Reforming American Defined-Contribution Retirement Plans

Great Debates
1

I’d like to sketch a plan to promote American retirement income security and ways to prevent poverty-stricken old age. I believe Australia’s superannuation system can serve as a lodestar for defined-contribution systems in other countries. Here’s a brief description of how it works (from Wikipedia). I will be adapting certain features of it to an American context.

Currently, there are a number of accounts that can be used for retirement savings. The 401(k) can be offered by employers, and the Individual Retirement Account can be set up by individuals. These can be made as either tax-deferred contributions, where income tax on the principal and earnings is due upon withdrawal, or as post-tax contributions, where taxes are paid on the principal upfront and can be withdrawn tax-free (along with earnings) at retirement age. In addition, federal employees and uniformed services are eligible to participate in the Thrift Savings Plan (TSP), which is similar to the 401(k) but with its own investment funds. Most employers that offer a 401(k) also match employee contributions up to a certain amount. In an IRA, the employee can use his choice of investment vehicle through a firm of his choice, while those in a 401(k) are limited to investment options offered by the company’s contracted 401(k) provider. After leaving an employer, employees may leave their money in the company’s 401(k) (although unable to make further contributions), roll it over into a new employer’s 401(k) plan, or roll it over into an IRA.

The first problem I see is there are too many types of accounts. I suggest merging all of them into a single Universal Retirement Account (URA), which can be subdivided into pre- and post- tax contributions. Further, many (mostly small) businesses don’t offer 401(k)’s which limits workers’ ability to save. In addition, when you invest in a 401(k), you are stuck with the plan’s investment options. To resolve these issues, I propose making URAs universal and not employer-dependent. My employer can deposit my paycheck where I want; there’s no reason why they can’t do the same for retirement contributions. If an employee doesn’t already have one or doesn’t provide the information, the employer would auto-enroll the employee with a provider of the employer’s choice and funds would be invested in an appropriate target-date fund (which is already the default for most 401(k)’s). Another option would be opening the TSP, which are currently reserved for federal employees, as a default option. This both resolves the access problem and provides maximal employee choice and control for those who want to be hands-on. Note that the employer’s obligation is limited to enrolling employees who don’t have one and sending contributions. This is similar to many state programs that require IRA auto-enrollment.

I believe this needs to be made mandatory. Currently, Australian employers are required to contribute 9.5% of salary. In America, we have a culture of employee contributions with some level of employer matching. Economic theory suggests that the full burden of these contributions would fall on employees, with employer contributions being made up in terms of lower wages. I would propose that, initially, 6% of pre-tax salary be required, rising to 10% over a period of time. This could be employer or employee contributions, or a combination of both. Employees could make additional pre- or post-tax contributions. Total contributions are capped at the current 401(k) cap. If a mandate is undesirable or politically unpalatable, simply making this opt-out would get most of the benefit.

Finally, I realize there is the issue of low-income people having difficulty investing a sufficient amount. There are a few options for helping here. One is to divert a portion of poor people’s FICA taxes to their URA and make up that amount by raising the FICA-tax cap on higher-income people. Another is that the government could divert a portion of the Earned Income Tax Credit to the URA.

Reforms along these lines could have appeal across the political spectrum. For those on the Left, this would reduce wealth inequality by helping those lower on the economic ladder grow assets. Currently, the retirement savings system benefits mostly the upper and upper-middle classes. For those on the Right, this could be a move towards fulfilling former President George W. Bush’s vision of an “ownership society” where workers have maximal control of their retirement savings.

In closing, I want to suggest that this policy sketch be considered merely a starting-off point for discussion. It does not represent my final, firmly-held policy view. Many incremental changes are worth considering, such as those state laws that require automatic IRA enrollment or Marco Rubio’s plan to allow small business that don’t offer 401(k)’s to join the federal TSP.

I’m really looking forward to hearing your thoughts.

2

Vice President Pence?

3

I think there are three primary problems with retirement plans (and these are true in general, but are particularly bad for the US).

  1. The demographic pyramid has the US going from 5.2 workers / retiree in 1970 to 4.06 in 2015, to a projected 2.5 in 2050.

This demographic pyramid is affecting most developed nations as fertility has gone down and life-spans have increased, and many are worse off than the US - but a situation where in 2050 workers are going to have to be supporting twice as much “retiree weight” is an obvious problem.

  1. Many people in the US are too poor to contribute meaningfully to defined-contribution plans. 63% of americans would be unable to cover an unexpected $500 expense from savings, and median wages have stayed flat as productivity has soared 77%, housing costs have risen 8x, tuition costs have risen 13x, and healthcare costs have risen 9x.

A big chunk of people just flat out don’t have a lot of money, because median wages haven’t been going up, but major unavoidable things like housing and healthcare have been rising stratospherically.

  1. People are dumb / discount the future too much. This not only leads to not saving enough to begin with (the average US savings rate is ~5%, where the recommended amount by retirement planners is 15%), but coupled with factor 2, leads to around 50% of people who are capable of borrowing from / against their 401k to do so.

So if your ultimate plan is to keep grandma and grandpa off the street and not eating cat food in their old age, I think your system needs to take these 3 things into account.

So forced contribution is good (but this is just SS taxes), because people don’t save enough and have other pressing uses for the money. So are accounts that you can’t withdraw from or take loans against (but again, this is like SS).

Individual contribution 401k’s that people individually own and can tap will probably lead to more cat-food grandparents, as they will be both underfunded and drained or borrowed against.

So basically, Social Security as it exists today is doing a decent job of forcing some retirement savings in a way that minimizes messing up, and if you did anything, you might just want to tweak the % contributed there, by either individuals or the government, or both. But this is STILL going to blow up as the demographic pyramid tips over, because 2 workers for every retiree is going to lead to major problems in a few decades.

So if you REALLY want to put retirement on a better footing for most Americans, you need to start encouraging working-age immigration, and KEEP encouraging it for the next 3 decades, because only that is going to stave off demographic and retirement system collapse, by moving that ratio from 2 workers per retiree to a more manageable 4 or 5.

4

Do people with expensive medical costs have to forego medical treatment they can’t afford because of the retirement contribution?

What good is retirement funding if you can’t afford your medicine today?

5

All sorts of problems.
Given the uproar about raising the MW a couple of bucks, forcing large employer contributions - for everyone - will make that seem minor.
Second, if employers are giving money into programs, they can be forgiven for wanting to vet where the money goes. Large employers can also negotiate lower fees, which is especially important for target date funds.
Second while you say the limited number of options is an issue (which has gotten better since 401Ks began) you are super limiting the options by requiring target date funds. How to keep employees from investing in scam funds? If there is only one, or a very limited number, stocks picked for them will rise as money flows in which is not always a good thing. This is also a problem if you are moving money from FICA to URAs - Social Security invests as it does for security.
I believe that during the Obama administration 401K investment was made the default, thanks in part to work by Thaler and Sunstein.
This is in addition to all the good points Textual Innuendo made.

6

For those too young to remember before 401Ks, defined benefit plans had problems also. ACM and IEEE letter columns were full of complaints from consultants and those who switched jobs every few years about pensions. The problem was that pensions vested after a few years, so if you moved every three you wound up with very little. They wanted “portable pensions” which would vest immediately and which could be moved across companies. 401Ks and IRAs are like this, except they are not defined benefit.
And the poor were still screwed - but now a lot of the middle class are getting screwed also.

7

So…it’s wrong to force people to have medical coverage, but ok to force them to have a retirement account?

That seems weird!

8

Well, just like it’s “wrong” to treat mental illness, have large mental illness asylums and hospitals, or have publicly paid-for rehab or detox options, but it’s ok to imprison more people (large portions of which are imprisoned due to mental illness and drugs) both per capita and in absolute numbers than any other country in the world.

USA! We’re number 1! USA!

Sure, in an ideal world we’d have a public health system like literally every other developed nation on earth, and I’m sure that would alleviate some of the pressure on retirees and future retirees - and then with the changes I proposed increasing the SS funding, we’d basically be where the Nordic countries are.

So the real big levers to pull to ensure a better retirement for most americans: public health, lots of immigration over the next 3 decades, and increased SS contributions on both ends. But we all know what chance THAT platform has of happening in the US!

And it could be noted, Social Security was originally established because during the Depression old people WERE homeless and living on cat food (metaphorically) in large numbers (more than 50% of them), so it was decided some sort of forced retirement plan needed to be in place.

9

On immigration, you don’t actually need it if you just incentivise people to actually breed. We currently, savagely disincentivise successful people from reproducing and mildly encourage people who are in the poverty trap to reproduce. So the people who really ought to have five kids have none, the middle class is screwed as always, and the people who have no business bringing a fourth child into the world are busy with their fifth.

While you’re at it, why not fix the maternity/paternity leave problem, increase tax breaks/credits for children, and include child care in the healthcare package?

That’d certainly be more appealing to the types who abhor immigration above all else, and it would solve the demographic problem.

10

Allow me to respond to a few points by other posters:

Regarding Social Security, I haven’t advocated any changes to benefits, only a revenue-neutral tax shift to allow low-income people to build private savings by diverting a portion of FICA taxes to the URAs, which is made up by raising the cap on wages subject to taxation. Social Security should remain as a defined-benefit portion of the retirement system. That said, I realize some changes need to occur for it’s long-term sustainability. But, I’m hesitant to go too far down that road for fear of hijacking my own thread. Let me say this much: We need more defined-contribution private savings regardless of how we adjust Social Security.

Just as I don’t think private savings can replace Social Security, neither can expanded Social Security substitute for private savings. The reason is that private investments bring a much higher rate of return than Social Security, which is a pay-as-you-go system where current benefits are paid by current workers. This is especially important in the context of demographic changes. Increasing Social Security benefits requires a greater increase in tax rates in the context of an aging population. With stock and bond investments, you get a much greater return per dollar invested. Payroll-tax raises also disproportionatley affect poor and working-class families. My plan allows these same families to build assets, thus reducing wealth inequality.

Also, Voyager, I don’t want to mandate any specific investment. I think target-date index funds such as those offered by Vanguard or Fidelity are a great default option. In fact, my current 401(k) puts you in one unless you choose otherwise. Investors who want other options can put their URA funds wherever they want. It’s no different than IRAs today. I understand the concern about scam funds, but regulatory guardrails can be put into place.

11

Setting aside the issue that some (many) people are unable to set aside any money for retirement, there are still improvements that could be made to the retirement vehicles that we have now. First, the contribution limit on IRAs is too low to realistically provide an adequate amount of money in retirement. Sure, every bit helps, but $5500 per year isn’t enough. 401k plans have a contribution limit that is better, but scrapping and replacing IRAs and 401k plans with a URA is worse if the contribution limit on the URA isn’t at least $24,000 per year. Second, retirement plans are pretty good at actually saving and accumulating money, but pretty bad at turning that money into income in retirement. A lot of firms out there with high fees or insurance companies selling annuities, which are likely not in the best interest of the retiree. The URA would really need to address this.

12

Why not keep SS as it is and use an increase in FICA taxes to fund URA for the less privileged? After getting SS in better shape that is. Increasing the cap does not impact the lower income people and decreases income inequality. Where I live the cap is not far from median income - raising it won’t really hurt people very much.
Defaults are very powerful - making target date funds the default will drive lots of money to them. They have higher fees than index funds, say, so this makes me nervous. I’m also not that confident of regulation preventing trouble. We’d be lucky if the regulators manage to send someone to jail. Sweden, I think, has a kind of URA, which is limited to maybe two dozen funds. That can be regulated, but even there people tend to put their money into funds which have grown faster, which over time is not the best choice since they are buying high. (Source - Nudge by Thaler.)

13

Sure, I agree that IF these private defined-contribution plans could not be accessed or loaned against and IF employers magically ponied up for these plans too, such a thing could be a part of a better retirement solution. Let’s throw in Dag Otto’s higher contribution limits as well, because that’s a fair point.

But the thing is, this only really helps the ~15% of the population with household income of $100k or higher. Or if we got generous, say it helps the top 25%, going down to $80k HHI.

Everyone below that simply doesn’t have the extra money to put into these things on their own, because they’re being squeezed by housing and healthcare and tuition costs, and their wages haven’t been going up as fast as all these costs.

If you’re really interested in improving retirement prospects for EVERYONE, you’ve either got to address some of the macro problems making them unable to save (stagnant wages, housing costs, absurd healthcare costs, absurd tuition costs, discounting the future too much), or address the macro problem of “soon there will be too few workers per retiree,” and ideally both.

Because otherwise, you’re just changing things at the margin, and the great bulk of the lower and middle class is still headed for a cat-food retirement, while the top 15%-25% will have even nicer retirements because they had a 401k while they were independently contracting, and that 401k and their IRA’s had higher contribution limits so they were able to save enough to live quite comfortably after retirement.

14

Textual Innuendo, this plan cannot and isn’t intended to solve every problem affecting the working class. I agree that wage stagnation, health care, housing and tuition costs, etc. are all important problems and affect people’s ability to save for retirement. But, if you think retirement reform isn’t worth doing without fixing all those things first, then we’ve hit a fundamental disagreement and I’ll just have to agree to disagree.

That said, I believe URAs would substantially improve the situation for lower-income workers in comparison to the current situation. First, a portion of the money would come from money already being paid in FICA taxes. Additionally, current law provides a Savers’ Tax Credit for low-income people.

You raised several behavioral concerns. First, you were concerned that savers may discount the future too much. The mandatory and automatic nature of the URAs takes care of that. The second concern is that low-income people may be more likely to withdraw or borrow against their savings. I share this concern. One option would be to do like Australia and forbid early withdrawal except in cases of permanent disability or terminal illness and severely restrict loans. But, I want to avoid a situation where someone has $250k in a URA and is homeless.

One option is sidecar accounts. Already, some state automatic Roth IRA programs keep $1k or so in a money market, which can be withdrawn without penalty. I also think allowing some loans in cases of hardship can be done while minimizing the effect on retirement income.

A couple more points to close: I’m not too concerned about whether contributions come from employers or employees because the economic incidence of the employer portion of payroll taxes and benefits is nearly all borne by the employee in the form of lower wages. I recognize this would have some benefits for upper-middle income earners. However, I’m okay with that and it’s still capped at a contribution limit.