Retirement planning is a multidimensional field. As such it requires that the planner be schooled in the nuances of many financial planning specialties as well as other areas. Unfortunately, many so-called planners approach retirement planning from only one point of view, investments, for example. This perspective, the perspective offered by specializing in just one field, is too limited for dealing with the diversified needs of the would-be retiree. A client is better served by a team of planners who have specialized but complementary backgrounds or by a single planner who is experienced in a variety of important retirement topics.

Whether the retirement team or the multitalented individual is the vehicle, the holistic approach to retirement planning is the only means by which a client’s needs can be fully and adequately met. Under the holistic approach to retirement planning the planner is required to communicate with clients concerning such topics as

The successful retirement planner must not only have a working knowledge of a large variety of financial planning and retirement related topics but also know how to apply the knowledge to a client’s particular situation. This requires understanding a client’s objectives, attitudes, and personal preferences. For example, retirement planners should be prepared to help clients to meet the important general objectives of maintaining their preretirement standard of living during retirement, becoming economically self-sufficient, minimizing taxes on retirement distributions, adapting to the retirement lifestyle, and the client’s individual objectives, such as taking care of a dependent parent or dealing with special health needs (see table 1, which is based on an American College study). In addition, planners should be prepared to deal with a variety of attitudes on how long the client wants to work, what the client’s prospects are for health and longevity, whether the client can be disciplined enough to save for retirement and to what extent the client accepts investment risk. It is this application of a broad range of knowledge to a diverse group of clients that makes retirement planning more art than science.

Perhaps the biggest roadblock to retirement planning is the tendency of many working people to use their full after-tax income to support their current standard of living. For this reason clients must be taught when they are young to follow a budget that allows them to live within their means and that also provides for retirement savings. Planners should make their clients aware that a spending ratio of no higher than 90/10 is generally desired. Under a 90/10 spending ratio, 90 percent of the client’s earnings are directed toward the current standard of living, and 10 percent is directed toward other long-term financial objectives, such as the children’s education and the client’s own retirement. For example, a family with a gross annual income of $50,000 should allocate no more than $45,000 (including taxes) of its total income to standard-of-living and lifestyle items, leaving $5,000 or more for the long-term objectives. Furthermore, planners should recommend that as income rises, the percentage spent on the current standard of living should decline.

A second impediment to retirement saving is unexpected expenses (including expenses arising from inadequate insurance or the cost of major repairs to a home) and unexpected decreases in income (for example, due to unemployment). The client should set up an emergency fund to handle these inevitable problems. Usually about 3 to 6 months’ income should be set aside for this objective. In addition, agents should conduct a thorough review of their clients’ insurance needs to make sure they are adequately covered. Two often overlooked areas are long-term disability insurance and umbrella liability insurance.

Another important task in retirement planning is determining how much the client will need to save in order to achieve his or her retirement goals. Estimating a client’s financial needs during retirement is like trying to predict the future: Such estimates are fraught with complicating factors and clouded by unknown variables. For example, the planner and client must establish what standard of living is desired during retirement, when retirement will begin, what inflation assumptions should be made before and after retirement, and what interest can be earned on invested funds. In addition, for clients who are forced by economic necessity to liquidate their retirement nest egg the client and planner must estimate the life expectancy over which liquidation will occur. Many of these variables can dramatically change overnight and without warning. The following are examples of how variables could change.

While it is important to understand that planning is, at best, an educated guess, it still beats the alternative. What’s more, changing variables can be overcome if the retirement plan is revised and adjusted annually. Once the planner has explained to his or her client the tentative nature of the plan and the need for hands-on monitoring, then the task of setting out a plan for the client begins.

There are three basic facets to any retirement plan. The planner must first determine where the client stands financially for retirement purposes. Then the planner must assess where the client wants to be financially during retirement and the client’s ability to reach this goal. Finally, the planner must road map the way for a client to achieve his or her goals.

In order to calculate a client’s retirement needs, the planner must first add up the client’s existing resources. These may include the amount of any social security benefits due, the amount of any pension benefits due, any private savings the client has accumulated to date, including IRAs and personally owned life insurance, and any other sources of retirement income, such as the proceeds from the sale of a home.

Once a financial inventory of possible sources of retirement income has been taken, the next step is to determine how much annual income will be needed in the first year of retirement to achieve the client’s goals. There are two common ways of determining this: the replacement ratio method and the expense method.

Replacement Ratio Method. The replacement ratio method of retirement planning assumes that the standard of living enjoyed during the years just prior to retirement will be the determining factor for the standard of living during retirement. For clients at or near retirement it is much easier to define the target. For example, if the 64-year-old near-retiree is earning $50,000, then the retirement income for that retiree should maintain most of the current purchasing power that that person has. If, however, a younger client is involved, growth estimates should be made to approximate what the salary will be at retirement.

Note that the entire final salary is not needed for determining the proper amount of purchasing power. In general, a 70 to 90 percent replacement ratio of a client’s final average salary is typically used for individual retirement planning purposes. Support for this range rests upon the elimination of some employment-related taxes and some expected changes in spending patterns that reduce the retiree’s need for income (see figure 1).

Reduced Taxes. Retirees can assume that a lower percentage of their income will go toward paying taxes in the retirement years because, in many cases, there is an elimination or a reduction of certain taxes that they previously had to pay. Tax advantages for the retiree include the elimination of the social security tax, an increased standard deduction depending on the retiree’s age and filing status, the exclusion of all or part of the amount of the social security benefit from gross income, reductions in state and local income taxes, and an increased ability to use deductible medical expenses.

Reduced Living Expenses. Retirees face a variety of changes in spending patterns after retirement, and some of these changes will reduce a retiree’s living expenses. These reductions include elimination of work-related expenses; elimination of home-mortgage expenses; elimination of dependent care, that is, child-rearing expenses; elimination of long-term savings obligations; and reduction in automotive expenditures.

Additional Factors. It is not all good news for the retiree, however. Retirees also face several factors that tend to increase the amount of income they will need during the retirement period. These include possible increases in long-term inflation, increased medical expenses, increased travel expenses, and other retirement-related expenses.

Expense Method. The expense method of retirement planning focuses on the projected expenses that the retiree will have. As with the replacement ratio method it is much easier to define the potential expenses for those clients who are at or near retirement. For example, if the 64-year-old near-retiree expects to have $3,000 in monthly bills ($36,000 annually), then the retirement income for that retiree should maintain $36,000 worth of purchasing power in today’s dollars. If, however, a younger client is involved more speculative estimates of retirement expenses must be made (and periodically revised).

A list of expenses that should be considered includes expenses that may be unique to the particular client as well as other more general expenses.

Some expenses that tend to increase for retirees include the following:

On the other hand, some expenses tend to decrease for the retiree:

retirement date. Next, a capital sum is calculated (lines 15–19) that will be sufficient, together with interest earnings, to provide an inflation-adjusted income during the estimated number of years in the retirement period.

Understanding how much a client will need for retirement is only one part of sound retirement planning. In addition, understanding the potential sources of

retirement income is another crucial function with which the retirement planner must be familiar. In addition, there are several sources of retirement income that bear close examination. These include

Perhaps the most valuable way to save for retirement is through a qualified plan. The advantageous nature of a qualified plan stems from the fact that, even though the employer is able to take a tax deduction when contributions are made, contributions to the plan are made on a before-tax basis. In other words, the employee does not have to pay income tax on those contributions when they are made. Instead, the employee pays income tax when funds are distributed from the plan some years later. In addition, investment earnings on plan assets are also tax-deferred. This combination of tax-deferred contributions and tax-deferred earnings is like receiving an interest-free loan from the government. In other words, Uncle Sam allows the client to invest funds for retirement that otherwise would be lost to taxation.

A final tax advantage applicable to qualified plans is that distributions from these plans—although taxed at retirement—are subject to special tax treatment. For example, clients might be able either to reduce the taxes they pay out on a lump-sum distribution by using forward averaging or to delay paying taxes on a distribution by rolling over the funds into an IRA.

Figure 4 demonstrates the income tax advantages of a qualified plan.

Qualified plans can be categorized in several ways. One way they can be categorized is by focusing on what the employer provides. For one category of plans the employer promises to pay an annual retirement benefit (defined-benefit plans). For another category, the employer pays a specified amount of deferred compensation into an employee’s individual account (defined-contribution plans). A second way to categorize qualified plans is to distinguish plans that are typically geared to employer profits (profit-sharing plans) from those that are not (pension plans). A third way to categorize qualified plans is to focus on the business entity that is adopting the plan. If a corporate entity qualifies a retirement plan, the plan is simply known as a qualified plan; if a partnership or self-employed person sponsors a qualified plan, the plan is known as a Keogh plan. Over the years the rules for Keogh and corporate plans have evolved so that only a few minor distinctions exist between the two plans. Therefore only the defined-benefit/defined-contribution and pension/profit-sharing differences are examined in the following paragraphs.

Under a defined-benefit plan the required employer contributions vary depending on what is needed to pay the promised benefits. The maximum annual benefit that can be provided in a defined-benefit plan is 100 percent of the employee’s average compensation for the employee’s 3 consecutive years of highest pay up to a maximum of $90,000 per year (as indexed in 1996 to $120,000). A defined-benefit plan usually uses a benefit formula to stipulate a promised retirement benefit. This promised benefit is typically a percentage of the employee’s final salary (for example, 50 percent of final salary).

Defined-contribution plans, on the other hand, specify the contribution the employer makes annually and provide an unknown benefit to the employee. The maximum annual contribution that can be provided in a defined-contribution plan is the lesser of $30,000 or 25 percent of the first $150,000 of the employee’s salary. By their nature defined-contribution plans base an employee’s benefit on the employee’s entire career earnings and not the employee’s final salary. Defined-contribution plans are sometimes called individual account plans because they provide an individual account similar to a bank account for each employee.

Retirement Planning Considerations. Clients covered by defined-contribution plans may find themselves short of retirement income if investment results are unfavorable. This is because, unlike a defined-benefit plan, the employer’s obligation begins and ends with making the annual contribution. If plan investments are poor in a defined-contribution plan, the employee suffers the loss and may have inadequate retirement resources. For example, a person who had planned to retire in November 1987—one month after the October stock market crash—might have seen his or her plan assets decline by one-third. Therefore, this client had to delay retirement for several years. In a defined-benefit plan the employer suffers the loss.

A second problem is that contributions in a defined-contribution plan are based on participants’ salaries for each year of their career, rather than on their salary at retirement as in most defined-benefit plans. For example, if inflation increases sharply in the years just prior to retirement, the chances of achieving an adequate income-replacement ratio are diminished because most of the annual contributions were based on deflated salaries that occurred before the inflationary spiral. By contrast, if the participant had been covered by a final-average defined-benefit plan, the employer would have had to make significant contributions to account for the increased final-average salary due to higher inflation.

Another instance where either a defined-benefit plan or a defined-contribution plan may provide inadequate retirement income occurs if the client joins the plan late in his or her career. Under this circumstance, since years to retirement are growing short, a defined-contribution plan may not provide enough time to accumulate an acceptable amount of assets. A defined-benefit plan, where the benefit is based in part on length of service, would also provide a relatively small benefit since these plans are geared to provide adequate replacement ratios for long-service employees only.

Under a pension plan the organization is committed to making annual payments to the retirement plan, since the main purpose of the plan is to provide a pension benefit. Under a profit-sharing plan, however, an organization can retain the flexibility necessary to avoid funding the plan annually. What’s more, a profit-sharing plan isn’t necessarily intended to provide a retirement benefit as much as to provide tax deferral of present compensation. To this end, under certain profit-sharing plans employees are permitted to withdraw funds after they have been in the profit-sharing account for 2 years.

Retirement Planning Considerations. Two important factors should be kept in mind if a client has a profit-sharing plan: First, retirement planners should closely monitor the funding of the plan. It would be an easy mistake to assume that the employer is making scheduled payments when in actuality the employer isn’t contributing as expected because employer contributions to the profit-sharing plan are discretionary. It would also be an easy mistake to assume that the employee is allowing the funds to accumulate for retirement when in actuality the employee is depleting the account by taking withdrawals.

Another important factor concerning profit-sharing plans is that the ability to withdraw funds prior to retirement under some profit-sharing plans opens up some interesting planning possibilities for the client and his or her planner. For example, the client may want to gradually take money out while employed (starting after age 59 1/2 to avoid a 10 percent tax penalty) in order to reposition assets or take advantage of an excellent investment opportunity. In addition, the client may want to prepay any debt that would carry over into retirement, such as prepaying a mortgage or reducing interest expenses on a major capital purchase.

Once the planner understands the basic characteristics of each category of qualified plans, the planner is well on the way to understanding the specific type of plan that a client has. For example, if a client has a plan that falls into the defined-contribution and pension categories, the planner knows that employer contributions are mandatory but that the employee takes the risks associated with investment performance and preretirement inflation.

The final component that the planner needs to understand is the plan’s benefit or contribution formula. These formulas are unique to the specific type of plan involved.

Defined-Benefit Pension Plans. As its name implies, a defined-benefit pension plan falls within both the defined-benefit and pension categories. In a defined-benefit pension plan the employer’s contributions under the plan are determined actuarially on the basis of the benefits expected to become payable. These benefits are determined under a benefit formula. There are four types of defined-benefit formulas. The most popular type, the unit-benefit formula, accounts for both service and salary in determining the participant’s pension benefit. For example, a unit-benefit formula might read

Under this formula an employee with 20 years of service and a $50,000 final average salary will receive $20,000 a year in the form of life annuity payments (.02 x $50,000 x 20).

A second type of defined-benefit benefit formula, found primarily in church plans, is the flat-percentage-of-earnings formula. This formula relates solely to a participant’s salary and does not reflect an employee’s service in the benefit calculation. A flat-percentage-of-earnings formula might read

A third type of defined-benefit benefit formula, found primarily in union plans, is the flat-amount-per-year-of-service formula, which relates the pension benefit solely to the participant’s length of service and does not reflect the participant’s salary. The benefit is calculated by multiplying all years of service by a stated dollar amount. For example, the flat-amount-per-year-of-service formula might read

A final type of defined-benefit benefit formula is a flat-amount formula. A flat-amount formula provides the same monthly benefit for each participant. For example, "Each plan participant will receive a pension benefit of $200 a month."

Some plans are designed to contain just one of the four types of benefit formulas (most typically the unit-benefit formula). Many plans, however, contain a mix of benefit formulas. For example, the flat-amount formula is seldom used by itself, but is often used in conjunction with the unit-benefit formula to provide a base amount of coverage for all employees regardless of how long they have been employed or the amount of their final average salary.

Another aspect of defined-benefit formulas is that they can be designed to take social security into account by subtracting part or all of the social security benefit from the monthly benefit or by giving highly paid employees greater benefits to compensate for the fact that social security benefits are geared toward lower-paid employees. In this way, most defined-benefit plans are integrated with social security. In addition, the second type of social security integration described is possible under all of the qualified plans that are discussed below.

Target-Benefit Pension Plans. Unlike defined-benefit pension plans, target-benefit pension plans are defined-contribution plans. Under a target-benefit pension plan annual contributions are limited to the lesser of $30,000 or 25 percent of the first $150,000 of salary, and each employee is given an individual account into which funds are deposited. Target-benefit plans are a unique form of defined-contribution plan because they include some of the features associated with defined-benefit plans. One of these features is that a defined-benefit formula is used to determine the annual contribution. Under a target-benefit plan an actuary determines the amount of funds needed as the level annual contribution by using actuarial and interest assumptions in conjunction with the benefit formula. This amount is then contributed to the employee’s account, at which point the investment and actuarial risks shift back to the employee.

A target-benefit plan provides a unique opportunity for a business owner to stockpile retirement funds in a plan installed toward the end of the business owner’s career. The benefit formula used in a target-benefit pension plan requires larger contributions for older employees because there is less time to fund the target benefit.

Money-Purchase Pension Plans. A money-purchase pension plan is a form of defined-contribution plan. It is also, as the name states, a pension plan. Under a money-purchase pension plan the company’s annual contributions are mandatory and are based on a percentage of each participant’s compensation. For example, the money-purchase benefit formula may provide that annual contributions will equal 10 percent of compensation for each participant. The definition of compensation will vary from plan to plan. In some cases it will include overtime, bonuses, and the like; in other cases it will be restricted to base salary. In order to correctly estimate the amount of retirement savings that clients will have, the planner must accurately forecast the approximate compensation that is involved in each case.

Profit-Sharing Plans. A profit-sharing plan falls into both the profit-sharing and defined-contribution categories. There are two types of contribution formulas that can be used in a profit-sharing plan, the allocation formula and the straight percentage of compensation formula. When the straight percentage of compensation formula is used the employer typically commits to make contributions whether the company has profits or not. The amount of the annual contribution may be specified in the employee’s plan (for example, 10 percent of compensation) or it may be determined annually by the employer. Under an allocation formula the employer allocates profits to the employees according to a fixed formula that recognizes both service and salary when determining the percentage of profits to which an employee is entitled.

401(k) Plans. One of the most popular types of qualified plans is the 401(k) defined-contribution profit-sharing plan. A 401(k) plan allows employees to elect deferral of taxation on current salaries or bonuses simply by placing the money into the plan. Participants who forgo receiving current salary or a bonus enjoy abundant tax savings.

In order to understand the state of 401(k) plans today, it’s important to look at their history. For many years employers who felt they could not adequately fund their employees’ (and their own) retirement needs provided thrift plans. (If employer matching contributions were not involved they were called savings plans.) Under thrift plans employees become partners of the employer in providing for their own retirement needs. A thrift plan calls for employees to contribute a fixed percentage of salary to the plan and for the employer to make a contribution in the same amount or in a reduced amount. Thrift plans, however, are not tax efficient because the employee’s contribution is made with after-tax dollars. In November 1981, the IRS issued proposed regulations that allowed employees to make before-tax thrift contributions to a qualified plan and plan sponsors began to adopt the new 401(k) plans.

In today’s market, many employers, even those with defined-benefit, target-benefit, or money-purchase plans, opt for a complementary 401(k) plan. These plans are still highly regarded, despite a maximum of $7,000 annually in employee deferrals. In 1996, this deferral had been indexed to $9,500.

One retirement planning consideration planners should keep in mind is that, for clients who were originally involved in a thrift plan and later came under a 401(k) plan, it is likely they will have some cost basis for annuity distribution purposes. Thus they will not be taxed on the full amount of their annuity because already-taxed amounts won’t be taxed twice.

A second retirement planning consideration is that these plans typically ask clients to sign a salary reduction agreement so that employee contributions to the plan can be made with before-tax contributions. From a retirement planning perspective it is important to encourage your client to take full advantage of these tax shelters. The before-tax nature of contributions can provide for significant retirement savings. In addition, these plans often have the added feature of employer matching contributions. A client who turns his or her back on employer-matching contributions is forfeiting the easiest and most profitable way to save for retirement.

In addition to encouraging participation in the plan, retirement planners must also be aware of the following factors concerning 401(k) plans.

403(b) Plans. A 403(b) plan (sometimes referred to as a tax-sheltered annuity [TSA] or tax-deferred annuity [TDA]) is similar to a 401(k) plan in many respects. Both plans permit an employee to defer taxes on income by allowing before-tax contributions to the employee’s individual account and by allowing deferrals in the form of salary reduction. However, 403(b) plans are distinguishable from 401(k) plans in several ways.

One of the most important sources of retirement income that retirement planners can counsel their clients about is an individual retirement account (IRA). Individual retirement accounts are similar to qualified plans in many respects. Both are tax-favored savings plans that encourage the accumulation of savings for retirement by allowing contributions to be made with pretax dollars (if the taxpayer is eligible) and earnings to be tax deferred until retirement. Also both plans have stringent rules to ensure that the goal of encouraging retirement savings is achieved and that revenue loss is minimized.

IRA Contributions. IRAs are subject to certain limitations, including the following:

For taxpayers whose adjusted gross income falls between the no-deduction level and the full-deduction level, their reduced deduction can be computed by using the following formula:

Another tax-advantaged way to save for retirement is to use a nonqualified retirement plan. In the case of nonqualified plans, the tax savings are not attributable to Uncle Sam but instead stem from the fact that, in most cases, the employer defers his or her business deduction so that specifically chosen employees won’t be deemed to be in constructive receipt of deferred compensation promised them.

A nonqualified deferred-compensation plan is an employer provided retirement benefit that is typically given to highly compensated executives and managers. There are three basic types of nonqualified plans. Under a so-called top-hat plan the executive defers part of his or her salary for retirement purposes. For this reason top-hat plans are sometimes referred to as pure deferred- compensation arrangements. Under an excess benefit plan the employer provides benefits beyond the dollar restrictions imposed on qualified plans. And under a supplemental executive retirement plan the employer provides a second tier of retirement benefits in addition to any qualified benefits. In this case, however, qualified benefits are not at their maximum legal limits.

Even though all three of these plans can provide for abundant retirement savings, planners must be wary of certain potential problems for clients covered by them. One trap awaiting clients covered by nonqualified deferred-compensation plans is that distributions from these plans will be subject to significantly more taxes than similar distributions from a qualified plan. The reason for this is that qualified plan distributions are eligible for favorable 5- or 10-year averaging—a technique used to effectively lower tax rates when a large taxable retirement withdrawal is made—whereas nonqualified distributions are not. Consequently, to avoid a tax disaster under a nonqualified plan, distributions should be spread over two or more tax years or an annuity should be considered.

A second trap awaiting clients covered by nonqualified deferred-compensation plans is that promised benefits from nonqualified plans are typically subject to loss for a variety of reasons. For example, the nonqualified plan may contain a forfeiture provision stipulating that benefits will be forfeited if certain conditions are not met. In many circumstances the client may be either unwilling or unable to meet his or her part of the commitment. A second way nonqualified benefits can be lost is if the employer sponsoring the plan goes bankrupt. Nonqualified plan funds are typically held as corporate assets that are subject to the claims of corporate creditors in bankruptcy. By contrast, funds in a qualified plan are held in a trust or insurance contract separate from business assets and are not subject to forfeiture in case of bankruptcy.

A final insecurity associated with nonqualified plans is the threat of immediate taxation to the employee that would result in a lower overall retirement accumulation. For example, despite employer contentions to the contrary some plans are construed by the IRS as providing an immediate economic benefit to the employee, or the employee may be deemed to be in constructive receipt of the income. In either case the pre-funded benefit will be taxable while the client is still employed and the advantages of tax deferral will be lost.

Despite all these problems, nonqualified plans have an important role in retirement planning for upscale clients. For one thing, they enable these clients to exceed the maximum limits imposed on qualified plans. Recall that a defined-benefit plan could not fund a benefit greater than $90,000 (as indexed in 1996 to $120,000) and a defined-contribution plan contribution was restricted to the lesser of 25 percent of compensation or $30,000. Secondly, they allow clients to circumvent a 15 percent excise tax that is applicable to annual distributions from qualified plans that are over $155,000 and lump-sum distributions over $775,000 (both as indexed for 1996). Distributions from a nonqualified plan are not subject to the excess distribution penalties. For these reasons a client with a two-tier retirement program sponsored by his or her employer, including both a qualified and a nonqualified plan, is in the best position to plan for retirement. Conversely an upscale client without the second nonqualified tier may be subject to an inadequate replacement ratio because of the caps placed on qualified plan benefits.

Another important source of retirement income is social security. When people use the term social security, they are actually referring to the Old-Age, Survivor’s, Disability, and Health Insurance program of the federal government. For retirement planning purposes planners should be familiar with the entire social security system, particularly the old-age and health insurance programs.

A client is eligible for retirement benefits under the old-age provision of social security if he or she is covered by social security and has credit for a stipulated amount of work. Credit for social security purposes is based on quarters of coverage. A worker receives credit for one quarter of coverage for earning a specified dollar amount on which social security taxes are paid. For example, in 1996 this dollar amount was $640. A worker earning $640 would receive a quarter of coverage. The maximum credit for a calendar year is four quarters. Therefore the worker paying social security taxes on as little as $2,560 during 1996, regardless of when it was earned during the year, would receive credit for the maximum four quarters. A person is fully insured for purposes of receiving social security retirement benefits if he or she has 40 quarters of coverage.

Old-age insurance benefits are based on a worker’s primary insurance amount (PIA). The PIA, in turn, is a function of the worker’s average indexed monthly earnings (AIME) on which social security taxes have been paid. For retirement planning purposes the planner need not know how to calculate the AIME and PIA. Instead, the best method to estimate a client’s expected social security benefits is to request the employee’s data from the Social Security Administration. To obtain this information the client can mail in either Form SSA-7050-F3 or Form SSA-7004-PC-0P1. The social security office will provide data relating to the client’s earnings history and estimated primary insurance amount.

Retirement Planning Considerations. Planners should make their clients aware that social security is geared toward providing benefits for those with a lower income and cannot be relied on as a proportionally large source of retirement income for well-off clients. For example, a person with a $10,000 salary prior to retirement will receive approximately a 50 percent income replacement ratio from social security whereas a person with a $100,000 salary will only receive a 10 percent income replacement ratio.

Early and Deferred Retirement. A worker who is fully insured is eligible to receive monthly retirement benefits as early as age 62. Electing to receive benefits prior to age 65, however, results in a permanently reduced retirement benefit. If a worker elects to receive retirement benefits prior to age 65, benefits are permanently reduced by five-ninths of one percent for every month that the early retirement precedes age 65. For example, if a worker retires at age 62, the monthly benefit will be only 80 percent of what the worker would have received had he or she waited until age 65.

Workers who delay applying for retirement benefits until after age 65 are eligible for an increased benefit for each month retirement is delayed beyond age 65 and up to age 70. For individuals reaching age 65 in 1996, this increase is a minimum of 9/24 percent per month delayed.

In addition to understanding the amount of retirement benefits provided by social security and the people who are covered by social security, retirement planners need to understand the medicare system.

Eligibility for Medicare. Part A, the hospital portion of medicare, is available at no monthly cost to any person aged 65 or older as long as the person is entitled to monthly retirement benefits under social security or the railroad retirement program.

Most persons who are 65 or over and do not meet the eligibility requirements may voluntarily enroll in medicare. However, they must pay a monthly premium. This monthly premium, maximum $289.00 in 1996, is adjusted annually to reflect the cost of the benefits provided. In addition, these persons must also enroll in part B and pay the applicable premiums there as well.

Any person eligible for part A of medicare is also eligible for part B. However, a monthly premium must be paid for part B. This monthly premium, $42.50 in 1996, is adjusted annually and represents only about 25 percent of the cost of the benefits provided. The remaining cost of the program is financed from the federal government’s general revenues.

Persons receiving social security or railroad retirement benefits are automatically enrolled in medicare if they are eligible. If they do not want part B, they must elect out in writing. Other persons eligible for medicare must apply for part B benefits. Anyone who elects out of part B or who does not enroll when initially eligible may later apply for benefits during the general enrollment period between January 1 and March 31 of each year. However, the monthly premium will be increased by 10 percent for each 12-month period during which the person was eligible but failed to enroll.

Medicare: Part A Benefits. Part A of medicare provides benefits for expenses incurred in hospitals (for stays up to 90 days in each benefit period), skilled nursing facilities (if a physician certifies that skilled nursing or therapeutic care is needed for a condition that was treated in a hospital within the last 30 days), and hospices (for terminally ill persons who have a life expectancy of 6 months or less). In addition, home health care benefits are covered if a patient needs further care at home for a condition treated in a hospital or skilled nursing facility. In fact, part A of medicare will pay the full cost for an unlimited number of home visits by a home health agency. In order for benefits to be paid, the facility or agency providing benefits must participate in the medicare program. Virtually all hospitals are participants, as are most other facilities or agencies that meet the requirements of medicare.

Medicare: Part B Benefits. Part B, the supplementary medical insurance portion of medicare, provides benefits for the following medical expenses not covered under part A:

With some exceptions, part B pays 80 percent of the approved charges for covered medical expenses after the satisfaction of a $100 annual deductible.

Retirement Planning Considerations. Although the preceding list for part B of medicare may appear to be comprehensive, planners need to make their clients aware that numerous medical products and services are not covered by part B. Some of these products and services that represent significant expenses for the elderly include the following:

In addition, benefits are not provided to persons who are eligible for workers’ compensation or treated in government hospitals. Benefits are provided only for services received in the United States, except for physicians’ services and ambulance services rendered for a covered hospitalization in Mexico or Canada under part A.

In addition to determining how much income a client will need to retire and understanding the various sources of retirement income, the planner must also help clients produce as much retirement income as possible from their existing resources. The final part of this chapter will address four strategies that the planner can recommend to accomplish this goal:

If your client can be persuaded to sell his or her home and relocate to a smaller, less expensive residence, the money made available from the transaction can be a valuable source of retirement income. For example, if your client can sell his or her house for $200,000 and buy a new residence for $100,000, the $100,000 gain can be used to produce an extra $10,000 a year in income (assuming a 10 percent interest rate). This can be very desirable from a financial perspective because retirees can capitalize on what for many is their single most important financial asset—their home. In addition, this can be very desirable from a tax standpoint because the IRS allows a one-time exclusion of up to $125,000 on the taxation of gain from the sale of a home. The $125,000 exclusion is subject to the following restrictions:

If your client would like to take some equity out of his or her house, but is reluctant to leave the home, an alternative that is available is a reverse annuity mortgage (RAM). Under one type of reverse annuity mortgage the client sells a remainder interest in the home but retains the right to occupy the house until death. The purchaser of the remainder interest acquires the right to take possession of the property after the homeowner’s death (or the death of the homeowner and the spouse). The consideration for acquiring the remainder interest in the house is that the purchaser agrees to make periodic payments to the seller during the seller’s life. These payments can significantly enhance a client’s retirement income.

Under another type of reverse annuity mortgage the annuity payments plus interest are held as a series of loans against the value of the home. In this case, the amount paid out in an income stream plus interest will be recovered by the lender from eventual sale proceeds after the death of the retiree.

A third alternative that can be used to provide the retiree with extra cash is a part-time job during the retirement years. Many retirees find that working on a scaled-back basis not only meets their financial needs but also helps them adapt psychologically to the changes that retirement brings. This is especially true for clients whose self-esteem and sense of self-worth were tied to their careers.

Working after retirement poses a potential problem for retirees, however. They can lose social security income benefits if their earnings exceed specified limits, called annual exempt amounts. In general, social security benefits will be reduced by $1.00 for each $3.00 earned in excess of the limit for retirees aged 65 through 69 (or by $1.00 for each $2.00 earned in excess of the limit for retirement benefit recipients under age 65). The earnings limit is scheduled to rise from $12,500 in 1996 to $30,000 in 2002. For clients aged 70 or above, there is no reduction in social security income benefits regardless of the amount of their earnings.