A call to scrap tax breaks for retirement plans and use the savings to shore up Social Security has some in the financial services industry up in arms. But the question is not whether the U.S. retirement savings system is costly, complex, and ineffective at boosting savings. It’s all of those things. The only question is what should replace it.
Retirement policy discussions are usually not the stuff of impassioned debates. This changed recently. Two retirement experts, Andrew Biggs from the center-right American Enterprise Institute, and Alicia Munnell, director of the Center for Retirement Research at Boston College created a stir with their suggestion that Congress end or substantially cut tax preferences for 401(k) and similar retirement savings plans. The U.S. tax code provides massive breaks – an estimated $185 billion in 2020 – to encourage people to save more for their retirement than they otherwise would. But, as Munnell and Biggs note, research has long shown these tax preferences do little to boost retirement savings. So, why, they ask, should the U.S. Treasury keep handing out billions every year in incentives that don’t work? Reactions from the retirement industry, which earns billions in fees servicing 401(k) plans, has been unkind to say the least.
Among retirement policy researchers, reactions have been more muted, reflecting that Munnell and Biggs have the weight of the evidence on their side, when it comes to the ineffectiveness of current retirement tax preferences. They also add to a decades-long call among retirement and tax experts to revamp the existing tax preferences. But despite a common understanding about the shortcomings of the existing system, the retirement policy world has no shortage of alternatives that are likely to boost savings much more effectively than the current system does. For instance, Biggs and Munnell favor re-deploying the money spent on 401(k) and similar plans to shore up Social Security’s finances. A decade ago, I proposed, jointly with Sam Ungar, to convert savings from ending current retirement tax breaks to fund a single, progressive tax credit for any form of savings. Teresa Ghilarducci at the New School University together with Kevin Hassett from the Hoover Institute has suggested savings matches into retirement accounts that mirror federal employees’ Thrift Savings Plan accounts. And MIT’s Jonathan Gruber and the Brookings Institution’s Bill Gale and Peter Orszag proposed a uniform 30% savings match in 2006. Any of these approaches would be an improvement on the wasteful use of tax preferences that pervades our current approach to retirement savings.
In the abstract, savings incentives in the tax code can help people save money, build wealth, and avoid facing financial hardship at older ages. Currently, retirement savings are subsidized if they happen in an employment relationship if an employer provides such a benefit or in Individual Retirement Accounts (IRAs) for those whose employers do not offer retirement benefits. In our current system, saving for retirement is entirely voluntary. It is up to employers to offer retirement benefits and it is up to employees to save for retirement. Research based on insights from psychology has long shown that people are generally not that good at planning and saving for very long-term goals such as retirement. Keeping the system entirely voluntary means that few people save too little for retirement. There is room for policy to change incentives for people to save, among them significant changes in tax incentives coupled with more options to automate savings.
Contributions to employer-based retirement plans, such as defined benefit pensions and 401(k) type accounts, as well as those to Individual Retirement Accounts (IRAs) are typically not subject to income taxes. Capital income – capital gains, interest and dividend income – in retirement plans are also excluded from people’s taxable incomes. Households only pay taxes on their retirement savings once they decide to withdraw those funds. It is assumed that these various tax advantages provide an incentive for people to save more than they otherwise would have and Congress has regularly expanded these tax incentives over the past few decades, ostensibly to better target them to small businesses and the self-employed. The result has been a costly, complex, unequal and, as it turns out, ineffective tax mess.
Biggs and Munnell amply detail some of the system’s failures. For one, savings incentives do not actually lead to a lot more savings. Most money in retirement savings plans would have happened even without the tax breaks. Similarly, the bulk of the current tax shelters has little effect on who saves. Despite an expansion of savings incentives over time, the share of households who have tax advantaged retirement savings has remained fairly constant over the past three decades. Yet, those expansions of tax incentives have meant that more tax breaks are being thrown at the same people while retirement savings are made more and more complex as people face multiple options for saving taxes in the present and the future.
Savings incentives have failed to increase retirement savings because they are heavily skewed towards higher-income earners, who would have saved money anyway, and because their complexity makes it more difficult for people to figure out the actual tax benefits of various saving options. The bulk of those incentives – 59% — go to those with the highest 20% of incomes. In fact, households with incomes between the 80th and 99.9th percentile received 24 times the savings incentives relative to income as did households with incomes from the 40th to 60th percentile in 2020. Further, the complexity of the system makes it difficult for people to figure out which retirement savings form is most beneficial to them. People often do not participate when employers offer a retirement plan, they are even less likely to save for retirement on their own, they contribute too little to avoid significant income shortfalls in retirement, even in the face of employer contributions, and they get stymied by the myriad of investment options in retirement savings accounts, which again leads to too few savings and low rates of return. While default options in retirement savings plans seem to improve some retirement outcomes, they are not enough within our current system to compensate for the lack of effective savings incentives for those who need the extra help the most.
Reforming savings incentives to address these two “fatal flaws” – complexity and regressivity – is the solution to fixing what ails our retirement system. Better targeting incentives to reach lower-income households and significantly reducing the complexity of current savings incentives is the best way to achieve more and more broad-based savings. My co-author and I proposed that Congress should convert all existing deductions and exclusions into a single, refundable tax credit that would function as a progressive savings match. We called it the Universal Savings Credit. Lower-income earners would receive larger benefits relative to their incomes and there would only be one tax incentive.
Research tells us that low-income earners will increase their savings in response to savings incentives such as savings matches. Indeed, that is why the federal government created the so-called Saver’s Credit in 2001 and recently improved it to ensure it reaches more low-income earners and reduces bureaucratic hurdles. And while expansion of the Saver’s Credit is a small step in the right direction, the renewed discussion over the failure of existing tax incentives can hopefully result in a giant leap for retirement security for all.
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