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Automatic offers an innovative new way to think about how Americans can save for retirement.
Over the past quarter century, America's pension system has shifted away from defined benefit plans and toward defined contribution savings programs such as 401(k)s and IRAs. There is much to be done to improve the defined contribution system. Many workers fail to participate and those who do often contribute too little, invest the funds poorly, and are...
Automatic offers an innovative new way to think about how Americans can save for retirement.
Over the past quarter century, America's pension system has shifted away from defined benefit plans and toward defined contribution savings programs such as 401(k)s and IRAs. There is much to be done to improve the defined contribution system. Many workers fail to participate and those who do often contribute too little, invest the funds poorly, and are not adequately prepared to manage funds while in retirement.
To resolve these problems, the authors propose that employees should be automatically enrolled into a 401(k) plan when they are hired, with the right to opt out, change the amount that they contribute, or change investment choices if they choose. If the employer does not sponsor a 401(k) or similar retirement plan, they would be enrolled in a payroll deduction Automatic IRA. This vision of a transformed defined contribution system incorporates key positive features of defined benefit plans to improve retirement security. Employess contributions would increase over time, their investments would benefit from professional management and rebalancing, and they would receive lifetime income upon retirement. These automatic features will make the 401(k) and similar plans a more effective tool for retirement saving, and they can be extended to the many workers who do not currently have access to an employer plan.
In Automatic, the authors present proposals to implement automatic features in all phases of the 401(k) and in IRAs for workers with no employer plan. They also draw from the experience of countries that have implemented automatic saving structures.
WILLIAM G. GALE, BENJAMIN H. HARRIS, J. MARK IWRY, AND DAVID C. JOHN
This book is the second of two volumes put together by the Retirement Security Project (RSP). A partnership between Georgetown University's Public Policy Institute and the Brookings Institution, supported by the Pew Charitable Trusts and the Rockefeller Foundation, RSP was founded in 2005 to develop and help enact commonsense reforms that attract bipartisan support and make saving for retirement easier and more rewarding for lower- and moderate-income households. While everyone recognizes that retirement policy entails a host of sweeping and interrelated concerns—from reforming Medicare and long-term care, to making Social Security fiscally sustainable, to shoring up and reforming the private defined benefit pension system, to improving day-today living for the elderly—the Retirement Security Project has chosen to focus its mission on making significant and tangible progress in one particularly important area.
The first RSP volume, Aging Gracefully, identified several key shortcomings in the retirement income system facing lower- and moderate-income workers. The continuing trend away from traditional pension plans and toward defined contribution plans, such as 401(k)s and individual retirement accounts (IRAs), has placed more responsibility on the individual worker to save for his or her own retirement. Fully half the working population is left out of the retirement system. Among those who do participate, contribution rates are often too low, investments are often poorly allocated, and participants often cash in their benefits before retirement. In addition, the tax benefits of participation are small for moderate- and lower-income households, and the overall distribution of tax-favored retirement and tax benefits has been skewed toward the most affluent.
To address these challenges, the papers in the first volume described and motivated a policy agenda with four key components. First, expand 401(k) participation by automating plans to reduce the decisionmaking burden on workers and improve 401(k) outcomes while still preserving workers' freedom of choice. Second, move the system toward universal coverage by extending the power of automatic enrollment—through the creation of Automatic IRAs—to those who have no workplace plan. Third, expand and revamp the Saver's Credit, which is intended to encourage lower-income households to save, so that it provides a more effective and transparent matching incentive for retirement contributions. Fourth, reduce the steep and confusing implicit taxes on retirement saving often imposed through means-tested government programs such as Medicaid, Supplemental Security Income, food stamps, and Temporary Assistance for Needy Families. Taken together, these proposals would expand access to saving, remove procedural obstacles and negative incentives for saving, and increase the transparency of and rewards to putting money away.
Since that volume was completed in 2006, much has been accomplished. The acceptance and take-up of automatic enrollment and other automatic features has increased dramatically in the 401(k) market—both before and after the Pension Protection Act of 2006 encouraged this movement by eliminating a number of key obstacles. Surveys suggest that the percentage of larger 401(k) plans using automatic enrollment rose from about 19 percent in 2005 to about 51 percent in 2009. The Department of Labor further encouraged the spread of automatic 401(k) features by publishing regulations making it easier to include diversified equities (such as balanced or target-date funds or managed accounts) in 401(k) investments. Investment patterns in the 401(k) system appear to have moved toward greater diversification, including at least somewhat diminished concentration in employer stock. As a further measure of progress, the board of the three-million-member federal employee Thrift Savings Plan decided to switch to automatic enrollment (subject to congressional approval) even though the participation rate (about 87 percent) in that plan was already considered quite successful.
The Automatic IRA proposal was introduced as legislation on a bipartisan basis in both the House and Senate. The proposal was the subject of several congressional hearings and was endorsed in the 2008 presidential campaign by then-Senator Barack Obama as well as by his Republican opponent, Senator John McCain. In a related development, the Internal Revenue Service was persuaded to facilitate saving outside of the workplace by allowing taxpayers entitled to income tax refunds to instruct the IRS to directly deposit a portion of the refund in an IRA while depositing the remainder in the taxpayer's checking account.
The Saver's Credit, previously scheduled to expire after five years, was made permanent and indexed for inflation by the Pension Protection Act of 2006, thereby increasing saving incentives for moderate- and lower-income households. In addition, Congress in 2008 stipulated that savings in tax-preferred retirement accounts would no longer be counted in the asset test determining eligibility for the food stamp program. Most recently, as this book goes to press, President Obama's 2009 budget contains proposals for an Automatic IRA, a revamped Saver's Credit, and additional asset test reforms.
At the same time, however, the massive decline in financial markets since late 2007 has shaken confidence in many of the most commonly used diversified 401(k) financial investments. This, in turn, has led some to question the validity of the basic 401(k) and wealth accumulation model, even though the 401(k) is a saving vehicle that can accommodate a wide range of investment strategies. Moreover, even before equity markets toppled, many feasible and well-designed improvements to the retirement system had not been implemented, proposals to encourage effective payout of 401(k) benefits had received little attention, and several key populations remained outside the retirement system and vulnerable to economic shortfalls in old age.
The chapters in this volume pick up where previous research and development stopped and are divided into three sets. The first set provides new analysis of the automatic 401(k) and Automatic IRA. The second set extends the analysis of automatic saving structures from the "accumulation" to the "decumulation," or payout, phase to encourage the provision of lifetime income. The third set of essays looks at the circumstances and saving behavior of vulnerable groups—Latinos, women, and African-Americans—and proposes specific policies to help them achieve retirement security. These papers provide an integrated set of findings that can help policymakers make retirement security a feasible and accessible outcome for millions of American households.
Improving the Automatic 401(k) and Creating the Automatic IRA
As William Gale, Mark Iwry, and Spencer Walters explain in chapter 2, the Pension Protection Act of 2006 made significant improvements to 401(k) plans, but much additional work remains to be done. For employers who offer automatic 401(k)s, these improvements include a measure of protection from fiduciary liability for automatic (default) investment choices, preemption of state regulation to protect employers from being treated as violating state law by instituting automatic enrollment, and flexibility for 401(k) plans to undo automatic enrollment (without risk of penalty) for employees who so request within ninety days. As noted, the Pension Protection Act also made the Saver's Credit permanent and indexed its eligibility thresholds to inflation.
Further reform, however, could improve households' incentives to save and help Americans better prepare for retirement. First-generation automatic 401(k) plans were adopted mainly by large firms and featured automatic enrollment for new employees only, low default contribution rates that do not escalate over time, and money market or stable-value default investments. The goal now is to develop second-generation automatic 401(k)s adopted by as many 401(k) sponsors as possible, of all sizes, automatically enroll all nonparticipating employees (not just new hires), significantly escalate default contribution rates over time, and offer default investments (and other options) that appropriately reflect the best thinking in the expert financial and policy communities.
In chapter 3, Christopher Geissler and Benjamin Harris examine the revenue and distributional effects of automatic enrollment in 401(k) plans. The authors find that if automatic enrollment were adopted by all 401(k) plans—which would reduce federal revenue by increasing tax-free contributions to retirement plans—it would cost the federal government between $35 billion and $69 billion over ten years (about 2 percent of the total amount of federal tax expenditures devoted to retirement saving). This benefit would be particularly valuable to those in the bottom 80 percent of the income distribution, helping to equalize the gains from retirement tax benefits that traditionally have most benefited those with the highest incomes.
The fourth chapter describes a proposal—the Automatic IRA—to extend the benefits of automatic saving structures to the 50 percent of the labor force that does not have access to any work-based pension or 401(k) plan. As David John and Iwry explain, Automatic IRAs would build on the success of automatic 401(k)s, extending easy access to tax-favored, workplace-based retirement savings to tens of millions of American workers. The chapter fleshes out many of the operational and logistical aspects of the automatic IRA. Under the proposal, most firms that do not sponsor any kind of retirement plan would be required to automatically enroll workers in IRAs that provide a standard, low-cost default investment. Workers would be free to opt out. Contributions would be made by direct deposit to accounts managed by a financial institution, using existing electronic payroll systems to facilitate the transfer whenever possible. Private-sector financial institutions would continue to compete for the right to act as IRA trustee or custodian, but arrangements would be made to guarantee availability of low-cost accounts to all, including nonemployees. Businesses would receive small temporary tax credits for instituting the Automatic IRA, in recognition of the modest administrative effort required.
As David John and Ruth Levine point out in the fifth chapter, the United States is not the only country to experiment with retirement saving policy. The authors explain the key features of Chile's privatized pension system with individual accounts; Australia's hybrid system of mandatory contributions with a guaranteed means-tested benefit; New Zealand's KiwiSaver program, a voluntary government-sponsored pension plan incorporating automatic enrollment; and the United Kingdom's complex, multipillar system incorporating both public and private accounts. Based on this review, John and Levine reach several conclusions: high saving rates can be achieved through automatic enrollment without the political cost of a mandatory system; having a limited set of investment options is both necessary and sufficient; simple investment platforms—with default investment funds and a high proportion of index-type funds—can hold down administrative costs; sufficient income guarantees are crucial to the health of a retirement scheme; and retirement systems can and should encourage, but not mandate, some degree of annuitization of retiree assets.
Taking the Money Out
The chapters in the first section of the book, like most of the analysis and discussion in the retirement saving world, focus on getting money into retirement accounts and managing those funds. Hence, the focus on automatic enrollment, escalation of contributions, and investment allocation. Less attention has been devoted to the distribution, or payout, stage. How the money comes out of the plan, however, is critically important. Indeed, a flawed withdrawal strategy can negate the benefits of decades of intelligent accumulation strategies. As the 401(k) system reaches maturity and as the number of retirees and near-retirees grows, with the baby boomers entering retirement years, these issues will become even more critical. Thus, the next frontier in automatic saving structures involves developing better ways to manage and pay out the accumulated savings.
Lifetime income products, however, present a quandary. On one hand, it seems clear that many households could realize significant improvements in their well-being and retirement security were they to convert some of their existing asset balances into annuities or into related financial products that provide income flows over time. This would reduce their asset risk and reduce the chance that they outlive their resources. On the other hand, very few households tend to make such choices. The suggested reasons for this vary from consumers' unfamiliarity with lifetime income products, to certain consumer biases, to the fact that some people may not want to purchase more annuities since they already have Social Security and Medicare benefits, to unattractive pricing of annuities, to fear of the loss of control resulting from permanently giving up liquid assets. At the same time, the private market is experimenting with a wide variety of alternative ideas and hybrid instruments to attract more consumers to lifetime income products. The challenge, then, for designing an effective structure for lifetime income payments is to respect the diversity of people's situations and the evolving market, while helping to overcome consumer unfamiliarity and biases and make pricing more attractive. A related challenge stems from the fact that defaulting a worker into a particular 401(k) contribution rate might generate a less than fully optimal saving level that could be changed by increasing contributions. In contrast, defaulting someone into an annuity that is inappropriate for his or her circumstances carries greater risks and is more difficult to undo. How, then, can the benefits of automatic saving structures be extended to the payout phase? The chapters in the second section of the book focus on this issue.
In chapter 6 Gale, Iwry, John, and Lina Walker propose defaulting retirees into a "test drive" of an annuity by automatically enrolling recent 401(k) retirees in a two-year monthly payment plan. After the two-year trial, the regular monthly income would continue for life unless the individual opted out in favor of an alternative distribution option. The proposal would help expose retirees to the benefits of annuities or other guaranteed income without forcing them to buy fully into the arrangement at the time of retirement. In addition, it would likely reduce the price of an annuity by taking advantage of the plan's bargaining power while exposing a broader group to annuities and hence reducing the adverse selection that affects annuity markets. The automatic nature of the proposal takes advantage of inertia and makes it easier for participants to sample the benefits of guaranteed lifetime income. The opt-out provision allows individuals to tailor the program to their own specific needs, and forgo participation if it is not the best choice for their circumstances.
In a companion chapter (7), Iwry and John Turner propose strategies to encourage the accumulation of lifetime income in 401(k) plans on a partial, continual basis throughout an individual's working years. Workers who do not opt out would be defaulted into accumulating units of annuity income in their 401(k) accounts over many years. This would "dollar cost average" the risk of purchasing lifetime income when interest rates are low and avoid the resistance many individuals have to annuitizing when confronted with a one-time all-or-nothing choice between an annuity and a lump sum at retirement. The annuity purchases could be funded by employer matching contributions (which have often been invested in employer stock) or could be embedded in a target-date fund or other qualified default investment alternative as the gradually increasing fixed-income portion of that fund. The proposal would also allow savers a period in which to grow comfortable with the concept of lifetime income. Partial annuitization would help workers tailor their portfolio to include their preferred level of risk and lifetime income. Moreover, the gradual accumulation of lifetime income would frame a portion of the plan benefit as a "pension paycheck" income stream rather than a lump sum.
While the first two sections of the book address proposals to reform the retirement system, the last section focuses directly on vulnerable populations. In particular, the goals are to understand the saving and economic experience of Latinos, women, and African-Americans, and to design public policies that can effectively address each group's distinctive situations and needs.
Peter Orszag and Eric Rodriguez show in chapter 8 that, relative to other groups, Hispanics tend to participate less frequently in retirement saving accounts, with fewer than half of Hispanic adults nearing retirement age having any assets in a 401(k) or IRA. Hispanics also have, on average, lower incomes than other households, meaning that saving incentives may be insufficient to induce many households to contribute to a retirement account. In response to these circumstances, Orszag and Rodriguez propose promoting financial literacy programs tailored to the particular problems faced by Latinos and automatically enrolling workers in IRAs to increase participation rates in retirement saving accounts.
Excerpted from Automatic Copyright © 2009 by THE BROOKINGS INSTITUTION. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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