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

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

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