Main Street Money: Oh, the webs we weave…

It’s perhaps more than coincidental that as I sat down to write this column, I received and email about a “neat trick to generate 4.75 percent income.” It involves a convoluted plan having to do with a mixture of dividends and stock buybacks. As a registered investment adviser, I found it to be a complex and confusing scheme that felt quite risky. It seemed a lot of elements had to line up just right, and it mentioned nothing about what could happen in another market crash. But it was sold, in the article, as a viable way to generate income from the market.

It amazes me that, in this day and age, nearly 40 years into the era of 401ks and other defined contribution plans, my industry is still selling these convoluted income-generation schemes. I do understand why we do this, but that does not make it OK.

Here’s what I mean. Back in the days of the Revenue Act of 1978, tax-deferred plans made sense for high-income individuals. The top marginal tax rate was 70 percent, so when Xerox and Kodak contacted the representative for their congressional district with a request for a tax-dodge to extend deferred compensation to their executives, they were asking for and received a meaningful, and at the time, rarified benefit. To understand why, it’s important to understand how marginal tax rates work. If the top rate is 70 percent for incomes above $250k, for example, you don’t pay 70 percent of the whole $250k; you only pay the top rate on the portion that goes over the threshold. For example, if your income was $275k, you would pay the 70 percent on $25k, and lower amounts on the amounts below that.

So, the bonuses being offered to these highly-paid executives were bonuses on top of high salaries that would have been taxed at a sky-high rate and being able to defer the taxes until they retired into a lower rate made lots of sense. And, as often happens, when influential people and companies ask for favors, they are often granted by our government. They got their tax-dodge, buried deeply in the tax code so no one would notice, in section 401, subsection (k), and the 401(k) was born.

Now, understand what it started as. These executives were going to get the bonuses anyway. By getting the deferred tax arrangement, they lowered the taxes dramatically, putting much more money in their pockets without taking on any more risk at all. It was a win all the way around.

Fast-forward five years, and industry was waking up to the fact that it could save significant amounts of money by offering these plans to rank and file employees in lieu of the existing pensions. Pensions cost about 9 percent of total payroll to fund and maintain, while defined contribution plans cost only about 3 percent, so; this amounted to hundreds of billions of dollars. Not only that, but it transferred all of the risk from the employers to the employees. Think about it: a defined benefits plan details what you are going to get from the plan, meaning any shortfall is on the plan, not you. But a defined contribution plan only details how much you are putting in; what comes out is anybody’s guess. A big black hole, if you will.

Wall Street was quick to pick up on the opportunity to sell murky long-term financial products to captive clients. It was the Wild West. Very few regulations existed at the time, and here they were able to craft high-cost mutual funds, laden with hidden fees, that provided no guarantees or even expected performance metrics, to a growing body of inexperienced and uneducated investors that were trapped in long-term arrangements sponsored by their employers, whom they were supposed to be able to trust. In the couple of decades that followed, thousands of mutual funds containing trillions of dollars flowed into the market, bidding up stock prices by more than 1,200 percent. It was a self-fulfilling arrangement. Trillions of dollars of new money, which offered limited options restricted by defined contribution plan creators, were gathered and locked up into long-term funds that provided little or no visibility into cost, risk, or quality. At the same time, pensions were nearly completely phased out for most of the private sector, and all of the investment and longevity risk was passed from the employers to the employees. Hundreds of billions of dollars a year were made by companies that put up none of the money and took none of the risk. It was truly a permanent and obscene feeding-frenzy by these companies, and they gorged on it.

Now, however, the people who funded this one-sided bonanza are starting to need that money to live on, and the $15 trillion Wall Street gravy train is being threatened. As Wall Street sees its hold on its meal ticket starting to wane, it is doing everything it can to hold on. And so, it continues to come up with income schemes that favor the status quo, rather than the retirees who funded the whole.

Think about your own situation. Do you really want to have to rely on cryptic and risky buyback schemes and the like to generate income for your retirement? What happens when these schemes crash along with the rest of the market the next time we are hit by Wall Street malfeasance? Wouldn’t you really rather be able to reinvest that money in a permanent and guaranteed stream of income you cannot outlive? Especially if the amount was two to three times what you could get out of the market?

Don’t take my word for this. Check it out. Come in and talk. We’ll show you the details and then send you home to research everything you need to know before making a decision. And, if in the end, guaranteed income you can’t outlive doesn’t appeal to you, you can always figure out how to leverage corporate stock buybacks.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach Steve at 603-881-8811 or at www.FreeToRetireRadio.com.

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