Leverage in Retirement Planning:
Does Leverage Belong in Your Retirement Accumulation Strategy?
The Answer Could Enhance Your Golden Years.
William L. MacDonald
Chairman, President and CEO
Retirement Capital Group, Inc.
Retirement planning is becoming more difficult for a number of reasons. People are living longer and will need to accumulate far more than previous generations. Many fear that social security will not play any role, and future tax rate increases could diminish our retirement income.
There have been many tools created over the last two decades to help highly compensated executives accumulate money for their retirement, the most prevalent being nonqualified deferred compensation plans sponsored by employers.
Many Fortune 1000 companies have adopted plans for their key employees, and those plans have provided the leverage needed to accumulate more money than these executives could have accrued on their own through personal savings (Chart I).
Leverage in Nonqualified Deferred Compensation
Under these nonqualified arrangements, the executive’s employer provides the leverage by acting as a conduit. When an executive elects to defer income, he or she is “postponing” their taxes until they take distributions at a later date. In other words, a $100,000 bonus that is deferred is saving $40,000 in taxes today. Under a nonqualified plan, the executive will have the ability to invest the full pre-tax amount ($100,000) until they elect to take distribution at retirement. The fact that they can compound earnings on the pre-tax deferred amount is what provides the accumulation advantage over a personal investment (Chart I).
In this case, it was the executive’s employer that provided the leverage. Since the sponsoring employer cannot take a current tax deduction on amounts deferred, it is in essence loaning the executive the taxes that would have been paid. The cost of borrowing is the tax rate at distribution.
Let’s look at this example in more detail. Let’s examine the executive with a $100,000 deferral, who is in a 40% tax bracket. If he had accepted his bonus of $100,000, he would have been left with only $60,000, after-tax, to invest. However, since his employer offers a tax-deferred nonqualified compensation plan, the executive is able to avoid the $40,000 in taxes today, and enjoy the investment returns on the entire $100,000 for many years.
His employer, however, must report his deferred amounts as income and pay current corporate tax on the amount. The employer will get the benefit of a full tax deduction, but they must wait until the executive actually takes distributions, which could be many years. In most cases, the employer will establish a Rabbi Trust, and informally fund the amount deferred to help hedge its liability. In doing so, they are parting with $40,000 of cash ($100,000 minus $40,000 corporate tax equals net cash $60,000) to restore the taxes paid (i.e., $40,000). So, indirectly, they are loaning the executive this amount (Chart II).
At retirement, the executive will pay income tax on the amount deferred and the investment earnings that have accumulated. At that time, the employer will take its tax deduction, recapturing the amounts it loaned. After reviewing the accumulation, as outlined in Chart II, the executive’s “cost of borrowing” is the tax paid on distribution, assuming a 40% tax bracket they have paid $186,438 (40% of $466,096). This is equivalent to an interest rate of 3.16%. If the executive is more successful on their investments, and earns 10% or 12%, vs. the 8% illustrated in Chart I, their taxes or cost of borrowing would be $269,100, $385,852 respectfully, or the equivalent of 5.07% and 6.98% interest. Now that the executive has paid back the loan (i.e., taxes), they will only have the after-tax amount working for them in retirement.
Leverage in Qualified Plans
Most of us participate in a 401(k) or 403(b) plan. These plans are leveraged too. However, instead of the employer lending the money for taxes during the accumulation period, it’s the IRS that provides the leverage.
If you defer $10,000 into your 401(k) plan, you are saving $4,000 today, and will be able to accumulate investment earnings on the pre-tax amount, just as with the nonqualified plan (Chart III).
In this case, the IRS is lending you money for the taxes; however, they will collect it back when you take distribution. The cost for borrowing will be the tax on the original amount deferred, plus tax on all the investment earnings at the relevant tax bracket at the time of distribution. The loan interest rate (i.e., taxes) is really unknown. As with our example of the nonqualified plan, it would depend on the earnings on your investment.
Leveraging Other Assets
Today, leverage is common in our daily lives. Most people leverage their assets to invest in real estate, principally their homes. If you look at the investment over the years in a home purchase, you can see the importance of leverage. If the original purchase price of a home was $250,000, and you held that home for 20 years and sold it at $1,000,000, you would have a 7.57% internal rate of return, which is quite respectable. But if you calculate the rate of return against the money you actually had to invest up front - the $50,000 down payment, plus principal and interest payments - that equates to a higher rate of return. You leveraged the $50,000 into $1,000,000.
This is not unusual. Most homeowners use leverage to buy their homes. It’s the largest investment most of us make in our lifetimes, and it generally causes us the least amount of stress. We don’t worry about getting our money back, and we’re fairly confident that our investment will appreciate over time.
We have this confidence about real estate because historically it has turned out to be a good investment.
In this case, the reason the idea of leverage doesn’t keep you up at night because, unlike with your stocks and bonds, you are not constantly aware of the fluctuations in value that occur. And since most of us hold our homes for a relatively long time, the odds are decidedly in favor of it going up in value.
Leverage Can Be a Valuable Tool in Retirement
As we get closer to retirement, we want to be a little more conservative with our investment asset allocation. When you are young, you can afford to have some up and down years; therefore, focusing on equity returns is not a bad thing. But as we age, we have a tendency to balance our portfolios more on the conservative side.
Leverage can help achieve your retirement income goals. Let’s say you want to maintain a retirement income that requires a 12% return on your $1 million, but a relatively conservative, properly diversified retirement portfolio should generate a fairly reliable 8% each year. In order to generate the level of return required, you’d typically have to reallocate the portfolio and go pretty far out on the risk/return scale, with a larger percentage of the portfolio invested in equities.
Another solution is to leverage the principal by borrowing an additional $1 million, and allocating it in the same diversified fashion as the first $1 million. Assuming an 8% rate of return, you would realize twice the dollars you would get from the $1 million. You can use half of the additional money to fund your retirement (hitting that 12% target) and the other half to repay the loan. Long term, this can work well, if the investments are chosen wisely. Of course, if the investments aren’t chosen wisely, you have the potential to lose the initial investment and more.
You could also open a margin account, but that solution runs the risk of a call on the assets. A better choice you might consider is a new concept called the Insured Security Option Plan (ISOP®).
Insured Security Option Plan (ISOP®)
The ISOP® is an after-tax retirement savings plan that works similarly to a Roth IRA and 401(k). Your annual contributions are made with after-tax dollars, which means all income at retirement will be non-taxable. After-tax contributions also mean you are secure from your employer’s creditors, something that concerns many executives.
The ISOP® is funded by a Variable Universal Life insurance policy (VUL) that offers more than 60 mutual fund-type investments called subaccounts. It is designed to help highly compensated employees accumulate the assets needed to meet retirement objectives. The VUL is the reason you can accumulate money tax-deferred and take income on a non-taxable basis.
Through its unique design, the ISOP® creates the effect of pre-tax savings and tax-deferred investment growth by offering the participants some leverage from a non-recourse policy loan in the VUL. The policy loan restores the taxes paid at the time of deferral (i.e., $40,000), giving you the effect of a pre-tax plan.
Assume you want to contribute $100,000 to the ISOP®. After paying all applicable taxes, there is approximately $60,000 to invest, assuming a 40% tax rate. When the after-tax $60,000 is deposited into your account, the insurance carrier “loans” your account the amount paid in taxes, $40,000 in this example. So you have the entire $100,000 earning interest on the investments you select, and you have deferred the impact of the taxes.
The $40,000 is a non-recourse policy loan, with no required pre-payment period except through policy proceeds at surrender or death, and no pre-payment penalties. If you hold the policy until maturity, the death proceeds will pay off the loan and interest, with additional proceeds to go to your family. Unlike the examples (Charts I-III) with the nonqualified and qualified plans, the executive has the ability to continue your leverage into retirement and use the life insurance proceeds as the repayment.
Conclusion
From a leverage standpoint, the ISOP® allows you to control your borrowed funds through the non-recourse policy loan. Improved investment performance will not increase your cost of this leverage, unlike nonqualified deferred compensation plans and your 401(k).
The ISOP® can be an important tool for retirement accumulation, working in concert with your entire retirement planning strategy. Some portion of your retirement income should be in a non-taxable devise that is also secured from creditors. If you qualify, the ISOP® could be the plan for you.
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Securities Offered Through Retirement Capital Group Securities,
a Registered Broker/Dealer, Member FINRA/SIPC
William L. MacDonald, Registered Representative - California Insurance License #055698
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