401(k) Plan Revamp Eyed By Senate Finance Committee
On Thursday, the U.S. Senate Finance committee will listen to proposals from a range of interests. On the table are such ideas as revamping the tax treatment of 401(k) plans to make the system more automatic, and possibly adding caps to make contributions less tax-favorable to higher-income workers.
The hearing comes as the so-called retirement deficient Income, the gap between the pension and retirement plans Americans have today and what is necessary to maintain living standards, is at a high of $6.6 trillion, according to the Retirement Research Center.
"Fewer than half of the working public currently have access to a workplace-based retirement plan, so the hearing will address ways to encourage more employers to sponsor – and more employees to participate in – 401(k)-type plans, individual retirement accounts and other vehicles, while maintaining and protecting the existing programs and savings that millions of Americans are counting on for retirement," according to a statement from the Finance Committee.
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One controversial proposal comes from the Brookings Institute. Senior Fellow William Gale will talk about reinventing 401(k)s by substituting the current deduction for contributions with a flat-rate refundable credit that would be deposited directly into the saver's account.
Gale of the Brookings Institute, says that a flat rate refundable credit will:
1."Address long-standing concerns in the retirement saving system by improving incentives for most households to participate and by raising national saving.
2. Offset pressures created by the current weak economy for households to reduce their retirement saving.
3. Help solve the long-term fiscal problem facing the country by raising $450 billion over the next decade in a manner that is consistent with the principles of broad-based tax reform and distributes the fiscal burden in a progressive manner."
Some, like Judy Miller, a chief of Actuarial Issues/Director of Retirement Policy at the American Society of Pension Professionals and Actuaries, say the system needs fine-tuning but not a complete overhaul. "We really don't think that the system needs to be totally restructured. We think it's about more minor modifications and making some adjustments," Miller told ABC News. "The system is working really well for millions of people."
401(k) Plan Revamp Eyed By Senate Finance Committee
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Officials emphasize that no decisions have been made and the committee is just gathering information at this point. Congress would likely have to enact any substantial changes.
The Retirement Income Deficit
What is the financial magnitude of the nation’s retirement income crisis? Retirement USA asked the respected non-partisan Center for Retirement Research at Boston College to calculate the figure that represents our current retirement income deficit – that is, the gap between the pensions and retirement savings that American households have today and what they should have today to maintain their standard of living. Using the data from the Federal Reserve Board’s Survey of Consumer Finances, the Retirement Research Center has calculated that figure at $6.6 trillion.The deficit figure covers households in their peak earning and saving years—those in the 32-64 age range—excluding younger workers who are just beginning to save for retirement as well as most retirees. It takes into account all major sources of retirement income and assets: Social Security, traditional pension plans, 401(k)-style plans, and other forms of saving, and housing.
The measure assumes people will continue to work, save, and accumulate additional pension and Social Security benefits until they retire at age 65, later than most people currently retire. It also assumes that retirees will spend down all their wealth in retirement, including home equity. The deficit is thus in many respects a conservative number.
The Center calculated the Retirement Income Deficit for Retirement USA in a three-step process.
Step 1: The Center first calculated a replacement rate — projected retirement income as a percent of pre-retirement income — for each household in a representative sample.
Step 2: Next, it compared that projected replacement rate with a target rate that would allow the household to maintain its standard of living in retirement.
Step 3: Finally, if the projected replacement rate was less than the target rate, it estimated how much additional savings each household would need today to close the retirement income gap, and then summed these amounts across households.
Data
The Retirement Income Deficit uses data from the Federal Reserve’s Survey of Consumer Finances, a survey of a representative sample of U.S. households, which collects detailed information on households’ assets, liabilities, and demographic characteristics. This survey has been conducted every three years since 1983. It questions households about their income, wealth, retirement plan coverage, and other variables and provides a comprehensive snapshot of American families’ financial position.The Center for Retirement Research updated 2007 survey data to take into account recent declines in stock and housing values. Earlier surveys were also used in order to track historical patterns in wealth and pension benefit accumulation. In addition, the Center used Social Security earnings records from the Health and Retirement Study in order to construct lifetime earnings profiles used to estimate Social Security benefits. The Study is conducted by the University of Michigan’s Institute for Social Research.
Methodology
The Retirement Income Deficit is based on methodology developed by the Center for Retirement Research for its National Retirement Risk Index (NRRI), which measures the share of households at risk of not being able to maintain their standard of living in retirement. The initial steps in calculating the Retirement Income Deficit and the NRRI are identical.The first step is projecting a replacement rate – retirement income as a share of pre-retirement income – for each household in the sample. These projections assume people will continue to save and accumulate pension and Social Security benefits until they retire at age 65. Individual components of retirement wealth and income are estimated separately, based on historical accumulation patterns from the Survey of Consumer Finances, taking into account differences between birth cohorts and individual households as described in the original NRRI report, Retirements at Risk: a New National Retirement Risk Index (for updated index numbers, see The National Retirement Risk Index: after the Crash).
For financial assets, such as 401(k) balances, projections are based on observed wealth-to-income ratios by age group from earlier surveys. Income from defined benefit pensions and Social Security is estimated directly. To calculate future defined benefit income requires projecting benefits for those with defined benefit pension coverage and projecting both coverage and benefits for those currently expected to pick up coverage over their work life. These projections take into account the fact that defined benefit pension coverage is declining, but that workers tend to become covered later in their careers.
Social Security benefits are based on estimated lifetime earnings profiles. For housing, projections take into account the equity households could extract through reverse mortgages as well as the rental value that homeowners receive from living in their homes rent free. Although the take-up of reverse mortgages remains very low, the income from such a mortgage is included to reflect the maximum income available to the household.
The second step is comparing the projected replacement rate for each household to a target replacement rate that would allow the household to maintain its pre-retirement standard of living in retirement. Target replacement rates are less than 100 percent because retired households typically pay lower taxes, are no longer saving for retirement, and have somewhat lower expenses than younger households. The targets vary depending on household type (single male, single female, married with two earners, and married with one earner), income group (low, middle, and high), defined benefit pension coverage, and home ownership.
Finally, for each household with a gap between the projected and target replacement rate, the Center for Retirement Research estimated the additional savings or pension benefits each household would need today to close the future income gap, then summed these amounts across households.
The Retirement Income Deficit and the NRRI also differ in certain respects. Most important, of course, the NRRI is a measure of households at risk, and the Retirement Income Deficit is a measure of the size of the aggregate shortfall. In addition, the NRRI considers a household “at risk” only if it falls short of its target by more than 10 percent. The Retirement Income Deficit, in contrast, includes all households with projected shortfalls.
Assumptions
In many ways, the Retirement Income Deficit is a conservative measure of the aggregate shortfall in retirement savings and pension benefits. It assumes that households retire at 65,[1] tap their housing wealth through a reverse mortgage, and convert financial assets into lifetime steams of income by purchasing inflation-indexed joint-and-survivor annuities. In other words, it assumes all savings are depleted.In practice, most households retire before 65, do not access most of their housing wealth, and do not annuitize. The fact that most people retire before 65 means they receive reduced Social Security benefits, their 401(k) plan and other savings have less time to grow, and they have to support themselves over a greater number of years. And because few people annuitize their financial wealth, including the proceeds from a reverse mortgage on their home, they need additional savings to insure against longer-than-average life spans.
The measure also assumes no cuts in Social Security beyond the scheduled increase in the Normal Retirement Age and that the recent market downturn will not speed up the decline in defined benefit pension coverage.
The Retirement Income Deficit assumes an inflation-adjusted 3 percent rate of return to calculate the present value of future income gaps. This is similar to the 2.9 percent real Treasury bond interest rate assumed by the Social Security Trustees, but is lower than the 4.6 percent real rate of return the Center uses to calculate pre-retirement income from assets for both the NRRI and the Retirement Income Deficit.[2] The rationale is that 4.6 percent is the Center’s “best guess” estimate of the real rate of return on 401(k) savings and other assets, but that households should probably not count on a rate of return higher than 3 percent above inflation, given that the return on Treasury Inflation-Protected Securities (TIPS) is currently 1.87 percent.[3] If the higher 4.6 percent return is used as a discount rate, the Retirement Income Deficit shrinks somewhat to $5.2 trillion. If the lower 1.87 percent rate of return is used, the deficit increases to $7.9 trillion.
[1] The
assumption is that single individuals and the older member of a couple
claim benefits at 65. The younger spouse is assumed to claim at the
same time as the older spouse, but no earlier than 62.
[2] Note that
the Center does not project forward asset values using an assumed rate
of return but rather bases accumulations on historical wealth-to-income
growth patterns as households approach retirement.
[3] TIPS rate as of 7/22/2010 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest...Liz Skinner, InvestmentNews
Retirement tax proposal could endanger 401(k)s
Brookings plan swaps tax breaks for flat tax credit
September 12, 2011 - 11:40am
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WASHINGTON—Americans would lose their variable tax breaks on retirement contributions in exchange for a flat tax credit to be deposited automatically into the saver's account under a proposal by The Brookings Institution discussed before the Senate Special Committee on Aging last week.
About three-quarters of Americans would have more of a financial incentive to save for retirement if the tax credit were set at a 30% rate for all Americans, according to the proposal. At that same rate, however, upper-income households, now in the 35% marginal tax bracket, would lose tax benefits.
The proposal is aimed at boosting overall retirement savings and leveling the tax benefits among those with different incomes. With current deductions, a higher-income individual saves 35 cents for every $1 contributed, and that contribution is excluded from his or her taxable income. In comparison, a middle-income person saves 15 cents in income taxes for the $1 contribution.
“The proposal is timely,” said William Gale, the Brookings senior fellow who presented the proposal. “By improving retirement incentives for most households, it would help offset the pressure households face to reduce or eliminate their participation in retirement saving during a weak economy.”
The Tax Policy Center estimates that about 40% of those in the top 1% income bracket would lose an average of about $5,500 under the proposal. One-third of households in the middle fifth of the income distribution would gain almost $500.
Tax reform is at the top of many lawmakers' agendas as the nation grapples with the federal deficit and government spending limitations. Under this plan and a 30% rate, the change would be revenue-neutral for the U.S. Treasury. However, another form of the proposal, which would set an 18% flat rate, would raise $450 billion in revenue over a decade.
The Brookings plan has not yet been crafted into any legislation. Critics of the proposal said such a plan would wreak havoc in the retirement savings industry and thus ultimately hurt retirement savings. They argue that private companies would stop sponsoring 401(k) plans, which now hold about $3 trillion in retirement assets.
“It's amazing to me how folks who've never worked in the industry can attempt to fix perceived problems with ideas that would devastate our current system,” Brian Graff, CEO of the Arlington, Va.-based American Society of Pension Professionals & Actuaries, said in an interview. “Basically, it would be the end of corporate profit-sharing plans and lead to the termination of hundreds of retirement plans, because business owners would have no incentive to offer 401(k) plans.”
Ed Ferrigno, vp of Washington affairs for the Profit Sharing/401(k) Council of America, agrees that employer plans are the key to any retirement savings incentive. Instead of changing the tax rate, “you need to look holistically at tax policy, because if this will hurt employer plans, it will hurt lower- and middle-income workers,” he said in an interview.
David John, senior research fellow at The Heritage Foundation in Washington, said businesses will still want to offer retirement savings plans and a contribution match for employees in order to keep their valued workforce.
“I don't believe this will reduce the incentives of businesses to have 401(k)s,” because the proposal should not really damage upper-income workers, especially those who start saving young, Mr. John said.
The employer match should stay the same because companies want to keep the best possible talent they can get, he said.
“Conversations we've had with small businesses and large businesses suggest that this will continue to be true,” Mr. John said.
The basic idea outlined in the Brookings proposal was brought up five years ago in a proposal that would apply the flat tax treatment to real estate and health insurance, too.
Liz Skinner is a reporter at InvestmentNews, a sister publication of Business Insurance.
A Proposal to Restructure Retirement Saving Incentives in a Weak Economy with Long-Term Deficits
Summary
This paper discusses a proposal that would reform public policies toward retirement saving by replacing the current deduction for contributions to retirement saving accounts with a flat-rate refundable credit that would be deposited directly into the saver's account. The proposal would (a) address long-standing concerns in the retirement saving system by improving incentives for most households to participate and by raising national saving, (b) offset pressures created by the current weak economy for households to reduce their retirement saving, (c) help solve the long-term fiscal problem facing the country by raising $450 billion over the next decade in a manner that is consistent with the principles of broad-based tax reform and distributes the fiscal burden in a progressive manner.
I. Introduction
This paper discusses a proposal that would reform public policies toward retirement saving by replacing the current deduction for contributions to retirement saving accounts with a flat-rate refundable credit that would be deposited directly into the saver's account. The proposal would (a) address long-standing concerns in the retirement saving system by improving incentives for most households to participate and by raising national saving, (b) offset pressures created by the current weak economy for households to reduce their retirement saving, (c) help solve the long-term fiscal problem facing the country by raising $450 billion over the next decade in a manner that is consistent with the principles of broad-based tax reform and distributes the fiscal burden in a progressive manner.
Concerns with the adequacy and security of the retirement system in the United States are well-known and long-standing. Many households do not save for retirement, and those that do contribute too little, invest poorly, or withdraw funds early. These patterns leave households vulnerable to insufficient savings during old age.
A weak economy has exacerbated these issues. Unemployment in general (and long-term unemployment in particular) is exceedingly high relative to historical norms. Real wages have stagnated, housing prices have fallen far below previous peaks, and the stock market has grown more volatile. Each of these factors threatens to reduce the vitality of the retirement system-for example, by driving workers to stop participating in their 401(k) plans or IRAs, to contribute less for retirement saving, to invest more conservatively, or to withdraw funds early.
At the same time, the nation's medium- and long-term fiscal outlook is unsustainable, even with the recent debt-limit legislation. The retirement of the baby boomers, the aging of the population, and health care inflation will place increasing pressure on Social Security and Medicare (Auerbach and Gale 2011). Without reform, the Social Security trust funds will be depleted by 2036 (OASDI Trustees 2011) and will only be able to pay roughly three quarters of the benefits retirees have been promised. This will further weaken the retirement prospects of low- and middle-income households and make them more vulnerable to poverty in old age. As the Joint Select Committee on Deficit Reduction deliberates on medium-term budget options, consideration of reforms to strengthen the private retirement system would be appropriate and constructive, especially since any plausible long-term fiscal plan will involve some reductions in Social Security and Medicare benefits.
The Tax Policy Center estimates that the immediate, direct revenue loss associated with contributions to IRAs and 401(k) plans will exceed $1 trillion over the next decade, under current law. This figure is calculated as the product of contributions to such plans, multiplied by the marginal income tax rate applied to such contributions. It is presented to show the magnitude of the issue and the potential for revenue gain. It does not, however, represent a complete tax expenditure estimate for IRAs and 401(k) plans because it does not include the value of the tax treatment of accrued earnings (which would raise the figure) or the taxation of withdrawals (which would reduce the figure).
This paper offers a proposal to encourage additional retirement saving by converting the system of income tax deductions for retirement saving contributions to a system of flat-rate refundable credits, where the credits are deposited directly into the saver's account. Stated simply, this proposal will make it viable for low- and middle-income households to increase their savings for retirement. The proposed reform has several notable features:
- The proposal would enhance the retirement saving system. By improving retirement saving incentives for the majority of households, the proposal would help address traditional concerns about take-up and usage of retirement saving vehicles.
- The proposal could help raise national saving. By promoting saving among households in the middle and bottom of the income distribution (those least likely to sufficiently save) the proposal would encourage new contributions from precisely the type of households for whom 401(k)s and similar plans likely represent net increases in saving, rather than a re-allocation of saving that would have been done anyway.
- The proposal is timely. By improving retirement incentives for most households, it would help offset the pressure households face to reduce or eliminate their participation in retirement saving during a weak economy.
- The proposal is consistent with long-term deficit reduction and could raise substantial amounts of revenue: a reform that converted current deductions to a tax credit worth 18 percent of a taxpayer's retirement saving contributions would leave those in the 15 percent bracket unaffected. As discussed in more detail below, an 18 percent matching credit is the equivalent of a 15 percent deduction. Such reform would raise more than $450 billion in revenues over the next decade relative to current law.
- The proposal is consistent with principles of broad-based tax reform and reducing tax expenditures.
- The proposal is progressive. The proposal would help lower- and middle-income households significantly, decreasing their reliance on Social Security benefits as the primary source of retirement income, and it would distribute the benefits of retirement saving more equitably than the current system.
- In alternative version of the proposal, a 30 percent credit would be revenue-neutral for the next decade relative to current law and would be even more progressive. This reform would reduce taxes for 26 percent of the population (mainly in the bottom 90 percent of the income distribution) and decrease tax deductions for 6 percent of the population (largely in the top decile).
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