Ericca Maas - Community Affairs Senior Project Manager
Published May 1, 2007 | May 2007 issue
Financial projections indicate the retirement of the Baby Boom generation will put an unprecedented strain on programs like Social Security and Medicare. With those programs strained and the importance of traditional, employer-funded pension programs in decline, retirees will come to depend more and more on their personal retirement savings plans as sources of income. Although recent studies suggest most older Americans have saved enough to retire comfortably, there are millions of individuals and households whose savings may prove inadequate to provide them with the same standard of living they experienced before retirement. The risk is elevated for low- and moderate-income retirees, among others.
To reduce the risk, Congress passed the Pension Protection Act (PPA), which was signed into law in August 2006. A response to the expiration of several short-term acts passed by Congress, the PPA represents a major overhaul of the pension and retirement benefit system in the U.S. It is estimated that the legislation will affect more than 105 million Americans, slightly more than one-third of the population.1/
One goal of the PPA is to encourage greater personal retirement savings. The act gives employers tools to facilitate participation in defined contribution plans, specifically addressing 401(k) enrollment. In addition, it creates tax incentives to make saving in 401(k) plans and Individual Retirement Accounts (IRA) easier and more attractive.
This article discusses the state of personal retirement savings in the U.S. and describes some key provisions of the PPA. Along the way, it highlights research that explores the effectiveness of incentives and plan features designed to encourage retirement saving. Taken as a whole, the research suggests some of the PPA’s provisions have greater potential for promoting retirement savings participation and contributions than others. However, further action from employers, individuals and community groups could help make up the difference.
The current state of retirement savings in the U.S. is characterized by the move away from defined benefit (DB) plans, such as traditional, employer-funded pensions. Increasingly, workers are receiving retirement benefits in the form of defined contribution (DC) plans, such as 401(k)s and IRAs. Such plans give employees much more responsibility for their own retirement savings than DB plans do. In contrast to DB plans, DC plans put employees in control of how much they add to their accounts, where the money is invested and how benefits will be managed in retirement. (For more on the differences between DB and DC plans, see the sidebar below.)
According to the Retirement Security Project (RSP), which uses data from the Federal Reserve System’s Survey of Consumer Finances, 49.5 percent of all households in the U.S. had savings in an employer-based DC plan or in a tax-preferred savings account like an IRA in 2004. The median balance for account holders was only $34,000.2/
The percentage of workers who participate in retirement plans decreases as family income, net worth, and educational attainment decrease. Figures from the Employee Benefit Research Institute (EBRI), a trade group for companies that manage 401(k) and IRA plans, show that in 2004, 90.6 percent of families with incomes of $100,000 or more had a retirement plan from a current or previous employer or an IRA/Keogh plan. The corresponding percentage for families with incomes between $10,000 and $24,999 was 22.6. For families with incomes lower than $10,000, the percentage was just 10.3. Among families who rank in the top 10 percent by net worth, 84.7 percent had an employment-based retirement plan or IRA/Keogh plan. Among families whose net worth falls in the bottom quarter, just 21.6 percent participated in a retirement plan. There are notable racial disparities as well. Across all income groups, 62.9 percent of white, non-Hispanic families participated in retirement plans in 2004, compared to 41.3 percent of nonwhite families.3/
Many factors contribute to low retirement-plan participation. Workers with very low incomes may find it impossible to cover basic living expenses and also participate in a retirement plan. Another major factor is that many low-wage jobs do not offer retirement benefits, thus reducing the pool of individuals who have the convenient option of participating in an employer-sponsored plan. Still, several demographic groups are less likely than others to be saving for retirement, even if they have access to an employer-sponsored plan like a 401(k).
This may be due to some common features of employer-sponsored plans. For example, participation in most 401(k) plans requires enrollees to do several things. Employees must “opt in” to these plans. That is, they must choose to enroll and then actively do so. They then have to determine what percentage of their salary to contribute and how those funds will be invested. These decisions are usually presented at a time when new employees are also choosing a health plan, filling out their W-2 forms and completing other routine paperwork. It can seem overwhelming, and may be enough to dissuade new hires from enrolling in a plan.
In addition, many employees who choose to enroll in a plan end up contributing at low levels or failing to optimize their investments. The RSP estimates only about 1 percent of workers earning less than $60,000 a year made the maximum annual contribution to their DC plans in 2004. Further research concludes that most 401(k) participants do not adequately diversify their investment portfolios. A 2003 study found that 46 percent of DC plan participants held more than 20 percent of their account balances in employer stocks.4/
Some of the key provisions of the PPA were designed to boost retirement plan enrollment and encourage employees to make the most of their savings. Several of these provisions relate to 401(k) plans.
The most notable of the PPA’s 401(k)-related measures will encourage companies to enroll employees in a 401(k) plan automatically. So, instead of having to opt in to a plan, employees will have to make an effort to opt out. Research indicates that automatic enrollment leads to higher 401(k) participation, especially in an employee’s initial years on a job. Studies have shown that enrollment rates increase by as much as 37 percent when an opt-out policy is in place, with even larger increases for low-income workers. In one study, their participation rate increased from 16 percent to 80 percent. This research also shows that over time, very few of those automatically enrolled in a plan actually opt out.5/
However, it’s unclear how beneficial automatic enrollment is for employees in the long term, because procrastination and inertia play a role after enrollment. Employees who are enrolled in plans by default are usually enrolled at a low level, often around 3 percent of salary, and in a conservative investment strategy like a money market fund. While these individuals are saving, they are often not saving enough to receive the entire employer match and likely are not maximizing the potential of their investments.
The PPA attempts to remedy this problem by creating incentives for employers to set up automatic enrollment arrangements that include automatic escalation features. Under these arrangements, employers automatically enroll their employees in a 401(k) plan and specify minimum and maximum contribution rates. The rates automatically increase by a specified amount each year until the maximum rate, capped by law at 10 percent, is reached. For instance, if an individual enrolls at an annual contribution rate of 3 percent of salary, his or her contribution automatically escalates to 4 percent the next year, and so on up to the specified maximum. Research has shown that automatic escalation arrangements result in substantially increased contribution rates over time.6/
To help employees maximize their investments, the PPA allows employers to provide employees with access to qualified investment advisors. It also allows plan fiduciaries to invest the accounts of default participants in more balanced, higher-yield portfolios than the conservative, low-yield money market funds often used with automatic enrollment. The PPA offers employers some protection from liability related to the potential losses associated with higher-risk, higher-return default funds.
In addition, the PPA expands tax benefits for low- and moderate-income households by making the saver’s credit permanent and indexing it for inflation. The saver’s credit, first enacted in the 2001 tax cut legislation and originally set to expire at the end of 2006, provides a tax credit of up to 50 percent for voluntary contributions to 401(k) plans, IRAs and similar retirement savings accounts. The saver’s credit is a nonrefundable tax credit, which means it can be applied to tax liability owed to the government, but cannot be received as a cash refund. Based on their income and family status, taxpayers qualify for credits of 10, 20 or 50 percent of their tax liability, up to a limit of $2,000. (For an example of how the saver’s credit works, see the box below.) Credits are targeted to those with incomes of $50,000 or less, with the largest credits available to the lowest earners.7/
Work done by the Tax Policy Center (TPC), a joint venture of the Urban Institute and The Brookings Institution that is made up of nationally recognized experts in tax, budget and social policy, presents the saver’s credit as a step toward changing America’s “upside-down” structure of tax incentives for retirement savings, which currently gives the highest earners the largest incentives for saving and the lowest earners the smallest. TPC’s work also describes the saver’s credit as an implicit government match, through the tax code, for contributions to retirement savings accounts.8/
While research has shown that incentives such as matches increase personal savings, the saver’s credit has not proven to be as powerful of an incentive, despite being an effective 100 percent match in certain cases. A field experiment carried out by H&R Block offered matching incentives for IRA contributions at the time of tax preparation. Researchers who examined the experiment found that higher match rates raise IRA participation and contributions. Specifically, individuals who were offered 20 percent or 50 percent contribution matches participated at rates of 8 percent and 14 percent, respectively, compared to 3 percent among those who were not offered a match. However, when researchers considered the saver’s credit as a match, they found much more modest effects on participation and contribution amounts.9/
Authors of the H&R Block study suggest the complexity of the saver’s credit may be responsible for its ineffectiveness as a matching incentive. Specifically, they point out that the credit is not refundable and may not have been effectively advertised or explained to tax filers. A study of saver’s credit utilization found that the credit went unclaimed by 34 percent of qualified tax filers. Of those who did claim the credit, 43 percent found their credit amount limited because it exceeded the amount of their tax liability. Also, qualified filers were 70 percent more likely to claim the credit if they used a professional tax preparer or computer software program to file.10/
In short, the PPA made the saver’s credit permanent and indexed it to inflation in order to encourage low- and moderate-income taxpayers to save more for retirement. However, many low- or moderate-income taxpayers neither claim the credit nor receive its full benefit. The use of tax preparation services or products significantly boosts the percentage of tax filers who claim the credit. This finding suggests nonprofit organizations that provide free tax preparation assistance to low-income taxpayers may have a role to play in promoting the saver’s credit.
The final PPA provision designed to encourage greater personal retirement savings will allow individuals to have their directly deposited federal income tax refunds split among as many as three different accounts. For individuals who need to prioritize various commitments for their refunds at tax time, the split-refunds provision eliminates the hands-on disbursement of funds and, in turn, reduces the temptation to spend those funds instead of save them. This simple change in refund processing could encourage not only greater retirement savings, but greater “rainy day” savings as well. For example, a taxpayer could have a refund split among a checking account, an IRA and a conventional savings account.
The split-refund option could encourage many low- and moderate-income families to hold on to refunds received through the Earned Income Tax Credit (EITC) program and other targeted tax benefits. Americans claim over $34 billion in EITC benefits each year, with an average refund of $1,700 per recipient. In a pilot project conducted by the Community Action Project of Tulsa County, Okla., the split refund option was offered to filers at a free tax preparation site. Of the 488 people who were offered the opportunity, about one-third chose the split-refund option. On average, participants deposited $649, or 47 percent of their refunds, into savings accounts. Significantly, 76 percent of these individuals had no prior savings.11/
In summary, research suggests some of the PPA’s provisions will work in favor of low- and moderate-income individuals and families. For example, automatic enrollment in 401(k) plans is expected to dramatically increase plan participation, at least among new hires. The split-refund option is likely to encourage taxpayers to save more of their federal tax refunds.
Other provisions of the PPA may require follow-up support in order to be effective. According to researchers, the long-term effectiveness of automatic 401(k) plan enrollment depends on good post-enrollment decisions about contribution rates and investment allocations. Also, the effectiveness of the saver’s credit in promoting retirement savings has yet to be determined. It appears the credit may become an effective savings incentive if low-income families get the tools, information and assistance needed to claim it.
Passage of the PPA makes major changes in our retirement benefit system possible, but the act is not an end in itself. The work of successfully implementing its provisions will largely fall to employers, individuals and community organizations. Further action from these players could ensure all of the PPA’s provisions have equal chances to succeed. For instance, it will be up to employers to alter their retirement benefit policies. Individual employees who find themselves automatically enrolled in 401(k) plans at work will need to take action and manage their investments wisely in order to maximize their returns. Community groups, whose missions often involve providing trusted guidance to low- and moderate-income people, are in a position to educate taxpayers and their tax preparers about the benefits of the saver’s credit. If all the stakeholders do their part, the PPA may reach its full potential for encouraging greater personal retirement savings.
A retirement plan primer
Defined contribution plans. A defined contribution (DC) plan is a retirement plan that provides each member with an individual account. An employee contributes to his or her individual account and the contributions may be supplemented by employer contributions. Account balances are invested, with the individual account holder assuming all of the risk and reward of the investments. Under DC plans, the total retirement benefit is defined by the employee’s and/or the employer’s account contributions, plus or minus any investment earnings or losses. Typically, the total account balance is paid out in one lump sum upon retirement, at which point employees are responsible for managing the money. Examples of DC plans include 401(k) plans and Individual Retirement Accounts (IRAs).
Defined benefit plans. Under a defined (DB) plan, an employee is promised certain benefits but is not responsible for managing the funds needed to pay the benefits. The most common type of DB plan is a traditional pension plan, wherein an employer provides all the contributions, which are pooled into a single fund on behalf of all participating employees. The benefit amount an individual employee receives is determined by a formula that can incorporate the employee’s pay, years of employment, age at retirement and other factors. Employee benefits are not directly affected by investment performance, provided the employer remains solvent and doesn’t discontinue the plan. A DB plan pays out a set amount of money at a regular interval—say, $1,000 a month—from the time a retiree begins to draw on the plan until the retiree’s death.
Koegh plans. Keogh plans are pension plans for individuals who are self-employed. They can be structured as either DC or DB plans.
How the saver’s credit works
Ruth and Tom are married, file a joint return, and have $34,000 of income, all from Ruth’s salary. Ruth is eligible to participate in her employer’s 401(k) plan but has not done so in the past. Neither spouse has an Individual Retirement Account (IRA).
After Ruth receives a notice about the saver’s credit from her employer, she and Tom decide that she will contribute $2,000 to the 401(k) and he will contribute $2,000 to an IRA. Their contributions reduce their adjusted gross income from $34,000 to $30,000, which means they qualify for the 50 percent credit rate. As a result, they receive a $2,000 tax credit (50 percent of $4,000).
Excerpted from William G. Gale, J. Mark Iwry, and Peter R. Orszag, Improving Tax Incentives for Low-Income Savers: The Saver’s Credit, The Urban-Brookings Tax Policy Center, Discussion Paper No. 22, June 2005.
1/ John MacDonald, Employee Benefit Research Institute Fast Facts from EBRI #30, August 2006. Calculation based on 2004 Survey of Consumer Finances data.
3/ Craig Copeland, Employee Benefit Research Institute, Individual Account Retirement Plans: An Analysis of the 2004 Survey of Consumer Finances, Issue Brief No. 293, May 2006.
4/ Retirement Security Project, Fast Facts on Retirement Security.
5/ Brigitte Madrian and Dennis Shea, “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” Quarterly Journal of Economics 116, No. 4, November 2001.
6/ Richard Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy 112, No. 1, Pt. 2, 2004.
7/ William G. Gale, J. Mark Iwry and Peter R. Orszag, Improving the Saver’s Credit, The Brookings Institution, Policy Brief #135, July 2005.
8/ William G. Gale, J. Mark Iwry and Peter R. Orszag, Improving Tax Incentives for Low-Income Savers: The Saver’s Credit, Tax Policy Center Discussion Paper No. 22, June 2005.
9/ Esther Duflo, William Gale, Jeffrey Liebman, Peter Orszag and Emmanuel Saez, Saving Incentives for Low- and Middle-Income Families: Evidence From a Field Experiment with H&R Block, National Bureau of Economic Research, Working Paper No. 11680, September 2005.
10/ Gary Koenig and Robert Harvey, “Utilization of the Saver’s Credit: An Analysis of the First Year,” National Tax Journal, Vol. LVIII, No. 4, December 2005.