A Time to Act on the Illinois State Universities Retirement System (SURS)

Filed Under (Retirement Policy) by Jeffrey Brown on Dec 12, 2012

Earlier this week, I released a report co-authored with Avijit Ghosh and Scott Weisbenner (both of the University of Illinois) and Steve Cunningham (Northern Illinois) that – yet again – tries to make the case for pension reform.  The news release can be found here and the full paper (including a one page summary) can be found here.

In a nutshell, the plan has three components:

1.  Change some of the SURS rules to reduce costs and increase transparency.  This includes pegging the SURS’ effective rate of interest to long-term bond rates.  For my prior musings on this topic, click here to see the blog I wrote on this back in June of 2010, entitled “A Hidden Pension Subsidy in SURS.”

2.  Providing participants with an opportunity to opt out of their automatic annual adjustment (sometimes called the COLA) in exchange for a lump-sum that is calculated to give participants a bit of a “haircut.”  We consider this to be a reasonably fair exchange, especially given its voluntary nature, in sharp contrast to the forced choice that has been proposed in other legislation (for example, see Nolan Miller’s post entitled “The Choice Between Two Unconstitutional Options is Not Constitutional.”)

3.  Expand the Illinois state income tax base to include retirement income.  There is really no compelling economic reason to exempt retirement income from the Illinois state income tax, and this may be the only way to get the retired generation to be able to contribute to solving our fiscal problems.

Whether or not our proposal has an influence on the debates in Springfield is anybody’s guess.  But one thing is clear: absent some time of substantial reform, Illinois is teetering close to a true fiscal cliff, one that will make the Washington DC fiscal cliff look like a small step down.


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.

The Worst Tax of All is Not Even a Tax: The Case of the Social Security Earnings Test

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 8, 2011

Most people dislike paying taxes because every dollar sent to the government is one less dollar they have to spend themselves.  Because taxes make people “poorer” (ignoring, for a moment, the fact that many of those tax dollars are returned to citizens in the form of Social Security income, health benefits, or other government services), they have less money to spend on goods and services.  This is what economists call the “income effect” of taxes.  While this is the part that most normal people dislike, it is not what economists typically care about. 

You see, economists recognize that if you need to raise revenue, then it has to come out of somebody’s pocket.  And whoever’s pocket you choose to take it from will cause that person to have less money to spend.  That is just arithmetic. 

We can also have very spirited debates about whose pocket we should take those taxes from.  This is the “distributional” question.  Or to put it in laymen’s terms, this is the issue of “fairness” or “equity.”  While economists have a lot to contribute to these discussions in terms of analytical rigor, at the end of the day, one’s views on this are determined by non-economic factors, such as ideology, religion, one’s sense of justice, and so on.  Economists may get passionate on these issues, but there is really no reason that a randomly drawn economist’s view of the “fair” level of income redistribution should be given any more weight than a randomly-drawn non-economist’s view.

But there is a third factor – one that is at the heart of economics.  It is the issue of the “efficiency” of a tax system.  And by efficiency, we don’t mean something as narrowly conceived of how much it costs the IRS to collect your taxes (although that is a part of it, albeit a tiny one).  Rather, what we really care about are the incentive effects of taxation.  To use economics terms, we care about “substitution effects” of taxes (as opposed to the income effects above).  And we care about the “deadweight losses” that arise when taxes distort incentives. 

Put simply, for a given amount of revenue raised, some taxes destroy more economic activity and/or population well-being than do others.  This is because of the natural human behavioral response to switch away from taxed goods or activities and towards untaxed (or lower taxed) goods or activities.  So, when we tax labor earnings, people work less.  When we tax capital, people invest less.  When we tax wage income more heavily than health insurance, people get paid a higher share of their compensation in the form of health insurance.  When we tax dividends more highly than interest, firms issue more debt and less equity.  When we levy tariffs on foreign-made goods, people buy more American-made and fewer foreign-made goods.

In all of these cases, the taxes distort decisions, leading to a reallocation of economic activity.  And it is this reallocation that is inefficient, because in addition to raising revenue, the reallocation of activity destroys value.  So, for every dollar raised by levying a tax, we might destroy two dollars of economic value.  The amount of value destroyed over and above the revenue raised is what we refer to as a “deadweight loss.”  And this is what economists really dislike.  (As an aside, there are some unusual cases where imposing a tax is actually good for social well-being, such as when we tax something that the private market fails to account for on its own, such as pollution.  This is the basis for my earlier blog in which I called for an Osama bin Laden tax on carbon to reduce our dependence on foreign oil.)

So, if you wanted to design the PERFECT example of the WORST possible tax, what would it look like?  It would be a tax that created a lot of deadweight loss, but raised no revenue.  That is, you would impose a tax that changed the way people behave, making them worse off, while raising no revenue.

Why would anyone ever want to do this?  Well, my hope is that no one ever would want to do it.  But that does not stop politicians from actually doing it. 

My example?  The Social Security Earnings Test.

If you want an explanation of how the Earnings Test works, you can read all about it by clicking here.  But the quick version is this: If you claim Social Security benefits at age 62 but continue to work and earn money over a threshold, then Social Security reduces your monthly benefit by 50 cents for each additional dollar you earn.  This is on top of any income and payroll taxes you may have to pay.

The Earnings Test is actually not a tax in reality.  It raises no revenue whatsoever.  Why?  Because the money that Social Security reduces your benefit by is actually returned to you in the form of higher future Social Security payments!  And the calculation is roughly “actuarially fair” – meaning that for the average person, you get back the same amount with interest that you put in. 

In other words, the government raises NO revenue from this tax.  That is ingredient #1 for the worst possible tax.

Ingredient #2 is that the earnings test distorts behavior, causing people to work less than they otherwise would.  At least that is my working hypothesis.  The issue is this – if people understood that the earnings test is not really a tax, then it should have very little impact on the work versus retirement decision.  But most people do not understand this.  Rather, they view it as a 50% tax on earnings.

As evidence of this, the AARP conducted a survey of Social Security knowledge.  When they asked people what would happen to a hypothetical 63-year old who continues to earn $40,000 per year while collecting benefits, four out of 5 people ages 55 -66 correctly answered that this would reduce his current benefit.  Then, equally importantly, 3 out of 5 respondents believed that this person would never get the money back. 

So there you have it.  The “tax that is not a tax.”  You get all the negatives (i.e., distortion of labor supply decisions) and none of the revenue.

This idea was implemented so poorly that one might just think it was thought up by the U.S. Congress.  And you’d be right.

How Generations of Seniors Were Framed …

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on May 13, 2011

I had planned to post a blog discussing my research about how the way the Social Security Administration framed the benefits claiming decision may have led generations of seniors to claim benefits earlier than they otherwise would have.  But the U.S. News and World Report beat me to writing about my own research.  So I will simply link to their blog here.  Enjoy!

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.

Using Pension Obligation Bonds to Feed our Spending Addiction

Filed Under (Retirement Policy) by Jeffrey Brown on Jul 20, 2010

Several recent news reports have indicated that Illinois is planning on selling pension obligation bonds in order to come up with the cash to make its contributions to the five state public retirement systems for the next fiscal year.  This is by no means the first time that the state has used POBs: In 2009 it issued just under $3.5 billion of bonds to fund its pension contributions for 2010.  Back in 2003, it issued about $10 billion in bonds for the same purpose.

So, are issuing such bonds a good idea or not?  The answer depends on who you are, and what you are trying to achieve.

If you are a participant in one of the five public plans, the issuance of these bonds sure beats another year of having the state fail to make its contributions.  While I have written before that public employees have little to worry about given the nature of the constitution benefit protections that are in place, any lingering concerns about the state’s inability to make good on pension promises ought to be at least partially mitigated by having additional contributions made into the pension funds.  This is true regardless of whether the funds came from higher taxes, reduced spending, or borrowed funds.

If you are a politician, this is really a good plan because it allows you to – once again – avoid behaving like a responsible adult and making the difficult fiscal choices that ultimately need to be made.

If you are a current taxpayer, it also looks pretty good.  First, we avoid raising taxes now.  Second, we are essentially converting implicit debt (money owed to pensioners) into explicit debt (money owed to bondholders), with the key difference being that it is actually somewhat easier to default on the explicit debt than it is to violate the constitutional non-impairment clause (this is precisely the opposite for Social Security, in which it is easier to reduce benefits than to default on U.S. government debt). 

If you are a beneficiary of other government spending programs, you are also pretty happy.  After all, borrowing to fund the pensions puts less pressure on politicians to cut your favorite spending program.

So far, so good.  Sounds like everyone is a winner.  So, what is the catch? 

The catch is that issuing these bonds takes the pressure off of our elected officials to exert fiscal discipline.  It is like trying to cure a spend-a-holics debt problem by giving them a credit card.    

As such, the losers are all the future generations of taxpayers and program beneficiaries who are going to be saddled with several additional billion dollars worth of debt that must be serviced because we gave today’s politicians an “easy out” from facing their responsibilities today.  This reduction in fiscal discipline is made all-the-more dangerous when these bonds are portrayed as a way to magically reduce our obligations by more than the amount of the debt issuance.  All too often, one hears proponents of these bonds make statements about how the state can borrow at a low rate and invest at a high rate, and thus make money on the difference.  Invariably, such statements ignore the risk differences in the investments, and are akin to try to create a free lunch where none exists. 

Thus, the biggest downside to the use of these bonds is that they are an “enabler” for politicians who are addicted to deficit spending.  The direct effect of this resulting debt burden will be to increase the pressure to raise future taxes and cut future spending on education, health care, roads, state police and every other spending program that people may value.

The indirect effect is that higher future taxes will turn Illinois into an unattractive place for businesses to invest or for our most talented young people to build careers, homes and families.  Who wants to invest in a state that is saddling future generations of businesses and workers with debt?