Introduction:
Many American workers are not preparing well enough for retirement.
Around half of older workers do not have any funds in a defined contribution plan (401(k) or IRA.)
The median amount of retirement assets for people with retirement plans is around $109,000.
Around 13.7 percent of the 65-and-over population lives in poverty.
More older workers are entering retirement with mortgage debt or consumer debt.
Many older workers cannot remain in the workforce because of poor health.
Economic downturns tend to result in a larger increase in unemployment for older workers than for younger or middle-aged workers.
Around 40 percent of older Americans are entirely dependent on Social Security.
Current law links future Social Security payments to the balance in the trust fund. Projected decreases in the trust fund would lead to a 20 percent in Social Security benefits in 2035, barring changes to the trust fund or current law.
Nearly 60 percent of young workers between the ages of 18 and 34 have already taken funds out of their retirement accounts to maintain current spending. Early disbursements from retirement plans by young adults are especially high for people with high levels of student debt.
The traditional 60/40 portfolio held by many retirees loses substantial value in a period where the stock market falls, and interest rates rise.
Congress and the Administration have not prioritized retirement income issues and are not close to addressing the looming Social Security problem.
Documenting the lack of progress:
Our leaders are not moving us forward on efforts to increase private savings for retirement or on efforts to fix the looming Social Security problem.
Congress has passed some legislation, most recently, the Secure Act 2.0, impacting savings through 401(k) plans and IRAs. Unfortunately, the recently enacted law does more to benefit investment firms and high net-worth savers than the workers who are struggling the most to save for retirement. A more complete description of the Secure Act 2.0 can be found here and some of its shortcomings are listed below.
- Delays in implementation of Required Minimum Distribution do not assist retirees with low levels of retirement assets, people who tend to deplete their retirement accounts early in their retirement. Provision increases fees received by investment firms.
- Shorter waiting period for participation in 401(k) plans does not shorten vesting requirement and may benefit relatively few workers because many part-time workers do not stay at the same firm for a long time.
- A provision clarifying that employers can contribute matching funds to 401(k) plans for student loan payments does not assist workers at firms without a 401(k) plan or firms with a 401(k) plan that do not match employee contributions.
- The automatic 401(k) enrollment provision and automatic increases in contribution will reduce savings through other vehicles and will lead to relatively little additional savings if funds are distributed prior to retirement.
Around 40 percent of retired households are totally dependent on Social Security and many more are highly dependent on Social Security. Expansion of private retirement spending is important by itself and has major implications for Social Security reform efforts.
The implementation of some Social Security reform proposals that would lead to abrupt changes in benefits could not be applied to workers nearing retirement without causing large increases in poverty among the elderly.
The Social Security trustees project that automatic benefit cuts to Social Security could occur in 2035 and that automatic Medicare benefit cuts could occur as early as 2028.
Democrats and Republicans are wide apart on what needs to be done to prevent automatic cuts to entitlement programs. Democrats stress the need for additional revenue. Republican proposals often call for large benefit cuts, many of which are applied to workers nearing retirement.
One proposal that could receive some bipartisan support inside a larger package involves increasing the cap on wages subject to Social Security taxes. Current rules apply Social Security taxes to the first $160,200 of wages. Go here for a discussion of proposals to eliminate or modify the cap on Social Security taxes.
Republicans tend to favor plans to reduce benefits, raise the retirement age, and create private accounts to replace all or part of the current Social Security system. Some of the Republican proposals discussed herewould result in quick changes impacting potentially impacting workers close to retirement. For example, a proposal to increase the retirement age for full Social Security benefits by 3 months per year until 2040, when the full retirement age reached 70 would result in substantial poverty among the elderly because private retirement savings could not be increased in this time frame.
Timely changes to Social Security are essential to prevent automatic benefit cuts that would lead to large increases in poverty because of the lack of private retirement savings.
Reforming private retirement savings:
Reforms of private retirement savings that expand savings for low-income and middle-income households are a prerequisite for meaningful Social Security reforms because so many households are dependent on Social Security.
There are six problems preventing workers from accumulating sufficient retirement savings prior to retirement. Steps must be taken to address each problem.
First, workers are free to disburse all entire savings from their 401(k) plans prior to retirement. Around 60 percent of young workers have tapped part of their retirement savings prior to age 34. Steps must be taken to restrict pre-retirement disbursements from retirement plans and to incentivize workers from reducing retirement savings prior to retirement.
Proposed policy changes to address pre-retirement leakages from retirement accounts include:
- Prohibit pre-retirement distributions from retirement plans for 25 percent of all contributions. The prohibited distributions could be used to purchase an annuity that would not pay out until the retiree reaches a certain age.
- Require automatic rollover into IRAs for all workers making a job transition with 401(k) balances less than $50,000. (Current law allows but does not require automatic rollovers.)
- Prohibit loans from 401(k) plans. Replace loans with limited tax-free and penalty-free distributions from the newly created emergency funds inside a 401(k) plan.
Second, workers reliant on Individual Retirement Accounts (IRAs) have less generous saving incentives than workers with access to employer-based 401(K) plans. Workers dependent on an IRA without access to a 401(k) have a lower contributions limit, do not have access to an employer match, and do not have access to retirement incentives for student loan payments.
Proposed changes to rules that reduce or eliminate discrepancies between savings through IRAs and savings through 401(k) plans include:
- Create automatic contributions to IRAs for people without access to employer-sponsored 401(k) plans, patterned after the rules that are currently applied to automatic enrollment into 401(k) plans.
- Change tax law to allow for employers to make matching contributions to worker contributions to IRAs like the ones currently allowed for 401(k) plans.
- Equalize IRA and 401(k) contributions limit and deductibility limits on IRA and 401(k) contributions.
- Change tax law to allow tax-free contributions to IRAs by firms hiring contractors or gig workers instead of direct employees.
Third, the current tax preference for contributions to 401(k) plans and deductible IRAs favors higher income people with higher marginal tax rates. Tax savings from expenditures from Roth IRAs in retirement also disproportionately benefit higher-income taxpayers. Income related gap in subsidies could be altered by changes to the tax code.
- Replace existing tax exemption for contributions to traditional 401(k) plans and the tax deduction for contributions to deductible IRAs with a tax credit.
- Create a tax credit for first $2,000 contributed to a retirement plan and allow tax deduction for additional contributions up to a cap.
Fourth, many workers are now diverting retirement savings to health savings accounts and flexible savings accounts to pay for health expenses that are no longer covered by health insurance. This is a growing problem due to the growing use of high-deductible health plans.
Proposed policy changes to offset the loss of retirement income due to the growth of cost-sharing between insurance companies and insured households include:
- Allow for the use of health savings accounts for people with lower deductible health plans to reduce the need for large contributions to health savings accounts.
- Change rules governing flexible savings account to allow people to place unused flexible savings account funds in a 401(k) plan or IRA rather than lose the unused funds. It would be appropriate to tax funds transferred from a flexible savings account to a retirement account.
Fifth, fewer than 15 percent of retirees have an annuity inside their retirement plan. The primary reason for the low level of annuity income is the cost of annuities.
- Mandate that 25 percent of funds contributed to a retirement plan be used to purchase an annuity.
The source of funds for the mandatory annuity purchase could be the funds the person is not allowed to disburse prior to reaching retirement age.
The rule requiring all workers make an annuity purchase would lower annuity prices because voluntary annuity purchases are favored by healthy people with long life expectancy.
Sixth, retirees often suffer when inflation erodes the value of bond and stocks. Many workers cannot afford to save much outside their retirement plan and current tax law does not allow individuals to purchase series I bonds inside a 401(k) plan or an IRA. Many assets inside a 401(k) plan that proport to be inflation hedges lose value in an inflationary or high interest rate environment.
- The most effective way to prevent reduction in retirement plan wealth in a period when inflation and interest rates rise, and stock prices fall is to allow and encourage the purchase of Series I savings bonds inside a 401(k) plan or IRA. Series I savings bonds never fall in value and have substantial upside in an inflationary environment. Go here for a discussion of advantages of Series I Savings Bonds.
The primary effect of the current restrictions on Series I Savings bonds is to increase the demand for financial assets and ETFs that are less effective in protecting investors from inflation than Series I Bonds.
Reforming Social Security:
The expansion and improvement of private retirement savings options will reduce dependence on Social Security by future generations and allow for the consideration of a broader range of Social Security reform options including eventual reductions in benefits.
The Social Security reform measures considered here include:
- A new tax earmarked for Social Security and Medicare. The tax would be imposed on all forms of income and would have a progressive tax structure.
- Increase in both the minimum retirement age for Social Security benefits and the age for full benefits, by one year each phased in over a 24-year period with a one month increase in the retirement age every two years. The age at which people receive the maximum allowable Social Security benefit would remain unchanged.
- Guarantee future Social Security benefits by allocating some general tax revenue towards future benefits if the Trust fund balance falls to a certain level.
Economic Notes on the Policy Package:
- The combination of tax credits to stimulate private retirement savings, tax increases to fund current Social Security and Medicare benefits and long-term increases in the retirement age create a healthy macroeconomic environment and will lower household financial distress in retirement.
- Short-term changes in tax revenue will be modest because losses in tax revenue from tax credits to stimulate private retirement savings are offset by increases in tax revenue from the new tax to maintain Social Security and Medicare benefits.
- The phased in increases in the retirement age will not have an immediate impact on government deficits but will reduce future Debt-to-GDP ratios. Since markets are forward looking the projected lower future debt burdens will have a beneficial impact on asset prices even if near term deficits rise.
- The tax base to continue funding Social Security and Medicare benefits should be relatively broad. The tax could be imposed for all households making more than $50,000. The tax would be progressive. The marginal tax rate might range from 0.5 percent to a cap of 5.0 percent. The tax would be applied to both wages and investment income.
Concluding Remarks: Unless changes are made to rules governing Social Security and Medicare there will be automatic benefit cuts once trust funds assets are partially depleted. Many Republicans favor large and abrupt changes to Social Security benefits and the retirement age. Any abrupt change in benefits would have an extremely adverse impact on household poverty and on aggregate demand.
A reduction in Social Security benefits that is not preceded by a substantial expansion in private retirement savings by the workers who are now having the most difficulty saving for retirement would lead to catastrophic financial impacts for many households. This outcome can only be avoided by coupling private pension reforms with Social Security reforms.
David Bernstein is the author of A 2024 Health Care Reform Proposal.