Automatic Retirement Savings Gains Momentum

Some liberal analysts object that automatic enrollment in retirement savings accounts will accelerate a trend away from traditional, employer-underwritten pensions. Aside from that concern, however, it’s difficult to find anyone who rejects the presumed benefits or otherwise opposes this idea on behalf of workers or employers.

The libertarian Cato Institute, a strong proponent of individual freedom and limited government, favors personal savings for retirement and opposes traditional pensions. But Cato has nothing to say on the topic of automatically enrolling workers. Like Nationwide, the U.S. Chamber of Commerce recently implemented automatic enrollment for the retirement plan it offers its own workers. And the American Benefits Council, whose members are large employers, endorses the concept.

The increased attention on retirement savings has led to a bipartisan groundswell in Congress, among advocates for seniors and within think tank circles. Many believe action will soon follow. Position papers are being written and hearing records amassed, and advocates of a fundamental overhaul of retirement policy say they expect both presumed presidential nominees, Republican Sen. John McCain of Arizona and Democratic Sen. Barack Obama of Illinois, to start talking soon in detail about improving the income security of seniors.

Groups such as AARP are trying to inject the issue into the presidential campaign and are hoping the next administration will put the issue high on its agenda. Worries about the near-term economy will pale in comparison with the needs of seniors down the road, they say.

Congress and the next president, these experts say, will need to focus on the drop in savings that has occurred over the past three decades as employers have increasingly ended their traditional pensions, which are known as defined-benefit retirement plans, in favor of savings accounts such as 401(k)s, known as defined-contribution plans.

Since 1979, the share of workers covered by defined-benefit plans has dropped to 10 percent from 62 percent, according to the Employee Benefits Research Institute. Meanwhile, the trend for 401(k) plans has been the reverse, rising to 63 percent today from 16 percent three decades ago.

Under a defined-benefit plan, companies invest money in their employees’ behalf in accounts overseen by pension-fund managers, and workers don’t have to think about it until they retire and start drawing steady checks that will keep coming for the rest of their lives.

Meanwhile, defined-contribution plans such as 401(k)s leave all of the responsibility in the hands of the employee. Workers with such accounts decide how much to save, if anything, and how to invest it. They have access to the whole lump sum in the account once they retire, so it’s possible that they could spend it all long before they die.

In theory, the shift to this defined-contribution retirement system gives workers additional power and more choices. But many are still operating under the old psychology, as if they are living in the days when they could rely on their companies to put money into a pension for them. The result is, they’re just not saving enough — even if they really want to.

Changing Behavior

Some of the underpinnings for this new thinking can be found in a recently released book, “Nudge,” by University of Chicago economics and law professors Richard H. Thaler and Cass R. Sunstein, which has become all the rage in policy circles. “Nudge” attempts to explain, on a popular level, the thriving field of behavioral economics, which takes irrational choices into account by blending traditional economic thought with psychology.

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The authors analyze a host of seemingly self-destructive but common choices: why people spend more money to buy an item that they can put on a credit card when the price is lower when they pay with cash, why people buy stocks when the price is at a high and why people are more likely to buy insurance after they’ve suffered through a natural disaster.

Automatic Retirement Savings Gains Momentum

The study of human behavior and choices is at the heart of the proposed solutions to the savings problem that are now moving to the forefront of the policy discussion.

In “Nudge,” Thaler and Sunstein compare people’s behavior and attitudes about saving to the way they nibble compulsively on snack food while begging others to take it away from them.

Lawmakers need to move away from policies based on traditional economic theory, Thaler said in an interview. Current laws give tax incentives to people who stash money in retirement accounts on the assumption that they will be motivated by the opportunity to reduce their tax bills. “But tax breaks are not as important as traditional economic theory suggests,” Thaler said. “What’s important is just making savings easy and automatic.”

That’s why giving the tax incentives to companies instead so that they’ll automatically enroll workers in savings plans is gaining currency. The evidence for this shows up not only in anecdotes like the experience at Nationwide, but in data on worker participation rates in 401(k) plans that the Federal Reserve, the Census Bureau and numerous private surveys have collected.

The majority of companies that offer 401(k)s leave it to their workers to decide to enroll and, if they do sign up, to determine what amount they want to set aside out of each paycheck. Only about three-fourths of all eligible workers enroll in their employer’s 401(k), and that figure drops as income goes down. Only about 13 percent of workers making less than $20,000 a year save through a 401(k).

But an interesting thing happens when workers are automatically enrolled in 401(k)s by their companies — which has been permitted for a decade. The participation rate jumps to above 90 percent for automatically enrolled workers who are signed up with an initial contribution of at least 3 percent of their salary. That means the vast majority of workers don’t decide to withdraw, although they can.

This increase in participation holds true for those in the lowest income bracket and for groups of workers who are generally much less likely to save, such as women and Hispanics. For women, participation more than doubles, to 86 percent from 35 percent, when they are automatically enrolled, and for Hispanics, it jumps to 75 percent from 19 percent.

Many economists say the experience with automatic 401(k) enrollment suggests that such plans should be broadened to all companies. And they say that for the 50 percent of workers whose companies don’t offer 401(k)s, Congress should create automatic enrollment in individual retirement accounts (IRAs).

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That would improve the retirement choices for low- and middle-income Americans, who are heavily represented among the millions of people who have neither a traditional pension nor any retirement savings, economists say. More than half of all households had zero savings in a 401(k) or IRA-style retirement plan in 2004, according to the Retirement Security Project, a joint operation of the Brookings Institution, the Pew Charitable Trusts and Georgetown University’s Public Policy Institute. And half of those in households headed by adults close to retirement age had less than $15,000 in such a plan.

Automatic retirement savings would also mitigate distortions in the tax code that tend to favor the wealthy, experts say.

Beyond Social Security, federal retirement policy almost always involves using tax laws to provide incentives for people to save and employers to help them. Those who pay the most in taxes — and have the most income — stand to benefit most from the existing tax breaks when they put cash into a 401(k) or an IRA.

Indeed, tax experts calculate that almost $110 billion in potential tax receipts is forgone annually by the federal government though retirement incentives. But much of that may just enable the wealthy to shift their assets from one pocket to another to reduce their tax bills, while contributing little to overall national savings, researchers have found.

Automatic Retirement Savings Gains Momentum

In 2007, federal income tax breaks for retirement saving exceeded actual savings by more than $60 billion, according to one study by the Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution.

Automating Savings

Nationwide moved to automatic 401(k) enrollment after lawmakers added liability protections and other incentives for employers as part of a broad pension overhaul law in 2006. The percentage of 401(k) plans in which workers are automatically enrolled has since risen to about 44 percent, from about 19 percent in 2005.

Income and Savings, A Clear Relationship: Click here to view chart

But that’s still far too little, experts say, which is why the next big effort to expand automatic retirement savings is focusing on workers with no access to employer-sponsored 401(k)s. And bipartisan legislation has been introduced in both houses of Congress to create a system of automatic IRAs.

Theoretically, workers whose employers don’t offer 401(k) plans can stash some money in IRAs on their own. But given the steps involved in setting up an account, few do. The proposal for automatic IRAs would help solve that by allowing employers to divert a percentage of their employees’ paychecks into such plans. As with automatic 401(k)s, workers could opt out. But proponents expect that few would do so, and that the result would be a significant increase in the number of people with automatic savings.

The idea is a no-brainer, many experts say, because it doesn’t cost employers much, but they get a small tax break as an incentive to start. Small businesses that may avoid setting up their own 401(k) plans because of the administrative hassles and expense will be able to simply send deposits to IRA accounts exactly the way they directly deposit paychecks into employees’ personal bank accounts.

“Automatic enrollment transplants one of the cardinal attributes of the defined-benefit plan into the 401(k) system, in that it covers everyone in the workforce,” said J. Mark Iwry of the Retirement Security Project. “It doesn’t depend on whether the individual takes the initiative or not.”

The concept appeals to both liberals and conservatives and has the backing of influential groups such as AARP. The Bush administration has expressed approval for the idea. But it has gotten lost amid other legislative priorities, such as the debate over how to fix Social Security. Sen. Jeff Bingaman , a New Mexico Democrat who has sponsored automatic IRA legislation in the last two Congresses, says that may soon change.

“I think we’re building toward a time when we’re going to be able to act on this,” he said. “The problem is becoming more and more visible as more and more people reach retirement age without having made adequate preparation for retirement. And as we approach a new administration, a change of guard here in Washington, that provides the opportunity to get some things moved up on the agenda.”

Republican Phil English of Pennsylvania, a member of the Ways and Means Committee and cosponsor of the House version of the automatic IRA bill, said he will press the case for moving forward quickly at a hearing on retirement this week.

“It’s narrow, it’s affordable, and it appeals to a broad ideological cross-section,” English said. “There are many other pieces to the retirement puzzle and the national savings puzzle that also need to be addressed, but the value of addressing this more narrowly or as a stand-alone is that it’s achievable and could be done practically overnight.”

Both the presumed presidential nominees support the broad concept of automatic IRAs, though neither has taken a position on the particular bills in circulation.

Automatic Retirement Savings Gains Momentum

McCain has yet to release a detailed plan on retirement security. But Obama this month started talking about automatic IRAs on the campaign trail — though he says the concept would not go far enough. He would add an annual government-funded savings match of up to $500 for families earning less than $75,000 a year.

Indeed, most critics of the automatic IRA plan simply say more needs to be done. Supporters counter that they’re hoping it will encourage more employers to start offering 401(k)s.

“Some employers will step up to a 401(k) plan after they see how their employees appreciate being able to save in the workplace and see how easy it is to offer payroll-deduction savings,” Iwry said. “It’s just a step from there to a retirement plan.”

Looking for More

The whole concept of automatic enrollment in IRA and 401(k) plans is predicated on the belief that the nation will never return to a system dominated by traditional pensions, which offer the security of a steady lifetime check. Yet there is a sizable group of thinkers and advocates who believe defined-benefit pensions, or at least the protections inherent in them, should be brought back, especially for the poor.

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A recent study by the Government Accountability Office found that defined-contribution plans “can provide a meaningful contribution to retirement security for some workers, but may not ensure the retirement security of lower-income workers.”

Teresa Ghilarducci, an economics professor at the New School for Social Research and author of “When I’m Sixty-Four,” a recent book on retirement policy, is proposing a solution she calls “guaranteed retirement accounts.” These would essentially require workers who don’t have defined-benefit pension plans at work to save 5 percent of their earnings in individual accounts and then convert the money into annuities upon retirement. The federal government would guarantee that retirees would get at least a 3 percent rate of return on the money invested.

When combined with Social Security, Ghilarducci says, guaranteed retirement accounts would allow people to replace about 70 percent of their pre-retirement earnings.

Critics of her proposal say it would force people to save — in contrast to the opt-out provisions of automatic 401(k)s and IRAs. But Ghilarducci notes that the Social Security system itself is a form of compulsory savings. People need to save more on top of Social Security and have the government shoulder the investment risk, she contends.

“I have come to the conclusion that people need to be forced to save on a consistent basis,” Ghilarducci said. “And there is no way that an individual can guarantee what their return is going to be. The only institution that can guarantee a long-term rate of return is a government.”

She also wants to eliminate the tax breaks for money put aside in 401(k) and IRA accounts to remove the incentive to save in those types of plans. She would use the same amount to create flat tax credits to offset the cost of the new compulsory accounts.

Converting retirement accounts into annuities — essentially insurance policies that make guaranteed payments over time — would be a way to give workers the assurance of the sort of lifetime income that traditional pensions provide, she said. Although retirees now have the option to buy annuities with their savings, they don’t do it either because they prefer maintaining a lump sum or because of simple inertia.

Automatic Retirement Savings Gains Momentum

Moreover, Ghilarducci said, annuities offered on the private market can be confusing and sometimes predatory. Those offered through a government program would probably carry a lower cost for participants, she said.

Britain is in the process of enacting a pension law that is somewhat similar: It would require employers to enroll all workers making more than about $10,000 annually in a pension plan or in a government-run personal account. Beginning in 2012, employees would put 4 percent of their earnings into the accounts, matched by a 3 percent employer contribution and a 1 percent government tax credit.

In keeping with behavioral economic theory, workers would have to actively opt out if they did not want to save. The money would be converted into annuities upon retirement.

Like Obama, many economists think the government should also make more of a contribution to encourage low-income workers to save. Gene Sperling at the Center for American Progress, for example, has outlined a “universal 401(k)” plan that would give a two-to-one federal match for the lowest earners.

Can It Happen Here?

All of these ideas seize on the notion that the retirement system needs to be changed so that employees either are forced to save or are forced to opt out of doing so. The main difference in opinion centers on how much government should spend to induce people to save, whether employer contributions should be compulsory and whether employees should be able to choose not to put money aside.

While Britain may be able to enact a universal pension scheme requiring employer contributions and a government match, that approach may be a tough sell in the United States.

Economists at the Retirement Security Project say a more politically realistic path would be to focus on changing default retirement saving options so that people, and employers, are likely to drift into contributing more to retirement accounts.

“We think a lot of people are not acting in their own best long-term interests, but there’s no political appetite for forcing them to change,” said William Gale, the project’s director. “It seems like you can get most of the benefit of getting them to change by changing the default choices.”

In addition to the automatic IRA plans, Gale, Iwry and others are proposing policies that would increase the percentage of income diverted to automatic savings plans from a typical 3 percent to perhaps twice that amount. They would institute default investment options for retirement plans that include stock-index funds or other choices that would protect employees from putting most of their money into their own company’s shares. And they would automatically convert retirement accounts into reasonably priced annuities for a temporary period of two years.

They also propose a change in the so-called saver’s credit, which was instituted in 2001 to give taxpayers earning less than $50,000 a credit for depositing money in 401(k) accounts and IRAs. Because workers must pay income taxes to receive that credit, it doesn’t offer an incentive to households that don’t earn enough to have tax liability. Making the saver’s credit refundable, they say, would give more people a reason to save.

Advocates of these ideas concede that they may be a series of small steps, but that may be the way ahead, they say.

When lawmakers might act on retirement savings is another question. Despite think tank presentations and committee hearings, the issue isn’t yet on the front burner in either presidential or congressional politics.

Automatic Retirement Savings Gains Momentum

“I think the good news is that you’ve got good, bipartisan, bicameral leadership in Congress, but we’re not seeing the candidates talk enough about this,” said Nelson of AARP. “We are pleased with the discussion on health care. There really hasn’t been the attention paid to financial security issues.”

In Congress, the automatic IRA is the most politically developed of the ideas being floated. But even its proponents aren’t talking about putting it atop the agenda before next year.

“It has become so difficult to predict when vehicles will be moving in the House and Senate that I decline to predict whether this will move this year,” said English. “I do believe, though, that it will be an obvious candidate to run at the beginning of the next Congress if it doesn’t move this year.”

FOR FURTHER READING: Declining national savings, 2007 CQ Weekly, p. 1028; 2006 pension law overhaul (PL 109-380), 2006 Almanac p. 7-3; Social Security overhaul debate, 2005 CQ Weekly, pp. 2896, 1238; Senate automatic IRA bill is S 1141; House IRA bill is HR 2167.