Global Investing:preventing a private pensions meltdown

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Global Investing:

Preventing a private pensions meltdown

Financial Times, May 08, 2003

As the baby boom generation nears retirement, the US system of pension and tax-preferred savings is facing its own nemesis. Only half the workforce is covered at any one time, the system is complex and its impact on national savings and the adequacy of personal pension provision is suspect despite the drain it imposes on the US Treasury. Pensions currently cost the Treasury $200bn a year.

And yet, as a discussion paper - 'Private Pensions, Issues and Options', published last month by the Washington-based Tax Policy Center - notes, benefits are skewed towards more affluent households who are more likely to have made adequate provisions for retirement and have failed to raise overall levels of savings.

"In the light of longer life spans, earlier retirement, and projected financial shortfalls in Social Security and Medicare, the financial status of the elderly will depend heavily on private saving for retirement and the central goal of the private pension system should be to encourage or provide adequate retirement income in a cost-efficient and equitable manner," says the paper, penned by economists William Gale and Peter Orszag.

The study evaluates reform proposals and sets out an alternative agenda of incremental reforms including changes to default choices in 401(k) plans and simplification of the pension tax code.

The authors note that early retirement has become the norm, creating challenges for public policy. At the start of the last century, nearly two out of five men aged 65 or older were in the workforce. By 2000, that figure had dropped to less than one in five.

Other than Social Security taxes, which began in 1935, the main savings vehicles for most households are tax-favoured savings plans, which form a second tier of retirement income. Incentives for employer-based pensions were introduced in 1921 and expanded rapidly after World War II. Since then, the rules governing them have been modified repeatedly.

The creation of Keogh accounts and Individual Retirement Arrangements (IRAs) expanded eligibility for tax-sheltered savings plans beyond the employer-based system. By 1998, pensions and tax-preferred savings plans covered more than 70m workers, received more than $200bn in new contributions annually and provided about a fifth of the income of the elderly.

Now, with Social Security projected to face a long-term deficit and Medicare heading for financial challenges, the economists argue that private pensions and savings plans will have to play a bigger role in meeting the needs of future retirees.

The 2001 tax reforms included a series of changes to pension and IRA laws including raising the contribution limits on IRAs and 401(k) plans, increasing the maximum benefit payable under so-called defined benefit plans, and increasing the maximum level of compensation that can be considered in determining pension benefits.

The Act also created a new Roth 401(k), modeled after the Roth IRA. Under Roth 401(k)s, contributions are made on an after-tax basis, accumulate tax-free and can be withdrawn without tax.

Nevertheless, the paper's authors argue that, with a few exceptions, the changes did not score highly. In particularthey are disproportionately aimed at high earners and therefore fail to boost retirement income adequacy or raise national saving.

Over the past several years pension experts have proposed a number of structural reforms for the system. Messrs Gale and Orszag examine, and largely dismiss, two. The Groom-Shoven Plan put forward by Theodore Groom of the Groom Law group and John Shoven of Stanford University would eliminate the detailed requirements and limits on contributions to qualified pension plans. As a result, it scores well on simplicity "but would have little effect on private savings because higher-income households would simply shift assets from current taxable accounts into the expanded tax-preferred accounts".

The Halperin-Munnell Plan, proposed by Daniel Halperin of Harvard Law and Alicia Munnell of Boston College, would also expand tax incentives for higher earners but only as part of a comprehensive plan to boost participation and benefits of employer-provided pension plans. Mssrs Gale and Orszag argue that the benefits would be offset by negative factors including complexity.

The paper's authors suggest incremental reforms designed "to move the pension system in the right direction". These include extending the provisions in the 2001 tax cut plan for savers' credits by creating permanent progressive savings credits to encourage savings for retirement, particularly among lower income groups.

They also argue a seemingly minor change in the options governing 401(k) plans inviting employees to commit to saving a portion of future pay rises rather than cutting current spendable income could "massively increase savings".