Retirement Security Project

Pursuing Universal Retirement Security Through Automatic IRAs

SUMMARY

This paper proposes an ambitious yet practical set of initiatives to expand dramatically retirement saving in the United States, especially for the 75 million Americans working for employers that do not offer a retirement plan. Half of our workforce has no effective way to save at work because they have no employer plan. This fact, a national saving rate that has been declining steadily since the 1980s, and the expectation that Social Security is unlikely to provide increased benefits, make inadequate retirement saving a major national problem. Research and experience both point to a simple and effective solution, which we call the "automatic IRA."

The essential strategy we propose is to make saving more automatic–and hence easier, more convenient, and more likely to occur. Making saving easier by making it automatic has been shown to be remarkably effective at boosting participation in 401(k) plans, but roughly half of U.S. workers are not offered a 401(k) or any other type of employer-sponsored plan. We would take a new approach to extending the benefits of automatic saving to a wider array of the population by combining several key elements of our current system: payroll deposit saving, automatic enrollment, low-cost, diversified default investments, and IRAs. The automatic IRA approach offers most employees not covered by an employer-sponsored retirement plan the opportunity to save through the powerful mechanism of regular payroll deposits that continue automatically. (This is an opportunity now limited mainly to 401(k)-eligible workers.) Under this approach,

• Employers above a certain size (e.g., 10 employees) that have been in business for at least two years and do not sponsor any plan for their employees are called upon to allow employees to use the employer's payroll system to channel the employees' own money to an IRA.

° Employers would retain the option of setting up a 401(k), SIMPLE, or other retirement plan instead of payroll deposit IRAs at any time. Those retirement plans offer much higher contributions and tax credits.

• These employers – as well as smaller or newer firms that voluntarily offer payroll deposit as a conduit for employee contributions – receive a small temporary tax credit based on the number of employees who participate.

• For most employees, payroll deductions are made by direct deposit, similar to the common practice of direct deposit of paychecks to employees' bank accounts.

• The arrangement is market-oriented: IRAs are provided by the same private financial institutions that currently provide them.

• Employers choose whether the IRA provider is selected (1) by the employer (but allowing employees to transfer to other IRA providers if they so choose), or (2) directly by each employee.

• As a fallback, individuals and employers who cannot find an acceptable IRA on the market can use ready-made, low-cost automatic IRA accounts provided by an entity somewhat similar to the federal employees' Thrift Savings Plan (which might alternatively take the form of an industry consortium or nonprofit organization) with investments that are contracted out to the financial services industry.

• Saving is automatic. Automatic enrollment – employees participate unless they affirmatively choose to opt out – and sensible default investments harness the power of inertia to maximize participation and increase saving.

While the presumptive method of enrollment would be automatic (employees would automatically contribute at a statutorily specified rate unless they opted out), employers not wishing to use this method with their employees could likewise opt out and instead have every employee make an explicit choice. In all events, while no employee would be required to participate, no employee could be left out simply because of inattention or inertia. Anyone declining to contribute would need to sign a waiver. Evidence from the 401(k) universe strongly suggests that high levels of participation tend to result not only from auto enrollment but also from the practice of eliciting from each eligible individual an explicit decision on whether or not to participate.

A national web site would give firms a standard notice informing employees of the payroll-deduction IRA option and standard employee election forms and enrollment procedures. (If possible, the election form would be added to IRS Form W-4.) The web site would also promote best practices as they evolve (such as automatic enrollment and potentially annuitization), innovation, and employee education regarding saving and investment.

Employers making payroll deposit available would be protected from potential fiduciary liability for investment performance and from having to choose or arrange default investments. Instead, whether the IRA provider was employee- or employer-designated or was the fallback standard account offered by the TSP-like entity, workers' contributions would automatically be directed to a diversified investment (initially, an asset-allocated life cycle fund) unless they chose a different option. Payroll deduction contributions would be transferred, at the employer's option,

• to an IRA provider designated by the employer,

• to IRAs designated by employees (and an employer that did not offer direct deposit of paychecks could simply forward all employee contributions along with the employer's federal tax deposits for remittance to the employees' designated IRAs), or,

• absent employer or employee designation, to a fallback collective retirement account.

The proposal is designed to minimize the employer's administrative functions, and should involve no out of pocket employer cost. Many firms already offer their workers direct deposit of paychecks; virtually all make payroll deposits to comply with income tax withholding. Payroll deposit to IRAs would not require much more effort from employers. They would facilitate employee saving by forwarding employees' contributions to their IRAs without having to: (1) sponsor a plan; (2) make any matching or other employer contributions; (3) comply with plan qualification or ERISA requirements; (4) select investments for employees; (5) set up IRAs or other accounts for employees; or (6) determine employees' eligibility to contribute to an IRA.

Many employers that still process payroll by hand would be exempted under the exception for very small employers. Firms not exempted would have the option of "piggybacking" the payroll deposits to IRAs onto the federal tax deposits they currently make, whether online, by mail, or by delivery to the local bank.

The self-employed and other nonemployees would be encouraged to contribute to IRAs by automatic debit (with electronic fund transfers), including on-line and traditional means of access. Automatic debit – replicating automatic payroll deduction – and IRAs could be arranged through professional and trade associations. The self-employed could also send deposits to IRAs with their quarterly estimated taxes or instruct the IRS to make direct deposit to IRAs of part or all of their income tax refunds. Independent contractors receiving regular payments from a business could arrange for automatic payroll deduction (direct deposit) to an IRA in the same way as employees.

The automatic IRA is carefully designed to avoid competing with or crowding out employer-based retirement plans and employer contributions for employees. In fact, for several reasons, extensive use of automatic IRAs can be expected to expand opportunities to market 401(k), SIMPLE, and other tax-favored plans to employers.

• First, the maximum permitted contribution to IRAs (currently $4,000) exceeds employees' average 401(k) contribution but is not enough to satisfy the appetite for taxfavored saving of business owners or decision makers (who would still have an incentive to adopt a SIMPLE plan or 401(k) because those plans allow contributions of up to $10,500 or $15,500, respectively).

• Second, the automatic IRA tax credit would be smaller than the tax credit small employers get when adopting a new retirement plan.

• Third, to encourage employer plans, firms would not be asked (or allowed) to match employee savings to automatic IRAs or otherwise contribute to them. Employers interested in contributing for their employees or in saving more for themselves would adopt 401(k)s or other plans.

• Thus the proposal steers clear of any adverse impact on employers' incentives to sponsor actual retirement plans. In fact, the indirect intended effect of the proposal is to draw small employers into the private pension system by demonstrating the power of tax-preferred payroll deposit saving and whetting employees' appetite for it.

Within the fall-back investment platform, investment management, record keeping and other administrative functions would be contracted to private financial institutions to the fullest extent practicable. Costs would be minimized through a no-frills design relying on index funds, economies of scale, and maximum use of electronic technologies, and modeled to some degree on the Thrift Savings Plan for federal government employees. The investment menu would be kept simple: money would go to a low-cost, diversified, asset-allocated fund unless the individual instead selected from among a few low-cost, diversified alternatives (probably including Treasury inflation-protected securities). Once accounts reached a predetermined balance (e.g., $15,000) sufficient to make them profitable enough to attract the interest of the full range of IRA providers, account owners would have the option to transfer them to IRAs of their choosing.

In addition, a powerful financial incentive for individuals to contribute might be provided by means of matching deposits to the IRAs (not by employers). For example, private financial institutions that maintain the accounts could deliver matching contributions and be reimbursed through federal tax credits. Matching deposits are not, however, part of the basic automatic IRA proposal.