BUSI 686 Week 6 DB Forum 3 Example

Discussion Board Forum 3: Thread and Replies

BUSI 686 Financial Planning, Discussion Board Forum 3 (thread and two replies)

Thread by [Student Name]

The forum topic, the client and the classmates are composites standing in for the course's own; the tax figures are illustrative, and the textbook and research cited are real; the requirements follow Liberty's public course guide for BUSI 686.

Thread

The topic describes a composite client, age 40, earning $90,000, who contributes 6 percent of pay to a traditional 401(k) and receives a 3 percent employer match. A coworker told him the Roth option is better, and he asks whether to switch. Dalton et al. (2016) teach planners to understand the client's full situation before answering the question the client brings, and his situation raises a larger issue: at 9 percent of pay including the match, starting at 40, he is unlikely to replace enough of his income in retirement.

The account choice itself turns on tax rates. Suppose he contributes $5,400 a year. In a traditional account, the full $5,400 goes in before tax, and withdrawals are taxed later. In a Roth, he pays tax first, so at a 22 percent rate only about $4,212 of the same take-home cost goes in, but withdrawals are tax-free. If his tax rate in retirement is also 22 percent, the two produce the same after-tax income. The Roth wins only if his rate is higher later, and the traditional account wins if it is lower, as it is for many retirees with smaller incomes.

Behavior complicates the arithmetic. Beshears et al. (2017) studied companies that introduced a Roth option and found that total contribution rates did not change significantly, meaning that employees who chose the Roth contributed the same percentage of pay. Because Roth dollars are after-tax, keeping the same percentage meant saving more in after-tax terms and taking home less. For our client, a switch at the same 6 percent would quietly raise his real saving, which may be the switch's main benefit. The best feature of the Roth may be that people do not adjust the percentage when they choose it.

The broader need is clear. Munnell et al. (2015) reported that about half of working-age households were at risk of being unable to maintain their living standard in retirement. When my employer raised its match from 3 to 5 percent, I raised my contribution the same week, and I still remember how little I noticed the difference in my paycheck. I would advise the client to raise his contribution to 10 percent now, stepping up a point each January until he hits 15, and to split new contributions between Roth and traditional accounts to diversify his tax exposure, since no one knows tax rates thirty years from now.

Reply to Alicia

Alicia, you recommended that the client move everything to the Roth because tax rates are likely to rise to cover federal deficits. That is a reasonable concern, and your point that today's rates are low by historical standards is fair. But the recommendation rests on a prediction about the client's own tax rate in retirement, not the nation's rates in general, and those can differ. Dalton et al. (2016) explain that retirement income needs and sources should be estimated before deciding where to save. Many retirees have lower taxable incomes than they did while working, so they fall into lower brackets even if statutory rates rise. If our client retires with Social Security and modest withdrawals, his rate could be lower than 22 percent, which would favor the traditional account. Required minimum distributions and the taxation of Social Security benefits can push some retirees into higher brackets, so the answer is not certain either way, which is itself an argument against an all-or-nothing choice. At the same time, Beshears et al. (2017) found that employees who use a Roth tend to keep their contribution rate unchanged, which raises their after-tax saving. That suggests a compromise: split contributions between the two accounts, so the client gains some protection against higher future taxes and some of the Roth's behavioral advantage without betting everything on one forecast. In my own planning, I split my contributions for exactly this reason, because I could not decide which forecast to believe. Would you still recommend an all-Roth strategy if the client expected to retire on less than half his current income, as many people in his position do?

Reply to Marcus

Marcus, I agreed with your main point that the Roth question is a distraction from the real problem, a 9 percent total savings rate that started late. Your experience of watching your parents work past 70 because they had saved too little made the stakes concrete. Munnell et al. (2015) estimated that about half of working-age households were at risk of falling short of maintaining their living standard in retirement, so the client is in common company. Where I would add to your thread is in how to raise the rate. You recommended jumping straight to 15 percent, which is the right target but may be hard to sustain if the client feels the cut in take-home pay at once. Workers in the program Thaler and Benartzi (2004) built could pledge future raises to savings, and enrollees' saving climbed to several times its starting level within a few years, because no increase ever cut a paycheck. Dalton et al. (2016) emphasize monitoring the plan after implementation, and an escalation schedule gives the planner something concrete to monitor. Pairing your target with an automatic escalation could get the client to 15 percent with less resistance. If his raises average 3 percent a year, a one-point increase each January would leave his take-home pay rising, just more slowly, which is far easier to accept than an immediate cut. A planner can also show him what each point of contribution adds to his projected balance at 67, which turns an abstract percentage into a number he can picture. Would the client's employer plan allow automatic annual increases?

References

Beshears, J., Choi, J. J., Laibson, D., & Madrian, B. C. (2017). Does front-loading taxation increase savings? Evidence from Roth 401(k) introductions. Journal of Public Economics, 151, 84-95. https://doi.org/10.1016/j.jpubeco.2015.09.007

Dalton, M. A., Dalton, J. F., Gillice, J. M., & Langdon, T. P. (2016). Fundamentals of financial planning (4th ed.). Money Education.

Munnell, A. H., Hou, W., & Webb, A. (2015). National Retirement Risk Index (NRRI) update shows half of working-age Americans still falling short. The Journal of Retirement, 3(2), 34-42. https://doi.org/10.3905/jor.2015.3.2.034

Thaler, R. H., & Benartzi, S. (2004). Save More Tomorrow: Using behavioral economics to increase employee saving. Journal of Political Economy, 112(S1), S164-S187. https://doi.org/10.1086/380085