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
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.
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.
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.
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:
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: