To view this article in digital magazine format, click here.
Frequently glossed over in discussions about tax reform and tax preferences is that those accorded retirement plans receive a temporary deferral of taxes, rather than a permanent exemption. Still, as policy makers debate ways to deal with the nation’s fiscal situation, they are, much like the once-prolific bank robber Willie Sutton, turning to where the money is—and that means a hard look at tax preferences.
The arguments in favor of changing the current options for workplace retirement plans tend to fall into one of three camps: those who say the current tax code disproportionately favor higher-income workers, creating so-called “upside down” incentives; those who argue there are more efficient and effective ways to encourage savings, such as automatic enrollment or mandates; and those who argue that incentives aren’t needed because they don’t have any real impact on savings behaviors, certainly among lower-income workers.
From a financial economics perspective, the current federal tax treatment for 401(k) plans has advantages for workers with a higher marginal tax rate if other elements of the tax code are ignored. However, after controlling for tenure, Employee Benefit Research Institute (EBRI) analysis finds that for participants in their sixties, the ratio of participant account balance to salary is, and has been, relatively flat across salary categories. This suggests that the nondiscrimination limits imposed on workplace retirement plans have, in fact, resulted in a relatively flat multiple of final earnings at retirement as a function of salary.
Those who view the current tax preferences as ineffective have allegedly found support in a recent study of Danish savings behaviors (“Active vs. Passive Decisions and Crowd-Out in Retirement Savings Accounts: Evidence from Denmark”), which concluded tax incentives weren’t effective at encouraging savings.
They reached those conclusions based on responses when the Danish government reduced the subsidy for contributing to pension accounts for individuals in the top -income tax bracket, noting that while contributions fell sharply for those individuals, they “remained virtually unchanged for individuals just -below that bracket.” In other words, individuals directly affected reacted, and others- did not. Moreover, those impacted by the change were higher income individuals with larger account balances.
Conventional wisdom might suggest that upper-income workers in the US would be most affected by a change in tax policy; findings from the 2011 Retirement Confidence Survey suggest otherwise. More than half (56%) of full-time worker respondents with household income of $15,000 to $25,000 currently saving for retirement said they would reduce that amount if they were no longer able to deduct retirement savings plan contributions from taxable income. In contrast, just 22% of full-time workers currently saving for retirement with household incomes of $100,000 or more said they would save less.
Unfortunately, many academic studies, including the Danish study, focus exclusively on worker behaviors, generally assuming that employers will be obliged to continue providing these programs to maintain a competitive hiring advantage, regardless of tax policy changes. Others claim that employer costs to offer these programs are so small they would continue to do so, regardless of tax policy, or that worker savings could simply be rechanneled to IRAs.
Ignoring the employer response might make sense in studying the Danish system, where for most workers access to a pension savings plan is negotiated through collective bargaining. But the US private sector currently relies primarily on a voluntary retirement system—both on the part of workers to participate and save, and, significantly, on the part of employers—not only to sponsor, but also encourage participation with education, payroll deduction, and matching contributions.
A survey conducted on behalf of the Principal Financial Group in 2011 determined that if workers’ ability to deduct the 401(k) contribution from taxable income was eliminated, 65% of plan sponsor respondents would have less desire to continue their 401(k). A separate survey by AllianceBernstein found that small plan sponsors were more likely than larger employers to respond negatively to a proposed change in the deductibility of contributions by employees.
A 2012 EBRI analysis of the impact of a specific proposal (based on the AllianceBernstein survey responses and the 2012 Retirement Confidence Survey) determined that if the federal tax treatment of employer and worker contributions for 401(k) plans were ended in exchange for an 18% match from the federal government, the resulting modifications by plan sponsors, combined with individual-participant reactions, could result in an average percentage reduction in 401(k) balances of between 6% and 22% at Social Security normal retirement age (for workers currently ages 26 to 35). Moreover, participants in 401(k) plans with less than $10 million in assets would experience an average reduction in participant balances at retirement age of between 23% and 40%.
The success of workplace retirement plans in the United States depends on the behavior of two parties: employers that sponsor (and, in many cases, contribute to) these plans, and workers who voluntarily elect to defer compensation. Efforts to redress the perceived shortcomings of the current system, or to redirect the current structures, would be well-served by keeping the full picture in mind.
Nevin Adams, JD, is Director, Education & External Relations, at the Employee Benefit Research Institute (EBRI), a private, non-partisan, nonprofit research institute based in Washington, DC, that focuses on health, savings, retirement, and economic security issues.
