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

 

 

 

 

 

 

 

 

 

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.

 

 

The Democratic Split

Democrats are optimistic that the Russian and corruptions scandals will propel the party to victory in 2018.  Perhaps they are correct but I fear that they are wrong for two reasons.

First, President Trump continues to give weekly rallies to his enthusiastic base.  There are no figures on the Democratic giving large robust rallies.

Second, aside from Russia and corruption (admittedly two big asides) the entire debate today centers around Trump priorities – basically immigration, trade and low taxes.

The Democrats do much better when the conversation involves health care, student debt, pensions and Social Security.   The common theme linking these issues is that despite the currently strong economy many Americans are financially insecure and are having trouble saving for the future or for education.

Why aren’t Democrats out there rallying their base the way Trump is?

Why aren’t Democrats talking more about financial security — health care, student debt and retirement – issues of concern to working-class households?

The basic answer is that there is a huge split in the Democratic party both on economic priorities and appropriate policies.  This split is paralyzing the party and impeding the delivery of a viable progressive agenda.

 The liberal wing of the Democratic Party offers transformative radical change.  The centrists believe that the liberal wing’s policy proposals are unrealistic and could make many people worse off.

The centrists offer relatively modest policy changes and appear to only reluctantly embrace left-wing proposals when they need votes.   The current message offered by the centrists will not rouse the base.

The liberals correctly believe the current centrist agenda would at best maintain the status quo and at worse could implement compromises with Republicans that will weaken the existing safety net.

This conflict can be illustrated by a discussion of three issues – health care, student debt and retirement savings.   These issues allow for the Democrats to create a theme for 2020.   The theme is how do we make Americans more financial secure and what party do you trust to do this?

This is a good place for me to state my bias.   I am a centrist not a liberal.  However, many of the current policy proposals offered by centrists are insufficient.

Here is an outline of some policy ideas, which could bridge the gap between centrists and liberals.

Policy Priorities

Discussion of Health Care:

It is hard to understand why Democrats aren’t spending more time talking about health care.   The number of uninsured Americans without health insurance rose by 3.2 million people during President Trump’s first year in office.   This issue and other problems with health insurance markets received more coverage in CNBC than by MSNBC.

The liberals want single payer health care.   The fact that single-pay works well in some countries, which have only known single payer, does not mean that the United States could transition from the current system to a single payer system.

The adoption of a single-payer system would make some people more financially secure but would make many people worse off than the current situation.   Many health care providers and doctors would have substantially lower compensations.   This would be a disaster for new doctors with substantial medical school debt.  The single-payer would be more generous than some private plans but might deny or provide insufficient reimbursement for expensive procedures.

Many centrists have endorsed and voted for a Medicare for all plan, even though their more detailed thoughts are more in line with ACA modification proposals.   They argue their vote is a symbolic one in support of universal coverage.   I would argue this vote is a pander.

The centrists want to repair the ACA but their discussions do not fully acknowledge that problems with the ACA existed even before the Trump Administration weakened the program. The ACA was a big step forward but also a disappointment compared to where we want to be.

Despite the enactment of the ACA, insurance premiums and out-of-pocket expenses have continued to rise.  There is some evidence that state exchange insurance has narrower networks and entail higher costs than some employer-based insurance.  Moreover, people who take ACA coverage are required to take employer-based insurance if they obtain a job with an employer that offers coverage.  Rules and tax incentives favoring employer-based insurance over state exchange insurance weaken state market places.

There is no doubt that Trump Administration polices – ending the individual mandate, reducing funds for ACA enrollment, potential new rules allowing alternatives to ACA policies and a freeze on ACA reinsurance payments – have weakened state exchanges and are responsible for the increase in the number of uninsured.

However, centrists need to do more than offer a patch to the ACA.   They need to offer a vision on how we can move to a system that provides more coverage, lower out-of-pocket expenses, and access to all procedures and drugs.

Authors Note: I am currently working on a health care proposal.   It will be published by the end of 2018.

Discussion of student debt:  It is hard to believe that the Democrats aren’t talking a lot more about student debt, especially given recent Trump Administration proposals.   Recent actions or positions taken by the Trump Administration on student debt include:

  1. The proposed elimination of the public service loan program,
  2. The proposed elimination of subsidized student loans,
  3. The end of compensation for student borrowers who are victims of fraud,
  4. The reduced enforcement of rules allowing enrollment in Income Based Replacement loan programs

Why aren’t Democrats talking more about these student debt issues?

The liberal wing wants free college for people attending public universities.   This does work in some countries.  However, free public college is very expensive and the transition would adversely impact private institutions.

The centrists need to come up with innovative pragmatic solutions to the college debt problem and incorporate these proposals in their standard speech.

I have published a working paper, which lists 12 pragmatic ways to reduce the growth of student borrowers with excessive student debt and mitigate debt burdens for overextended borrowers.

One of my proposals involves providing additional financial assistance and reduce student loans to first-year students who do not have an extensive credit history or proven academic record.

A second proposal reduces interest payments after 15 years.   This approach is likely to be more effective than current loan forgiveness programs, which are designed to discharge debt.

My student debt proposals are available in my working paper on Amazon.

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

Discussion of retirement security issues:   Retirement security entails Medicare, Social Security and 401(k) plans.

The discussion on this issue should start with a recognition that under current law there will be automatic cuts to Social Security and Medicare benefits unless Congress acts.   Democrats need to ask whether Republicans can be trusted to act given their performance on ACA repeal or replace.

In the 1980s, President Reagan and Democrats in Congress came together to fix Social Security.   The Democrats need to ask whether the current Republican party can be trusted to compromise on this issue.

The other aspect of the retirement security problem is that many workers have insufficient retirement savings. Today few companies provide workers with traditional pension plans.   Many 401(k) plans have high fees and most lack an annuity option during retirement.   Many workers are unable or unwilling to maximize their contribution to 401(k) plans and often the money in these plans is disbursed prior to retirement.

The Democrats then need to provide detailed proposals on how to improve retirement security.   These proposals should recognize two important goals – (1) Social Security needs to be placed on a sound finance system and (2) the entire retirement savings system needs to be improved.

The Democrats need to advance policies that achieve both these goals and must reiterate opposition to Social Security benefit cuts that worsen retirement security.   The proposed solution is likely to include either additional revenue or use of some general tax revenue to maintain current Social Security income.

The Best Dialogue for Democrats

The current political dialogue is being set almost entirely by Trump and the Republicans.   Their focus is on trade and tariffs, immigration, and standing for the national anthem.

My thesis in this essay is that Democrats need to put financial security — health care, student debt, and retirement income at the center of the national discussion.

Centrists must move forward with a pragmatic progressive approach to these issues.  Many key centrists are spending more of their time either pandering to liberals or bashing liberals for being too radical than proposing polices that solve problems.

Some Democrats, both progressives and centrists, are more focused on tax issues and/or inequality.  The centrists are concerned that proposals by liberals will explode the deficit.  They should be more focused on revenue losses from the recently enacted Trump tax cut.

Elizabeth Warren recently pointed out the America was more prosperous when marginal tax rates were over 50 percent.  This defense of high tax rates is a losing argument both substantively and politically.  The decrease in prosperity or the increase in inequality was more likely caused by loss of jobs from factories moving overseas and from technological changes which reduced wages of low-skilled workers.

Tax policy is complicated.   A case can be made for changes in the tax code to obtain more revenue.   However, economists have found that high marginal tax rates change distort behavior.   Most notably, high marginal tax rates can decrease work, especially in two-worker households.

An economic agenda stressing reforms that will improve household financial security will resonate more with voters than an agenda focused on taxes and income inequality.

We live in a world where every one of Trump’s utterances and farts dominates the news cycle. Democrats seem totally incapable of prioritizing the farts.   In my view, Trump’s treasonous approach to Russia and separation of children from parents at the border are more important than Stormy Daniels

Democrats must respond to the moral dilemma created by the Trump Presidency.   However, at the end of the day a person struggling with student debt, worried about health care coverage for her family, and worried about whether she will be able to retire with decent income is more concerned about financial security than the scandal of the day.

Democrats need to get out there and reset the nation’s agenda.  To modify Bill Clinton said it was the economy stupid.   My view is that the economy must be broadly defined to include financial security.