March 2020 - Finance Memos

Modifying 401(k) Plans

According to the Bureau of Labor Statistics around 29 percent of people with access to a 401(k) plan choose to not contribute to their plan. In addition, The Employee Benefits Research Institute (EBRI) reports that in 2015 around $92 billion was removed from 401(k) plans prior to retirement. The combination of people refusing to contribute to their 401(k) plans and people taking premature contributions will result in many people with inadequate retirement income. The rules governing 401(k) plans need to be changed so that fewer people choose to forego making contributions and distributions prior to retirement are limited to a certain extent.

Current rules governing contributions to 401(k) plans provide significant financial advantages to workers who contribute. The contributions are not subject to federal or state income tax in the year they are made. Returns on investments are not taxed until retirement. Many firms match or partially match employee contributions. Many financial advisors believe that workers who fail to contribute, especially those at firms that provide an employee match, are irrational.

There are several rational reasons why some workers forego contributions to 401(k) plans. Recently reported statistics indicate that around 40 percent of households do not have enough savings to cover a $400 bill. A person without a basic emergency fund could be late on her mortgage or rent, unable to pay for a doctor or emergency room or fix a car. A decision to place funds in a 401(k) plan that leads to late payments on bills will lead to late fees, a bad credit rating, higher borrowing costs and other adverse financial outcomes.

A decision to make substantial 401(k) contributions might result in a person selecting a 20-year student loan over a 10-year student loan. Consider a married couple with $60,000 of combined student debt at a 5 percent interest rate. Lifetime student debt payments are $19,000 lower if student debt is repaid in 10 years rather than 20 years. Many student borrowers could only afford the shorter-term student loan by reducing 401(k) contributions.

A decision to make substantial 401(k) contributions might force a person to take out a 30-year mortgage over a 15-year mortgage. A person taking out a $400,000 30-year mortgage at 3.9 percent would have an outstanding balance of $257.000 after 15 years. The 15-year mortgage would have been totally repaid, and in addition the borrower would have obtained a lower interest rate. Again, many student borrowers can only afford the shorter-term mortgage by reducing 401(k) contributions.

In some states a person with assets in a 401(k) plan are not eligible for food stamps or Medicaid for nursing home expenses. Go here for a paper on how retirement savings impact eligibility for food stamps. Go here for a paper on how retirement savings impact eligibility for Medicaid nursing home expenses. The underlying assumption behind such laws is the worker who comes upon bad times must deplete her retirement account prior to receiving any financial assistance from the government.

Many people retire early often because of the loss of a job or for health reasons. People who retire early and have all of their funds in a 401(k) plan will be worse off than people who have saved both inside and outside their retirement plans both because early distributions from a 401(k) plan are subject to a 10 percent penalty and because distributions from conventional 401(k) plans are fully taxed.

Many older workers must choose between paying off their mortgage prior to retirement or increasing the amount of funds they place in their 401(k) plan. Financial planners tend to favor additional accumulation in 401(k) plans over more rapid paydown of mortgage debt. This choice often fails to work out well because people with a mortgage in retirement must, all else equal, make a larger distribution than people without mortgage obligations and the entire distribution from the conventional 401(k) plan is fully taxed. The higher 401(k) distributions due to the need to make mortgage payments is especially difficult for retirees when a market downturn occurs at the beginning of retirement.

A household that is 401(k) rich and cash poor faces substantial financial risks. Some households with 401(k) wealth but other financial needs raid their 401(k) plan and pay a 10 percent penalty in addition to tax on their early distribution leading to inadequate funds in retirement. These problems could be reduced by changing the rules governing distributions from a 401(k) plan.

Three rules should be modified. First, workers should be allowed to withdraw 30 percent of funds contributed to a 401(k) plan without financial penalty. Second, the worker should be prohibited from withdrawing any other funds from the 401(k) plan (the other 70 percent of contributions and all returns if any) until after age 59 ½. Third, loans from 401(k) plans would be prohibited.

This combination of rule changes incentivizes workers to make additional contributions to their 401(k) plan while assuring that they do not raid their account prior to retirement.

The provision for penalty-free withdrawal creates an emergency fund inside a 401(k) plan. The provision for penalty-free withdrawal will allow a worker with student debt or mortgage debt to pursue a more aggressive repayment strategy while simultaneously saving for retirement.

Under current law, workers are allowed to distribute their entire 401(k) account prior to retirement. This outcome could be forced upon a worker who loses his job in order to obtain Medicaid or food-stamp benefits. The new rule by prohibiting most distributions prior to retirement will leave all workers with most funds in their 401(k) funds at retirement.

A final advantage of the rule change is that it allows more workers to reduce their tax obligations in retirement. Under current tax rules, contributions to 401(k) plans result in tax savings in working years and higher tax obligations in retirement. Some taxpayers use Roth accounts to minimize future tax obligations. The new rules create a simpler way for workers to minimize their tax obligation in retirement. They can simply transfer 30 percent of their funds outside of their 401(k) account and purchase either stock, which is taxed at long term capital gains rates or an inflation linked Treasury bond, which is taxed at preferential rates.

The current 401(k) rules are not working for a lot of people, especially people with limited liquidity and large debts in relation to their income. The proposals presented here provides incentives for people who can’t contribute to start savings and also benefits current savers reduce their tax obligations in retirement.

David Bernstein is an economist living in Colorado. He is the author of a policy primer on student debt, health care, and retirement income titled “Defying Magnets: Centrist Policies in a Polarized World.”

Policy Question on Payroll Tax Holiday

This post will be updated sporadically with a policy question that troubles me. People who want to follow these thoughts need to either check this blog or my groups Policy & Politics and Finance Memos on Facebook.

The payroll tax holiday in the 2.0 trillion pandemic stimulus bill includes a requirement that businesses repay payroll tax relief in the future. A previous payroll tax holiday created in 2010 had the Treasury reimburse the Trust fund with general tax revenue.

Many defenders of Social Security thought the 2010 approach was bad policy because historically only payroll taxes and not general tax revenue was used to fund the trust fund. They though this approach might, by increasing deficits, reduce support for Social Security.

My view is that no one cares about the deficit anymore. Trump increased the deficit during a prosperous economy and the new stimulus bill is 50 percent of the budget without meaningful offsets.

My concern is that small companies will be unable to simultaneously pay back payroll taxes and new tax on ongoing payrolls. The double payments after the payroll tax ends will bankrupt some companies and slow the economy.

Should the Treasury reimburse the Trust funds for revenue lost from the payroll tax or should the government require companies make extra payments in the future to make up for this lost revenue?

My vote is that the Treasury should use general tax revenue to shore up the Social Security system both now in this emergency and in an ongoing basis. Hard for Republican budget hawks to argue for cuts to Social Security when every single one of them voted for Trump’s corporate tax cuts in relatively prosperous times.

Put your vote in the comment section of Policy & Politics.

The Politics of Student Debt

There are two distinct lanes in the Democratic party. The progressive lane gravitates towards big ideas, which if implemented would transform society and the economy. The centrist land proposes modest changes to existing programs, which often would not substantially change the status quo. Most of the focus of the political discussion centers on the big proposals offered by participants in the progressive lane often leading to their rejection. Proposals offered in the centrist lane receive much less scrutiny. Problems and limitations of centrist proposals are often ignored.

The debate among candidates on student debt closely follows this pattern. The progressive lane advocates for free college and for immediate and substantial debt forgiveness for all or almost all people currently with student debt. The centrist lane advocates additional assistance for community college, and expansion of existing programs including Pell grants, Income Driven Loans, and Public Service Loans. The discussion centers on the economic and political feasibility of proposals offered by the progressive lane and does not consider the adequacy or potential problems with solutions offered by centrists.

An objective analysis of the progressive agenda suggests that its enactment requires a complete transformation of the U.S. economic, political, education, and tax systems. The consensus from this discussion is that a solution that works in a high-tax high-regulation European economy cannot be easily or quickly transferred to the United States. Moreover, many people argue that large subsidies for student borrowers are unfair to workers and taxpayers who do not attend school and are unfair to previous cohorts of student borrowers who paid off their student debt.

Centrist plans for making college more affordable and alleviating student debt burdens get far less scrutiny than progressive plans. In recent decades, there has been a substantial increase in the number of student borrowers, average student debt and the number of people entering retirement years with outstanding student loans. Centrist proposals, while more generous than policies espoused by the Trump Administration, are unlikely to reverse these trends.

A major education policy goal for many politicians in the centrist lane is on assuring an adequate supply of workers in hard to fill positions. Klobuchar in her New York Times interview on education spoke about the lack of shortage for MBAs or CEOs and the need to fill positions for home health care workers. The financial incentives in her proposals and the proposals offered by other centrists would steer many students away from academic four-year colleges towards two-year schools emphasizing practical career choices. The argument that people with substantial talent need to gravitate towards practical career choices early in their life because of economic reality is not highly inspirational or consistent with the view that education can lead to upward mobility.

The emphasis on education for practical positions leads centrists to support substantial increases in funds for community colleges. A policy that decreases the relative price of community college to four-year college could lead to fewer students from low-income households at four-year colleges. This approach could create a two-track academic structure where students from low-income households are slotted towards community college and students from households with more financial resources are slotted towards more prestigious four-year institutions. The student from the low-income and mid-income household may have enough talent to become a CEO or an MBA or a doctor. It is not clear whether the increased emphasis on community colleges will keep these doors open.

The centrist plan also includes increases in the budget for Pell grants. Pell grants target relatively low-income households and would have a relatively small impact on student debt for the typical student borrower. It would be extremely difficult and expensive to expand the Pell grant program to reduce debt burdens on students from middle-income households. Funds for Pell grants are part of the annual budget and subject to the whims of Congress.

Two additional ways to assist students from low-income households deserve consideration.

The first method involves free tuition or substantially reduced costs for the first year of four-year colleges. A free first year of college would decrease student debt for all student borrowers. Benefits would be especially large for students who fail to ever complete their degrees or students who take a long period of time to graduate, two populations that often experience repayment problems.

A free first year of college would allow for private grant funds to be allocated across a smaller population. (First year students would theoretically not need private grants if the first year was free.) An increase in grant funds per student after the first year of college would further reduce student debt burdens.

The second method involves the creation of additional two-year degrees at major four-year institutions. This approach allows more students access to major universities. The availability of more two-year degrees at four-year colleges could reduce the number of people who leave school without a degree. There may also be some students ready for graduate school after two years of undergraduate work.

The debate over debt relief options also centers on extremely ambitious proposals offered by candidates in the progressive lane. Less attention is focused on options favored by candidates in the centrist lane including the expansion of income driven loan programs and the Public Service Loan Forgiveness program.

A proposal offered by Senator Warren would discharge $50,000 of student debt for people with income less than $100,000 and a reduced amount of debt relief for borrowers with income above that threshold. Senator Sanders has offered universal discharge of student debt for student borrowers.

These broad debt relief programs are not economically efficient because they divert scarce resources away from more pressing problems. Many of the student borrowers who would receive assistance under these proposals are able to repay their loans without government assistance. The proposals are also unfair to workers who don’t benefit from higher education and to previous students who repaid their loans.

The candidates in the centrist lane favor expanding Income Driven Loan programs and the Public Service Loan Forgiveness programs. There are major problems with loan programs that link student loan payments to income and programs that offer debt relief for public service. However, problems with these programs and potential improvements are barely addressed because all of the attention is focused on the more ambitious progressive proposals.

Income Driven Loan programs link loan payments to annual income and allow for the possibility of loan discharges after a number of years. There are many problems with this approach. Student borrowers must choose to enter an Income Driven Loan program or remain in a conventional loans program when leaving school. Whether a student borrower is better off under an Income Driven Loan program or a conventional loan program depends on income and marital status over the lifetime of the loan and is often impossible to predict when students make their loan selection.

Moreover, student borrowers must reenroll annually in income driven loan programs. Errors by loan services could result in the denial of loan discharge applications for some student borrowers. The loan discharge is contingent on student borrowers making 240 on-time loan payments. Income driven loan programs may fail to provide debt relief to student borrowers who fail to make payments because of financial hardship. This is the group most in need of assistance.

The Public Service Loan Forgiveness program does not have a great track record. The program makes loan discharges contingent on an applicant staying in a public service position for 10 years. Some applicants lose debt relief when they switch careers. Over 99 percent of people in the first cohort of applicants to apply for a loan discharge under the Public Service Loan Forgiveness program had their discharge applications denied, even though the applicant had made loan payments for 10 years. There are several reasons for the large rejection rate on loan discharge applications. Some applicants were informed that they were employed at firms in positions, which were not eligible for the public service loan program. Some applicants were informed after 10 years or payments they had chosen a payment plan that was not consistent with the public service loan forgiveness program. Problems involved with administering the public service loan program are documented in this report written by the Consumer Finance Protection Board.

There are superior alternatives to Income Driven Loan programs and Public Service Loan Forgiveness programs that are not even currently being considered.

A provision in a loan contract eliminating interest charges near the end of the loan term would be simpler to administer and fairer to both borrowers and the taxpayer than a program offering loan discharges after 20 year of payments. A loan discharge provision creates an incentive for some students to increase the amount they borrow and discourage quick repayment of student debt. Students with a loan that allows interest rate reductions near the end of the loan term will always repay more if they borrow more and are not discouraged from entering a short- term payment plan.

The elimination of interest near the end of the loan term also offers some debt relief to student borrowers who miss payments and are ineligible for a loan discharge.

The Trump Administration and Congress propose to eliminate the Public Service Loan Forgiveness program because of its cost to taxpayers. In order to obtain debt relief from a public service loan program, applicants must stay in a public service career for 10 years. Some applicants may choose to eschew more productive positions to obtain a debt discharge.

A narrower Public Service Loan Forgiveness program that provided less debt relief for a short period of time when student borrower begin repayment could increase loan repayments when people are starting their careers and salaries are relatively low. This program would be easier to administer and less expensive than the current Public Service Loan Forgiveness program. More importantly, the revised shorter-term benefit would not create job lock.

The discussion and the energy in the Democratic party revolves around support for or opposition to big ideas. The potential and problems associated with modest proposals are not fully evaluated. Not surprisingly, this debate is not leading to the formation of practical policies that would actually reduce student debt burdens. We need a third lane offering pragmatic progressive policies, which could lead to real change.

Observations on the 2020 Economic Crisis — March 18, 2019

I have several comments about the severity of the current situation and prospects for bailouts.

Many financial analysts believe the stock market is oversold and will rebound quite quickly once the pandemic ends. However, many companies with debt are likely headed towards bankruptcy. The economic fallout could result in an economic downturn that leads to a long recession and a sustained downturn in stock prices.

Many politicians in the “center” are going to want to bailout Boeing, airlines, hotels and other industries. A distinction has to be made between bailing out companies and bailing out shareholders. Hard for me to justify unconditional bailouts of companies that issued a lot of debt and used cash to buy back stock to reward shareholders and CEOs with large bonuses. Taxpayers should receive an equity stake in businesses receiving financial assistance as they did for bailing out companies like GM and AIG in 2009. There should be restrictions on management salaries and dividends at companies accepting federal funds. Some bailouts will occur through a chapter 11 bankruptcy process and reorganization that impacts creditors and shareholders. I suspect Congress will eventually bail out some firms but there must be conditions and the process towards a bailout may not be a smooth one.

One way to structure a bailout so that the American people obtain some financial benefit is to give each household shares of companies receiving financial assistance. Another way for American taxpayers to benefit from a bailout is to give the Social Security Administration ownership of share in companies purchased with general Treasury funds.

The tax code needs to be modified to reduce incentives for companies to issue debt and purchase company shares.

Bank stocks are cratering even though bank analysts argue that banks are in good financial shape. The banking sector is likely to realize large losses from loans to oil sector on top of losses related to the pandemic.

The 10-year U.S. government bond interest rate is rising rapidly going from 0.65 on Monday 3/16 to 1.26 on Wednesday 3/18. Rate was even lower last week. The Fed does not have much control over long rates and may be out of ammo. Typically, investors count on increased bond prices to coincide with and offset downturns in stock prices. This result is unlikely this time because interest rates are starting at such a low level and people are selling all assets, including bonds, to get cash.