Sunday, March 13, 2011

Guaranteed Retirement Accounts: Redefining Retirement?

The turmoil surrounding pension plans for public employees provides an appropriate context in which to do some serious thinking about how to provide economic security for retirees. Let us define “security” as meaning that a retiree can expect to have a disposable income of about 70% of the pre-retirement income. Social Security may provide that for our lowest income workers, but it is woefully inadequate for most. Defined benefit plans (DBs), where an employee was promised a certain retirement income based on pre-retirement income and years of service, are rapidly becoming a thing of the past. They served a generation of workers well, but the concept has been overcome by events. In their place are what are referred to as defined contribution plans (DCs), most generally represented by the 401(k). This is a scheme by which the government allows the worker to defer taxes on a fraction of his income that can be placed in an employer supported investment fund. The employer often matches the employee’s contribution up to a few percent of his income. Companies love this approach because they have fixed and well-defined costs, and no long term commitment. The advantage to the employee is that these plans are portable and no taxes are levied on earnings until they are withdrawn. The funds accrued can be moved to another account with no tax liability when a person changes jobs.

The strength of his trend towards defined contribution plans can be seen in the following chart.

The problem with the defined contribution approach is that it demands too much of the individual employee. Most of the funds for investment must come from him, but most workers are not able to contribute enough to create an amount adequate for retirement. He is also responsible for making wise investment decisions. And in addition, he is also allowed to withdraw his money early if he decides he has a more important use for it (with considerable financial penalty). It is a great plan for those with excess disposable income, providing a convenient tax shelter and investment opportunity.

The net result is that we will have at least a generation or more of people who will reach retirement age and will not be able to retire and maintain anything like their current lifestyle. Workers will be forced to delay retirement and clog up the system by denying jobs to younger workers.

What to do? Teresa Ghilarducci has been the most prominent proponent of what is referred to as a Guaranteed Retirement Account. She describes this as a supplement to the existing social security structure.
“In a perfect world, an average worker could amass something like $400,000 in a 401(k) by retirement. After nearly three decades of 401(k) contributions, though, the average account balance for people nearing retirement age is about $60,000, far less than what's needed. So it's no surprise that when a recent Gallup poll asked what Americans want most from government, more chose guaranteed pensions than guaranteed jobs or health care.”

“Taxpayers are shouldering far more of these leaky retirement boats than anyone imagines. All the tax-free contributions going into 401(k)s, Keoghs, and other retirement schemes reduce federal tax receipts by $193 billion a year. And almost 80 percent of the tax breaks go to the top 20 percent of taxpayers.”

“So let's scale back the tax breaks. Instead, we can use the money to help everyone sock away 5 percent of their pay in safe retirement accounts that would serve as a universal supplement to Social Security. People could keep their employer plan if it met more stringent standards such as a contribution rate of at least 5 percent, a ban on early withdrawals, and conversion into an annuity at retirement. Anyone without an employer plan would automatically be enrolled in a Guaranteed Retirement Account to which employees and employers would each contribute 2.5 percent. The government would then provide everyone a modest tax credit to offset the employee contributions. The return would be guaranteed by the government at about 3 percent above the rate of inflation--or close to the real growth rate in gross domestic product.“

“The key to this proposal is pooling individual accounts. These would be professionally managed, but with trillions of dollars in the pools, management fees would be lower than on conventional retirement accounts. That means every dollar in tax breaks would translate into almost a dollar in retirement income instead of going toward fees or being diverted to other purposes by people who make withdrawals before retirement. National savings would get a boost. All Americans, including the 64 million who have no pension plan, would get one at no extra cost. What's not to like?”
This all sounds like a great idea for the next generation, although it doesn’t do much for those already nearing retirement. The people who do not seem to be enthused are those who fear the government will take over their amassed 401(k) funds somehow. Some employers may not be happy because they will actually have to contribute something, small though it is. And there are those who will view this merely as a tax increase and therefore not to be allowed.

I am surprised that there has not been more serious discussion of this approach in Washington. Someone ought to at least unleash the Congressional Budget Office and have them take a look at the financial implications of such a scheme.

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