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The Pro Rata Problem

| April 24, 2020
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The Overview

  • Employer sponsored retirement plans are amazing for accumulation
  • Most employer sponsored retirement plans are terrible for distributions due to pro rata liquidations from your investments
  • Pro Rata Definition: When discussing investment withdrawals, a pro rata withdrawal would come proportionately from all of your holdings
    • Example: You own four investments in your account. Each investment totals 25% of your portfolio. If you make a $100 withdrawal on a pro rata basis $25 will come from each investment to cover your withdrawal.
  • As you approach retirement you should consider developing a liquidation plan that intentionally maps out which investments you will be selling to cover your immediate spending needs
  • Rollover IRA’s may be a more appropriate alternative to your 401k to solve the “Pro Rata Problem”

The Pro Rata Problem

Most Americans rely on their employer sponsored retirement plans to do the majority of their investment planning. It is a logical approach. These plans (401k, 403b, 457, etc.) allow for high annual contributions limits, offer significant tax advantages, and typically are very cost effective due to the fact that many plans have millions, if not, billions of dollars invested in them which can help collectively keep expenses down. In addition, you can typically build an investment portfolio that gives you all the tools you need to be diversified appropriately.

However, as you approach retirement it is crucial that you understand some potential pitfalls of leaning on your employer sponsored retirement plan for retirement income distributions. One major pitfall revolves around the concept I have coined “The Pro Rata Problem”. This problem points to the fact that most employer plans will indeed allow for distributions after you retire but will force you to take the funds proportionally from all your investments or on a Pro-Rata basis.

Example:

Jane Doe has retired and has a $750,000 401k plan that allows for distributions after she retires. Jane decides to take a 3% distribution in her first year of retirement from her 401k plan equaling $22,500. She has a portfolio of low risk, medium risk, and high-risk investments. Her current allocation is as follows:

Jane’s plan does not allow her to choose where she takes her withdrawal from. In other words, she must take her distribution proportionally from all her holdings. As a result, her withdrawal looks like this:



At first glance, this may not seem to matter too much. However, the implications of selling your investments on a pro-rata basis can have a devastating affect on your long-term probabilities of success. After all, each of these investments will gain and lose each year depending on the level of risk you take, market conditions, and other factors out of your control. By selling on a pro rata basis from your 401k, you could be selling investments at an inopportune time effectively locking in losses. If Jane retires in a year where her high-risk investments have lost significant value, she will lose the ability to let those higher risk assets recover.

An Alternative Approach

If your employer plan only offers Pro Rata withdrawal options, an alternative you should consider could be rolling your funds out of your 401k plan and into a rollover IRA. If done correctly, this transaction creates zero tax liability and allows you to have
significantly more control of your retirement spending.

One approach you could consider involves segmenting your low risk, medium risk, and high-risk investments into different silos. Here is a continuation of the previous example for your reference.

Example:

Upon retiring, Jane decides to roll her funds from her employer sponsored retirement plan into a rollover IRA. She keeps her investment allocation identical but decides to draw from her Low Risk investments and allow her Medium and High-Risk investments the opportunity to grow over time.



Over time, Jane strategically re-balances her accounts to make sure that her near term withdrawals are never subject to unnecessary market risk. As a result, she has a greater likelihood of not having to realize large losses on an annual basis from her riskier investments and maintains significantly more control of her distribution plan.

This approach creates a much more intentional approach to distribution planning. Her Pro Rata Problem is solved!

If you would like to discuss solving your pro rata problem, feel free to reach out to schedule a phone call or video conference meeting. We can review your current investment portfolio and discuss distribution options that may meet your income needs more efficiently.

About the Author

As Co-Founder of Blakely Walters, Sloan Walters strives to provide clients with the highest level of financial advice, education, and experience. Since establishing the firm, Sloan has been able to help clients enhance their financial independence across a comprehensive menu of services. In addition to his oversight of the firm and its many strategic partnerships, Sloan is a respected guest speaker across a spectrum of financial topics.

 

**The investments are hypothetical in nature, and are not designed to reflect specific portfolio’s, or specific recommendations

**Please check in with your financial advisor to determine your appropriate investment risk tolerance

*Securities and Investment Advisory Services offered through NEXT Financial Group Inc., member FINRA and SIPC. Blakely Walters is not an affiliate of NEXT Financial Group Inc.  Neither NEXT Financial Group Inc. nor its representatives give tax or legal advice.

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