The following is a memo recently published by the Economic Policy Institute outlining the inadequacies of President Obama’s plan for retirement savings. More than anything it illustrates the fallacies and perpetuation of the conventional wisdom I write so much against. Very interesting reading thus its inclusion as a blog…my remarks are highlighted in red.
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By Monique Morrissey 6.26.2009
Tucked into the blueprint for financial regulatory reform released last week is an outline of the president’s proposals for strengthening retirement plans and encouraging retirement savings. Though some of the proposals in the Department of Treasury’s white paper are welcome and overdue, they should not be mistaken for the kind of comprehensive reform that is needed to fix a system in crisis.
Barring a dramatic turnaround in stock and housing prices, the Baby Boomers will be the first generation in modern U.S. history to have less retirement security than their predecessors(this is following one of the greatest stock market booms in history) , a reversal that many experts trace to the shift from employer-provided pensions to individual savings accounts. (Pay attention, employers have the shifted the burden for retirement to the employee because it is cheaper than administering a pension plan).Yet despite the clear failure of the 401(k) experiment (they simply don’t work), the administration is still focusing on incremental reforms that would expand and tweak the current system rather than squarely address its failures. (Government will continue to kick this can down the road.)
Placing the burden of saving on households, not employers
In a sign of the times, the administration takes as a given that the primary responsibility for retirement falls on households rather than employers. (Read between the lines…you are on your own for retirement.) The white paper points to the low personal saving rate of recent years and notes that “tens of millions of U.S. households have not placed themselves on a path to become financially prepared for retirement.”
There is no mention of the role employers have played in shrinking retirement by abandoning pensions and shifting the burden to individuals. (i.e. 401k plans) The White House plan is two-pronged. First, it would require many employers who do not offer retirement plans to set up automatic payroll deductions into Individual Retirement Accounts (IRAs), using inertia to boost participation by having workers opt out rather than opt in. (The Government will now FORCE you to save money.)Second, it would expand eligibility for the Saver’s Credit and make it refundable, giving low- and moderate-income families who owe little or no income tax an incentive to save.
Ignoring the root causes of the retirement crisis
Among the problems the president’s plan does not address is the fact that workers bear enormous investment risks with 401(k)s and IRAs. (Read that sentence again)The white paper does not even mention that trillions of dollars in retirement savings and housing wealth have evaporated in the wake of two burst asset bubbles, leaving many older workers who had hoped to retire clinging to scarce jobs or swelling the ranks of the unemployed. (A market downturn at retirement can cost you everything you worked so hard to accumulate)As noted, the president’s plan simply accepts that the role of employers is now largely reduced to facilitating employee saving in tax-favored accounts. (An employer’s job is simply to provide the plan…its up to you whether or not you participate.)Even when the economy was growing strongly, workers made the lion’s share of contributions to 401(k)s, a trend that has only worsened over time. The white paper does not mention that employers ranging from AARP to Zygo Corporation have suspended their 401(k) matches during the current downturn. (An employer match is the chief reason why people invest in 401ks to begin with…without it participation drops considerably.)
The administration’s plan would make our system of tax subsidies for retirement savings slightly less inequitable, but that is different from making it fair or even progressive. Currently, 70% of subsidies for individual savings accounts go to taxpayers in the top fifth of the income distribution. (Wealthy benefit most from the perceived tax breaks.)Though an expanded Saver’s Credit would make the distribution somewhat less skewed, subsidies would continue to flow disproportionately to the wealthy, who can easily shift funds to tax-favored accounts.
Do-it- yourself model fails even on its own terms
Since it fails the fairness test, the individual savings account model is usually justified on efficiency and libertarian grounds: subsidies are supposed to leverage private savings, and to do so in a way that is less heavy-handed than one-size fits-all solutions such as expanding Social Security or requiring employers to provide retirement benefits.
This argument does not bear up under close scrutiny. First, tax incentives do not necessarily increase net saving —they simply increase saving in tax-favored accounts (meaning if it was not for your 401k account you would not save money at all). Wealthier families, especially, can shift funds or reduce saving in other ways. (Isn’t interesting what the wealthy can do?)As a result, subsidies for retirement savings grew in recent decades even as the savings rate declined. The efficiency claim is also belied by the high fees charged by 401(k) providers, a problem exacerbated by the fact that these fees are not transparent and that plan providers are selected by employers, yet most fees are paid by workers. (I have yet to meet a person who can tell me how much they are paying in fees inside their 401k plan yet they continue to contribute without hesitation.)
But even if these problems were corrected, individual accounts would remain more expensive to manage than pooled pension funds. What about the claim that a do-it-yourself system leads to savings levels and portfolios tailored to individual preferences? There is little evidence that workers manage their retirement savings effectively. (Read: People do not know how to invest inside their plans.)To the contrary, most 401(k) participants underestimate their savings needs and tend to take an all-or-nothing approach to risk rather than maintaining balanced investment portfolios.(People have too much exposure to the stock market inside their plans.)
Homo economicus
In any case, the idea that individuals are rational optimizers is an argument for no government intervention (people need help but Uncle Sam is not the answer), rather than for taxpayer-subsidized savings schemes (Social Security or private accounts), except to the extent that subsidies overcome barriers to saving. Yet under the current system, those who face the biggest barriers receive the least help. And because tax breaks must be paid for, the system robs Peter to pay Paul (taxes go up on the wealthy…we haven’t heard that lately have we?). Though there is nothing inherently wrong with redistributive tax schemes(I think a wealthy person might disagree with that statement), this one redistributes to the well-off and does not achieve its aims.
Far more people are dismayed than thrilled at the prospect of being amateur financial analysts (again people do not know how to invest in the stock market). No amount of financial education will meaningfully change that, any more than health education is a substitute for professional medical care. Sophisticated investors who want to tailor their risk-return profile can achieve similar results by balancing low-risk retirement benefits (safe guaranteed investments) with higher-risk investment strategies pursued outside the retirement system.
401(k)s and IRAs work best as supplementary plans (It can not be any clearer…)
If there is a case to be made for tax-subsidized savings accounts, it is as the top layer in a multi-tiered system (you must have multiple types of retirement accounts) that begins with a base of secure retirement benefits(there it is again…safe secure investments form the base of retirement planning) : 401(k) plans were once rightly viewed as a way to supplement pensions, not replace them(401k was NEVER meant to be a primary retirement savings vehicle). Once adequacy is achieved, there is a point beyond which some households would be better off with lower taxes or higher wages than with additional Social Security or pension benefits. At that point, it can make sense to provide incentives to overcome shortsightedness and other barriers to saving, rather than expanding a universal system like Social Security(we all know SSI is broken and does not provide enough in terms of benefits). But with Social Security replacing less than 40% of pre-retirement earnings on average (average SSI check is $1153 per month in 2009), and only one in five private-sector workers covered by a secure defined-benefit pension (pension plans continue to disappear or benefits frozen), the current system is nowhere near the point where we should be expanding risky (i.e. 401k) voluntary savings rather than secure universal benefits (are you sensing a theme here?).
The choice that’s missing: a secure pension (guaranteed lifetime income)
The white paper also cites the need to “restore more lifetime income throughout the retirement system.” But no one has figured out how to do this in the context of an individual account system. While the system allows workers to pursue such ill-advised investment strategies as loading up on own-employer stock, it does not provide access to affordable annuities that would provide the same secure lifetime benefits as traditional pensions (pensions are essentially annuities). There are many reasons for this, but perhaps the most intractable is the problem of adverse selection: since those most likely to purchase life annuities are those who expect to live the longest, this drives up the price of annuities, further reducing the number of participants who choose annuities, and so on. (Annuities get a bad reputation in the press for their “perceived ” high fees but in relation to what?) (A similar problem occurs in markets for individual health insurance, where those most likely to purchase coverage are the sickest.)
Similarly, the white paper mentions the need to reduce leakage from retirement accounts without explaining how this can be achieved. The hitch is that most people will not save much in these accounts if they cannot borrow or withdraw the funds. (What 401k plans and the like do not take into consideration is that things happen in life, believe it or not, that may cause a person to need some of their money. Not having access has always been a disadvantage of these plans and it is simply never mentioned as a flaw in the plan.)
A bolder vision is needed
The president has health care on his plate. And incremental retirement reforms can be worth pursuing: in particular, making the Saver’s Credit refundable is a long-overdue patch to a system that currently provides no help at all to low-income workers who want to save for retirement. Another no-brainer, mentioned in passing in the white paper, is requiring plans to offer a handful of standardized, low-cost investment options (Really? Is there such a thing? Once again illustrates the investments limitation and inflexibility of 401k plans). This proposal, however, is not likely to survive the legislative process without a bigger lift from the president, since, unlike expanded tax credits, it would be strenuously opposed by the financial industry. (When it is all said and done Wall Street will fight it to the death that no changes be made…they like the system just the way it is. Money flowing out of your pockets and directly in to theirs and you have no idea it is even taking place.)
The administration’s plan lets the retirement crisis go to waste, to paraphrase chief of staff Rahm Emanuel. In fact, it does not even acknowledge that a crisis exists, defining the problem narrowly and offering proposals designed to avoid treading on powerful toes(this lobby is extremely powerful in Washington) . But no one should confuse political expediency with practicality: the current system is enormously wasteful, unfair, and ineffective, and will leave most Americans at risk of facing a choice between poverty and working into advanced old age—assuming they have a choice. (What an extremely powerful way to end this memo…another wake up call.)
Endnotes
U.S. Department of the Treasury. 2009. “Financial Regulatory Reform: A New Foundation.” Washington D.C.: Department of the Treasury1. , pp. 74-75.
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