Industrialized societies are facing major challenges with respect to their citizens' retirement security. Across the globe, populations are aging rapidly. At the same time, too many households are not saving adequately for their retirement and other long-term needs even though saving vehicles are available.
This policy brief summarizes major parallel efforts currently under consideration in the US, the UK and New Zealand to address the retirement security shortfall by expanding personal saving for retirement.
In the United States, much of the shortfall in private retirement savings is attributable to two factors. First, the structure of financial incentives for saving in the United States is ineffective. For decades, our system of tax preferences for retirement saving has been essentially “upside down.” By basing our employer plan and individual retirement account (“IRA”) income tax incentives mainly on deductions and exclusions — which are proportional to the saver's tax bracket — we tend to “encourage saving least for those who need to increase their saving most, and most for those who need to increase their saving least.”
A second major reason for the shortfall — and the focus of the proposals described here — is that the system does not make it easy enough to save. In the U.S. (as in the United Kingdom), a shrinking percentage of workers are covered by a defined benefit or other employer pension plan that does the job of saving for them through automatic employer contributions that demand no employee initiative. Most American employees who have a retirement plan at work are covered by a 401(k) plan, which typically requires them to take initiative and work their way through several key decisions in order to save. Most 401(k) plans currently require employees to decide whether to participate, to take action if they wish to enroll in the plan, to decide on the level of their contributions, and to decide how those contributions will be invested.
In fact, these employees are the fortunate ones. About half of the U.S. work force — some 71 million employees and self-employed individuals — have no employer plan. If these individuals wish to save for retirement on a tax-favored basis, they generally need to do even more than those who are 401(k)-eligible: they need to select an IRA provider from among many financial institutions and then take the steps necessary to open the IRA, in addition to navigating the decisions regarding level of contributions and investment.
Employees who do join 401(k) plans (as well as some IRAs) benefit from the automatic nature of payroll deduction. Plans typically permit but do not require participating employees to renew their contribution elections every year, so payroll deductions and the related contributions, once begun, continue automatically until the employee elects to make a change. However, 401(k)s traditionally have not made the initial election to participate automatic, nor have they encouraged participants to increase their contributions or to rebalance their investment portfolios over time. The force of inertia and the difficulty of making some of the associated decisions have adversely affected millions of employees.
These shortcomings can be remedied by a simple approach called the “automatic 401(k),” a plan designed “to recognize the power of inertia in human behavior and enlist it to promote rather than hinder saving.” The automatic 401(k) is based on an integrated strategy, formulated by the U.S. Treasury in the late 1990s, of using default arrangements to promote saving without sacrificing individual choice. Starting when automatic enrollment was first defined and approved as a permissible option for 401(k) plans in 1998, increasing numbers of plans have provided that employees will automatically participate in the plan at a prescribed contribution level and with a default investment unless the employee takes the initiative to opt for a different contribution percentage or investment or to opt out entirely.
Ideally, unless the employee chooses otherwise at any time, contributions would automatically increase from year to year (or in conjunction with pay raises), would automatically be invested in appropriately asset-allocated, balanced, diversified, and low-cost funds, and, ultimately, when the employee leaves the employer, would be automatically rolled over to an IRA or another plan. Workers could always choose to override these defaults.
As of last year, an estimated 30 percent of large 401(k) plans were using automatic enrollment. Economists who have systematically observed several of these plans have concluded that the evidence strongly indicates that automatic enrollment has been effective at increasing participation, especially among lower- and moderate-income workers, minorities and women. This evidence, including the expanding use of automatic features in U.S. 401(k) plans, has had a persuasive influence on the three proposals discussed here.
1 See, e.g., William G. Gale, J. Mark Iwry, and Peter R. Orszag, “The Saver's Credit: Expanding Retirement Savings for Middle- and Lower-Income Americans” (Retirement Security Project Policy Brief No. 2005-2, March 2005), page 3. The major exception to this deduction-based tax structure is the Saver's Credit, enacted in 2001, which provides a progressive government match for retirement savings, delivered as a tax credit. The Retirement Security Project has proposed to expand and improve the Saver's Credit in various ways. See id.
2 For a fuller discussion of the problem and suggested solutions, see William G. Gale, J. Mark Iwry, and Peter R. Orszag, “The Automatic 401(k): A Simple Way to Strengthen Retirement Savings” (Retirement Security Project Policy Brief No. 2005-1, March 2005) and William G. Gale and J. Mark Iwry, “Automatic Investment: Improving 401(k) Portfolio Investment Choices” (Retirement Security Project Policy Brief No. 2005-4, May 2005). The Retirement Security Project policy briefs are available at www.retirementsecurityproject.org.
3 J. Mark Iwry and David C. John, “Pursuing Universal Retirement Security Through Automatic IRAs” (Retirement Security Project Working Paper, February 2006), pages 1-4 (“Automatic IRAs”), available at www.retirementsecurityproject.org.
4 Gale, Iwry and Orszag, cited at note 2, pages 4-5.
5 Id., page 5.
6 See Revenue Ruling 98-30, 1998-25 I.R.B. 8; Revenue Ruling 2000-8, 2000-7 I.R.B. 617; General Information Letter dated March 17, 2004 from the Internal Revenue Service to J. Mark Iwry. See also Testimony of J. Mark Iwry Before the Special Committee on Aging, United States Senate (April 12, 2005); “Using the Private Pension System and IRAs to Promote Asset Accumulation for Lower-Income Families,” Testimony of J. Mark Iwry Before the Subcommittee on Social Security and Family Policy of the Committee on Finance, United States Senate (April 28, 2005).
7 Profit Sharing/401(k) Council of America, “The 48th Annual Survey of Profit Sharing and 401(k) Plans,” October 2005.
8 See, e.g., Brigitte Madrian and Dennis Shea, “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” Quarterly Journal of Economics 116, no. 4 (Nov. 2001), pp. 1149-87; Richard Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy 112, no. 1, pt. 2, pp. S164-87; James Choi, David Laibson, Brigitte Madrian and Andrew Metrick, “For Better or Worse: Default Effects and 401k) Savings Behavior,” in Perspectives in the Economics of Aging, edited by D. Wise (University of Chicago Press, 2003), pp. 81-121. See also Cass R. Sunstein and Richard H. Thaler, “Libertarian Paternalism is Not an Oxymoron,” University of Chicago Law Review 70, no. 4 (2003), pp. 1159-1202; Alicia Munnell and Annika Sunden, Coming Up Short: The Challenge of 401(k) Plans (Brookings, 2004).
9 See New Zealand Treasury, “KiwiSaver: Detailed Information” (February 2006) (“NZT 2006”), page 1; Department for Work and Pensions, “Security in retirement: towards a new pensions system” (Presented to Parliament by the Secretary of State for Work and Pensions by Command of Her Majesty, May 2006) (“DWP 2006”); Automatic IRAs, cited at note 3, above, pages 1-13.
10 DWP 2006.
11 Pensions Commission, 2005, “A new pension settlement for the twenty-first century: The second report of the Pensions Commission”; Pensions Commission 2004, “Pensions: challenges and choices: The first report of the pensions commission.”
12 NZT 2006.
13 DWP 2006, page 15.
14 Id., page 16. “…[T]hese reforms will mean that it is much simpler for individuals to save.” Id., page 23.
15 NZT 2006, pages 2-3.
16 Id., page 5.
17 Automatic IRAs, page 1.
19 See DWP 2006, pages 15-16, 20-81.
20 The new proposal would build on and go beyond the existing stakeholder pensions, which were introduced in April 2001. These are individual plans that employers with at least five employees are required to make available to their work force unless the employer already sponsors a plan of its own or pays at least three percent of pay for these “personal pensions.” The stakeholder pensions are subject to a 1.5 percent cap on annual management charges, scheduled to decline to 1 percent in the future. It has been estimated that over 2.7 million stakeholder pensions have been sold, mostly to moderate- and lower-income workers, and the British Government estimates that the low cost of stakeholder pensions has helped put downward pressure on costs of individual accounts generally. See DWP 2006, pages 37-38.
21 Id., page 72.
22 Id, page 71.
23 Id., page 69.
24 Id., page 81. The white paper also indicates that the Department for Work and Pensions has commissioned two case studies on the “Save More Tomorrow” (SMarT TM) technique of automatically increasing contributions in conjunction with pay raises. Id., pages 77-78. See Shlomo Benartzi and Richard H. Thaler, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy (2003).
25 Id., page 46.
26 Id., page 57.
27 See NZT 2006, pages 2-21.
28 The Department of Labor is preparing to propose regulatory guidance to this effect as well.
29 See H.R. 2830, The Pension Protection Act of 2005, and S. 1783, The Pension Security and Transparency Act of 2005.
30 See J. Mark Iwry, “Using Tax Refunds to Increase Savings and Retirement Security” (Retirement Security Project Policy Brief No. 2006-1, January 2006).