Expanding retirement savings opportunities

March 06, 2014

January saw three different initiatives aimed at expanding the retirement savings of US workers. Senator Collins's (R-ME) Retirement Security Act of 2014 (RSA 2014) and the Administration's myRA proposal were relatively modest (both were reviewed in this article). RSA 2014 would ease regulatory burdens on multiple employer plans (MEPs -- pooled retirement plans generally for small employers) and create a new 401(k) auto-enrollment safe harbor with higher (more aggressive) default saving rates. The myRA is an effort at finding a viable investment vehicle for the small accounts likely to be generated as lower-paid employees are ‘nudged’ into saving more.

The other initiative – Senator Harkin's (D-IA) long-awaited USA Retirement Funds (USARF) proposal – is much more ambitious (we discuss the USARF proposal here). It would create a new retirement system that would be generally independent of employers and includes a number of features advocated by some retirement policy experts: mandatory coverage (except where there is a qualifying defined benefit or defined contribution plan); automatic enrollment; conservative investment management overseen by "a board of qualified, independent trustees able to represent the interests of employees, retirees, and employers;" risk-sharing amongst a (presumably) large pool of unrelated employees; (very) limited participant access to savings; and payout as an annuity.

These proposals reflect dissatisfaction with the ‘adequacy’ of the current system. In this article we want to review the issues these reformers are raising and the challenges to reform confronting them. We begin by identifying the fundamental problem: inadequate retirement savings.

For many employees, retirement savings/benefits are believed to be inadequate

Whatever the cause of or solution to the ‘retirement crisis’ (and there are many different and opposed views on both questions), the fundamental problem is seen as US workers not having enough retirement savings/benefits. We've written elsewhere about the question “how much retirement savings is enough?” For purposes of this article we're going to assume – as most policymakers of whatever persuasion do – that the answer to that question is “more than they (US workers) have now.”

Painting with a broad brush, in this regard the key problem areas are (1) employees who are not covered by any retirement plan and (2) employees covered by 401(k) plans that are either not participating or are contributing at inadequate levels. These problems are seen to matter primarily for low-paid employees. Indeed, there seems to be a general consensus that we do not have to worry about high earner retirement security.

Many believe that there are policy tools in place to address the inadequate savings of Group (2): a broad push among sponsors and supported by Congress to implement automatic enrollment programs. For purposes of this article, therefore, we are going to focus (as do most policymakers) on Group (1) -- the ‘uncovered.’ According to Senator Harkin, 75 million US workers are not covered by any employer retirement plan. All three proposals discussed above (and many others) are aimed at improving coverage for this group.

Three big questions

With regard to extending coverage to the un-covered, we are going to consider the following questions:

Can low-paid employees afford to save, and, if they can, how can they be persuaded to do so?

Should coverage be extended within the current employer-mediated system?

Should new retirement savings be invested through current institutions (most obviously, mutual funds) or through an alternative?

1. Can (currently) un-covered low-paid employees afford to save, and how can they be persuaded to do so?

This is kind of a deep issue. Consider the following: in Cost Shifting and the Freezing of Corporate Pension Plans (Joshua D. Rauh, Irina Stefanescu and Stephen P. Zeldes, June 2013) Rauh et al. conclude that the freezing of DB plans and shift to DC plans at US corporations resulted in a saving to the corporations of 2.7-3.6% of payroll per year. At the end of this paper the authors raise the question: "whether pension freezes are bringing employee compensation more in line with their marginal product or moving it further away. If freezes represent the ability of employers to seize rents through bargaining power, the implications for economic efficiency are quite different than if they represent the ability of employers to restore balance between compensation and marginal product." In other words, before the freeze, were the employees in the DB plans being paid too much or were they, after the freeze, being paid too little?

Are benefits compensation? If they are, then, unless you assume that the 75 million uncovered employees are undercompensated, increasing their retirement savings will necessarily reduce their cash compensation. This point needs to be emphasized, because some in the retirement policy world seem to have no notion of this fairly obvious truth: additional retirement savings aren't going to fall from the sky – someone is going to have to pay for them. Unless all (or most of) the 75 million US employees currently not covered by a retirement plan are being paid less than their marginal product (that is, less than what their labor is actually worth), employers cannot afford to fund a retirement benefit for them out of their (the employer's) pocket. The 75 million employees not currently saving for retirement will have to fund retirement savings themselves, out of money they are currently spending on other things, like rent. Or their savings will have to be subsidized by taxpayers generally.

That raises the very obvious question: can a low-paid employee afford a 3% or 6% reduction in pay to fund retirement savings? One fairly common answer to this question is, most of them probably can. And the proof of it is the experience with Group (2) – experience with automatic enrollment in the 401(k) world. There we have seen significant increases in low-paid employees' contribution rates by exploiting human inertia. If you default low-paid employees into contributing 3% or 6% of pay to a 401(k) plan, a lot of them simply go along with it. So the proposal is to ‘nudge’ low-paid employees into saving, and those that really can't afford to will opt out.

Most reformers would supplement this nudge in/opt out approach with a savings subsidy financed with taxes: the Saver's Credit. Because of very low income limits and the fact that you actually have to pay taxes to get the credit (that is, the current Saver's Credit is not refundable), the current Saver's Credit is not used much by low-paid employees. But if (as most reformers propose) you increase the income limits, make the credit refundable and combine it with an aggressive program of nudging low-paid employees to save, it could become a meaningful retirement savings subsidy for the target group.

So, the answer to the first question is: yes, low-paid employees generally can afford to save, and the way to get them to save is a nudge in/opt out system. Such a system will significantly increase low-paid savings while allowing those low-paid employees who truly cannot save to opt out. The amount ‘nudged-in’ employees save may not be enough, but it can be supplemented with the Saver's Credit financed out of general tax revenues.

Not every reformer is satisfied with this answer, but this nudge in/opt out strategy is viewed by many as preferable to, say, forcing all un-covered employees to save through increased Social Security benefits and a concomitant increase in Social Security taxes.

A final and controversial issue is whether the expansion of default retirement savings should be mandatory, that is, whether all employers not maintaining a qualified plan (meeting certain minimum standards) should be required to set up, at least, some sort of auto-IRA facility. The bias of reformers seems to be towards making the system mandatory. That is what the USARF does. There is, however, a lot of resistance to this approach. After the experience with the Affordable Care Act (ACA), many in Congress are leery of mandates.

2. An employer-mediated system or something else?

Having settled on a target for reform – the ‘un-covered’ – and a strategy – ‘nudge’ – how do we get these un-covered employees into a default retirement savings program? By (somehow) getting more employers to set up automatic enrollment 401(k) plans? Or by creating retirement savings vehicles that don't depend on employer involvement? What should be the extent of employer involvement?

Why should the employer be the nexus for retirement savings?

In the 2000s, the Bush Administration proposed creating a new system of ‘super-IRAs,’ including Retirement Savings Accounts (RSAs) and Lifetime Savings Accounts (LSAs) providing significant (e.g., $20,000 per couple per year) retirement savings tax benefits in IRAs. Under this proposal, employees would not have needed an employer to get significant tax benefits for retirement savings. If adopted, the RSA/LSA proposal would have made most retirement savings a totally individual, non-employer-mediated affair. And yet the proposal attracted very little support in Congress. Why?

We would identify the following as reasons why policymakers want continued employer involvement in retirement savings and the provision of retirement benefits.

Employers as a nexus of wealth redistribution

One of the elements of the current system that is not well understood is the set of Tax Code ‘nondiscrimination’ rules that encourage employers to provide benefits to lower-paid employees. Under the current system, employees in effect get a deduction for retirement savings in a tax qualified plan. That deduction, obviously, is worth more to a high-paid employee with a higher marginal tax rate than it is to a low paid-employee with a lower marginal tax rate.

In order to achieve the policy goal of retirement security for lower-paid employees, an employer-provided tax qualified plan must generally provide benefits to a broad cross section of employees. (This is, obviously, an oversimplification. The Tax Code nondiscrimination rules are notoriously complicated and involve all sorts of complicated tests, minimum standards and compensation and contribution limits.)

In effect, qualified plan sponsors are being bribed with tax deductions for the high-paid to provide benefits for the low-paid. We asked, above, where the money would come from to provide retirement benefits for employees who could not produce enough to save for retirement. This is one answer – the Tax Code, through the roundabout (and very complicated) mechanism of the nondiscrimination rules.

One of the problems with this (current) approach to funding benefits for lower-paid employees is its complexity and non-transparency. We really don't know how much of the tax benefit is going to high-paid retirement savings, how much to low-paid benefits and how much is just wasted. There is an argument for a more explicit and transparent system of deductions plus refundable tax credits (e.g., proposals to reform the Savers' Credit discussed above). Scrapping the nondiscrimination rules, or finding a simpler, non-employer meditated alternative to them, could make the employer unnecessary for this wealth redistribution.

Employers as a nexus of risk redistribution

The ability to pool risk is generally recognized as a net benefit to pool members. It's why we buy car insurance. Large employers provide a convenient pool (of employees) which can be exploited to spread risk. This argument works well for what might be called ‘true’ insurance risks, like employee health or mortality. With respect to retirement plans, a large employer provides an obvious pool for (mortality-related) annuity risk. A problem arises when policymakers (or participant advocates) extend this risk pooling idea to non-insurance risks, like market performance.

It may be, however, that you don't need the employer to create the pool. The pooling of mortality risk is less fraught than the issues (e.g., pre-existing conditions) faced when you try (as under the ACA) to create non-employer-based pools for health care (the health care exchanges). There is some adverse selection risk with respect to annuities, and retail annuity purchase rates reflect this. But this risk (and annuity cost) is thought to go down considerably when annuitization is part – as for instance it is in the USA Retirement Funds proposal – of a comprehensive system that includes both accumulation (savings) and de-cumulation (annuitization).

There currently are no satisfying answers to the problem of market risk. Many employers are no longer willing to accept it – one of the reasons for the trend away from DB and to DC plans. But, post-the 2008 financial crisis, many participants, participant advocates and policymakers are unhappy with participants bearing all of this risk. DC participants seem to be presented with a choice of (1) taking risks they are neither comfortable with nor able to manage effectively or (2) accepting very low returns in exchange for more certainty. In a sense this problem is as old as capital markets themselves.

Employers as providers of scale

There was a time when it was axiomatic that greater scale equaled greater efficiency. That time has passed. Nevertheless, there are areas of retirement savings administration where more employees/participants/assets equals a lower per capita cost. Recordkeeping, custody, administration and investment management all tend to get cheaper (per person), and arguably better, as you increase size.

Large employers can provide this scale. Smaller ones not so much – which is why ‘getting smaller employers to adopt retirement plans’ may not be the panacea some reformers believe it to be. Indeed, with respect to the currently un-covered employees of small employers it may be easier to produce scale outside the employer-employee nexus, as, for instance, the USA Retirement Funds proposal would do. The comparison to health care reform (ACA exchanges, for instance) is unavoidable here.

Employers as providers of a payroll deduction utility

Most reform proposals (RSA/LSA is an exception) would at least keep the employer involved as a collector of retirement savings via payroll deduction. Given nudge in/opt out as the master strategy for increasing savings, payroll deduction is the obvious way to implement it, taking savings out of an employee's pay before she even sees it.

Employers as a nexus for spreading the word

Finally, many policymakers see the employer as the most convenient/effective ‘vehicle’ for getting the word out that employees need to save more for retirement, invest their retirement savings more wisely and provide a possibly very long life.

But – many employers can't maintain a plan

So there's a strong case for some employer involvement (e.g., for payroll deduction) and a slightly less strong (or less comprehensive) case for more robust involvement (wealth redistribution, pooling of mortality risk and scale). Is employer involvement worth it?

Maintaining a retirement plan comes with a certain overhead. First, generally the employer will have to make contributions to the plan. It is possible to maintain a 401(k) funded only by employee contributions, but the employer will have to administer a tricky nondiscrimination test (the 401(k) actual deferral percentage test). Otherwise (e.g., if a safe harbor is used), the employer will have to fund some contributions. Second, plan recordkeeping will have to be paid for. This is generally funded out of participant accounts, but that practice brings with it elaborate disclosure requirements and significant fiduciary risk. Third, the employer will have to design a fund menu and choose investment funds (again raising fiduciary issues). And finally there are significant reporting (e.g., form 5500) and disclosure (e.g., summary plan description) requirements. All of this may be routine for a large employer with a benefits staff, but for a small, under-resourced employer, these burdens are a good reason not to set up a plan at all.

A good argument can be made that we have reached the limits of coverage under the current system. 401(k) plans are less burdensome for employers than DB plans were – so we have more employees covered by them than were ever covered under the DB system. But many of those employers who haven't adopted a 401(k) plan yet may well have good reasons for not doing so.

So, for reformers, the answer to the question – do we keep the employer involved in retirement savings? – is (1) emphatically yes with respect to payroll deduction and (2) for larger employers (where scale and risk pooling and conceivably even wealth redistribution are working currently) yes. For smaller employers, however, reformers are thinking about some vehicle/set of policies that will achieve the goals of the current system without asking small employers to do things they cannot afford to do. The USA Retirement Funds proposal is an obvious example of this, as are (in a more modest way) proposals to expand the use of MEPs.

An interesting question is, if a non-employer mediated system can be gotten off the ground, how many employers currently maintaining a qualified plan will simply bail into the new system? For example, if the USA Retirement Funds system were established, how many employers would terminate their qualified plans in favor of participating in a USARF? For these employers, the current system ‘works’ (the burdens are acceptable given the benefits) but a non-employer system might be better. Again, the parallels with the ACA are obvious.

3. Where will we put the money?

This issue is perhaps the biggest obstacle to reform. One can conceive of, say, one huge 401(k) plan covering all US workers at a default rate of 6% of pay. Scale should make the administration of such a plan – perhaps like the Bush Administration's idea for a Social Security ‘side-car’ account – relatively efficient. But who is going to invest all that money and, perhaps most importantly, how will it be invested?

There are (at least) two problems here. One is practical. Many of the accounts of low-paid employees ‘nudged’ into saving for retirement will be small – under $5,000. Few financial services firms want these accounts, and those that do charge high fees. This isn't some flaw in our financial system – these firms aren't being ‘mean’ to small account holders. It's actually hard to figure out how to efficiently keep track of, report on and invest small accounts. This looks like a solvable problem, and something like the Administration's myRA proposal – a federal retirement savings bond – may be a solution.

The second problem is bigger and less tractable. At the end of 2012, retirement savings assets were almost $20 trillion. Let's say the savings for another 75 million (currently un-covered) employees would be 10% of that – $2 trillion. Who is going to get all that money? Which banks? Which enterprises? Which projects will be funded, and which ones won't? Who is going to decide all that?

With respect to current retirement savings (the $20 trillion) those decisions are generally made through private market institutions – a huge variety of insurance companies and banks and mutual funds and investment managers, overseen by investment consultants or plan sponsor investment committees or just individuals and their brokers. This ‘system’ (in quotes because it sometimes seems very un-systemic) is criticized for its fees and fee structures, for its inconsistent competence, for multiple conflicts of interest and general inefficiency. But it has one huge virtue: it is a vast and varied group of private actors making private decisions based on private interests. What sort of world would we live in if, instead, all of that money (or, say, half of it) were overseen (at the top) by a board of trustees appointed by the Secretaries of Treasury and Labor?

Most reformers understand that this is a problem. One of the more unusual solutions is a proposal that investment managers be randomly assigned participants’ (or employers’) retirement assets. Another proposal was to just invest all these new retirement assets in the trust for the Thrift Savings Plan (TSP) for federal employees. Indeed, for some reformers the TSP seems like a model for how to manage retirement assets; for instance, the Administration's myRa retirement savings security will earn at the same rate as Government Securities Investment Fund in the TSP. But – setting aside issues of how managers of the TSP are picked (and the possible politicization of that process) – at some point even the TSP will run out of capacity.

One of the very interesting things about Senator Harkin's USARF proposal is that it would create an entirely new retirement savings investment vehicle, the USA Retirement Fund. In a sense, USARFs would be a new industry – an alternative to the mutual fund industry. Some question whether retirement assets could be efficiently managed by companies "overseen by the Department of Labor" and "managed and administered by a board of qualified trustees able to represent the interests of employees, retirees and employers." To some that concept sounds more aspirational than realistic. But USARFs do represent an alternative to, on the one hand, what some would describe as a too costly, retail, mutual fund-based 401(k) system, and on the other hand a nationalized system (like Social Security).

The big and obvious question is: how do you create an entire retirement investment industry more or less out of nothing? One response to that question is that something very like it was done in Australia (Superannuation Funds) and in Chile (the Administradoras de Fondos de Pensiones).

The answer to this third question -- where do we put the money? – is still up in the air. For many, the current, mutual fund-based system is good enough. But most reformers seem to favor the creation of a new investment vehicle/industry that somehow avoids the problems and inefficiencies the current system is perceived (by them) to have.

* * *

The purpose of this article has been to give sponsors a view of the thinking of those advocating fundamental reform of the current retirement savings system. For some sponsors the current system is working very well – they are able to use their scale and knowledge-capital to provide benefits that employees consider valuable. Other sponsors may be frustrated with the current system's limits, and some of the ideas of the reformers may have appeal to them.

We will continue to follow these issues.

October Three, LLC is a full service actuarial, consulting and technology firm that is a leading force behind the reemergence of defined benefit plans across the country. A primary focus of the consultants at October Three is the design and administration of comprehensive retirement benefits to employees that minimize the financial risks and volatility concerns employers face.

Through effective plan design strategies October Three believes successful financial outcomes are achievable for employers and employees alike. A critical element of those strategies is the ReDB® plan design. The ReDefined Benefit Plan® represents an entirely new, design-based approach to retirement and to the management of both the employer’s and the employee’s financial risk, focusing on maximizing financial efficiency and employee value.

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