Views on the fairness and effectiveness of 401(k) retirement savings incentives

November 21, 2011

There are active discussions in Congress about decreasing contribution limits to 401(k) and other defined contribution plans. These discussions are driven, in part, by current pressure to "fix" the budget problem. Advocates of fundamental tax reform propose reducing marginal tax rates and eliminating or reducing special tax treatment for certain programs. The list of targets for elimination/reduction typically includes retirement savings tax incentives and, specifically, DC tax benefits. (Details of those initiatives are provided in our earlier article.)

Probably the most "discussed" proposal for reducing retirement savings tax incentives comes from the President's National Commission on Fiscal Responsibility and Reform (the Simpson-Bowles Commission). Generally referred to as the "20/20 proposal," as most understand it, this proposal would reduce annual DC contribution limits to $20,000 or 20% of income . (The current (2011) DC limits are $49,000 or 100% of income.)

Our sense is, however, that there is, primarily, a sentiment for reducing limits, with the actual level of reduction depending, at least in part, on how much revenue any particular cut will produce, or be treated as producing the Congressional Budget Office when the CBO "scores" the proposal.

Among the reasons tax benefits for 401(k) plans are being targeted is a belief by some policymakers that they (1) only benefit high margin taxpayers and (2) do not increase net savings. In connection with a re-consideration of 401(k) tax policy, the Government Accountability Office issued a report earlier this year, PRIVATE PENSIONS Some Key Features Lead to an Uneven Distribution of Benefits; the CBO issued a report in October, Use of Tax Incentives for Retirement Saving in 2006; and the Senate Finance Committee held hearings on "Tax Reform Options: Promoting Retirement Security."

In this article we survey some of the data and analyses presented in these reports and in testimony at the Senate Hearing.

Significance of 2001 limit increases

A particular focus of those considering the fairness and effectiveness of 401(k) tax policy is the increases in limits that were part of the "Bush tax cuts" of 2001 (The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)). Unlike, e.g., EGTRRA marginal rate cuts and estate tax rules, those limit increases were made permanent by the Pension Protection Act of 2006. They provide a "test case" for whether limit increases (or cuts) are "good" or "bad."

The following table from the GAO's report provides a useful summary of those limit increases.

Select Statutory Limits for Defined Contribution Plans, 2001, 2007, and 2011

Statutory limit

2001

2007

2011

402(g)(1) Limit on elective deferrals made by employees

$10,500

$15,500

$16,500

415(c)(1)(A) Limit on combined employer and employee contributions

35,000

45,000

49,000

414(v)(2)(B)(i) Limit on catch-up contributions for DC participants aged 50 and older

N/A

5,000

5,500

 

GAO report

To repeat, the critique of 401(k) tax policy generally focuses on fairness and effectiveness. The arguments (of the critics) are that 401(k) plans primarily benefit the highly paid and that they do not increase net savings. The GAO report supports these views:

DC Participants with High-Incomes and Other Assets Benefited the Most from Increases in Contribution Limits: Most … participants whose contributions [to DC plans] were at or above the [Tax Code contribution] limits were high-earners .... We estimated that about 72 percent of them had individual earnings at the 90th percentile ($126,000) or above for all DC participants. In comparison, only 7 percent of the DC participants contributing below the limits had individual earnings at the 90th percentile or above. [Note: To be clear about the argument here, increases in limits are assumed only to benefit participants whose current contributions are "at the limit." So if most of the participants at the limit are "high-earners," then they are the ones who have or will benefit from limit increases.]

Some industry groups have suggested that the increases in the contribution limits could motivate employers to sponsor new pension plans, according to our past work. While the number of new plans formed has risen since 2003 ... the rate of increase has been small overall, and the total number of plans actually declined from 2003 to 2005 .... Further, from 2003 to 2007 the total number of pension plans has remained relatively constant at about 700,000 plans, suggesting that there is no net increase in plans. Other factors may have been at work, but at a minimum, the number of pension plans and the number of workers covered by pension plans has remained relatively steady.

CBO report

The CBO report (Use of Tax Incentives for Retirement Saving in 2006) came out in October, 2011. It speaks to the same issues -- the fairness and effectiveness of EGTRRA limit increases. The following table-excerpt from the CBO report provides a useful summary of CBO's findings bearing on the two key issues.

The Effect of EGTRRA on Maximum Contributions to 401(k)-Type Plans, 2006

Category

Percentage of participants

Constrained pre-

EGTRRA

Percentage of participants

Constrained post- EGTRRA

Change due to EGTRRA

Under $20,000

1

<1

-1

$20,000 to $39,999

1

<1

-1

$40,000 to $79,999

3

1

-2

$80,000 to $119,999

9

2

-7

$120,000 to $159,999

21

7

-14

$160,000 and Above

51

27

-24

These data indicate that, as the critics claim, the EGTRRA limit increases primarily benefited "high earners." On the one hand, 3% of participants with incomes $40,000 to $79,999 were constrained under pre-EGTRRA rules, and only 1% post-EGTRRA, for a net increase in "headroom" of 2%. On the other hand, 51% of participants with incomes $160,000 and above were constrained under pre-EGTRRA rules, and only 27% post-EGTRRA, for a net increase in "headroom" of 24%. So -- high earners were able to contribute significantly more post EGTRRA.

It does appear that, with respect to issue two (effectiveness in encouraging retirement savings), the effect of the EGTRRA changes was not inconsequential -- that is, there was a reasonably significant increase in net retirement savings. (These data are interesting because rather than focusing, as the GAO report does, on the net number of plans, the CBO report focuses on the net amount of savings.) The CBO states that "Average contributions to all types of plans increased in real (inflation-adjusted) terms between 2003 and 2006, reflecting mostly the scheduled increases in the maximum contribution under EGTRRA." But the CBO added this caveat: "Changes in average contributions in excess of income growth might not indicate any change in the overall saving rate; instead, the differences in average contributions might reflect the shifting of assets between taxable and tax-favored accounts."

EBRI findings

At the September, 2011, Senate Finance Committee hearings on "Tax Reform Options: Promoting Retirement Security," Jack VanDerhei of the Employee Benefit Research Institute testified. With respect to the issue "who would lose if limits are cut?" and looking specifically at the Simpson-Bowles 20/20 proposal (which, as described above, includes a cut in the income limit in addition to a cut in the dollar limit), Mr. VanDerhei testified that this proposal would have an impact on some "low earner" employees, in addition to cutting tax benefits for "high earners:"

The finding that the highest-income quartile within each age cohort experiences the largest average percentage reduction [under the 20/20 proposal] is no surprise, given the increased likelihood that workers in this cohort either currently exceed the $20,000 (indexed) limit when their contributions are combined with employer contributions or are predicted to do so in the future. However, for each age cohort other than the oldest one, the lowest-income quartile has the second-highest average percentage reductions. Although this may be due to several considerations, it is almost always a result of their current or expected future contributions exceeding 20 percent of compensation when combined with employer contributions. Phrased another way, the 20/20 cap would, as expected, most affect the highest-income workers, but it also would cause a significant reduction in retirement accumulations for the lowest-income workers.

"Uneven-ness" and age

One response to the criticism that 401(k) plans provide what GAO calls "an uneven distribution of benefits" is that analyses that focus strictly on differences in income do not take into account the important relationship between such differences and age. That is, older workers generally are higher paid, and the size of 401(k) balances is more or less the same at all income levels if you adjust for age and tenure. At the Senate Finance Committee hearings Mr. VanDerhei presented data from a November, 2010, EBRI study summarizing this phenomenon.

[From EBRI Issue Brief November, 2010, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2009, By Jack VanDerhei, EBRI; Sarah Holden, ICI; and Luis Alonso]

In this regard, the EBRI Issue Brief states:

There is a positive correlation between age and account balance among participants covered by the 2009 database. Examination of the age composition of account balances finds that 52 percent of participants with account balances of less than $10,000 were in their 20s or 30s …. Similarly, 59 percent of participants with account balances greater than $100,000 were in their 50s or 60s. The positive correlation between age and account balance is expected because younger workers are likely to have lower incomes and to have had less time to accumulate a balance with their current employer. In addition, they are less likely to have rollovers from a previous employer’s plan in their current plan accounts.

Conclusion

With the "failure" of the Supercommittee to act, it is still unclear whether there will be an attempt at comprehensive tax reform this year, next year or in 2013. But it certainly seems that at some point -- by, say, 2013 -- the issue of 401(k) tax policy will be taken up. The critiques of that policy, and the data supporting them, will be a critical element in policymaker decisions.

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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