When policy makers and commentators express concerns about how little most American workers have saved for retirement, they should focus on three related facts:
Roughly half of all American workers are employed by a firm that does NOT offer them any retirement plan.
Only 14% of small firms — with fewer than 100 employees — offer them any type of retirement plan.
42 million workers –approximately one third of full-time workers in the private sector — work for small firms.
Of course, these employees of small firms have the right to go to a financial institution, file an application for an Individual Retirement Account ( IRA ), and enjoy federal tax deductions for their IRA contributions. Yet relatively few overcome the forces of inertia and take the time to open an IRA on their own. Only about 5% of employees without a retirement plan at work contribute to an IRA on a regular basis, according to best estimates.
In response to these problems, Mark Iwry and David John (both from Washington think tanks at the time) developed federal legislation that would create the Automatic IRA. This legislation would require all employers without a retirement plan, and with over a specified number of employees, to connect their payrolls to a retirement plan at a qualified financial institution. Then, approximately 3% of the salary of these employees would be contributed each month to this retirement plan, unless they decided to opt out.
Such opt-out plans have been very successful in raising the participation rate of employees in retirement plans, especially low-income and minority employees. In addition, the Automatic IRA does NOT require any contribution by the employer to the retirement plan of its employees. And the proposed legislation has garnered considerable support from both Democrats and Republicans. Nevertheless, Congress has not come close to passing the Automatic IRA.
As a result, several states have enacted their versions of the Automatic IRA — namely, California, Illinois and Oregon — and other states are conducting feasibility studies of establishing their own state-sponsored Automatic IRAs. Given the federal inaction on this subject, it is critical that states adopt well-designed plans and that the Labor Department provide supportive legal guidance.
To make a substantial impact, state versions of the Automatic IRA must REQUIRE small firms without retirement plans to connect their payrolls to the state sponsored retirement plan. The Obama Administration has already established the MyRA program that ALLOWS, but does not require, employers without a retirement plan to connect their payrolls to a federal retirement plan investing in U.S. Treasuries. So far, the voluntary adoption of the MyRA program by small employers has been modest.
On the other hand, the small business lobbies in certain states oppose any requirement for firms to connect their payrolls to the state version of the Automatic IRA. To diffuse this opposition, states should impose this requirement on firms having more than 25 employees as Illinois has done, rather than more than 5 or 10 employees. Almost all firms with more than 25 employees have some type of electronic payroll system, which minimizes the costs for connecting to the state retirement plan. Moreover, states should provide a state tax credit to small firms to help defray their start up costs for setting up the connection.
Some states are now considering guaranteed returns for their versions of Automatic IRAs. California, for example, wants to announce a guaranteed rate of return for retirement contributions in advance every year. While this desire is understandable in light of the 2008 crisis, it would be very expensive to obtain guaranteed returns at more than minimal yields in the private sector given the volatility of the securities markets.
As mentioned above, the myRA already invests employee contributions in U.S. Treasuries — in reality, the only investment with a guaranteed investment return if held to maturity. But U.S. Treasuries have relatively low yields and are an inappropriate investment strategy for long-term retirement assets. A better choice would be a diversified balance fund, composed 60% of a S&P index fund and 40% of a high-quality bond index fund.
Most importantly, to have effective Automatic IRA plans, states need these plans to be exempted from ERISA (Employee Retirement Security Act), the federal law governing pensions. ERISA contains protections for participants in corporate retirement plans, though much less so for IRAs. Nevertheless, most small firms will vehemently oppose any Automatic IRA plan if they become ERISA fiduciaries simply by connecting their payroll to a state sponsored retirement plan.
Unfortunately, the Department of Labor has not yet confirmed that the Automatic IRA is exempt from the fiduciary provisions of ERISA — which would impose liability on participating employers for imprudent actions or potential conflicts of interest. It is clear that these provisions do not apply if all contributions to the plan are voluntarily made by employees. But there is considerable legal debate about whether an IRA with an opt-out procedure meets the voluntary standard for this purpose.
In my opinion, an opt-out procedure with advance disclosure to employees should be considered voluntary participation by the Department of Labor. To reinforce this argument, states should give employees 60 days to opt out after receiving appropriate disclosures. States should also provide that employees have the chance to opt out of the Automatic IRA each and every year.
Through interpretive guidance on ERISA, the federal government should support the state versions of the Automatic IRA. If the state experiments in this area succeed, perhaps Congress will apply the lessons learned from the states and enact the Automatic IRA on the federal level.
Editors Note: this op-ed originally appeared in Real Clear Markets.