Retirement Watch: Steering Clear of 72(t) Problems

INRA has put advisers on notice about "early retirement investment pitches that promise too much." Specifically, FINRA is concerned with abuses relating to early distributions from qualified plans based on section 72(t) of the Internal Revenue Code. That provision allows employees to take early distributions from their 401(k) or IRA without suffering the 10% early withdrawal penalty so long as withdrawals are part of a series of substantially equal periodic payments that last for five years or until the retiree reaches 59-1/2, whichever is longer.

Notably, the IRS permits modification of the withdrawal methodology, but may impose a penalty.

Read another way, Section 72(t) can be a way for advisers to recommend that employees retire early. And therein lies the problem. Last year, FINRA predecessor NASD fined Securities America Inc. of Omaha, Neb., $2.5 million and ordered it to pay $13.8 million in restitution in connection with "an investment scheme" aimed at Exxon retirees. This past June, Citigroup Inc. of New York was ordered to pay $15.2 million to settle charges that its brokers misled employees of BellSouth Corp.

Both the Securities America action and the Citigroup action involved unreasonable and misleading assumptions and promises of high returns coupled with unreasonable and misleading assumptions and promises of high permissible withdrawal rates.

Employees tending to be victims of 72(t) abuses typically are in their 50s, not well educated, and with little or no investment experience. In many cases they have worked for years in low-level supervisory or management positions earning $45,000 to $60,000 per year. They view receiving a lump sum payment from their retirement plan of, say, $350,000 as a fortune.

Their only question, posed to the adviser (and the adviser alone) with full faith, confidence and trust in his opinion, is, "Can I live on it for the rest of my life"?

Responsible advisers who want to avoid getting snared in 72(t) problems should take the following five steps:

First, discuss the risks. As FINRA's Investor Alert states, not everyone can or should retire early. Promises of earning investment income during retirement that is equivalent to income one would have earned by continuing to work "usually hinge on unrealistically high returns on investments and unsustainably large yearly withdrawals."

Second, explain the effect of fees and expenses (both initially and on an ongoing basis) that can have a material effect on the value of the portfolio. One section 72(t) expert estimates that a 1% fee on portfolio assets shortens payouts from 36 years to 29 years in most illustrations, while 2% fees shorten payouts to between 24 and 26 years.

Third, assume and project reasonable and conservative rates of return. The law does not require advisers to equate the return rate with the withdrawal rate, and advisers should not do so. Moreover, FINRA faults returns projected to be 12% or more, for several reasons: No one can predict investment returns; any return over 10.4% exceeds the historical long-term returns for the stock market, and greatly exceeds long-term returns for less risky securities like bonds, which are less than 6%; because the stock market is inherently volatile, returns during many years have been well below the historical average. Likewise, advisers should explain various asset allocations among the major asset classes, and demonstrate how each asset class and asset allocation has performed historically.

Fourth, assume and recommend reasonable and conservative withdrawal rates. According to FINRA, many experts recommend withdrawal rates between 3% and 5% per year. One expert who has analyzed the numbers states that using a 4% withdrawal rate, instead of an 8% withdrawal rate, nearly doubles the number of years that an investor's original principal can be expected to last, under normal market conditions. Advisers also should provide amortization schedules that are not limited to five to eight years. Instead, provide the full amortization schedule. This schedule will disclose declining principal balances, such that at the end of the retiree's life expectancy, the withdrawals will have fully depleted the value of the account.

Incurring such a penalty may be the best strategy to ensure that the client does not outlive his retirement nest egg.

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.