Fixing the U.S. Retirement System

Fixing the U.S. Retirement System

A 2014 Harris Poll found that around 3 of 4 Americans are worried about having enough funds for retirement

https://www.accountingtoday.com/news/74-of-americans-worried-about-retirement-income

This memo asks how policymakers might improve retirement outcomes for future generations of Americans.

Problem One:  How can policy makers create incentives to simultaneously expand 401(k) participation while limiting distributions prior to retirement age?

Solution to problem one:   Make two changes to rules governing disbursement of 401(k) funds.

  • Allow 25 percent of contributed funds to be distributed without tax and without penalty at any age.
  • Prohibit any disbursements from the other 75 percent of funds prior to age 59 ½.

Discussion:

At first glance, there is a potential tradeoff between rules encouraging increased 401(k) participation and contribution and rules assuring that funds are not disbursed prior to retirement.  Policy makers could prohibit all disbursements from 401(k) plans prior to retirement and prohibit 401(k) loans.   This would cause some people fearing an emergency from stopping all contributions.   A reduction or elimination of the penalty could cause more people to contribute and increase disbursements.

Some people with high debt and limited liquidity choose to make 401(k) contributions but find that their debt spirals.  When debt becomes unsustainable or when an emergency occurs these people often take out a 401(k) loan or disburse all funds and pay the tax and penalty.  Plans require workers to repay their 401(k) loan upon leaving employment.    Loans that are not repaid during workforce transitions are treated as disbursement subject to income tax and penalty.

The rate of return on 401(k) investments obtained from the immediate tax deduction and the employer match is substantial.   Many people with high debt levels and limited liquidity choose to forego these generous returns.  The current rules by subjecting all disbursements prior to age 59 ½ to income tax and a tax penalty discourage many younger workers with student debt from contributing to their 401(k) plans.

In many states, people with 401(k) plans are not eligible for food stamps or Medicaid.

https://www.brookings.edu/wp-content/uploads/2016/07/03_increasing_saving.pdf

https://www.agingcare.com/articles/how-401k-accounts-and-iras-affect-medicaid-eligibility-208382.htm

These rules discourage low-income workers with variable income from making 401(k) contributions.

The current financial penalty discourages some people from enrolling in 401(k) plans or increasing contributions.   The current rules also result in many 401(k) enrollees disbursing funds prior to retirement and paying a penalty on top of tax due.   Some of these people would have been better off by never contributing to their 401(k) plan.

The proposed rule will do a better job encouraging 401(k) contributions and limiting pre-retirement distributions than current law.

Problem Two:  What can policymakers do to increase retirement savings options for workers at smaller firms, which do not offer 401(k) plans?

Solution to problem two:  The lack of pension coverage for workers at small firms and for workers who change positions frequently could be resolved by expanding the role of IRAs.  The rules governing IRAs could be altered to allow employers to match IRA contributions, and to increase contribution limits for employees.

Discussion of problem two:   Small firms often forego 401(k) plans because of high administrative cost and their cash levels are low.   Employees at small firms can save for their retirement by opening and contributing to an Individual Retirement Account (IRA).   However, the allowable contribution to IRAs is far smaller than the allowable contribution to 401(k) plans.

  • The current annual total contribution limit to 401(k) plans is $55,000 with a limit of $18,000 on the employee contribution.
  • The limit for contributions to IRAs for people under $50 is $5,500 per year. This IRA contribution limit is $6,500 for people over 50.  No contributions are allowed from employers.

The most straight forward ways to expand retirement savings for workers at firms that lack 401(k) plans is to increase the amount which can be contribute to IRAs and to allow and encourage contributions from employers.

There are proposals in Congress to create multi-employer 401(k) plans.  It is not clear why new multi-employer 401(k) plans would be preferable to an expanded role for IRAs.  In fact, workers could be worse off if the multi-employer 401(k) plan offered limited investment options and high fees.  Investment firms like Vanguard and Fidelity are well positioned to offer expanded IRAs with low-cost fees.

Current 401(k) rules allow for workers to be automatically enrolled in a 401(k) plan unless they opt of automatic enrollment.   Automatic enrollment with an opt-out provision could also be applied to IRAs.

Problem Three: What can policymakers do to help investors protect their savings from a simultaneous increase in interest rate and decline in equity values?

Solution to Problem Three:   This problem could be minimized by decreased use of bond funds and increased use of zero-coupon bonds or I Bonds inside 401(k) plans and IRAs.  Government regulations should guarantee that government zero coupon bonds are a standard option inside 401(k) plans.

Discussion: Investors are currently moving investments in target-date funds, which automatically increase the share of investments placed in fixed-income assets as the person ages.  Many market observers believe that over the next decade equities will underperform and that interest rates will rise.  Target-date funds expose investors to substantial financial risks if interest rates rise when they retire.

The value of zero-coupon bonds also decreases when interest rates rise.  However, investors in zero-coupon bonds will receive the full face value of the bond when the bond matures.  By contrast, the value of shares in a bond fund or a target-date fund depend on the interest rate on the date of sale.

Another way to reduce interest rate risk inside 401(k) plans would be to include I Bonds as an investment in 401(k) plans or to encourage employers to match employee purchases of I Bonds outside 401(k) plans.

An excellent discussion of I Bonds can be found at link below.

https://www.linkedin.com/pulse/investment-thats-safer-bet-than-social-security-kent-smetters/

Problem Four: What can policymakers do to help investors reduce fees on 401(k) plans?

Solution to problem four: Investment companies report average fee ratios but do not report lifetime fees for a typical investor.  It is very difficult to take the average cost ratio of a fund or portfolio and understand the amount this implies in fees paid over a lifetime.  Investment companies should be required to report the lifetime fees paid by an investor who contributes $5,000 per year into a fund for 30 years based on annual returns for a given cost ratio.

Discussion:   Many funds charge fees substantially higher than index funds.   Often these plans do not realize larger returns.   A more aggressive solution to this problem outlined here involves enforcement of fiduciary rules to challenge funds with excessive fees.

Yale Law Journal article on fund fees:

https://www.yalelawjournal.org/article/excessive-fees-and-dominated-funds-in-401k-plans

 Problem Five: What can policymakers do to provide more stable income during retirement?

Solution to Problem Five:   Allow people who have invested in private 401(k) plans to transfer funds to state defined contribution plans or the FERS plan for federal employees and purchase the same annuity offered public employees.  Allow people to irrevocably commit a portion of their retirement to an annuity purchase at an early age.

Discussion:  The Trump Administration is focused on expanding the use of private annuities inside 401(k) plans.    There are two problems with this approach.  First, private annuities are expensive.  Second, the stability of the annuity depends on the financial status of the insurance firm behind the annuity, which can change over time.  Annuities associated with FERS or state defined contribution plans are likely to have less default risk.

The market for annuities is impacted by adverse selection because individuals who choose to purchase an annuity tend to live longer than individuals who choose to disburse from their 401(k) plan when they need cash.    The annuity provided by Social Security and large defined benefit pension plans are less expensive than voluntary annuities because all people, regardless of future life expectancy, purchase it.  A rule requiring that all people use some of their 401(k) funds to purchase an annuity would lower average annuity price and reduce the share of people with inadequate retirement funds.

Problem Six: What can policy makers do to reduce tax burdens in retirement for workers who have most of their funds in a 401(k) plan?

Solution to Problem Six:  Funds disbursed from a 401(k) and IRA to pay off or reduce a mortgage should be untaxed or taxed at a reduced rate.  Alternatively, employer subsidies for the purchase of Treasury I bonds should be untaxed compensation for workers, similar to the tax treatment on employer contributions to 401(k) plans.

Discussion:   Most financial advisors currently advise clients nearing retirement to prioritize 401(k) contributions over mortgage balance reductions.   This approach is supported by the current tax code, which provides a generous tax savings for 401(k) contributions during the working years. This approach leads to increased tax obligations because the larger 401(k) disbursements are fully taxed during retirement.   People with large mortgage balances in retirement can quickly deplete their 401(k) plan.

One way to reduce tax burdens on people with mortgages who must make large 401(k) disbursements is to reduce taxes for funds spent reducing the mortgage balance.  Another approach would be to persuade people to reallocate investments from 401(k) plans to accounts subject to a lower tax rate in retirement.

Authors Note:  I hope this discussion is of interest to some of the people who will run for political office in 2020.   I would like to contribute to a campaign by creating policy proposals.

Also, readers of this blog are likely to be interested in my book on student debt, which is available on both Kindle and Amazon.

Go here and buy my book:

https://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446

 

 

 

 

 

 

 

 

 

Reconsidering Use of 401(k) Funds for Emergencies

Question:

Current tax rules governing 401(k) plans allow workers to distribute funds for hardship expenses prior to age 59 ½. The distributed funds are fully taxed at the ordinary income tax rate and subject to a 10 percent penalty.

Should rules governing 401(k) plans be changed to allow for the allocation of limited 401(k) funds to an emergency fund and new restrictions on the bulk of 401(k) contributions prior to age 59 ½?

In many states, people with assets in 401(k) plans and IRAs are not eligible for government benefits including food stamps.

Should these rules be altered so that funds not available for immediate disbursement do not impact eligibility for government benefits?

Specifics of the proposed rule changes are as follows:

  • Workers may allocate 20 percent of their 401(k) contribution or IRA contribution to an emergency fund.
  • Funds placed in the emergency fund could be distributed for emergency expenses without being subjected to income tax or a tax penalty.
  • Disbursements from all 401(k) or IRA contributions not in the emergency fund prior to the age of 59 ½ would be prohibited.
  • Future 401(k) loans would be eliminated.
  • Funds in 401(k) plans and IRAS that were not available for immediate disbursement would not be counted toward Medicaid or food stamp eligibility.

Background:  Many workers, especially those entering the workforce, must choose between establishing an emergency fund or saving for retirement through a 401(k) plan.   The financial advantages associated with 401(k) plans, both in the form of an employer match and tax savings can be substantial.   However, many workers have insufficient funds to pay rent, health bills and outstanding loans.  Some workers with limited liquidity choose to create a retirement fund and delay saving for retirement.

The IRS allows workers to withdraw money from their 401(k) plan prior to retirement but the practice is discouraged through the imposition of a 10 percent penalty.

Around 87 percent of 401(k) plans allow workers to borrow funds form their 401(k) plan.  Around 18 percent of workers in plans allowing 401(k) loans had loans outstanding.   The average outstanding loan balance for 401(k) loans at the end of 2015 was a bit lower than $8,000.

Go to the ICI web site for some information on 401(k) plans.

https://www.ici.org/policy/retirement/plan/401k/faqs_401k

Workers with 401(k) plans who leave their current position must either repay their loan or be subject to additional tax and a financial penalty.

In many states, people with 401(k) plans are not eligible for food stamps or Medicaid.

https://www.brookings.edu/wp-content/uploads/2016/07/03_increasing_saving.pdf

 

https://www.agingcare.com/articles/how-401k-accounts-and-iras-affect-medicaid-eligibility-208382.htm

These rules discourage low-income workers with variable income from making 401(k) contributions.

Discussion

Contributions to 401(k) plans, unlike contributions to traditional pensions or Social Security, are voluntary.  Some people with limited liquid assets and high debt levels are reluctant to tie up funds in a retirement account.   The early disbursement option (albeit with taxes and penalty) and the loan option can encourage some people to contribute to their 401(k) plan.

Individuals who disburse funds from 401(k) plans prior to age 59 ½ may have insufficient resources in retirement.  Moreover, individuals who take disbursements prior to age 59 ½ and pay taxes and a penalty may become worse off than individuals who never contributed to their 401(k) plan.

 The emergency fund feature of the new 401(k) would provide substantial incentives for people with limited liquidity and large debts to make 401(k) contributions.   However, the prohibition against early disbursements from the bulk of 401(k) contributions could reduce the number of people with insufficient funds in retirement.

 Under the new rules, 401(k) or IRA funds not available for immediate disbursement would not affect eligibility for any government benefits.   This change would encourage low-income people to make additional contributions to 401(K) plans and IRAs.

 

 

 

 

 

The Politics of Student Debt

In a recent episode of Madam Secretary, the daughter of the Secretary quits her volunteer position on a Congressional campaign because her candidate did not have a bullet point on forgiving student debt.   The candidate explains to her that debt forgiveness is too controversial because it takes money from workers and taxpayers and give money to students.  The Secretary lectures the daughter and persuades her to vote despite her problems with this candidate on this one issue.

This episode relives one of the flash points of the 2016 Clinton/Sanders contest.   Bernie Sanders supported an expensive and unrealistic free college program. This idea was first scorned and then matched by Clinton.  Clinton continued to struggle with the issue by coming up with ideas like let’s forgive debt for employees at start-up firms an idea that was laughed at by virtually everyone who has studied the student debt problem.

Student debt is a growing problem much larger for the current cohort than for previous generations.

  • The percent of graduate with student debt went from 50 in 1989/1990 to near 70 today.
  • The percent of borrowers leaving school with more than $50,000 in debt went from 2 percent to 17 percent over same period.
  • The number of Americans over age 65 with student debt increased by a factor of 4 between 2005 and 2015.

High student debt levels have long term financial consequences.  People with high student debt levels often either delay savings for retirement or delay loan repayments.   Often student debtors also delay marriage, forego having children and choose to rent rather than purchase a home.

Trump Administration proposals will worsen student debt problems.  The Trump Administration is proposing to eliminate subsidized student loans, a change that will increase debt costs and cause many to forego college.  The Trump Administration has rejected loan forgiveness applications under the public service loan programs and their actions will weaken the Income Based Replacement loan program.   The Trump team does not support of enforce rules protecting students from fraud.

Student debt like health care should be a big wining issue for Democrats.  Unfortunately, Democrats are divided between keeping the status quo and giving free college to everyone.

Doing nothing should not be an option.  Part of the solution involves increased financial assistance to students, especially for first-year students.

Many students leave college after their first year because of academic performance.  Problems associated with first year students who fail to continue their education could be substantially reduced in a cost-effective way by expanding assistance to first-year students.

Part of the solution involves policies and programs which improve on-time and early graduation rates.

Many students either fail to graduate or take more than the allotted time to complete their program.  These students tend to take on more debt and are more likely to incur payment problems.

Realistically, improvements in and expansion of debt forgiveness programs must be part of the solution because many borrowers become hopelessly overextended.  Some Democrats are currently focused on expanding the Income Based Replacement loan program.   Loan servicers regularly ignore the IBR options and debt forgiveness programs centered on the IBR program are likely to fail.

There are other more cost-effective ways to assist overextended borrowers.

Granting priority to student debt over consumer loans in Chapter 13 bankruptcy:     Currently, many applicants for Chapter 13 bankruptcy reduce student loan payments to repay credit cards and other consumer loans.  Often the student borrower leaves bankruptcy with an increased student debt balance.  The quicker repayment of student loans in bankruptcy benefits both taxpayers and student debtors.

The elimination of the link between market interest rates and interest rates on federally guaranteed student loans.   Under current rules student debt interest rates are tied to market interest rates.   This policy automatically increases costs for an entire cohort should Treasury rates rise.  This is a timely problem given recent Fed statements and moves.

Modification of the standard contract on student loans to allow for interest-only payments rather than forbearances and to allow for reduction or even elimination of interest rates after 15 years of payments:   The IBR program allows some people to borrow more without increasing the amount they repay.  By contrast, under the proposed interest elimination plan, people who borrow more repay more.  This program has better incentives and is less expensive to the taxpayer than the IBR program.

Restricting parental guarantee obligations on PLUS loans and cosigned private student loans to 5 years from repayment date:   Many of the most severe financial problems associated with student debt involve PLUS loans guaranteed by parents.   This change would reduce these problems.

 Removal of the prohibition against the discharge of high-interest private student loans in bankruptcy: This proposal returns us to rules that existed prior to the enactment of the 2004 bankruptcy law.   The discharge of private student debt in bankruptcy could accelerate payment on government guaranteed debt and assist taxpayers.

Creation of a modified public service loan program, which will allow for partial loan forgiveness after 2 to 5 years rather than 10 years of public service:   The current program creates job lock by forcing applicants to wait at least 10 years for loan forgiveness.  The shorter period for partial loan relief for the new program reduces job lock.  This program will be less expensive and have lower administrative costs than the current program.

Issues like student debt and health insurance are core issues to Democratic voters, which should drive voters to the polls.  However, there are huge differences in the way the Sanders wing and the Clinton wing approach the problem.   The Sanders proposals would cause either a fiscal crisis or unsustainable tax increases combined with stagnation.   The Clinton wing is proposing a band aid for the sake of appearances.

I understand why the screen writers of the show on Madam Secretary are frustrated at the Sander’s supporters who chose to stay home in 2016 rather than vote for an imperfect candidate who is a thousand times better than Trump.   However, Democratic candidates must have a comprehensive vision and set of policies on student debt.   College costs and debt are an existential problem for current students and recent grads.   The cost of college will deter many from getting necessary education.   The debt incurred will have long term often crippling impacts on household finances and even happiness.

There are common sense centrist solutions to this problem that increase access to education, reduce costs for overextended students and are fair to workers and taxpayers.

The failure of the Democrats to address student debt issues is sort of like a football team deciding to punt on first down.  This is not an effective way to either win the game or excite your fan base.

 

Authors Note:

David Bernstein is the author of Innovative Solutions to the College Debt Problem.   Get his book on Amazon or on Kindle.

 

https://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446

David has also written on health care and the ACA.

 

Go here for a Centrist Health Plan:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3263159

 

 

I would love to work for a centrist Democrat in 2020.  Contact me at Bernstein.book1958@gmail.com or on my cell 202 413 5492.