Month: March 2023

Linking Social Security reform with Private Saving Reform

Increases in the eligibility age for Social Security benefits need to be phased in slowly to prevent financial shocks to households nearing retirement and coupled with new policies that increase savings by younger adults. This post considers how a gradual change in Social Security benefits could be attached to proposals that promote increased private saving.


Introduction:  One approach being considered to expand the lifespan of the Social Security Trust fund involves increases in the eligibility age for receipt of the minimum and full retirement benefit.  This approach would result in substantial improvements in the financial condition of the Trust fund.  It would both increase revenue by forcing people to work longer and would delay outflows from the Trust fund.  It would reduce the future debt to GDP ratio and reduce the likelihood of future increases in taxes to pay off debt.  

However, there are adverse impacts and limitations associated with increases in the eligibility age for Social Security benefits.

First, most current retirees are highly dependent on Social Security.  (A study based on data from the Current Population Survey reveals 52 percent of older households receive more than half of their income from Social Security and a third receive more than 75 percent of income from Social Security.)  Workers currently nearing retirement could not be expected to substantially increase their savings to prepare for the increased retirement age. 

Second, A phased in increase in the retirement age would not prevent project automatic reductions in Social Security benefits associated with reduced Trust fund reserves.

Third, many workers when they near the eligibility age for Social Security benefits need to retire or need to reduce the hours, they work because of health concerns.  Health related problems impacting older workers will impact both current workers nearing retirement and future cohorts of workers. 

Fourth, younger adults are having an extremely hard time saving for retirement.  Student debt is at a record level and continues to climb with college cost and many young adults with high student debt burdens are either delaying saving for retirement or disbursing funds in retirement accounts early in their careers to meet current obligations.  A discussion of the use of pre-retirement funds prior to retirement can be found here.  In addition, young workers must save more for retirement than previous retirees because they are less likely to have access to a traditional defined benefit pension plan.

Changes to Social Security retirement benefit formulas need to be implemented gradually to avoid an abrupt economic shock impacting people nearing retirement and need to be linked with changes in savings incentives and economic reforms which facilitate increased private savings for retirement.

Increasing the eligibility age for Social Security Benefits:  Under current law, workers initially become eligible to claim Social Security retirement benefits at age 62.  People born after 1960 are eligible for the full Social Security retirement benefit at age 67.  The largest possible Social Security benefit is received by people who delay claiming until 70.

Changes to three parameters – the initial eligibility age for Social Security benefits, the eligibility age for the full benefit, and the age where people receive the maximum allowable benefit – are considered here.  The proposed changes would start five years after enactment after legislation.  The three retirement age parameters would increase by one month every two years until all three retirement ages increased by two years.  After the full enactment of the increased retirement age, the minimum eligibility age would be 64, the age of full benefits would be 69 and the age of the maximum benefit would be 72.

When the Social Security eligibility age is phased in many recipients will receive two fewer years of benefits over their lifetime.  

The phased in benefit reductions put the United States on a more favorable and sounder fiscal trajectory. These benefit reductions will reduce the future debt to GDP ratio.  However, the phased in adjustments do not prevent the automatic reductions in Social Security, which are current projected to occur in 2034.  The prevention of the automatic benefit cuts requires some other action by Congress.

One approach to deal with the automatic benefit cuts would involve the use of general tax revenue, which would lead to higher annual budgets. The projected future debt to GDP ratio is a more important measure of fiscal health than annual budget deficits because markets are forward looking, hence the prospect of lower future debt levels will restrain interest rates even if deficits rise in the short term.

The avoidance of projected automatic cuts to Social Security will also require some additional revenue from an increase in the payroll tax or some other tax.

The phase in of these changes would have to be slow to avoid financial shocks on people nearing retirement and to allow for increased private savings. The slow phase of the benefit changes allows for people to increase retirement savings prior to retirement. Younger adults will experience the full brunt of the change in the Social Security eligibility change but will also have more time to take advantage of reforms that will facilitate increased private savings.

Facilitating increased private savings:  Since most households nearing retirement age will be highly dependent on Social Security and most younger households have either delayed or reduced saving for retirement to meet current needs the proposed increase in the eligibility age for Social Security benefits must be accompanied by policies that lead to increased savings for retirement. 

The first set of policy proposals involves direct improvements to savings incentives and investment vehicles offered by investment firms.  The proposed changes in tax incentives and financial rules favor households which are currently having a difficult time saving for retirement, including people without access to the most generous employer-sponsored and people reducing retirement savings because of medical expenses.  The new tax and financial rules will provide incentives for workers to start saving for retirement at a younger age.

 Modifications to Direct Savings Incentives and Rules:

Tax and pension rules should be changed to equalize savings opportunities for workers dependent IRAs and 401(k) plans. 

  • Currently, higher income taxpayers will receive a higher tax savings from a 401(k) contribution than a low-income taxpayer.  This disparity would be eliminated by replacing the tax credit for contributions to retirement plans with a tax credit.
  • Current tax law allows employers to match employee contributions to 401(k) plans but does not allow for matching contributions to IRAs.  The rules should be changed to allow employers to contribute match employee contributions to IRAs as well as to 401(k) plans.
  • Tax law could be changed to allow firms to provide tax free contributions to retirement accounts of gig employees.  
  • Current limits on employee contributions to IRAs are lower than contributions to 401(k) plans.  These contribution limits should be equalized.

Improve the automatic 401(k) enrollment option and create a similar automatic savings option for firms that do not offer a 401(k) plan.  

  • The newly enacted automatic 401(k) enrollment option allows for firms to automatically enroll workers in 401(K) plans that charge high fees or have few investment opportunities.  The government could improve investment outcomes and increase wealth at retirement by limiting fees and by requiring access to low-cost or zero-cost investment options like direct investments in Treasury securities.
  • Automatic enrollment into IRAs or savings through Series I savings bonds should be created for workers employed at firms without a 401(k) plan.  The new automatic enrollment provision would be patterned after the 401(k) automatic enrollment provision, which allows workers to opt out of the automatic contribution and sets the initial contribution at 3 percent of income.  The expanded automatic enrollment provisions create an incentive for younger adults to either open an IRA or some other savings vehicle.  (Most young workers do not have access to a firm-sponsored retirement plan or are subject to vesting requirements.)   The initiation of saving at a younger age is a crucial reform needed to assure increased wealth at retirement.

Create rules that prevent use of all retirement fund prior to retirement and encourage workers to reduce leakages of funds from retirement accounts.

  • Current tax laws allow for investors to disburse all savings from a 401(k) plan or IRA prior to retirement.  (Disbursement rules are complex and often involve payment of tax and penalty.)  A new rule might prohibit pre-retirement disbursements greater than a certain percent of contributions, perhaps 50 percent of contributions.
  • Many young workers automatically disburse all funds contributed to a retirement plan at their first permanent job.  The default option for 401(k) funds during job transfers should be automatic transfer to a low-fee independent account. The worker who wants to maintain retirement savings at her old employer or withdrawing funds from an existing account would have the option of opting out of default arrangement.

Modify tax rules governing Flexible Savings Accounts (FSAs) and Health Saving Accounts to allow for increased savings.

  • Current rules governing FSAs result in the FSA owner losing any unused funds in the account at the end of the year.  A change in FSA rules that allows unused FSA funds to be rolled over into a 401(k) or an IRA would encourage greater contributions to FSA accounts and increase retirement savings.
  • Current rules only allow people with qualified high deductible health insurance plans to contribute funds to a health savings account. A change in these rules to allow for health savings account contributions for people with a wider variety of accounts could expand savings for health care and for retirement.   The new rule could lower rate of depletion of funds in the health savings account or increase contributions to retirement accounts since health savings accounts are often funded by decreased contributions to retirement accounts.

Expand investment opportunities in 401(k) and 529 college savings plans to allow for direct investment in Treasury securities including Series I Savings bonds and the tax-free conversion of 529 assets to 401(k) plans:

  • Many retirement plans and virtually all College Savings 529 plans allow for investments in a few fixed-income and equity funds and do not allow for workers to purchase bonds with a specific maturity date.   These bond funds, even those with short maturity assets fall in value when interest rates rise.  Investors should be given the option of holding Treasury securities to maturity when they will be guaranteed access to the initial bond purchase and all interest.
  • Rules should require retirement plans to provide access to all Treasury bonds including Series I bonds and Treasury Inflation Protected Securities (TIPs).  Access to these investments would reduce loss of wealth from fees and reduce portfolio risk.  
  • Current law taxes disbursements from 529 plans not used for educational purchases.  Workers should be allowed to convert part of the unused 529 plans to a 401(k or IRA without paying tax.  (Typically, the 529 contribution is exempt for state tax but not exempt from federal tax.  Since the initial contribution to the 529 plan was subject to federal tax the loss of federal tax revenue from this proposal might be modest.) 

Removal of Impediments to Saving for Retirement:

Many people fail to save for retirement because they get caught in a spiral of debt and live paycheck to paycheck for a prolonged period.  Often young adults delay saving for retirement or even raid their retirement plan to maintain their student debt payments. Roughly 9 million borrowers over the age of 50 are still making payments on their federal student loans and are having trouble meeting expenses in retirement.  

Other households, especially people with employer-based health insurance often lose health insurance during job transitions.  A loss of health coverage and increased medical debt exacerbating disruptions in the process of savings for retirement routinely occur during recessions.  

A second set of policy initiatives attempts to remove impediments to saving experienced by people who have high student debt or lose health insurance during job transitions.

Implement policies to reduce student debt burdens to facilitate increased savings for retirement.

  • Many of the most vulnerable student borrowers that have difficulty both repaying their student debt and saving are people who borrow but never complete their degree.  The number of households in this situation could be drastically reduced by the implementation of policies that reduce or eliminate debt by first-year students.  The elimination of first-year student debt would also reduce average student debt burdens for all students with debt.  This proposal is far less expensive than the Sanders program to eliminate all college debt at public universities. 
  • Currently student borrowers must choose between a standard student loan contract and an Income Driven Loan (IDR) program as soon as they start loan repayment. In some instances, people who chose the IDR program paid more on their loan over the lifetime of the loan or failed to get the timely debt discharge as promised.  The standard loan contract does not offer the possibility of a loan discharge even if the borrower has low income in the future.   These problems can be mitigated by a modification of the standard student loan contract to include the elimination of all interest charges combined with accelerated repayment obligations 10 years after the initiation of repayment.

Modify rules governing tax incentives for employer-based health insurance and state exchange health insurance to allow for reduced loss of health insurance during economic downturns

  • The proposed solution to discontinuities in insurance coverage stemming from changes in employment involve – a rule change allowing employer subsidies of state-exchange insurance instead of employer-based insurance, the automatic conversion of employer-based insurance to state exchange insurance when employees are laid off, and a modification of the premium tax credit for state exchange insurance. More information on this proposal and other health care reforms can be found here.

New Political and Economic Dynamics:  The current political debate on Social Security involves proposals to either cut benefits or increase taxes and ignores problems caused by disparities in private retirement savings.

Any change to an inter-generational program must be phased in slowly to avoid political and economic turmoil.

However, most young adults would be unable to substantially increase their savings rate given current savings incentives or high debt burdens.

A higher eligibility age for Social Security benefits must be accompanied by reforms designed to reduce disparities in private savings.  These reforms will reduce the dependence of future generations on the Social Security program.

Many of the improvements in savings incentives, reductions in student debt and improvements to health insurance proposed here, are unaffordable if not accompanied by substantial new revenue or budget cuts.

Increases in retirement savings require changes in retirement plan rules and procedures.  Many current rules favor Wall Street over investors and tie investors into expensive products offering suboptimal returns or high levels of risk.

Social Security reform and private savings reform are intrinsically linked.

The proposals presented here would reduce wealth inequality and will improve the fiscal condition of the nation, truly a rare combination.

Comments on the SVP debacle

High interest rates did not cause the SVB collapse because interest rates remain below their historic average. Management of SVB and possibly other banks failed to implement their core responsibility – matching the duration of assets and liabilities. Efforts to deal with bank insolvencies will lead to higher and more prolonged inflation.


Prologue:  In 1991, the Treasury Department reviewed potential risks to the financial stability of Fannie Mae and Freddie Mac.  A government model had concluded that the companies would not face problems due to an increase in interest rates until rates rose to the 24 percent or 28 percent level.  

My review of this model found that the model understated interest rate risks for two reasons.  First, the model omitted information about annual and lifetime payment caps on Adjustable-Rate Mortgages, which reduce bank revenue when interest rates rise.  Second, the model did not fully consider the impact of interest rates on defaults and other outcomes that could exacerbate financial stress when interest rates rose.  

A revised version of the government model that I put together concluded an interest rate shock in the 12-14 percent range would lead to financial problems for the two companies.  Treasury officials were grateful for this input but were largely unconcerned because interest rates were on a downward trajectory.

The current generation of management at many banks takes extremely low interest rates for granted and understates risk associated, which exist when the duration of their asserts do not match the duration of their liabilities.

The 10-year Treasury interest rate a couple of years prior to the 2008 insolvency of Freddie Mac and Fannie Mae was around 5 percent, far lower than the interest rates that prevailed in most of the 1990s.

The 10-year interest rate at the time of the SVB debacle was around 4.0 percent and is now at 3.7 percent, below its historic average.

Comments

Comment One:  Don’t blame the Fed or high interest rates for this debacle.  High interest rates did not cause the SVP collapse because interest rates are not high as discussed in the post Should the Fed Pivot?

Comment Two:  It is hard to understand why anyone, let alone a sophisticated financial institution with short term obligations, would tie up funds in long-term bonds when the yield on the 10-year government bond was lower than 1.0 percent during the pandemic and remains below the long-term average. More information on the type of investments that lead to this debacle is needed. Note, even short-term bond ETFs invested in inflation protection bonds like VIPSX, VTIP, and STIP, have lost substantial value in the past year. Go herefor a discussion a discussion of use of bond ETFs in a low interest environment. The collapse of a bank due to an interest rate exposure when the 10-year bond yield remained at 4.5 percent could have occurred if the bank’s analysts had grossly miscalculated the impact of interest rates on certain assets.

 Bank officials purchasing these bonds and bond funds should have more carefully researched the impact of interest rates on all of their investments and realized there was more downside risk than upside potential from investing in fixed income assets when interest rates were at such a low

Comment Three:  SVP may be the canary in the coal mine.  The insolvencies of Freddie Mac and Fannie Mae were preceded by insolvencies of some smaller private mortgage insurers. The SVB closure occurred very quickly after the public became aware of the problems at the bank because there was a run for deposits.  The First Republic Bank, is now losing deposits.  Transparency causes depositors to flee but is necessary to assure better investments.

Comment Four:  Regulators need to actively monitor a second potential stress point — crypto Ponzi schemes like the ones at FTX and Silvergate.  Did crypto play a role in the SVB debacle? I wonder what impact if any exposure to crypto had on the SVB collapse.

Comment Five:  The CEO of SVB sold $3.5 million in stocks prior to the sale of the bank.  Federal regulators should move to claw back the proceeds of this gain.

Comment Six:  The blame game has started.  Republicans are blaming lax fiscal and monetary policy and have conveniently ignored their role.  Yes, Jerome Powell should have increased interest rates sooner.  However, there is a lot blame to be shared here.  The Trump era tax cuts and Trump’s threats to fire Chairman Powell if he did not lower interest rates had a major impact on the nation’s fiscal and monetary condition.  Also, Republicans have consistently argued for less regulation, a position that is hard to defend.   

Comment Seven:  The Fed is now in a tight box.  Inflation and the labor market remain robust.  A move by the Fed to prevent insolvencies, by lowering the cost of credit or by purchasing some of the long-term bonds owned by SVB, will lead to more inflation.  Bill Ackman is making the case that SVB is too big to fail and the Fed should consider some sort of bailout.   Dealing with the banking crisis could lead to higher inflation over a prolonged period.

The Choice Between Fixed Income Funds and Direct Purchases of Bonds

Whenever possible investors should seek out tax-preferred savings vehicles, which allow for direct investments into Treasury securities and hold Treasury bonds and notes instead of fixed-income funds. People saving for retirement or higher education can minimize risk by matching future obligations with specific bonds.


Introduction:

Many tax-preferred retirement accounts and 529 funds restrict investment choices to a small set of stock and bond ETFs or mutual funds.  The allowable investments inside a 401(k) plan are selected by the plans sponsor. For example, the Thrift Savings Plan (TSP) offered to federal employees has several funds and an option for mutual fund investing but does not allow workers to purchase Treasury Securities directly through the Treasury or through a broker.

Most individual retirement accounts (IRAs) and brokerage accounts allow for direct investments in the stock of individual companies, Treasury securities, agency securities, and corporate bonds.  Individual investors at Fidelity and Vanguard with an IRA account can purchase the same assets as investors with a brokerage account at the firm.

Individuals saving in plans that are not tax preferred can purchase bonds either through a brokerage account or through Treasury Direct.  Series I savings bonds can only be purchased directly from the Treasury and are therefore not available for retirement savers or for people utilizing 529 plans for college savings.

Retirement savers with an IRA can purchase Treasury Inflation Protected Securities (TIPs) through their brokerage company.   Whether this option is available through a 401(k) plan depends on the investment options chosen by the plan’s provider.  Most 401(k) plans that I am aware of do not allow for direct purchases of TIPs. 

Many financial advisors, including one mentioned in this CNBC article, favor the use of bond ETFs over direct purchases of Treasury securities.  The prices of the bond funds touted in this article appear highly variable. 

The use of bond funds instead of direct investments in bonds often results in inferior financial results.  Both bond prices and bond ETF or mutual fund prices vary inversely with interest rates.  The difference in financial exposure stemming from holding a bond and the financial exposure from holding a bond fund is that the bond holder can avoid losses by holding the bond until the maturity while returns for the holder of the bond funds are always dependent on interest rates.

All 401(K) plans have bond fund options. Many 401(k) plans have an option for short-term bonds that primarily invest in inflation protection securities.  However, even short-maturity bond funds designed to protect investors from the eroding effect of inflation can result in substantial financial losses for investors.

The returns for VIPSX are -10.45 % over a one-year holding period and 1.02 percent over a 10-year holding period.  Other short-term bond funds seeking to protect investors from inflation including STPZ and VTIP do not appear to be meeting their objective in the current macroeconomic environment.

There is one sure fire way to insulate your portfolio from inflation, the purchase of Series I bonds.  However, the IRS imposes an annual limit on the purchase of Series I bonds, and Series I bonds cannot be purchased in IRAs, 401(k) plans or 529 plans. Most household with most of their financial portfolio inside a retirement plan cannot purchase enough Series I Savings bonds to insulate themselves from inflation.

The performance of both long-term Treasury bonds and bond funds has also been miserable.  See BND, AGG, and FNBGX and look at the chart with the longest time span of historical prices.

Advantages of Direct Investments in Treasury Securities:

Investors who purchase a Treasury security at a positive yield and hold the Treasury security to maturity will never experience a nominal loss on the security.  

However, many investors will sell a long-term security prior to its maturity.

Investors should not purchase either a long-term bond or a long-term bond fund when interest rates are extremely low, as they were during the pandemic, since at that time interest rates were certain to rise and bond prices certain to fall.

Investors can spread out bond purchases over several months to assure monthly access to liquid retirement assets.  The purchase of six-month Treasury bills on six consecutive months would allow for monthly access to liquid assets.

The price risk of a Treasury security goes towards zero when the security nears its maturity date.  An investor needing funds shortly before the maturity date could sell the asset without a substantial loss, even if interest rates rise. By contrast, short-term bond funds have no maturity date, hence the price of the fund will fall if interest rates rise.

Investors can match the maturity of bonds that they hold with future liabilities.   This is an especially important feature for parents saving for college tuition who could match bond maturities with tuition payment due dates. 

However, 529 plans commonly used for saving for college generally do not have an option allowing for direct investments in Treasury securities.  Instead, the plans allocate investments into bond and stock ETFs or mutual funds.   The price of funds inside college 529 plans, even the short-term bond funds, vary substantially with market conditions.

Both savers in 529 plans and savers in retirement plans often save through a life-cycle fund that shifts assets from stocks to bonds as investors near retirement.  However, the component of the Lifecycle fund invested in a bond portfolio will fall in value when interest rates rise. 

Both bond and stock funds fell in tandem during the past year.  Lifecycle investing did not protect investors during the latest market downturn. 

Most retirees put all funds in instruments without a maturity date and base disbursements on a guideline like the four percent rule.  The four percent rule is not going to work if the value of both your stocks and bond funds simultaneously declines as they did most recently.

Retirees could and should purchase Treasury bonds and schedule the maturity of the bond for different dates each year.  The retiree would even consumption and reduce depletion of retirement assets by consuming from maturing bonds when the stock market is low and consuming from stock ETF distributions when the stock market is high.

Retirees with assets in bonds that mature on specific dates are better prepared for retirement than retirees with assets that have all savings tied up in funds without maturity dates.

Concluding Remarks:  The tax code provides preferences for investments in tax-preferred retirement accounts and 529 plans.  Congress recently passed legislation mandating automatic contributions to 401(k) plans. Financial advisors strongly recommend use of these tax-preferred savings vehicles.

Tax preferred savings vehicle often have limited investment options.

Tax-preferred savings plans often do not allow for the direct purchase of Treasury or government agency fixed-income securities with specific maturity dates, which could be matched with spending obligations.  

Moreover, financial advisors often advocate the use of bond funds instead of bonds with specific maturity date. 

Congress, through the tax code and their mandates and financial advisors through their insights guide investors to suboptimal higher-risk financial choices.

David Bernstein an economist living in Denver Colorado has written extensively on health and financial policy including a recent article outlining a 2024 Health Care Reform Proposal and an evaluation of President Biden’s student debt discharge proposal.