (in some policies) home medical equipment not paid for by Medicare, or minor home improvements; however, actuaries and LTCI companies are reluctant to offer more generous coverage that would increase claim payments. Essentially, most current LTCI policies include home-care provisions that are too inflexible to meet the needs of future seniors, given the growing shortages of caregivers, expected higher costs, and the preference for private caregivers (Clapp, 2003).
Because agencies usually compensate home-caregivers $6 to $7 hourly (only slightly more than minimum wage) and provide few, if any, benefits, they do not attract and keep the best caregivers. Agencies usually charge for their services on an hourly basis. Excluding an LTCI company discount arrangement, typical national fees for home health aides are: $17 hourly, $408 daily, or $148,920 annually. These outlays may be reduced if fewer hours of care are needed or if rates are lower. Family members, friends, and neighbors are a primary source of care-giving for many elders, especially those with lower income. With the seriousness of LTCI incapacity, however, to assume that an informal caregiver, such as under family care plans, will be effective may be unrealistic (Clapp, 2003).
Many home-caregivers prefer to be privately hired and better compensated, as well as to have more flexible work schedules and work outside of a licensed agency. Most individuals prefer private caregivers and therefore want their LTCI policies to permit their hiring, as well as that of a supervising care manager as supervisor (Clapp, 2003).
The 1996 Federal Health Insurance Portability and Accountability Act (HIPAA) covers all tax-qualified LTCI policies that have the two standard benefit triggers for an insured to qualify for benefits. To receive a benefit, an insured must be either:
Incapacitated or have serious problems performing two of six basic activities of daily living (ADL): bathing, dressing, transferring from a bed, toileting, feeding, and continence; or Seriously cognitively impaired, such as a person diagnosed with dementia, Alzheimer’s disease, or stroke.
While elderly individuals will generally require the services of skilled medical personnel to diagnose and treat serious health conditions for which they are partially reimbursed by Medicare, they also have to pay personally for custodial care, often full-time, when suffering chronic health and aging problems. According to HIPAA, for a tax-qualified plan’s benefit to be tax favored, a claim must be diagnosed as chronic (i.e., require care for over 90 days). An initial claim and periodic claim update requests should be coordinated with an applicant’s broker, possibly with a geriatric caregiver, and reviewed with a primary or specialist doctor who understands the policy’s benefit triggers and may reasonably support any claim paid (Clapp, 2003).
Selecting a Policy. When considering an LTCI policy and its specific configuration to determine its suitability, an important step is to review, with an independent LTCI broker specialist, the coverage in comparable specimen policies of a few recommended leading companies. Terminology tends to be fairly standard across policies, and policies usually provide definitions of widely used terms. An analysis of the policy’s benefits as compared to the premium costs can aid comparisons. The following factors should be used to make substantive decisions about the policy:
LTCI company rating, capability, and commitment
Home-care coverage flexibility
Premium pricing determinants, which vary by company and policy configurations but also by an applicant’s age; health; level of coverage selected; inflation rider; years of benefits; length of waiting period before benefits are paid; opportunities available for discounts (spousal, preferred, and group); and features or condition calling for higher prices
Underwriting approving or declining an applicant
Broker’s independence and specialized service commitment.
The following features should be considered at a premium price:
An inflation rider; a 5% CAGR inflation rider is usually recommended for individuals under 80
The length of waiting days before benefits paid
A restoration rider
The survivorship benefit, which provides for waiver of a surviving spouse’s premium payments under certain conditions.
The following features are generally of questionable value or high-priced:
A non-forfeiture rider that is required to be offered but not purchased
A shared spousal benefit
An abbreviated (not lifetime) funding of coverage
A level benefit with an option to buy additional coverage periodically; avoiding the extra cost of a 5% inflation rider will probably require a purchaser to absorb an even higher premium cost.
The following standard policy coverage should be available at no extra cost:
HIPAA-standardized benefit triggers
Coverage at home; nursing home; state-licensed assisted living facility (if insured meets benefit triggers); respite care; nursing home; alternative care
Other provisions, including a waiver of premium payments; company guaranteed renewability; no hospitalization requirement before benefits are paid; Medicare benefits that are paid before LTCI with benefit coordination; free-look period; lapse reinstatement; limited care planning management; and claims approval guidance.
The following items are generally excluded in most policies:
Informal care provided by a family member (except for a few flexible cash benefits)
Care outside of the United States
War-or self-inflicted injuries (Clapp, 2003).
Tax-Qualified Policies. The HIPAA and IRS regulations provide two types of tax advantages, under certain circumstances, for “tax-qualified” policies: tax-free benefits and deductible premiums. For a benefit to be tax-favored, a claim must be for a chronic medical problem. For example, a condition necessitating hip replacement is usually not chronic; an applicant must require care for over 90 days, whereas recovery from hip replacement is likely to be faster. Some or all of an individual’s LTCI premiums may be deductible from taxable income. How much may be deducted depends on the maximum allowable deduction assigned to a person’s age group, the total of other deductible medical expenses, and gross adjusted income for the year:
In accordance with IRS regulations, individuals can add LTCI premiums up to the maximum for their age bracket when totaling their deductible medical expenses. Depending on the amount by which their total medical expenses, including the LTCI premiums, exceed 7.5% of their adjusted gross, they may be able to deduct all or some of their LTCI premiums. Self-employed individuals, LLC members, partners, and 2% shareholders of pass-through entities may be taxed on the amount of premiums paid on their behalf, but they can take deductions as indicated above. Clearly, HIPAA’s tax treatment limits favorable tax treatment to individuals whose gross adjusted income is low or whose deductible medical expenses are high. Finally, while C corporations can pay and deduct the full amount of LTCI premiums paid without any eligibility limit, cafeteria plans cannot deduct premiums. Future legislation may allow a phased-in tax deduction of all premiums and permit employer cafeteria and flexible-spending accounts to cover LTCI (Clapp, 2003).
Homeowner’s Insurance. In contrast to commercial insurance policies, homeowner’s insurance covers individual, or nonbusiness, property. Homeowner’s insurance was first introduced in 1958, and gradually replaced the older method of insuring individual property under the “standard fire policy.” Essentially, a standard homeowner’s insurance policy is intended to protect you if your house is damaged or destroyed. Such policies also protect you from being sued should someone be injured on your property. “At the same time, homeowner’s policies go one step further to cover what’s inside your home. Typically, personal belongings such as clothes, valuables and appliances are insured for 50%-70% of the amount of coverage you have for your home’s structure” (Washington, 1998, p. 103). Therefore, if a home is covered for $100,000, then the homeowner should count on an additional $50,000-$70,000 coverage for the items inside; however, as anyone who has watched “Antique Roadshow” can verify, homeowner’s insurance policies can become complicated in estimating the value of what is actually owned. Under a basic homeowner’s policy, individual are probably automatically covered for what is called “standard dwelling replacement cost.” Washington notes that means if your home is destroyed through some type of catastrophe, the most an insurance company is obliged to pay out is only “stated value” — the amount insurers determine your home is worth, factoring in the style, structure and location. “Using those criteria, a $100,000 policy with the standard deduction of $250 will cost about $400 a year” (Washington, 1998, p. 103).
To begin, homeowners should carry guaranteed replacement coverage, an enhancement that generally adds no more than 10% to the premium. Under guaranteed replacement policies, an insurer agrees to pay 100% of the cost of completely rebuilding your home; this applies even if the cost exceeds the amount listed on the policy. The cost of the insurance depends on a number of factors, such as the age of your home, the material it is made of and whether it is located in a high-risk area prone to natural disasters like hurricanes or earthquakes (Washington, 1998). This is a good start but it only covers the four walls but not personal items. “For that, you also have the option of getting replacement-cost coverage for your personal items. The problem for many people is figuring out when to get additional coverage for personal items. As you accumulate more family heirlooms, jewelry or antiques, or start collections, standard coverage can quickly fill short of your needs” (Washington, 1998, p. 103).
A good rule of thumb is to consider that an ordinary homeowner’s policy assumes that whatever you have covered will not be worth more than what you paid for it; insurance companies ordinarily pay actual cash value, a way of calculating depreciation into whatever they have to reimburse you for your claim. For instance, assuming that the winter wardrobe you have collected over the years was destroyed in a fire and it would cost $20,000 to replace it. The insurance company would probably pay less than $10,000 because of the rapid depreciation of clothing over time; however, just as you can buy replacement cost coverage for your home, you can do the same for your possessions, which would pay you the actual $20,000 it costs to replace the same or comparable items (Washington, 1998).
While this approach works for clothing and other basic items, it is probably not adequate for more valuable possessions. “What if you’ve bought an important piece of art, or you have an antique lamp whose coverage isn’t limited? Even replacement cost coverage of your home won’t cover jewelry, money, guns and other items that are worth more than the special liability limits written into standard policies” (Washington, 1998, p. 103). For instance, coverage of jewelry losses is limited to about $1,000 (depending on the insurer) on most policies. Therefore, if you lose your $3,500 diamond engagement ring, even if you have replacement cost, the most you can recoup is around $1,000. If you experience the loss of your coin collection, the most you can collect is about $200. Assume you had a 100-year-old 2 cent stamp; the replacement for that stamp would be a 32 cent stamp; however, if the stamp were a collectible and had increased in value beyond 32 cents, you would simply be out of luck. The fact is, most homeowner’s policies limit coverage of items such as jewelry, stamps, guns and silverware. For example, jewelry is usually covered for $1,000-$2,500. Additional insurance on these types of valuables means that you have to buy enhancement insurance with the basic policy.
One way to achieve this level of additional coverage for your property is to purchase what’s called a “floater” or “endorsement.” Endorsements generally expand your homeowner’s policy to provide broader coverage. Further, there is usually no deductible that is applied in the event of a loss. When purchasing an endorsement, there is usually no haggling required with the insurance company when you place a claim. “With a standard policy, the insurance company may try to buy a replacement for the least amount of money possible,” said Bill Glascock of Independent Brokers and Agents of the West. Nevertheless, despite these advantages, Washington cautions that homeowners should be careful when considering the extra costs involved: “In exchange for broader coverage, you have to pay an additional premium every year based on the value of the item. At some companies, for instance, coverage of jewelry costs an additional $10.20 per $1,000 insured. For collectible items (wine, dolls, sports memorabilia, trains, etc.), you can count on shelling out less — around $4.50 per $1,000 worth of coverage annually. For furniture and art, the cost ranges from 90 cents to $4 per $1,000” (Washington, 1998, p. 103). This is because both furniture and art are less expensive to insure since they are not as susceptible to loss.
According to the authors of Keeping the Family Home (1998), “In this day and age, you can’t have too much life insurance” (p. 45). These experts say:
If you don’t have enough life insurance to pay off the mortgage and take care of your family’s immediate needs, mortgage insurance may be a good idea.
The term “mortgage insurance” can be misleading, because it can mean two very different things.
Private mortgage insurance, or PMI, doesn’t protect your family in any way. It’s something the bank gets — and then passes the cost on to you — to protect itself if you’re making a down payment of less than 20% on a new home. The kind of mortgage insurance that protects your family is actually a type of term life insurance that will pay off the outstanding balance on your mortgage if you die.
This type of policy can be purchased when an individual first takes out a first mortgage or refinance, or at any time during the life of the loan, as long as the payments are current.
Mortgage insurance can be expensive, and, like any life insurance, the cost increases with age. A 35-year-old with a $100,000 loan would pay about $35 a month, a 45-year-old would pay about $80 a month, and a 65-year-old would pay a monthly premium of about $395. In spite of its high costs, the authorities generally agree that mortgage insurance can be appropriate for people who don’t have regular life insurance or who need additional coverage.
There are several things to keep in mind when deciding whether to purchase a policy:
Mortgage life insurance has what’s referred to as a “declining benefit,” which means that its value decreases over the years, as the amount needed to pay off the mortgage decreases. In contrast, the value of a conventional term life insurance policy will stay the same.
With a mortgage life policy, insurance benefit must go to pay off the mortgage. With a broader term life policy, you can use the money any way you want.
Because the insurance is tied to your mortgage, the policy ends when you sell your home. If you take out a new policy on your next home, you’ll be older and your premium may be higher.
Don’t automatically buy the mortgage insurance that your lender offers. Contact several insurance companies to compare costs and benefits.
Finally, you may already have some life insurance, but, if you were to die, would it be enough to cover major obligations like the mortgage or a college fund — and maintain your family’s day-to-day standard of living?” (Keeping the Family Home, 1998, p. 45).
Whole Life, Term Insurance and Endowments. Life insurance contracts are a method by which large groups of individuals can equalize the burden of financial loss from death by distributing funds to the beneficiaries of those who die. Life insurance is most prevalent in more developed countries, where it has become a major channel of saving and investing.
The three basic types of life insurance contracts are term, whole life, and endowment. Under term insurance contracts issued for a specified number of years, (see more on this in the section below), the protection expires at the end of the period and there is no cash value remaining. Whole life contracts run for the whole of the insured’s life and also accumulate a cash value, which is paid when the contract matures or is surrendered; the cash value is less than the policy’s face value. By contrast, endowment contracts run for a specified time period and pay their full face value at the end of the period. When an insured person dies, the beneficiary may accept a lump sum settlement of the face amount, may choose to receive the proceeds over a given period, may leave the money with the insurer temporarily and draw interest on it, or may use it to purchase an annuity guaranteeing regular payments for life (Life Insurance, 2004).
Unlike their whole life insurance counterparts, term insurance contracts are issued for specified periods of years. Any protection under these contracts expires at the end of the stated period, with no cash value remaining. According to Aragona and Godfrey (1992), in its traditional form, Group Term Life Insurance (GTLI) is one of the most common employee benefits offered by employers. Studies by The American Council of Life Insurance for 1990 showed that GTLI in force in the U.S. has grown from $13,000 of total coverage under only 12 certificates in 1912 to more than $3.754 trillion of coverage under 141 million certificates issued under 707,000 master policies as of 1990 (Aragona & Godfrey, 1992). The typical employer sponsored GTLI plan frequently comprises a significant portion of coverage during an employee’s working years because the cost is generally deemed to be modest.
Also known as permanent life, a whole life insurance policy remains in force as long as the premiums are paid and the insured is still alive. With whole life insurance, the premiums remain the same throughout the life of the policy. If you want insurance protection only rather than a savings and investment product, buy a term life insurance policy. In the alternative, if you want to buy a whole life, universal life, or other cash value policy, you should plan to hold it for at least 15 years because canceling these policies after only a few years can more than double your life insurance costs (Bijlefeld & Zoumbaris, 2000).
Most whole life insurance policies also have a provision that policy holders can borrow against the proceeds, and in older policies the lending rate was very attractive. For instance, in 1979 the average policy loan rate was 5.65%, while the short-term rate on Treasury bills averaged 9.5%. Although policy holders could not get rich by borrowing against their policies, they could certainly borrow at a negative real rate. Warshawsky (1987), using 1979 data, found that less than 10% of those eligible to use such loans did so; he also examined the hypothesis that people gradually became aware of the arbitrage opportunity. Warshawsky concluded that if policy holders were learning, they did it very slowly. According to his estimates, it would require 9 full years for policy holders to make half of the appropriate adjustment (1987).
This point is reiterated by Richard L. Adelmann (1990), who points out that whole life insurance is a level-pay contract which is guaranteed by the entire net worth of the life insurance carrier, and possibly by a reinsurer. “The guarantee is that if the owner pays the scheduled premiums, upon the insured’s death the carrier will pay the face amount of the policy to the named beneficiary” (Adelmann, 1990, p. 72).
In order to counteract the fact that the annual risk of mortality increases with age, the insurance company collects additional premium in the early years of the policy and places it into a cash value account where it earns interest; the cash value actually belongs to the policy owner and is always available by loan or upon surrender of the policy. The cash value account works two ways to keep the premium level:
The interest earned on the cash value helps pay the rising cost of the increasing risk; and
Because the face amount of the death benefit is fixed, the cash value funds part of the benefit, so the insurance company’s risk is only the unfunded portion.
As a result, the policyholder is buying progressively less insurance as it becomes more expensive. “By age 95 or 100 the cash value account equals the death benefit. The actuaries have it all worked out” (Adelmann, 1990, p. 72). The guarantees in place for whole life insurance have been frequently criticized because they only guarantee that the cash value will earn 4.5 or 5%. The criticism is the result of insurance company actuaries assuming that modern medicine will make no further progress in extending life expectancies beyond what was average in 1980.
In spite of screening for medical problems and dangerous hobbies, the actuaries assume their preferred insurers will experience the same mortality as the general population at large; however, Adelmann also notes that these criticisms are valid only for the preliminary pricing process. “The insurance companies expect to beat every assumption. However, who knows what interest rates the investment people will be able to earn on new premiums received and on earnings reinvested 40 years in the future? Who knows what AIDS and related illnesses will do to life expectancies?” (Adelmann, 1990, p. 72).
The insurance company might achieve lower mortality rates through astute underwriting and achieves higher investment returns than it guaranteed, with the difference being rebated as a dividend in a guaranteed whole life policy from a mutual company or from a participating policy issued by a stock company. Consequently, any financial planner who recommends “buy term and invest the difference” should be prepared to show how his alternative plan can beat the life insurance security with the tax deferred investment growth. In the factual world “buy term and invest the difference” can result in “buy term and skip the advantaged investment.”
Automobile Insurance. As with all other types of insurance, automobile insurance is a contract by which the insurer assumes the risk of any loss the owner or operator of a motor vehicle may incur through damage to property or persons as the result of an accident. Likewise, there are a variety of specific forms of motor-vehicle insurance that vary not only in the types of risk that they cover but also in the legal principles upon which they are based:
Liability insurance pays for damage to someone else’s property or for injury to other persons resulting from an accident for which the insured is judged legally liable;
Collision insurance pays for damage to the insured car if it collides with another vehicle or object; comprehensive insurance pays for damage to the insured car resulting from fire or theft and also from many other causes;
Medical-payment insurance covers medical treatment for the policyholder and his passengers.
In a number of countries, other approaches to automobile accident insurance have also been used. These include compulsory liability insurance on a no-fault basis and loss insurance (accident and property insurance) carried by the driver or owner on behalf of any potential victim, who would recover without consideration as to fault. The majority of existing no-fault plans are restricted in the sense that they generally permit the insured party to sue the party at fault for damages in excess of those covered by the plan and permit insuring companies to recover costs from each other according to decisions on liability. By contrast, total no-fault insurance would not permit the insured to enter tort liability actions or the insurer to recover costs from another insurer (Motor-Vehicle Insurance, 2004).
Living Trusts. A living trust is a type of trust which remains operative during the life of the settlor; the settlor is one who creates a trust (Black’s Law Dictionary, 1990). According to Curtis C. Howell (1994), living trusts (a.k.a. inter-vivos or self-declaration trusts) may be useful gift/estate planning devices. “The use of a living trust in gift/estate planning depends largely on the individual circumstances of the taxpayer. Many of the reasons a living trust is selected instead of a will as a means of inter-generational asset transfer are non-financial in nature” (Howell, 1994, p. 32). However, any two taxpayers with identical assets who live in the same state may choose different forms of estate planning devices depending upon what amounts to personal preferences. Nevertheless, both living trusts and wills provide options that will suit some taxpayers better than others. The advice given by some living trust proponents that virtually everyone can benefit from a living trust usually tend to provide inadequate information concerning the entire living trust creation and maintenance process.
For instance, a small, simple, non-contentious estate where privacy, competency of the taxpayer, and the time involved in estate settlement are not crucial factors, a taxpayer may conclude that the will/probate process will be simpler and less expensive than transferring the estate’s assets through a living trusts. On the other hand, for large, complex, contentious estates where privacy, competency of the taxpayer, and the time involved in estate settlement are crucial factors, the taxpayer may reason that a living trust meets his or her needs better and proves less expensive than the will/probate process. In the final analysis, Howell suggests that the single most important factor attributing to the increased use of living trusts is the peace of mind they offer to taxpayers while they are still alive. “Time, trouble, and expense are all factors a rational person would consider in a normal decision making process. But, planning for the disposition of assets after death is not necessarily a completely rational process. The certainty concerning final disposition of a taxpayer’s assets may outweight any rational considerations” (Howell, 1994, p. 32).
401(k)-Type Plans. According to Springstead and Wilson (2000), salary reduction plans are one type of employer-sponsored defined contribution pension plan. “These plans include 401(k) plans for the private sector, 403(b) plans for the nonprofit sector,(2) and 457 plans for state and local governments” (p. 35). Under these plans, employees contribute a portion of their salary tax-deferred to a qualified retirement plan; such contributions are limited by the tax code to a maximum amount, which changes annually. Employers ordinarily match some portion of the employee contribution, and investment earnings accumulate tax-free until withdrawn (Springstead & Wilson, 2000).
The Federal Thrift Savings Plan (TSP). The TSP is a voluntary defined contribution plan for federal employees that was initiated in 1986. As in 401(k)-type plans, contributions are not taxed as income, and they accumulate, along with investment earnings, tax-free until withdrawn. Employees in the Federal Employees Retirement System (FERS) may contribute a maximum of 10% of their earnings to the TSP, with the federal government matching up to 5%. Civil Service Retirement System (CSRS) participants, who are not covered by Social Security, may contribute 5% of their earnings to the TSP, but they do not receive any matching contributions. The federal government makes a 1-percent contribution to TSP accounts for all employees covered under FERS regardless of whether or not they elect to participate (Springstead & Wilson, 2000).
According to Goff and Scott (1995), retirement planning is not really as complicated as it may seem. “Although some aspects are best left to experts, such as financial planners, tax specialists, attorneys or insurance and investment advisers, most of your own retirement planning should not be left to someone else” (p. 69). The basis for a decision to retire and its significance is referred to by researchers in the field: “To understand the impact of retirement and how people adjust to it, we need to know why people stop working. What retirement means for the individual is affected by the circumstances surrounding the retirement” (Prentis, 1992, p. 13). Past experience will largely influence how the retiree readjusts to this new life condition and will in part determine the way people deal with retirement problems (Streib & Schneider, 1971). Certainly, everyone makes their retirement decisions for a variety of reasons; for instance, economic issues tend to lead the list for the majority of people; these people have made the decision that they can afford to retire. “Whether or not their financial approach is based on sound footing, or whether they have resolved the future use of their time, retirement appears more pleasurable than continuing to work” (Prentis, 1992, p. 14).
Chapter 3: Methodology
The preceding chapters of this study introduced the problem under investigation and reviewed the scholarly literature concerning planning for life after college and what steps could be taken to ensure against losses along the way. This chapter provides a description and rationale for the study approach used, followed by a discussion of the data-gathering method and the database of study employed.
Description of the Study Approach
Wood and Ellis (2003) identified the following as important outcomes of a well conducted literature review of the scholarly literature:
It helps describe a topic of interest and refine either research questions or directions in which to look;
It presents a clear description and evaluation of the theories and concepts that have informed research into the topic of interest;
It clarifies the relationship to previous research and highlights where new research may contribute by identifying research possibilities which have been overlooked so far in the literature;
It provides insights into the topic of interest that are both methodological and substantive;
It demonstrates powers of critical analysis by, for instance, exposing taken for granted assumptions underpinning previous research and identifying the possibilities of replacing them with alternative assumptions;
It justifies any new research through a coherent critique of what has gone before and demonstrates why new research is both timely and important.
Data-gathering Method and Database of Study
The review of the relevant literature was focused primarily on peer-reviewed journals, texts and reliable online sources such as governmental web sites, Questia, EBSCO, and others.
Chapter 4: Data Analysis
As described above, there are a number of considerations involved when deciding whether a Roth IRA or alternative retirement alternative is appropriate for an individual’s personal objectives. The opportunity costs involved in investing in a Roth IRA mean that these funds will be unavailable to the taxpayer for other, potentially more lucrative investments during its tenure, particularly in view of the harsh penalties involved in early withdrawals. Further, Sabelhaus points out that empirical analysis of IRA accumulation and withdrawal patterns is restricted because information about IRA balances and flows is not available for a sample of taxpayers (2000, p. 865).
Table 1 below shows projected numbers for plans for different ages. According to Blackman, two important points that are immediately apparent from this analysis are the power of funds compounding in a tax-free environment and that younger people stand to benefit the most (by putting those education and retirement dollars away early) (Blackman, 2003).
Table 1. Projected Numbers for Plans for Different Ages.
Legend for Table 1:
B – Newborn
C – 15-Year-old
D – 40-Year-old
Paid to Age
Number of Years
Total Paid In
Tax Free Withdrawals
College (4 years)
Payments age (32)
Age 60 to 95
Total Lifetime Benefits
Death Benefits (age 95)
Total Benefit (age 95)
[Source: Blackman, 2003.]
The total lifetime benefits, death benefits (at age 95 years) and total benefit (at age 95 years) based on respective annual premiums of $10,000, $15,000, and $45,000 are presented graphically in Figure 1 below.
Figure 1. Total Lifetime Benefits, Death Benefits and Total Benefits for Newborn, 15-Year-old and 40-Year-old. [Source: Extracted from Blackman, 2003.]
The advantages of investing early are clearly shown, with enormous increases in both death and total benefits being realized through early investment in a Roth IRA for those who qualify.
Summary. A traditional IRA to a Roth IRA transforms a tax-deferred retirement plan to a tax-free retirement plan. After a 5-year period, all withdrawals will be untaxed, provided the account owner is at least 59-1/2 years old.
By contrast, with a regular IRA, withdrawals are taxed as ordinary income when taken out. There are a number of considerations involved in determining which retirement investment alternative is appropriate based on individual needs and goals, marital status and whether an individual expects to earn more in the future than at the present. The experts were consistent in their analysis that the Roth IRA represents an excellent approach for those who meet these criteria, and the sooner such a plan is started, the better.
Assuming that all appropriate provisions have been made for the types of insurance the individual requires, Goff and Scott provide 10 key steps that lead to a “first draft” of an individual retirement plan.
Step 1: Determine how much income you’ll need. The fundamental challenge is to provide a certain level of annual “buying power” (not merely annual income) for the rest of your life and the life of your spouse. Inflation is the major obstacle, and your plan must confront it directly. The researcher should select a level of income in current dollars that would provide adequate buying power today in the region where the individual plans to live. “Unless someone expects major increases or decreases in their standard of living, one good rule of thumb is to provide for buying power equal to 65% of current income. Then decide how soon you would like to retire” (Goff & Scott, p. 42). Table 1 below shows the annual dollars required to provide buying power equivalent to current income from $30,000 to $50,000 at any point up to 40 years in the future, assuming 4% inflation. Most planners assume 3% to 5% inflation, and it would be dangerous to assume a lower rate. The arithmetic is proportional; therefore, to calculate dollars required to provide buying power equal to $100,000 current dollars, for example, multiply the figures for $50,000 times 2 (Goff & Scott, 1995).
Table 1. Income Dollars Required to Sustain Buying Power Assuming 4%
2: Decide when you want to retire. Average life expectancy for middle-aged professionals, both male and female, now reaches well into the seventies, so it is prudent to plan that you will live well into your eighties. “Add inflation to the equation, and you may decide to retire later, rather than sooner” (Goff & Scott, 1995, p. 41). The retirement investigator may even decide to redefine “retirement” to include a part-time, less stressful second career. For instance, the authors note that, “If you are now 45 years old and planning to retire at age 65 with income equivalent to $50,000 today, assuming 4% inflation, your retirement plan must provide well over $100,000 in your first year of retirement and more than $240,000 per year when you reach 85! If you have done little or nothing so far to provide for retirement, the task ahead is enormous” (p. 42).
Step 3: Create an initial “benchmark plan” to use in evaluating options and alternatives. Because people today may reasonably expect to live longer than their parents — the authors suggest 85 years old is not unrealistic, it must be recognized that retirement plans will not be able to provide retirement income forever. Alternatives include building a retirement fund and planning to consume it over a long period of time — like a mortgage, but in reverse. Twenty to forty years after retirement, depending on the time frame you have chosen, your investment capital — and your ability to generate income — would be gone. Creating a benchmark plan based on this approach is one good way to start your personal planning process. The plan provides a sense of the magnitude of the task and becomes a framework for evaluating the impact of present assets, existing pension plan participation, possible inheritances, Social Security and other key factors (Goff & Scott, 1995, p. 73). A benchmark plan can be used to show how much a 45-year-old individual must save starting now to provide the equivalent of $50,000 of current buying power each year for 20 years, beginning at age 65, if money is simply set aside and invested at a 6% return. The contribution increases by 5% annually, assuming an increased capacity to save as time goes by, but even the initial deposits of just over $2,500 per month are significant for the average professional currently earning under $100,000 a year.
Step 4: Modify your benchmark plan to reflect your present assets, your spouse’s and your pension plans, Social Security, probable inheritances and other factors. By the time they begin to think seriously about retirement, usually in their 40s, most professionals have accumulated at least some liquid assets, and many have begun to participate in some kind of retirement fund accumulation, such as individual retirement accounts, Keogh plans and tax-deferred annuities. The impact of these elements and others should be reflected in a modified benchmark plan. Many professionals will be surprised at the degree to which their efforts to date fall short of providing adequate retirement funding. Most of us are quick to recognize the devastating impact of inflation on college tuition and automobile prices, but slow to see its effect on the arithmetic of retirement (Goff & Scott, 1995, p. 73).
Step 5: Estimate the future cash flow from sale of your practice or partnership interest and incorporate it into your planning framework. Goff and Scott suggest that the modified benchmark plan should reflect a conservative sales price estimate and this is where many people tend to overestimate. To plan for more than modest gains is “wishful thinking” (p. 74.)
Step 6: Determine and obtain adequate term life and disability insurance to provide a “safety net” in the event of your incapacity or death before retirement. Insurance is a complex topic that will not be considered at length in this article. However, there are two important retirement planning functions that life insurance can fulfill; professionals should evaluate both carefully.
First, practice sales usually involve significant payment over a five-year period; however, if a professional’s untimely death triggers buyout provisions of a practice protection or partnership agreement, the surviving spouse may find it difficult not only to wait five years for the full amount but also to assume the risk that practice dissipation under new management may jeopardize the payout. Life insurance provides immediate, certain payout to the spouse and protects the buyer against the need for an immediate buyout.
Second, a family’s income and a spouse’s overall retirement accumulation will be jeopardized by an untimely death. The earlier death occurs, the greater the dollar amount of the problem. Term insurance, especially decreasing term insurance, may be a suitable and cost-effective option because it is financially efficient.
Step 7: Explore alternative approaches to accumulation of the required retirement capital. This is where most professionals need, but often fail to seek, qualified and unbiased professional advice, after retirement needs have been defined and existing or anticipated assets have been inventoried. Most professionals today and in the future will be faced a significant gap between their existing situations and their retirement goals. These individuals should consult a reliable financial planner who can recommend an investment adviser. Even a professional who is otherwise successful and knowledgeable about many areas of their own field can benefit greatly by getting objective advice from another expert.
Step 8: Calculate and begin making monthly or quarterly deposits to build the necessary retirement capital. Self-discipline is the obvious key to implementing a retirement program because many important and desirable short-term goals may interfere with even the best intentions. The usual wide assortment of discretionary expenditures tempt us in many directions. “Priorities must be set, and hard decisions must be made, based on each professional’s unique personal values, but the process must be started as soon as possible if you are serious about achieving your retirement goals” (Goff & Scott, 1995, p. 73). A variety of approaches to retirement can succeed if they are started soon enough, but nothing will work if the individual waits too long.
Step 9: Develop a business protection plan to provide for eventual succession and immediate backup in the event of unexpected illness or untimely death. Many independent professionals wait too long to develop a successor or to plan for the orderly and profitable sale of their practice. Many hire the least expensive staff they can find — part-timers, recent graduates and paraprofessionals — thereby increasing their own current income by ignoring the need for long-term continuity. All too often, health problems develop when CPAs are in their 50s and 60s, and the practice base erodes just when the practice value should be peaking.
The value of a small professional firm such as an accounting practice is frequently hundreds of thousands of dollars. Together with equity in the principal residence, it may represent the vast majority of the professional’s net worth. “Unfortunately,” Goff and Scott say, “it is a fleeting kind of value, and any one of a long list of events can reduce it or destroy it entirely, literally overnight” (Goff & Scott, 1995, p. 72). For instance, the loss of a key staff member who may also want to start his or her own practice can result in the loss of clients worth tens of thousands of dollars annually, with an immediate and equal reduction in the practice value.
The impact of long-term disability or death on practice market value can also be devastating. When a professional is unable to assist in the transfer of his or her practice it is likely to be less successful, with a much greater probability of client loss. More to the point, competitors or key employees cannot be relied on to pay for something they can get for free.
In this regard, professionals should develop contractual arrangements for other professionals or key employees to service their clientele in the event of short-term disability or to buy the practice in the event of long-term disability or death. Such arrangements, plus written contracts with all key employees that include enforceable covenants not to compete, can go a long way toward preserving practice market value.
Step 10: Review Your plan annually to identify needed changes. Perspectives change with age, and new circumstances may redefine retirement needs or affect professional income. A retirement lifestyle that seems necessary at age 40 may hold less attraction as time passes. Death or illness in the family, divorce, relocation to a different part of the country, more — or less — professional success and a host of other factors may combine to alter retirement goals.
The professional’s world and life are dynamic, and the best retirement plans will require periodic modifications to remain suitable to changing circumstances. An annual review with your financial planner and investment adviser is a prudent step to maintain your plan’s integrity and usefulness.
For most professionals, retirement income must be self-generated. Commonly held notions about retirement funding are often wildly unrealistic. Inflation can destroy 70% of your buying power in 20 years or less, so professionals must begin early to plan for retirement if they are to be successful. They must protect against loss of their ability to generate retirement resources with health, disability and life insurance.
Each professional’s retirement plan must be unique, reflecting expectations and lifestyle, geographic area, family situation, asset base, other pensions and a multitude of factors and issues far beyond the scope of this article. But understanding the magnitude of the challenge is a good start.
Individuals must also understand the critical importance of the market value of their business interests in the arithmetic of retirement, and they must know how to maximize, protect and reap that full value in retirement, disability or death. “Recognizing the problem and studying the possibilities are 90% of the battle. The rest is persistence” (Goff & Scott, 1995, p. 74).
This chapter provided a series of actuarial tables and advice that can assist virtually anyone in determining what course of action is best suited for their individual needs and career goals, and described some steps that individuals can use to begin the retirement planning process in earnest.
Chapter 5: Summary, Conclusions and Recommendations
The research showed that college graduates today are faced with a wide range of opportunities and challenges.
The steps to prudent financial planning for life include the following:
Determining how much income will be needed;
Deciding when to retire;
Creating an initial “benchmark plan” to evaluate options;
Modifying the benchmark plan to reflect your specific status;
Estimating the future cash from the sale of your business interests;
Obtaining adequate life and disability insurance;
Exploring alternative approaches to accumulation of the required retirement capital;
Making regular deposits to build sufficient retirement capital;
Developing an income protection plan.
Reviewing the plan annually and making necessary changes (Goff & Scott, 1995).
Recent stock market fluctuations have triggered substantial losses for many retirement plans, leading many consumers to rethink their investment strategies and life insurance companies to advance IRC section 412(i) plans as a way to protect retirement funds.
According to Laffie (2003), such Section 412(i) plans are defined benefit pension plans that are guaranteed exclusively by annuity contracts and life insurance. (Defined benefit plans pay definitely determinable benefits to an employee over a period of years — usually for life — after retirement.) Section 412(i) plans have been around since 1974; in uncertain markets, their guaranteed returns are enticing. An employer funds such a plan by making annual deductible contributions for eligible workers; the employees are not taxed on the contributions; the plan then purchases from an insurance company annuity contracts with a guaranteed return (generally ranging from 3% to 5%). Upon a worker’s retirement, the annuity pays an annual retirement benefit taxable to the employee. The employer can make additional deductible contributions to the plan to purchase life insurance on employees’ lives, to be paid to a designated beneficiary (Laffie, 2003).
The owners of high-earning, stable businesses who want to contribute substantial deductible amounts to their retirement plans will be the most likely beneficiaries of section 412(i) plans. In order to achieve the maximum tax benefits, business owners should usually be 50 or older. Based on the nondiscrimination, participation and vesting rules typical to retirement plans also apply to section 412(i) plans, businesses with fewer than 10 employees benefit most. (As the number of employees increases, the total cost of contributions also rises and the business owner’s retirement goals are potentially hindered) (Laffie, 2003).
Other challenges facing retirement planners today and in the future will be the decision when to elect to draw their Social Security. Confronted with the prospect of changes to retirement plan provisions, many workers today will probably prefer lower early retirement benefits rather than pushing back the age at which retirement can commence. While its implementation is still several years away and may not be fully understood by those that will be affected, there has been very little outcry about the increase in the Social Security normal retirement age after the turn of the century. This will mean lower initial benefits than they would otherwise receive for the workers affected who want to retire early, but it will not preclude them from getting their Social Security benefits at the same age as their parents could (Rappaport & Schieber, 1993, p. 148).
Because long-term disability can jeopardize a professional’s retirement program, as well as his or her income, disability coverage also must be evaluated and integrated into the program. An exploratory discussion with a reliable insurance broker or agent should take place once the individual has realized the magnitude of the challenge of retirement.
[UNDER DEVELOPMENT BASED ON CLIENT FEEDBACK]
[UNDER DEVELOPMENT BASED ON CLIENT FEEDBACK]
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