Why Retirement Plan Tax Preferences are Not as Expensive as You Might Think

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Dec 13, 2012

Retirement plans such as the 401(k) receive favorable tax treatment under the U.S. income tax system.  Historically, this favorable tax treatment was provided to increase individual saving.  Recent research has called the efficacy of this approach into question, suggesting that individual saving rates may not be all that responsive to marginal tax rates.

Last week, I wrote about the danger of drawing the conclusion that tax incentives do not matter and that we should therefore look to eliminate the tax preference for retirement saving.  My focus was on the role that tax preferences play in providing an incentive for employers to offer plans, and to design them in a way that uses behavioral nudges to increase saving.

This week, I want to focus on a different aspect of this issue, the public discussion of which has been misleading – how much this tax preference costs the U.S. Treasury.  My contention is that the cost figures being bandied about (including my own use of the $100 billion figure in last week’s post) are substantially overstated.  The point of today’s post is to note that the amount of revenue that the government would receive by eliminating the preferential tax treatment for retirement saving would be much less than what it might appear.

To understand this, one must understand (1) how retirement plans are treated under U.S. tax law, (2) how the government actually accounts for the foregone revenue, and (3) how the government ought to account for the foregone revenue.  These are complex topics, but some simple exposition is sufficient for seeing the main point.

(1)   How are retirement plans treated under U.S. tax law?  In a nutshell, the income tax on retirement plan contributions is deferred, not eliminated.  This is an important distinction.  If I receive an additional $1000 in cash salary, and I am in a 35% tax bracket, I owe the government an additional $350 in taxes.  If, however, I receive this additional $1,000 in the form of a contribution to a 401(k) plan, I owe no taxes today.  However, I will owe taxes on the money when I withdraw it during retirement.  Of course, there is financial value to deferring my taxes (what we economists call tax free “inside build-up”), but it is not as if the initial contribution escapes the tax system entirely.

(2)   How does the government account for the foregone revenue?  The U.S. Department of Treasury and the Congressional Joint Committee on Taxation prepare annual estimates of what they label “tax expenditures.”  These tax expenditures are basically just an estimate of how much additional tax would be collected if a particular activity went from being untaxed to being taxed, assuming no behavioral response to the tax.  (As an aside, the fact that they do not account for a behavioral response is why they are careful to always note that “a tax expenditure estimate is not the same as a revenue estimate.”)  In the case of retirement plan contributions, they roughly calculate the amount of money being deferred, apply the relevant marginal tax rates to it, and obtain a rough estimate of how much revenue is not being collected as a result of this tax preference.  However, a key point is that they do not estimate this over the entire life of the account, but rather use an arbitrarily truncated time horizon to estimate the effects.

Going back to my simple example: suppose I contribute an additional $1,000 today to a 401(k) plan.  That saves me $350 in taxes today, and costs the government $350 in foregone revenue in the current tax year (assuming I would save the same amount either way).  So far, so good.  But suppose that I plan to pull the money out in 20 years.  I will pay income taxes on the amount I withdraw.  The present discounted value of the tax that I pay in 20 years will likely be less than $350, but it will be much greater than zero.  For the sake of example, suppose it is worth $150 in present value.  If so, then the net gain to me (and the net cost to government) over my lifetime is $200.  The problem is that the government does not use a present value method.  Instead, it looks at just the front end, and thus overstates the value of the deduction.

(3)   How should the government account for tax expenditures?  Ideally, the government would compute these tax expenditures using the “present value” concept just explained.  A number of experts have made this suggestion.  For example, a paper by the American Society of Pension Professionals and Actuaries (ASPPA) boldly states “tax expenditure estimates for retirement savings provisions should be prepared on a present-value basis” because this “would allow an ‘apples to apples’ comparison” with other tax deductions.

What does all this imply?  A paper written by two Treasury Department officials and published in the December 2011 National Tax Journal found that “the long-run NPV cost can be dramatically different if measured using relatively short time horizons.”  The calculations are a bit tricky because one must make assumptions about rates of return, the appropriate discount rate, current and future marginal tax rates, and so on.  And the extent to which estimates differ depends on the time horizon being examined.

But, these caveats aside, the ASPPA study concludes that “the present-value tax expenditure estimates of contributions made in the first five years are 55 percent lower than the JCT five-year estimates and 75 percent lower than the Treasury five-year estimates.”  That is a huge wedge.

How does all this matter for policy?  The fiscal cliff has DC policymakers scouring the four corners of the earth looking for ways to boost revenue without raising marginal tax rates.  One way to do this is to eliminate tax expenditures.  However, some of those tax expenditures exist for good economic reasons, and the provision of favorable tax treatment for retirement saving is one of them.

As noted last week, the elimination of this provision could have serious unintended consequences for the availability of retirement savings programs through employers.  Now add to that the fact that any revenue implications of such a policy change are substantially overstated and what you get is the potential for good intentions (closing the fiscal gap) to lead to bad policy.

Relevant Disclosures:  I serve as a trustee for TIAA, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.


Tax Subsides for 401(k)’s Work, But Not for the Reasons You May Think

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Nov 30, 2012

Earlier this week, the New York Times Economix Blog wrote a piece “Study Questions Tax Breaks’ Effect on Retirement Savings.”  The article summarizes the findings of a fantastic research paper issued by the National Bureau of Economic Research (NBER).  A quick summary of the paper written by the authors themselves can be found here.  The short version is that the researchers used data from Denmark (where much better date is available) to provide evidence that tax subsidies have little effect on overall savings rates.

Their main finding is that “when individuals in the top income tax bracket received a larger tax subsidy for retirement savings, they started saving more in retirement accounts.  But the same individuals reduced the amount they were saving outside retirement accounts by almost exactly the same amount, leaving total savings essentially unchanged. We estimate each that $1 of government expenditure on the subsidy raised total savings by 1 cent.”

The policy implications of their finding are extremely important given the current debate about fiscal policy in the U.S.  After all, if tax subsidies for saving do not actually increase saving, then perhaps we should re-think the $100 billion per year that we forego in tax revenue by exempting retirement savings from the income tax base?  Such a conclusion would be quite tempting to politicians who are desperately seeking ways of raising revenue without raising tax rates.

But I say “not so fast.”  Although I do not disagree with the empirical findings of the study, I strongly disagree with the assertions being made by some that this finding justifies the elimination of the tax preference for 401(k) and other retirement vehicles.

The study itself is an outstanding intellectual contribution, and one that will likely (and deservedly) end up being published in a leading scholarly journal.  I can personally vouch for the high intelligence and research integrity of the two U.S. authors.  Raj Chetty was named a MacArthur “Genius” earlier this year, and is widely expected to be awarded the prestigious John Bates Clark medal sometime in the next 6-8 years.  John Friedman of Harvard is also an emerging research star in the economics profession.

So, the researchers are top notch, the study is extremely well done, and the conclusion is that tax subsidies do not generate net much net savings.  So, why not simply eliminate the tax preference for 401(k) plans in the U.S. and raise a trillion dollars of revenue over the next decade?

Because of the important role of plan sponsors, that is why.

For better or for worse, the employer plays a central role in the U.S. retirement system.  Although there are several reasons that employers offer retirement plans and other employee benefits (e.g., to differentially attract certain types of workers, to help manage retirement dates, to motivate workers, etc.), there is little question that the large tax subsidy  looms very large in their decision to use retirement plans – as opposed to other types of benefits – to achieve these outcomes.

To qualify for favorable tax treatment, employer provided retirement plans, including the 401(k), must meet a long list of “plan qualification requirements.”  These requirements are what provide Congress and regulators the ability to influence the design of retirement plans.

An important example is the set of “non-discrimination rules” designed to ensure broad-based participation in an employer’s plan.  These rules provide incentives for plan sponsors to find innovative ways of encouraging saving by their employees.  Indeed, it is not much of a stretch to suggest that these rules are the reason we have seen the widespread adoption over the years of employer matching contributions, automatic enrollment, automatic escalation of contributions, and numerous other innovations in the retirement plan space that have been shown to increase saving.

The authors themselves note that “automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower fiscal cost.”  I agree that behavioral nudges have had an enormous impact.  But in an employer based retirement plan system, the only way to get employers to offer those nudges is to provide them with a compelling financial reason to do so.  In essence, tax subsidies are the nudge for employers to provide the nudge for employees.

Of course, this does not necessarily mean that the existing system should be treated as sacrosanct.  It may be that employers would continue to offer 401(k)’s – along with their numerous savings nudges – if the financial incentive were provided in a less expensive way (e.g., by capping deductibility).  That is a debate we ought to have (hopefully informed by evidence of the same high quality as the NBER study).  My point is simply that any policy discussion should recognize the very important role that employers play as trusted sponsors of the plan, and be careful not to throw out the baby with the bathwater.

Indeed, given that only about half of US workers have opportunities to save through their current employer, we should be looking for ways to encourage more employers to sponsor plans.  If we go after the tax incentives for retirement saving, we must be careful not to inadvertently destroy the plan sponsor infrastructure that is the foundation of retirement security for millions of Americans.


Relevant Disclosures:  I am a Research Associate of the NBER (through which the study above was released) and Associate Director of the NBER Retirement Research Center (through which the authors have received some funding for their study).  I am also a trustee for TIAA CREF, a provider of retirement plans to the not-for-profit sector.  I have also received compensation as a consultant or speaker for a wide range of other financial services institutions.  The opinions expressed in this blog (and any errors) are my own.

Reducing Regulatory Obstacles to Retirement Income Security

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 7, 2012

With nearly 80 million baby boomers starting their march into retirement, many policy-makers have begun to focus on how to provide secure retirement income in a fiscally sustainable way.  This is no small challenge in an era of enormous deficits.

Although Social Security plays an important role in providing income that retirees cannot outlive, the benefits provided by Social Security are insufficient to ensure that most retirees can maintain their pre-retirement living standards.  However, increasing these benefits would be horrible fiscal policy: because the pay-as-you-go nature of Social Security has collided with an aging population, this program faces enormous fiscal problems that are going to require reductions – not increases – in the rate at which benefits grow.

Thus we have two opposing forces: a need for more retirement income, and a need to cut government spending on entitlement programs like Social Security.  What can be done?

Fortunately, the private sector can play an important role here, but only if the regulatory environment allows for it.  Presently, the regulatory landscape surrounding employer sponsorship of retirement plans is burdensome and enormously complex.  In many cases, the best thing the government can do to promote a greater role for the private sector in providing guaranteed retirement income is to “get out of the way.”  Ironically, however, there are other instances in which the best way the government can promote private sector solutions is to get more involved – if only by providing guidance on how plan sponsors can improve their plans without running afoul of existing regulations.  Getting guaranteed income options into 401(k)’s and other retirement plans is one such case.

In recent years, the financial services industry has increasingly focused on how to provide plan sponsors and plan participants with products that help to provide guaranteed lifetime income.  The resulting innovation over the past decade has been impressive, as companies have introduced a wide range of insurance and investment products that provide individuals with lifetime income.

However, employers that sponsor 401(k) plans have been slow to adopt.  As a result, most 401(k) participants in the U.S. still do not have access to annuities or other income products in their plans.  Although there are many reasons for this, there is little question that part of the reluctance of plan sponsors to provide annuities is that they have been scared off by regulatory and fiduciary concerns.

Last week, the Treasury Department proposed guidance to help address a few of the many issues that stand in the way of better private sector retirement plans.

In a nutshell, the proposed guidance does three things:

First, it makes it easier for plan sponsors to allow retirees to have a mix of lump-sum and annuity choices.  Put simply, it makes very little sense for most retirees to annuitize either 0% or 100% of their retirement assets.  Annuities provide guaranteed income, help to protect against out-living one’s assets, and help to guard against market volatility.  On the other hand, having some non-annuitized wealth available is extremely valuable when faced with uncertain expenses such as for long-term care.  Given that the optimal financial plan for most individuals would be to have some of both (e.g., annuities and a lump-sum), it only makes sense for our regulatory infrastructure to encourage this.

Second, a number of academic papers have established the potential value of annuity products that have a deferred payoff structure.  That is, with a small fraction of one’s wealth at, say, age 65, one can buy a product that will start paying income at age 85.  In the industry, these are sometimes called “longevity insurance” (although the name is very unfortunate, because all life annuities – whether they are deferred or not – are providing insurance against the financial costs of longevity).  The proposed regulatory guidance would help ensure that these products are more easily available.

Third, Treasury issued two “revenue rulings” that clarify how rules designed to protect employees and their spouses apply when a plan offers an income option.

These rules are useful, but far from sufficient.  Looking ahead, plan sponsors and participants would be better off if policymakers also took at least three additional steps.

First, the Department of Labor needs to provide much greater clarity about how plan sponsors who wish to provide lifetime income options can do so while protecting themselves from fiduciary risk.  This could include providing a “safe harbor” rule for the selection of the annuity provider.  Too many plan sponsors continue to be spooked off by the specter of fiduciary liability if they choose an annuity provider that runs into financial distress in the future.

Second, Congress should reform the Required Minimum Distribution rules to eliminate the various implicit and explicit barriers to lifetime income.  These rules were written by tax lawyers to ensure that the IRS could eventually get its hands on tax-deferred savings.  If these rules were instead written with an eye towards retirement income security, they would look quite different.

Third, we should encourage plan sponsors to report 401(k) and other defined contribution (DC) balances in terms of the monthly income the plan will provide, rather than simply as an account balance.  The Lifetime Income Disclosure Act that received bipartisan sponsorship in the U.S. Senate last year would be a positive step in this direction.  (My Senate testimony on this Act can be found by clicking here).

This need not be a partisan issue.  Republicans should recognize that strengthening retirement income security in our private pension system will give us more freedom to address our burgeoning Social Security deficits.  Democrats should view this as an opportunity to ensure that employers “do the right thing” by providing retirement plans to employees that actually succeed in providing a secure retirement.

Why the Government Should Not Issue Annuities

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 1, 2011

In Sunday’s New York Times, Professors Hu and Odean published an op-ed entitled “Paying for Old Age.” After reading it, I concluded that it needs a response, as I am afraid that the authors have misdiagnosed the main problem.

First, let me say that I am a big fan of Odean’s academic work, including that which uses proprietary brokerage data to provide insights into individual investor behavior.  And Henry Hu is also a highly respected law and finance scholar who is well-known for his work on financial risk.  I am delighted to have more super smart academics taking an interest in the important issue of guaranteed lifetime income (and I don’t mean to imply by “more super smart academics” that I consider myself super smart!  Rather, this is a topic that has been researched by some of the brightest economic minds of the last 25 years, including Nobel Laureates Peter Diamond and Franco Modigliani, as well as other leading economists such as Jim Poterba, Doug Bernheim, Amy Finkelstein, Olivia Mitchell, and many others.)

In essence, Hu and Odean are suggesting that the U.S. government should issue inflation indexed life annuities directly to the public.  They are not the first to propose this – the Aspen Institute had a similar proposal several years ago.

I understand the motivation of their proposal.  After all, we know that counter-party risk is one reason that individuals may be concerned about entering into long-term annuity contracts with insurers, and this is especially true after the recent financial crisis that witnessed the disappearance of venerable financial institutions.  Perhaps even more importantly, we know that many 401(k) plan sponsors have concerns about fiduciary liability when it comes to choosing an annuity provider.  Having the government provide the annuities directly is meant to address this concern.  So it is fairly straightforward to write down a simple economic model in which I can show that optimally structured government intervention appears to make people better off.

Even so, I think the proposal is off base, for several reasons.

First, I think they have misdiagnosed the reason people do not buy annuities.  While concerns about counter-party risk are certainly heightened today, the demand for annuities was ridiculously low even a decade ago when most consumers were not even thinking about the issue.  Nor is there much evidence that the lack of inflation protection or high prices are the primary reasons for limited demand.  While these probably contribute a bit on the margin, they are only three items on a very long list of reasons that demand for annuities is limited, which I have discussed at length elsewhere.

Second, I have no confidence in the government’s ability to run this program effectively.  The same holds true for the idea of the government providing a government backstop for private annuity providers.  Last year I published a book (a collection of papers from an AEI conference that I organized two years ago) that includes analyses of 6 major government insurance or reinsurance programs, including programs to insure DB pensions (PBGC), bank deposits (FDIC), crops, terrorism, floods and natural catastrophes.  As I discuss in my intro chapter to that book, one of the themes that came out of these analyses is that the U.S. government simply does not seem to be capable of structuring insurance programs in a manner consistent with basic economic principles.  They almost universally fail to charge appropriate prices for the insurance (in two ways – premiums are too low on average, and they are not properly risk-adjusted), which distorts incentives and leads in some cases to excessive risk-taking (a form of moral hazard).  They tend to create large unfunded liabilities that put taxpayer funds at risk.  There are other problems as well (which you can read about if you read the book!)

So while an optimally-designed government backstop would have real value, the U.S. government has an abysmal record of optimally designing such systems.  So we are immediately thrust into the world of “second best” policies where it becomes difficult to ascertain whether a poorly designed program is really better than none at all.  I am extremely reluctant to run the “experiment” because, to paraphrase Milton Friedman, “there is nothing so permanent as a temporary government program.”

Third, despite the authors’ attempt to sell this as an “everybody wins” idea, I think it is pretty clear that this would crowd-out private annuity provision, and all the future innovation that may come out of it.  (Disclosure: I am a trustee for TIAA, one of the world’s largest annuity providers.  I have also done work over the years for many other life insurance companies. )

Finally, I believe that other market-based solutions are emerging.  There has recently been a lot of discussion, and some activity, of “multi-insurer solutions,” in which a plan sponsor enters into an agreement with multiple insurers who essentially each agree to kick in to cover one another in the event that one provider experiences financial distress (of course, this does not help if the whole industry goes down.)  The idea is still young and new, and I would hate to kill the innovation by starting yet another government program.

In essence, I do not think that direct government provision of annuities is necessary or desirable.  The problem in the private market is not that the products do not exist, it is that people do not buy them.  Nothing in this proposal will change that.  We would be better off focusing our efforts on policies such as reducing fiduciary risk to plan sponsors that would like to provide annuity options to employees.  Or reforming our minimum distribution requirements so that they no longer discourage annuities.

Bottomline – rather than having the government provide annuities, I would like to see the government stop discouraging the use of annuities that private providers would be happy to make available.

Will People Work Longer Due to the Great Recession?

Filed Under (Retirement Policy) by Jeffrey Brown on Jul 27, 2010

When the financial crisis hit last year, a lot of news sources started speculating that people would be forced to work longer to make up for the losses in their 401(k) plans.  Yet there seemed to be some puzzlement when data started indicating that more people were retiring earlier.  What happened here?

Some new research sheds a bit of light on this.  The answer to the puzzle is essentially that there are different groups out there who were affected differently.  Higher income individuals with large 401(k) balances were indeed likely to postpone retirement as a result of the negative wealth shock.

However, the financial crisis was also accompanied by a deep and prolonged recession that significantly increased unemployment, or more broadly, joblessness.  A study by Courtney Coile and Phil Levine of Wellesley College shows that a rise in unemployment during a recession leads to earlier retirement.  In essence, older individuals choose to retire rather than try to find another job. 

In aggregate, it appears that the unemployment-induced increase in retirement outweighs the 401(k)-loss-induced delay in retirement.  The net result is the average person retiring earlier, not working longer.

Of course, the most important point of all is that both effects are likely to reduce retirement security.  Whether forced out of the labor force early due to job loss or forced to stay in the labor force longer due to a negative wealth shock, individuals are made worse off.  And that, ultimately, is the real story.

Annuitizing 401(k) Plans: Class Warfare, or Just Good Economics?

Filed Under (Uncategorized) by Jeffrey Brown on Mar 16, 2010

Last month the Departments of Labor and Treasury issued a Request for Information in order to solicit public comment on ideas related to converting 401(k) account balances into annuities or other guaranteed retirement income streams.  This is a topic about which I have given a lot of thought – indeed, I even wrote a paper recommending that annuities become the “default option” for distributing from 401(k) plans.  (Click HERE to see the paper).

 As I see it, there is a good case to be made for thinking about guaranteed lifelong income as the default distribution option.  My primary motivation is to ensure that individuals have the private sector financial tools available to optimally manage their retirement portfolios in the presence of uncertainty about how long they will live.  Annuities solve this problem by allow one to trade a lump sum of wealth for an income stream that will last as long as you (and possibly a spouse) live.  There are mountains of academic research suggesting that annuities can make people better off by offering a higher level of sustainable consumption, insuring against longevity risk, and so on.

Enter stage right, Newt Gingrich and Peter Ferrara.  In a piece on Investor Business Daily’s website (read it here), they wrote an article entitled “Class Warfare’s Next Target: 401(k) Saving.”  In it, they essentially argue that treating annuities as the default distribution option is somehow a left-wing conspiracy to tax your retirement, force people to buy government bonds, and do other evil things in the name of “class warfare.”  (You can also find it on the AEI webpage and a related post on the conservative blog watch.)


I am extremely puzzled by their hostility towards the general idea.  But before I point out what I do not like, let me point out some valid points they raise:


First, they correctly point out one longer-term risk of a government program that starts out as optional – which is that they can, through the political process, end up paving the way toward a mandate.  There is no question that mandated annuitization would be a bad thing on many levels – it would interfere with individual liberty and choice, it would effectively redistribute resources from the poor (who don’t live as long) to the rich (who tend to live longer), and so on.  So they are right to be concerned about where an optional program will ultimately lead in a political environment – a point that academic economists too often overlook when thinking about optimal policy designs.

 Second, I completely agree with their general dislike of the Ghilarducci proposal to invest in a guaranteed retirement account administered by the Social Security Administration.  Indeed, I could write 20 blogs on all the things I dislike about this proposal, whether it be the absurdly high return that Ghilarducci proposes to guarantee at taxpayer expense (without appropriately accounting for the true economic cost) or the very idea that the under-resourced, overly-bureaucratic Social Security Administration should be expanded into an area that the private sector can run perfectly fine.  

 Third, I certainly cannot quibble with their general ideological distaste for policies that keep “punishing responsibility and rewarding failure.”  As readers of this blog can probably tell, I am an advocate of free market capitalism, and I generally distrust over-reaching government regulation.  

Given all of this, why do I support annuities as a default option?  And why do I disagree with the Gingrich/Ferrara critique?  Here are a few reasons.  I will keep it short so this post does not grow monstrous in size, but perhaps I will return later:

Part of the goal here is to do what conservatives like me generally like – to provide people with more choice, not less.  The idea is to get more plan sponsors to offer annuities as a distribution option from their 401(k) and other DC plans.  Right now, few do so, and so individual participants who want annuity income are forced into the individual market where they don’t get as good of a deal (due to concerns about adverse selection, etc.)

  1. We already have a default distribution option from 401(k) plans – in most cases it is to take a lump-sum distribution.  The question is about what type of default option makes the most sense for the most people.  I think the research is pretty clear that most individuals do not have adequate sources of guaranteed retirement income, and that a product that provides guaranteed lifetime income would make them better off.  A lump-sum strikes me as precisely the wrong default option for a retirement plan.
  2. What I favor is an optional program.  As I have outlined in my proposal, people would have plenty of opportunity to take an alternative distribution if they want it.  Those who (like me) place a high premium on individual liberty should take comfort in the fact that my proposal would place no restrictions on an individual’s ability to opt out of the annuity if they want.
  3. There is nothing in my proposal that forces people to hold treasury bonds or subject themselves to inflation risk, as implied by Gingrich and Ferrara.  Indeed, I am a big advocate of inflation-indexed annuities and/or variable payout life annuities in which the lifetime payouts are linked to an underlying portfolio like those offered by TIAA CREF (disclosure: I am a Trustee for TIAA.)  Plus, an annuity provides what some call a “mortality premium,” which is an extra rate of return in exchange for making the benefits life-contingent.
  4. Under my proposal – and under most of the serious proposals I have heard so far – the government (whether it be Social Security Administration or some other agency) would NOT be the administrator of this program.  Rather, plan sponsors could contract with private sector annuity providers – and there is a nice, active, competitive market for such products.

Yes, I am a big fan of free markets.  But only a fool would think that the existing 401(k) system looks like it does because of pure free market forces.  The complicated system we have in place today is as much a creature of government regulation as any program we have.  Indeed, the name “401(k)” itself refers to a section in the Internal Revenue Code! 

As long as we are operating in a world in which government rules largely drive plan sponsor decisions about what kind of retirement plan to offer – and as long as plan design influences participant behavior – and as long as participant behavior drives how well off these participants will be when they retire – then does it not at least make sense to ensure that the basic set of rules be ones that make people’s retirement more secure rather than less?  Especially if we can do it in a way that preserves individual choice?

I respect Gingrich/Ferrara’s healthy skepticism of government.  But sometimes ideology can get in the way of a good idea.  

We Need a New Retirement System

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 20, 2009

The past year has not been good for 401(k)s and other retirement plans.  Among many implications of the financial crisis and deep recession, we have seen the dramatic, correlated losses across nearly every major asset class underscore the fragility of a 401(k) system that is focused predominantly on wealth accumulation rather than secure retirement income.  In essence, the 401(k) system was exposed for what it truly is – a promising supplemental savings plan, but an inadequate vehicle for ensuring a secure retirement.  


I’m not alone in this view.  I spend much of my time interacting with people who specialize in thinking about retirement income security – academic researchers, policymakers on both sides of the political aisle, insurance companies, financial advisors, consultants and consumers.  Over the past 12 months I have noticed a striking degree of commonality in their thinking around the fact that we need a better retirement system in the U.S.  This is not to say there are not still important areas of disagreement – for example, I find proposals to increase Social Security benefits, to return to a defined benefit system, and/or to have the government guarantee retirement income to be a combination of naive, reckless and fiscally irresponsible.  But when it comes to the future of private sector retirement plans, I believe there are a number of common themes emerging that make very good sense.


Yesterday, I had the opportunity to speak at the annual conference of the American Council of Life Insurers (www.acli.com) about my proposal for encouraging plan sponsors to use guaranteed lifetime income products as the default distribution option.  Before my session, I had the privilege of hearing Dr. Roger Ferguson, President and CEO of TIAA-CREF – one of the largest providers of retirement income in the world – speak on this issue.  (In the interest of full disclosure, I should note that I am a trustee of TIAA). 


Dr. Ferguson outlined 5 areas that need improvement in our system.  (I should note that I am paraphrasing here and including some of my own thoughts – so please do not interpret this as an exact representation of his remarks!)


  1. We need to return to a focus on providing guaranteed income.  During the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) pension plans like the 401(k) and 403(b), we somehow lost sight of the fact that the point of saving for retirement is to provide income security.  We need to get the focus back on annuitized, lifetime income.  This does not mean a return to the old style DB systems.  It does mean looking for innovative ways to convert 401(k) and 403(b) wealth into income before, during, and after retirement.
  2. We need to broaden coverage.  Millions of households do not have access to any employer sponsored retirement plan.  Somehow, someway, we need to fix this.  While it is true that individuals can save on their own, the evidence is overwhelming that “employers matter” in promoting saving.  Social Security alone is sufficient to replace adequate income for only a minority of households.  Indeed, given the poor fiscal trajectory of the program, the rising normal retirement age that will reduce benefits for those who claim at earlier ages, and rising Medicare premiums, its adequacy will only diminish further.    
  3. We need to ensure that individuals are broadly diversified.  I, personally, would love to see us put together individualized retirement plans that include a life cycle portfolio trajectory that gradually converts into annuitized income the closer one gets to retirement.  The investment options need to include not just stocks and bonds, but also real estate and other asset classes.  
  4. We need to ensure that individuals have access to good information and advice.  Our current regulatory structure – designed to protect consumers from tainted advice by those who might have a conflict of interest – has had the unfortunate effect of making plan sponsors go through a torturous and administratively complex route to provide good advice to participants.  We need to find sensible ways to streamline this process. 
  5. We need to provide vehicles for individuals to be able to save for retiree health care expenses.  Health Savings Accounts and other similar tools have a useful role to play here.


To get there from here, we do need some regulatory and policy changes.  I suspect that we may see this discussion rise closer to the top of the agenda after health care reform is behind us …

So you don’t know how long you will live? Perhaps its time for an “auto-annuity”

Filed Under (Retirement Policy) by Jeffrey Brown on Sep 14, 2009

I don’t know about you, but I have no idea how long I will live.  In most ways, this is a blessing – given how much I like to quantify things, I don’t think I could help myself from starting the grand count-down if I knew my death date for certain.  But in at least one respect – financial planning for retirement – this uncertainty is a real nuisance. 

Fortunately, there are financial products – known by the unsexy name of “life annuities” – that help solve this problem by converting  wealth into a stream of income that will last as long as you do.   There is plenty of research out there showing why annuitization can improve individual well-being by providing a higher level of consumption in retirement.  The problem is that most 401(k) plan sponsors don’t offer them in their plans, and thus most retirees or soon-to-be-retirees don’t have the option to convert their wealth into a guaranteed income stream.

Last Friday, I presented a new policy proposal at a conference sponsored by the American Council of Life Insurers, the AARP, the American Benefits Council, and WISER (apologies if I missed any sponsors!)  The gist of the proposal is to encourage 401(k) and 403(b) plan sponsors to adopt life annuities as the default distribution option from their plans.  The policy steps suggested to encourage it include fiduciary relief and the easing of some administrative burdens associated with qualified joint and survivor annuity rules.  If I may say so myself, the proposal was very well received – including by officials at Treasury, Labor and most of the Congressional staffers present.

Using “automatic enrollment” has proven very successful at increasing 401(k) participation rates, and I believe that “automatic annuitization” could help do the same for increasing annuitization in the payout phase.  This seems a worthwhile goal.  After all, saving assets is not enough to ensure retirement security – you also need a way to ensure that you have enough to live on no matter how long you live. 

I know that this will not make the most scintillating reading for the masses, but you might want to check out the paper anyway.  Whether or not this proposal is ever enacted, I am pretty confident that the future of private sector retirement plans in this country is going to include a greater role for annuitization.  So you may as well start learning about it now … here is the link to the paper.