Tuesday, January 17, 2017

The 401(k): Revolutionary or a Cause of a Retirement Crisis?

About a couple of weeks ago, the Wall Street Journal (WSJ) came out with an intriguing article on the 401(k), mainly that the early champions of the 401(k) lament what they have unleashed. Their issue is that it was not meant to be a primary retirement savings tool, and that the initial projections were overly optimistic. This ties together with my blog entry a couple months ago on poverty reduction in Social Security, and how we can best ensure that retirees have enough money saved to make it through retirement.

The 401(k) is section of the IRS Internal Revenue Code that passed in 1978. The 401(k) provision allows for individuals to defer a certain portion of revenue (maximum of $18,000 annually) in their 401(k) account. The deferral is significant because the amount put into the 401(k) account is exempt from being taxed. The ability to exempt this portion is significant because in a progressive tax system, it reduces one's overall tax burden and incentivizes retirement savings (the even bigger incentive is the ability for employers to match their employees' contributions). The 401(k) is different from a traditional pension in that it is defined-contribution, i.e., the balance is determined both by the contributions made to the plan and the performance of the plan's investments. So what about it is appealing, and what about it has critics in arms?

The Good
  • Per the WSJ article, the 401(k) has more portability than the traditional pension, which is especially important given that people switch jobs more frequently than they used to.
  • According to Gallup polls, 74 percent of retirees are living comfortably. Even better, two studies from economists from my alma mater, the University of Wisconsin-Madison, project that 75 to 85 percent of Americans have been adequately saving for retirement since the 401(k) began (Scholz et al., 2009Scholz et al., 2004), as well as this study from Rand Corporation scholars (Hurd and Rohwedder, 2011).
  • As a matter of fact, the Boston College Center for Retirement Research concluded that the shift to 401(k)s did not reduce retirement savings. 
  • A shift toward the 401(k) has coincided with a large increase of people with retirement plans because let's be honest: those who glorify the traditional, defined-benefit plans forget that most workers did not have pension plans (i.e., at its peak, only 40 percent did). 
  • As the Right-leaning American Enterprise Institute points out that since 1996, Americans went from having their combined savings increase from 269 percent to 413 percent of incomes. AEI also points out that this improvement has not just been for the top 1 percent, but for working Americans, as well. 
  • From 1989 to 2013, individuals 65 and older have had their annual incomes increase 34 percent higher than inflation (Biggs, 2013, p. 14). This same paper by AEI scholar Andrew Biggs shows that private sector plan contributions as a percent of private wage sector wages is also increasing (p. 9), and that increase is happening for the "bottom 90 percent" of wage earners (p. 10).
  • I suppose that this is good news because it's not bad news: pension wealth was about 13 percent of wealth in 1984, and it is about 13 percent now (Munnell et al., 2015, p. 5). While the WSJ article stated that there are less savings, Left-leaning Mother Jones points out that there is more than one way to save. When you account for savings and housing equity, the percent in retirement wealth stays relatively stable as a percent of disposable income. 

The Bad
  • The Employee Benefit Research Institute found that 40 percent of retirees outlive their savings, which means the 401(k) does not provide lifetime protection for a significant number of retirees that use the 401(k), which is something with which Boston College's Center for Retirement Research concurs.
  • Individual retirement accounts, such as the 401(k), are subject to both market boons and market crashes, i.e., traditional pensions have more stability than the 401(k).
  • According to Gallup polls, more than half of non-retirees are worried about having enough saved up for retirement. 
  • In its lengthy report on retirement in America, the Left-leaning Economic Policy Institute makes an argument that the 401(k) exacerbates income inequality. 
  • A study from University of Kansas sociology professor ChangHwan Kim found that workers with a college degree are to save 26 percent more in a 401(k) than those with only a high school degree, although that could stem from lower financial literacy or lower availability of 401(k) options for less-educated workers. Part of the solution to help out these individuals is to make sure they have the tools and knowledge to navigate so they can save for retirement, as well. 

Looking at the available data, what I can say is that while 401(k) retirement accounts are far from perfect, we should not cling onto a false nostalgia that traditional, deferred-benefits pension plans were wonderful because they were not. Given that a) 401(k)s have not caused a retirement crisis, and b) 401(k)s are not going anywhere anytime soon, the focus should be on how to improve the 401(k). Just a few policy alternatives I could find: we can provide plan participants with more information so they can make well-informed decisions, give private-sector workers access to the federal Thrift Savings Plan, implement the Guaranteed Retirement Account, caps on management feespermit greater usage of annuities, make 401(k) an opt-out program [instead of an opt-in program], create a lower-cost option for smaller businesses so more people have the option of a 401(k), or modify the 401(k) so that small businesses could join 401(k)s without being considered fiduciaries. Especially since politicians don't feel the need to seriously reform Social Security and its path towards insolvency, we should at least find ways to improve the 401(k) so there is even better hope for future retirees.

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