I. Introduction
Mr. Chairman, I appreciate the opportunity to testify today before the Senate Banking Subcommittee on Financial Institutions on the topic of federal deposit insurance coverage of retirement accounts. I am Glenn Dahlke, President of the Dahlke Financial Group of Glastonbury, Connecticut, a family-owned sales and asset management company.
Mr. Chairman, it is my strong recommendation that Congress should substantially increase the value of federal deposit insurance for retirement accounts. Congress should recognize that the cost of retirement has skyrocketed since 1978, when retirement coverage was last increased.
In addition, those Americans who take responsibility for remaining self-sufficient in their later years should not be forced to jump through complicated and potentially costly hoops to protect those savings. I urge Congress to increase deposit insurance coverage for retirement savings well in excess of the outdated $100,000 limit, and to ensure that coverage keeps pace with the true costs of retirement.
This afternoon, I want to make four points:
First, without other assets, $100,000 in retirement savings is simply insufficient to support most retired individuals, especially given increased life expectancy and dramatically rising medical costs.
Second, it is rational for retirees who have low risk tolerance and need a predictable income stream to invest savings in excess of $100,000 primarily or exclusively in insured deposits.
Third, many retirees who invest in insured deposits are ill-equipped to cope with federal distribution requirements that are made vastly more complicated when accounts must be spread across institutions.
And finally, I believe it is inappropriate to require retirees to choose between the safety of their life savings and banking with someone they trust.
II. Background
A. Getting Above $100,000
Happily, America's "retirement years" are lengthening: we are living longer, and many Americans are retiring early to make way for a new generation of workers in a low-unemployment environment. As a result, however, careful planning is required to ensure self-sufficiency during this period, although the amount needed to sustain a comfortable lifestyle must obviously be determined on a case-by-case basis.
Over the years, Congress has created important tax incentives to encourage people to set aside money for retirement, recognizing the benefits to our society of individual self-sufficiency.
Several different pension and benefit plans exist, the better known of which include Individual Retirement Accounts ("IRA"s), 401(k) plans, and Keogh plans, among others. Under these plans, individuals may invest pre-tax dollars, the earnings on which are tax-deferred until the funds are eventually withdrawn, in many cases subject to a lower tax bracket than when the money was earned.
In a resounding re-endorsement of the principle that Americans should save for retirement and a recognition that retirement costs have increased dramatically, Congress earlier this year significantly increased the amount that individuals may save through tax-deferred programs such as IRAs. Over the course of the next several years, annual contribution limits will increase from $2,000 to $5,000 for IRA and Keogh accounts, with subsequent indexing for inflation, and $10,500 to $15,000 for 401(k) plans. Other defined benefit and contribution programs are based on a percentage of income, and permitted deposits often far exceed $5,000 annually.
Even without taking into consideration these higher contribution limits, a middle class individual who works for 20 or 30 years and saves in a disciplined manner will easily amass over $100,000 in savings. According to the FDIC, a worker who sets aside $2,000 annually at a tax-deferred 6 percent rate of return will reach $100,000 in savings after 20 years. For those who set aside higher annual amounts of retirement money through 401(k) plans and roll those funds into an IRA, the time period required to exceed $100,000 in savings is drastically reduced.
For purposes of this testimony, I focus primarily on IRAs, because that would be the most pervasive vehicle through which an individual would likely place retirement money into an insured depository.
B. Retirement Savings Vehicles
It is useful to review the fundamental rules governing tax-preferred IRAs. All single workers not covered by an employer-sponsored pension plan or earning less than $25,000 ($40,000 for married filing jointly) are eligible to contribute to an IRA and deduct the contribution amount from taxable income. Workers earning above the $25,000/$40,000 limits are subject to a phase-out of deductibility.
Below the income thresholds, workers may contribute up to $2,000 per person or $4,000 per couple (or up to 100% of compensation, if less than $2,000) to an IRA and deduct that amount from taxable income. Those limits are set to rise to $3,000/6,000 next year, $4,000/8,000 in 2005, and $5,000/10,000 in 2008, with indexation thereafter. Individuals over 50 years of age may take advantage of special "catch-up" provisions.
Above income thresholds, individuals may contribute the same amount to IRAs; however, they may not deduct the deposits from taxable income. This may nevertheless be desirable because earnings on IRAs are not taxed until that money is eventually withdrawn, and accordingly savings compound more quickly than many investments.
IRAs come with significant restrictions to ensure that these tax-preferred vehicles are used to support people in their later years. Withdrawals (for any reason except disability or medical costs) from IRAs before an individual reaches the age of 59 ½ , with some narrow exceptions, are charged an excise tax of 10 percent on the amount withdrawn, which is also subject to income tax.
Once an individual reaches 70 ½ years of age, certain prescribed amounts, based on longevity tables, must be withdrawn from an IRA. Failure to withdraw the prescribed amount results in a stiff penalty of 50 percent of the amount of the difference that should have been withdrawn, which is also subject to income tax. For example, assume a 75 year old woman has $100,000 invested in an IRA, which is subject to a 5 percent withdrawal rate in 2002. To avoid a penalty, she is obligated to distribute $5,000 out of her account in 2002. However, assume she distributes only $3,000. She owes a penalty of $1,000, i.e., 50 percent of $2,000. In addition, she is taxed on the full $5,000 of ordinary income.
It is important to note that middle class retirees without the benefit of professional financial advice are far more likely to fall subject to these penalties. In addition, while it may not be politically correct to point this out, in many cases the surviving spouse of a traditional one-worker family may lack an established understanding of the family's finances, further increasing the risk of incurring penalties.
As the previous example illustrates, it is important to understand that IRA holders are required to reduce the size of their accounts gradually, based on established longevity tables. IRAs can be understood to take the shape of a bell curve. In the early years, individuals may contribute to, but not withdraw from, a retirement account, resulting in a build-up of principal. Between the ages of 55 and 70 ½, individuals may, but are not required to, withdraw savings as needed. After 70 ½, IRAs will eventually decline (though they may stand still during years where distribution rates may equal rates of return on investment).
III. Arguments
In some important respects, $100,000 is not worth $100,000 in the retirement context. That is, where that money serves as the major source of income other than Social Security, $100,000 may be barely sufficient to cover basic living expenses.
For example, assume a 72 year-old widow has $100,000 plus a $10,000 annual Social Security pension on which to support herself. From the $100,000, assuming a five percent distribution rate (see discussion below), she will receive $5,000, which is taxable as ordinary income, along with the $10,000 in Social Security benefits, which may or may not be taxed depending on her circumstances. In other words, this widow has $15,000 annual income on which to support herself.
Mindful of the fact that many parts of America have lower cost of living than Connecticut, I am nevertheless prepared to declare to this Subcommittee that this woman is unlikely to enjoy a lavish lifestyle, and in fact could not absorb predictable financial shocks that might include anything from a new roof to an uninsured medical procedure.
This is a critical point, because many opponents of higher coverage limits often argue that anyone with $100,000 is well-off and can do without special favors. On the contrary, Mr. Chairman, Congress should ensure that those workers who save in a disciplined and responsible manner for their retirement have a secure investment option for an amount adequate to support themselves. It is fair, and frankly, it is good public policy.
Assuming an individual has over $100,000 in retirement savings invested through an IRA, the question becomes why would he or she choose to keep that money in a bank. During my career as a financial adviser, I have observed three principal factors at play for
clients who choose to keep their money in a local insured depository: risk tolerance, need for predictability and local relationships.
1. Risk Tolerance
When I advise clients on investment strategies, the most important piece of information I gather relates to that individual's risk tolerance, or willingness to put his or her savings at risk in exchange for a possible higher rate of return.
Risk tolerance does not necessarily correlate to an individual's wealth cushion, nor to his or her future income needs. As a general matter, however, we expect risk tolerance to decline with age. In some sense, risk tolerance is a function of how much a person wants to increase his or her wealth, in addition to how much that person can "afford to lose."
For example, Charlie with $2 million may have a strong desire to increase that base to $10 million because of his lifestyle aspirations, and may be willing to risk losing some of his $2 million for the chance of a higher return. At the same time, Addie with $200 million may decide to pursue a no-risk investment strategy because she would have no use for more money, even though she could certainly afford to take a few high-risk bets without much risk to her future security. And Carol with $200,000 may be perfectly happy living on $12,000 a year, and be loath to risk that $200,000 for higher returns because she is content with the lifestyle her savings can afford. Bags of gold come in different sizes, and each individual decides what level of savings is enough for a comfortable retirement.
I have found, however, that individuals with a smaller wealth cushion tend to have a lower risk tolerance with respect to a wealth accumulation that is just enough to meet their future needs with little room for loss. In most cases, a conservative investment strategy where there is sufficient, but not ample, savings is a wise course, as recent stock market volatility has indicated. In fact, the current environment underscores the importance of increasing deposit insurance coverage of retirement accounts, especially as the risk of bank failures increases with economic softening.
2. Predictability
Individuals with a smaller wealth cushion may also prefer investments that have predictability with respect to providing a fixed income. While there are certainly secure investments, such as Treasury securities, that provide safety for the principal of the investment, these instruments are interest rate sensitive, and can not be relied upon to provide a fixed monthly income. I advise clients who want or require predictability in their monthly income to invest in certificates of deposit, because these are the only investment that, assuming they are fully insured, can provide complete security of both the full principal as well as a fixed income stream.
3. Local Relationships
Clients who express a desire to invest significant resources in an insured depository often, but not always, want to keep their money with people they know and trust. Especially in small towns, personal relationships develop between bankers and clients, and while this may seem anachronistic to urban dwellers, local relationships remain an important feature of the modern banking system.
Higher coverage levels for retirement accounts would significantly reduce the risk that a retiree with over $100,000 in insured deposits would become subject to the 50 percent penalty for under-distribution of IRA savings.
Because distribution requirements are based on an individual's aggregate IRA savings, diversification of IRA money across several accounts increases the risk of under-distribution, especially as an individual grows older and perhaps loses some ability to manage complex financial situations. This risk is enhanced when an individual needs to spread money across several financial institutions, which is the practical effect of the current $100,000 limit.
Because of ownership restrictions in the Internal Revenue Code, IRA holders typically need to spread accounts across different institutions to obtain coverage for more than $100,000. Unlike general accounts, IRA holders cannot benefit from higher coverage levels from multiple accounts at the same institution because of ownership restrictions.
For example, whereas an individual with $200,000 in non-retirement funds could secure full insurance coverage in a single institution by opening two accounts in different legal capacities, the same owner of a $200,000 IRA could not do so. Rather, the money would need to be spread over two separate institutions to maintain coverage. This would also be the case for a widow or widower whose spouse maintained an IRA at the same institution as the surviving spouse. Once the six-month grace period had passed, the surviving spouse would need to transfer the account to another institution or risk holding uninsured deposits.
For many retirees who prefer insured deposits out of loyalty to a particular institution, this solution is unsatisfactory, and they are forced to choose between maintaining insured deposits and banking with someone they trust. For other retirees who live in small towns, there may in fact be only one local bank, and we cannot assume that they have access to a car or to the Internet.
And even when remote banking may be an option for rural Americans who live in a one-bank town, it is my strong sense that:
As a general matter, we in the financial planning community encourage investors to diversify their investments to reduce risk to their savings. However, in all candor, we do not necessarily encourage investors to diversify their sources of financial advice.
But spreading insured deposits across several banks accomplishes no risk-spreading for the individual investor other than staying within the deposit insurance limits. In fact, diversification of assets across multiple institutions has serious drawbacks, not least of which is a confusing array of financial statements, which can lead to mistakes in planning, investing and tax reporting.
From a systemic point of view, as Chairman Greenspan has noted wisely, the deposit insurance coverage limit is designed to accomplish exactly this objective of encouraging individuals to spread money across banks to reduce the government's risk in any given institutional failure.
In the retirement context, however, it is my strong belief that this is a bad tradeoff. The benefits from maintaining an inadequate level of insurance for retirement savings pale in comparison to the potential costs to retirees forced to maintain multiple accounts.
For all these reasons, Mr. Chairman, I strongly urge Congress to increase coverage levels that have not been touched since 1978, and to take measures to ensure that these limits keep pace with the true costs of retirement.
I thank you for this opportunity to present my views to the Subcommittee, and I welcome your questions.
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