As the baby boomer generation nears retirement, the shortcomings in the nation’s upside-down system of incentives for retirement saving are becoming increasingly apparent. The existing structure is upside down for two reasons:
First, it gives the strongest incentives to participate to higher-income households who least need to save more to achieve an adequate retirement living standard and who are the most likely to use pensions as a tax shelter, rather than as a vehicle to raise saving.
Second, the subsidies are worth the least to households who most need to save more for retirement and who, if they do contribute, are most likely to use the accounts to raise net saving.
In part reflecting this upside-down set of incentives, the nation’s broader pension system betrays several serious shortcomings:
Only about half of workers participate in an employer-based pension plan in any given year, and participation rates in Individual Retirement Accounts (IRAs) are substantially lower.
Even those workers who participate in tax-preferred retirement saving plans rarely make the maximum allowable contributions. Only about 5 percent of 401(k) participants make the maximum contribution allowed by law, and only about 5 percent of those eligible for IRAs make the maximum allowable contribution.
Despite the shift from defined benefit to defined contribution plans, many households approach retirement with meager defined contribution balances. The median defined contribution balance among all households aged 55 to 59 in 2001 was only about $10,000.
The bulk of the policy changes that have been enacted in recent years, moreover, move the pension and broader saving system further in the wrong direction: They provide disproportionate tax benefits to high-income households who would save adequately for retirement even in the absence of additional tax breaks, while doing little to encourage lower- and moderate-income households to save more.
The Administration’s new savings proposals would exacerbate this flawed approach. The Retirement Saving Account proposal and Lifetime Saving Account proposal would induce substantial asset shifting by high-income households, do little to boost saving among moderate income households, and significantly reduce revenue over the long term. Over the next 75 years, the revenue cost of the proposals would amount to a third or more of the actuarial deficit in Social Security.
A better strategy would encourage expanded pension coverage and participation among low- and middle-income households by:
Expanding the income eligibility range for the saver’s credit and making the credit refundable;
Reducing the implicit taxes on saving done by moderate income households through the asset tests under certain government programs;
Encouraging financial education provided by disinterested parties; and
Promoting automatic saving, including through changes to the default choices in 401(k) plans and through the “split refund” proposal included in the Administration’s budget.
I would also like to note that a new Retirement Security Project at Brookings and George Washington University, funded by the Pew Charitable Trusts, is studying ways of bolstering financial security for America’s aging population by raising retirement savings and improving long-term care insurance products. It brings together pension researchers and health care experts to examine areas such as the opportunities and challenges involved in using home equity to purchase long-term care insurance; reforming the existing saver’s credit to strengthen its incentives for moderate-income households to save; and removing the disincentive for pension saving implicit in the existing asset tests under various means-tested government programs.