The SECURE Act will have positive implications for college executives. One of the biggest benefits to college executives is the increased income reporting that is required on financial statements for participants in 401(k), 403(b), and deferred compensation plans. This article will detail which of the changes under the SECURE ACT are important for college executives to be aware of, as well as how they may use this to their advantage in both the short and long term.
The SECURE Act and college executives
College executives at both public and private institutions earn a considerable amount of pay outside of their base salary and bonus. Across the spectrum of college executive compensation, it is not uncommon for executives to save tens (if not hundreds) of thousands each year on a pre-tax basis using 401(k), 403(b), and deferred compensation plans. This is a way to reduce taxable income in any given year; essentially you are deferring taking these earnings as income until you retire – at which point you will hopefully be in a lower tax bracket.
The SECURE Act includes a component called the related income disclosure requirement. Under this provision, on an annual basis plan participants must be given an illustration of what their balance would amount to if it were to be converted to an annuity. In other words, instead of just having your 403(b) balance reflected as a certain amount, let’s say $2,000,000, you would be provided with a sketch of how much you would receive on a yearly basis as a payout if the balance were to be taken as an annuity within that year.
Why the related income disclosure matters
We feel that this is a significant and welcome change for plan participants. As many college executives are highly preoccupied with the responsibilities of their jobs (and rightfully so), often planning for retirement falls to the wayside. Seeing in tangible terms what retirement income would look like, expressed as an annual cash flow, will take the vision of retirement from the abstract to the concrete.
The related income disclosure will likely have two important implications for college executives. It will better inform participants as to if they are accumulating enough wealth for retirement. Second, and equally as important, it will encourage better distribution planning. Socking away millions on a pretax basis sounds good, but many are in for a rude awakening when it comes time to take those distributions (and be taxed on them).
We recommend that college executives come up with a strategy for distributing this income 5 to 10 years before retirement. With higher transparency about what the distributions are going to be, more college executives will see the importance of the deaccumulation phase of retirement. This is a whole different ballgame than the accumulation phase.
An example of why strategic distribution planning is so critical
Here is a scenario that illustrates the need for a well thought out distribution strategy. Let’s say that you are a college president earning $250,000 a year. By the time you retire, suppose you have $2,500,000 sitting there in your 403(b) account. Sounds good, right? Not entirely. You worked hard to earn it and save it, but the game is not over until you distribute it correctly.
Let’s say that upon retirement you become completely dependent upon income from your portfolio. You’ll require a minimum of 4% of that portfolio, or $100,000 a year, to live. This is a low estimate as an income of $100,000 would be less than half of what you have been living off of up until this point. You may even need more than 4%.
Here’s where risk comes in. If the majority of income that comes from your portfolio originates from the variable element (the market) as opposed to a guaranteed element (pension, annuity, etc.), you can potentially experience massive swings in your income. The earlier you take retirement, the more you bring sequence of return issues into play. If you start liquidating positions out of desperation in a time of market volatility, when are you going to climb back in? Now you’re in a position where you are trying to time the market and we all know how unpredictable this can be.
The vast majority of people have not given any thought to how much of their retirement income is guaranteed as opposed to variable. For those requiring income amounting to more than 4% of the asset base, the risk of damaging your portfolio by taking distributions carelessly increases.
Cash flow planning for college executives
The SECURE Act will provide higher transparency to college executives utilizing pre-tax retirement vehicles. Here is a summary of the steps that college executives should take to reap the full benefits of these changes.
· Begin to look at your retirement income distribution strategy 5 to 10 years before you plan to retire.
· Use the disclosures put in place by the SECURE Act to gain an understanding of what your pretax income will be, and try to forecast what this will be on a post tax basis.
· Engage in strategic planning to level out the amount of taxes that will be taken in any given year as large balances in 401(k), 403(b), and deferred compensation accounts can make for quite the heavy tax bill.
· Forecast what your retirement income will be and compare it to what you think will be required. Create a plan to address the shortfall.
· Assess how much of your retirement income is going to be variable versus guaranteed. Consider guaranteed income sources if your income requirement exceeds 4% of the portfolio balance.
College executive compensation can vary so widely from one person to the next. According to a recent study by the Chronicle of Higher Education, the highest earning college president in 2017 earned over $6,200,000 between base, bonus, and other pay, and you have other executives at institutions both public and private earning well into six figures (albeit not as much).
It is wise to keep in mind that what you earn is not as important as what you save, invest, and shield from taxes intelligently. At the end of the day, being retired comfortably for college executives is going to be a matter of getting the right amount of income in hand when you need it. Like any achievement, it takes rigor, attention, and a strategy that is thought out well in advance.
Bauman, Dan, Davis, Tyler, and O’Leary, Brian. (2020, January 14th). Chronicle of Higher Education Executive Compensation at Public and Private Colleges. Retrieved from https://www.chronicle.com/interactives/executive-compensation#id=table_private_2017
Disclosure: Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.