The Debt Commission and Retirement Policy

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1 The Debt Commission and Retirement Policy October 2010 Aon Hewitt 2010 Aon Corporation Brief Description: President Obama s National Commission on Fiscal Responsibility and Reform is thought to be considering two major policy innovations that would affect pension and retirement policy for corporate plan sponsors: a value added tax and an increase in the Social Security Retirement Age. We take a look at the retirement plan design consequences that these changes may bring.

2 On February 18, 2010 President Obama created the National Commission on Fiscal Responsibility and Reform, sometimes referred to in the press as the Debt Commission or Debt Panel. We will refer to it as the "Commission." The Commission's mission is: [I]dentifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run. Specifically, the Commission shall propose recommendations designed to balance the budget, excluding interest payments on the debt, by This result is projected to stabilize the debt-to-gdp ratio at an acceptable level once the economy recovers. The magnitude and timing of the policy measures necessary to achieve this goal are subject to considerable uncertainty and will depend on the evolution of the economy. In addition, the Commission shall propose recommendations that meaningfully improve the long-run fiscal outlook, including changes to address the growth of entitlement spending and the gap between the projected revenues and expenditures of the Federal Government. The Commission is to make a report and recommendations with respect to these issues by December 1, The Commission is said to be considering, at least in the abstract, two policy innovations that would affect pension and retirement policy for corporate plan sponsors: a value-added tax (VAT) and an increase in the Social Security normal retirement age (hereafter, SSNRA), likely to age 70. In this article we discuss the consequences either of these changes might have for retirement plan design. Emphatic disclaimer: both of these proposals are very controversial and are opposed by important constituencies. We make no comment on the wisdom of either of these proposals or their prospects, other than to say that their adoption is likely to involve a tough political battle. Our purpose in this article is to consider, from a plan sponsor's point of view, their implications for plan design. Value-Added Tax There are various versions of value-added tax (VAT) systems in other countries. For purposes of plan design, the essential feature of any VAT is that it is a tax on consumption. The current United States tax system is based on a tax on income. Taxing consumption is a radically different way of raising revenues radical in the sense that it is a difference at the root. Consider: in a system in which all revenues were raised through a VAT, the current tax incentives for retirement savings would not exist. That is, all savings would generally go untaxed, because they are not being used to consume anything. Therefore, there would be no need to save in a tax shelter like a 401(k) plan to avoid taxes. You could accomplish the same tax result by simply saving in a bank account. VAT + What? Most proposals to add a VAT to the U.S. tax system, however, have not eliminated income taxes. Instead, these proposals typically envision a limited VAT added on to the current income tax system. (See, for instance, the recent proposal to finance basic healthcare through a VAT.) 1

3 As a general matter, the addition of a VAT to the current system (with no other change) will not affect the relative value of retirement savings vs. either saving outside the plan or current spending. Effect on Plans The issue for sponsors is not whether some future Congress adopts a VAT. Rather, it is if in adopting a VAT, Congress makes other changes to the current system. For instance, if the VAT is adopted in connection with a reduction in current income taxes, then retirement saving, from a tax standpoint, becomes relatively less attractive than it previously was. Axiomatically, any increase in marginal tax rates increases the value of retirement savings; any reduction in them reduces it. Strictly from a plan design point of view, the key issue for sponsors in any debate over a VAT will be whether there will be any changes to the current income tax system and, critically, whether there will be a change in marginal tax rates. Much of the motivation for converting IRA and qualified plan money to Roth vehicles in 2010 comes from a concern that income tax rates in the future will be higher than current rates. Better to pay taxes now, goes the thinking, than risk having to pay at higher rates later. If, however, future taxes are raised through a VAT, rather than increasing income taxes, the advantage to a Roth conversion may not materialize. Social Security Normal Retirement Age and "Normal Retirement Age" in Plans The SSNRA was originally age 65, but was increased in Under the 1983 law, the SSNRA is gradually increasing, and will reach age 67 for those born in 1960 or later. Most defined benefit (DB) plans target a retirement age of 65, and indeed ERISA accrual rules are premised on age 65 retirement as the "normal" normal retirement age. Retirement income modeling in defined contribution (DC) plans is typically more flexible allowing the participant to choose a target retirement age. But it's probably fair to say that participants' current bias is towards an age 65 retirement age target, anchored by habit and things like Medicare eligibility. The Challenge for Plans A change in the SSNRA presents an explicit challenge for DB plans, because those plans generally premise their benefit on a normal retirement age. It also presents an implicit challenge for DC plan design, at least to the extent that DC plan design focuses on enabling a participant to accumulate an adequate retirement benefit at some assumed "retirement age." When the SSNRA was increased in 1983, sponsors generally did not re-conceptualize DB plan design to reflect that change. An increase in the SSNRA to 70 may have more dramatic consequences. Critically, for companies that perform complex nondiscrimination testing that considers, as part of the demonstration, Social Security benefits, a change in the SSNRA will produce a different result. Thus, a 2

4 change in the SSNRA may compel some companies to redesign their plans in order to stay in compliance. Alternative Responses If the SSNRA is increased to age 70, sponsors are faced with three obvious alternatives. Alternative 1 do nothing. Certainly the easiest alternative, in that it generally will require the fewest tough decisions. DB plans that are integrated with Social Security may get more expensive or may require design changes; DC retirement income models that include the value of Social Security will start producing new (and lower) results. But in the abstract (and disregarding the integration issue), the amount coming from Social Security will go down and the amount the sponsor provides will remain the same. The result, retirement pay for participants at the plan's normal retirement age will be smaller. Alternative 2 make up the difference. Theoretically this would require re-designing plan benefits to produce the same gross benefit plan benefit + Social Security benefit that was available before the change in SSNRA. Obviously, in DB plans, the cost of this approach will vary depending on plan design. In DC plans the issue will be how much more savings/contributions are necessary to hit the same age 65 retirement income target. Alternative 3 adopt an age 70 normal retirement age target. There are (for DB plans at least) legal obstacles to adopting an age 70 NRA, and anti-cutback rules will prevent any reduction in benefits because of such a change. But within those limits there are ways to, in effect, prospectively implement an age 70 retirement target. Generally this approach will reduce plan costs; again, the amount of savings will depend on current plan design. For DC plans the issue will be one of expectations. Shifting the retirement age target from 65 to 70 will, in effect, lower them all around. Traditional DB Plans The analysis for cash balance DB plans will, generally, be similar to that for DC plans. For traditional DB plans there are some special issues worth identifying. If the DB plan is a flat dollar plan (e.g., a benefit formula of an annuity beginning at age 65 of $100 per year of service), doing nothing will result in a significant reduction in the gross benefit (plan benefit + Social Security benefit), even though the plan benefit is unchanged. In a traditional final pay, Social Security offset plan, doing nothing will result in some increase in the plan benefit, because the value of the integrated Social Security benefit is going down. But plans generally (and oversimplifying) can only integrate half of the Social Security benefit, and many integrate less than the fully allowable amount. So while the plan benefit will go up, the gross benefit (plan benefit + Social Security benefit) will go down. 3

5 Broader Considerations Changing demographics, of which changing retirement ages is an aspect, present challenges for human resources departments that go beyond plan design and finance. Some companies are concerned about the loss of skill and experience as the (large) baby boom cohort retires and is replaced by the (smaller) following generation. That sounds abstract; in real life it is a question for some companies of not having enough workers with the needed skills and experience because they are all retiring. In that context, it may not be in the sponsor's interest to encourage older workers to retire. Thus, moving to an age 70 retirement target may be a good idea. On the other hand, it is not in the sponsor's interest to punish those older workers. Thus, HR will want to explore different incentives higher pay? a bigger post-age 70 benefit? for these workers. Conclusion All of this is still in the very early stages. But as the debate over these changes develops, sponsors will want to think through the implications for plan design. 4

6 Contact Information Brian Donohue Senior Vice President Aon Hewitt John Lowell Vice President Aon Hewitt