Prudent 72(t) Retirement Planning
Requires More Than Just Wishful Thinking
By James Eccleston
dvisers, and their clients, have been warned about "early retirement investment pitches that promise too much." A FINRA Investor Alert has cautioned employees to "look before you leave", and two well-publicized regulatory actions have highlighted problems with misleading sales practices and ineffective supervision. Let's review the warnings, and provide guidance to advisers on how best to stay clear of trouble.
Section 72(t) of the Internal Revenue Code is the provision that allows employees to take early distributions from their 401(k), IRA, pension and retirement plans without suffering the early withdrawal 10% penalty so long as the withdrawals are part of a "series of substantially equal periodic payments" which last for five years or until the retiree reaches 59 1/2, whichever is longer. Notably, the IRS permits modification of the withdrawal methodology sooner, but may impose a penalty.
Read another way, Section 72(t) is the means by which advisers can recommend that certain employees retire early. What kind of employees? Typically, these are employees who are in their 50s, not well educated, not wealthy, and with little or no investment experience, having worked for years in low-level supervisory or management positions earning $45,000 to $60,000 per year. These employees view the promise of receiving a lump sum payment from their retirement plan, of say $350,000, as a fortune. Their only question, posed to the adviser (and the adviser alone) with full faith, confidence and trust in his/her opinion, is, "Can I live on it for the rest of my life"?
Therein lies the problem. Advisers should review the regulatory actions brought by the NASD (now FINRA) against Securities America, Inc. (and its broker) as well as Citigroup Global Markets, Inc. (and its brokers). The NASD fined Securities America $2.5 million and ordered it to pay $13.8 million in restitution in "an investment scheme aimed at Exxon retirees." Citigroup was ordered to pay over $15 million to settle charges relating to "misleading documents and inadequate disclosure in retirement seminars, meetings for BellSouth Employees." Both the Securities America action and the Citigroup action involved unreasonable and misleading assumptions and promises of high returns coupled with unreasonable and misleading assumptions and promises of high permissible withdrawal rates.
Excellent guidance for advisers is found in FINRA's Investor Alert on this issue. First, discuss the risks. As the Investor Alert states, not everyone can or should retire early, and promises of making as much during retirement from investments as one would by continuing to work "usually hinge on unrealistically high returns on investments and unsustainably large yearly withdrawals."
Second, explain the effect of fees and expenses (both initially and on an ongoing basis) which can have a material effect on the value of the portfolio. One expert who has examined the numbers reports that a 1% fee on portfolio assets will shorten payouts from 36 years to 29 years in most illustrations, and 2% fees will further shorten payouts to between 24 and 26 years.
Third, assume and project reasonable and conservative rates of return. The law does not require advisers to equate the return rate with the withdrawal rate, and advisers should not do so. Likewise, FINRA faults returns projected to be 12% or more, for several reasons:
No one can predict investment returns;
Any return over 10.4% exceeds the historical long-term returns for the stock market, and greatly exceeds long-term returns for less risky securities like bonds, which are less than 6%;
The stock market is inherently volatile, with returns during many years well below the historical average.
Fourth, assume and recommend reasonable and conservative withdrawal rates. According to FINRA, many experts recommend withdrawal rates between 3% and 5% per year. One expert who has analyzed the numbers states that using a 4% withdrawal rate, instead of an 8% withdrawal rate, nearly doubles the number of years that an investor's original principal can be expected to last, under normal market conditions.
Advisers also should provide amortization schedules that are not limited to 5 to 8 years. Instead, provide the full amortization schedule. This schedule will disclose declining principal balances, such that at the end of the retiree's life expectancy, the withdrawals will have fully depleted the value of the account.
Finally, if the withdrawal rate becomes unsustainable, advisers should consider recommending that the client modify the withdrawal methodology, especially early on, regardless of whether the IRS imposes a penalty. Incurring such a penalty may be the best strategy to ensure that the client does not outlive his or her retirement nest egg.
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James Eccleston, an attorney specializing in adviser and broker-dealer issues, is a partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston in Chicago.
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