The Role of Tax Incentives in Retirement Preparation

The Role of Tax Incentives in Retirement Preparation March 27, 2014 Lynn Dudley American Benefits Council

Retirement Plan Tax Incentives Basics What are the tax incentives for retirement savings in employer-sponsored plans? Employer contributions are tax deductible Employee contributions are tax-deferred when made Earnings are tax-deferred Contributions and earnings taxed on distribution 2

Putting Tax Incentives in Perspective Value to Employee The value of a tax deferral to an employee is the value of the taxes they would have paid except for the deferral over what taxes they pay when the money is distributed Good for the employee because it costs them less upfront to save and allows them to save more; ensuring a better retirement outcome 3

Contributions Are Tax-Deferred Not Tax Free The value to the employee of the deferral is a good deal for future taxpayers More money comes out than goes in and so there is a greater taxable revenue stream; keeping taxes on the future taxpayers lower It would cost more to pay the same retirement benefit from government programs 4

Putting Tax Incentives in Perspective Encouraging Plan Sponsorship Tax incentives are the foundation of employer-sponsored savings and features of voluntary employer-sponsored plans cannot be duplicated in other structures. Employer-sponsored plans help employers keep and retain talented workers. Employees like employer-sponsored retirement plans 5

Tax Incentives Encourage Sponsorship Employer-sponsored plans have valuable features: Culture of savings that is routine and consistent Help savers across income spectrum Benchmarks that ensure people can retire Employer contributions Cost efficiencies and access to investments Protections through trust structure 6

Putting Tax Incentives in Perspective Potential Unintended Consequences Changing the rules mid-game will have unintended negative consequences for all of the stakeholders Loss of stability and trust Loss of Employer/Employee Influence Less savings and less retirement security; greater costs to future taxpayers 7

For more information: ldudley@abcstaff.org 202-289-6700 8

The U.S. Retirement System: Successful & Strong Briefing to Discuss Tax Incentives For Retirement Plans ABC, ACLI, ICI March 27, 2014 Washington, DC Peter Brady Senior Economist Investment Company Institute Copyright 2014 by the Investment Company Institute. All rights reserved. Copyright 2013 by the Investment Company Institute. All rights reserved.

Motivation Conventional wisdom on retirement typically includes the following: Americans are woefully under-prepared for retirement The situation has gotten worse over time We are either in the midst of a retirement savings crisis, or the crisis is around the corner The conventional wisdom is at odds with academic research and our analysis of the data Purpose of this talk: Examine the empirical evidence on the effectiveness of the U.S. retirement system Examine how changes to the system may alter the success of the system in the future 1

Overview The U.S. Retirement System & Evidence of its Success Components of the U.S. Retirement System Private Sector Pensions: Coverage and Switch from DB to DC The Future of the U.S. Retirement System References 2

The U.S. Retirement System & Evidence of its Success 3

Employment-Based Resources: A Retirement Resource Pyramid Other assets IRAs (including rollovers) Employer-sponsored retirement plans (DB and DC plans) Homeownership Social Security & Medicare Source: Investment Company Institute; see Brady, Burham, and Holden, The Success of the U.S. Retirement System (December 2012) 4

Evidence of the Success of the U.S. Retirement System Most households are properly preparing for retirement Scholz, Seshadri, and Khitarakun (2006), Scholz and Seshadri (2008, 2012) Retirees maintain their living standards in retirement Hurd and Rohwedder (2008); Hurst (2008) Brady and Pierce (2011) Haveman, Holden, Wolfe, and Romanov (2005) Love, Palumbo, and Smith (2008) Poterba, Venti, and Wise (2012) Living standards of retirees have improved over time Haveman, Holden, Wolfe, and Romanov 2007 Gustman, Steinmeier, and Tabatabai 2009 5

Poverty Rates Among People Aged 65 or Older Have Fallen over Time 30% Poverty rates by age, percentage of individuals in age group, 1966 2012 Individual s age: Younger than 18 18 to 64 65 or older 25% 20% 22% 15% 10% 14% 9% 5% 0% 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 *Note: The data points are placed at the midpoints of the respective years Source: U.S. Census Bureau, Current Population Survey: 1967 to 2012 Annual Social and Economic Supplements 6

Households Have More Assets Earmarked for Retirement Average retirement assets for all U.S. household, constant 2013 dollars, rounded to nearest $100, end of period, selected dates Annuities Federal pension plans State and local government pension plans Private DB plans DC plans IRAs 152,581 164,606 156,634 166,884 190,738 16,594 14,522 32,193 107,023 24,808 57,021 48,571 27,691 3,247 2,480 6,140 10,569 5,078 177 54,050 1975 1985 1995 2005 2010 2011 2012 2013 Sources: Investment Company Institute, Federal Reserve Board, National Association of Government Defined Contribution Administrators, American Council of Life Insurers, Internal Revenue Service Statistics of Income Division, U.S. Department of Commerce, Census Bureau, and U.S. Department of Labor, Bureau of Labor Statistics 7

Components of the U.S. Retirement System 8

Social Security Benefits Have Grown More Generous over Time Estimates of replacement rates (first year benefits relative to average indexed earnings) at normal retirement age; percentage of lifetime earnings; 1940 2035 80 70 60 50 40 30 Low earner Medium earner High earner 20 10 0 Note: Low, medium, and high earner refer to scaled earnings that reflect patterns of work and earnings for hypothetical workers over the course of a career. Projections assume no change in current policy. Sources: Social Security Administration, Office of the Chief Actuary 9

Social Security Benefits are More Generous to Workers with Low Lifetime Earnings CBO estimates of median first-year benefits relative to average indexed earnings by household lifetime earnings, 1940s birth cohort (age 64 to 73 in 2013), percent 77 51 45 40 32 Lowest Second Middle Fourth Highest Lifetime earnings quintile Source: Congressional Budget Office (see Congressional Budget Office 2013) March 27, 2014 The U.S. Retirement System: Successful & Strong 10

Homeownership Rises with Age; Mortgage Burden Falls with Age Percentage of households by cohort, 2010 1970s birth cohort (age 31 to 40 in 2010) 1930s birth cohort (age 71 to 80 in 2010) 96.1 82.7 81.0 57.8 47.0 35.0 March 27, 2014 Home ownership Mortgage incidence Loan-to-value ratio Source: ICI tabulations of the Survey of Consumer Finances; see Brady, Burham, and Holden, The Success of the U.S. Retirement System (December 2012) The U.S. Retirement System: Successful & Strong 11

Percentage of households Near-Retiree Households Across All Income Groups Have Retirement Assets, DB Plans Benefits, or Both Households with working head age 55 to 64; excludes top and bottom 1 percent of the income distribution, 2010 Retirement assets only Both DB benefits and retirement assets DB benefits only 95 96 89 81 71 43 43 48 48 40 38 28 32 45 20 45 31 9 11 12 14 7 3 10 Lower Lower-Middle Middle Upper-Middle Higher All $30,000 to $55,000 to $80,000 to $150,000 $54,999 $79,999 $149,999 or more 16% 24% 19% 23% 18% 100% Less than $30,000 Household income group Source: Investment Company Institute tabulations of the Survey of Consumer Finances; see Brady, Burham, and Holden, The Success of the U.S. Retirement System (December 2012) 12

The Retirement Resource Pyramid Varies Across Households Percentage of wealth by wealth quintile for households with at least one member born between 1948 and 1953; balance sheet in 2010 Other 2 4 6 9 DC pension + IRA 2 6 13 12 9 8 15 27 DB pension wealth 17 Net housing wealth 25 21 14 Social Security wealth 16 34 22 20 15 33 80 62 44 Bottom Second Third Fourth Top [$121,500] [$358,000] [$641,000] [$1,072,000] [$2,1380,000] Quintile of augmented wealth Note: Households with the top and bottom 1 percent of wealth are excluded. Social Security wealth is estimated as the present discounted value (PDV) of the stream of Social Security benefits. Net housing wealth is the value of the home less mortgages. DB pension wealth is estimated as the PDV of the stream of DB benefits. Retirement assets include DC plan assets (401(k), 403(b), 457, thrift, and other DC plans) and IRAs (traditional, Roth, SEP, SAR-SEP, and SIMPLE). DB pension and retirement assets are derived from work in both the private-sector and the government sector. Source: Investment Company Institute tabulation derived from Gustman, Steinmeier, and Tabatabai (2009) using Health and Retirement Study (HRS) data 13 16 30 19 15 17

Summary: Components of the U.S. Retirement System The U.S. retirement system is more akin to a pyramid than a stool Retirees rely on many resources in retirement Social Security Homeownership Employer-provided plans & IRAs Other assets The importance of each resource will vary from household to household Those with lower lifetime earnings rely heavily on Social Security benefits Vast majority of the population supplement Social Security with employer plans and IRAs 14

Private Sector Pensions: Coverage and Switch from DB to DC 15

Tax Data Indicate Higher Rates of Retirement Plan Participation Than Survey Data Percentage of all wage and salary workers, 2010 CPS Participation SOI Participation 11.9% 7.0% $1 under $10,000 27.1% 17.6% $10,000 under $20,000 45.7% 35.3% $20,000 under $30,000 59.0% 51.4% $30,000 under $40,000 68.8% 60.4% $40,000 under $50,000 Wage income 76.4% 68.2% $50,000 under $75,000 82.9% 84.0% 84.9% 74.2% 73.1% 71.3% $75,000 under $100,000 $100,000 under $200,000 $200,000 and over Source: ICI tabulations of CPS data and IRS tabulations of tax data reported in Pierce and Gober (2013) 16

Retirement Savings Focus Is Linked to Retirement Plan Coverage Percentage of private-sector wage and salary workers with access to employersponsored retirement plans, 2012 74% 69% 60% 50% Own employer sponsors plan All workers, aged 21 64 Own employer sponsors plan Full-time, full-year workers, aged 30 64 Own employer sponsors plan Own employer or spouse's employer sponsors plan *Full-time, full-year workers who earn $45,000 or more and are aged 30 to 64,or earn $26,000 to $44,999 and are aged 45 to 64. Among full-time, full-year workers aged 35 to 44, $26,000 represents the top earnings of the 20th percentile of annual earnings, while $45,000 represents the top earnings for the 50th percentile of annual earnings. Source: Investment Company Institute tabulations of March 2013 Current Population Survey; see Brady and Bogdan, Who Gets Retirement Plans and Why, 2012, ICI Research Perspective (October 2013) March 27, 2014 The U.S. Retirement System: Successful & Strong Full-time, full-year workers, aged 30 64, likely to be focused on saving for retirement* 17

Percentage of households Near-Retiree Households Across All Income Groups Have Retirement Assets, DB Plans Benefits, or Both Households with working head age 55 to 64; excludes top and bottom 1 percent of the income distribution, 2010 Retirement assets only Both DB benefits and retirement assets DB benefits only 95 96 89 81 71 43 43 48 48 40 38 28 32 45 20 45 31 9 11 12 14 7 3 10 Lower Lower-Middle Middle Upper-Middle Higher All $30,000 to $55,000 to $80,000 to $150,000 $54,999 $79,999 $149,999 or more 16% 24% 19% 23% 18% 100% Less than $30,000 Household income group Source: Investment Company Institute tabulations of the Survey of Consumer Finances; see Brady, Burham, and Holden, The Success of the U.S. Retirement System (December 2012) 18

Employer Plan Coverage Survey data understates coverage rates That said, workforce coverage at a single point in time is the wrong measure Most workers accumulate retirement assets or retirement benefits by the time they approach retirement 19

Share with Retirement Accumulations Steady, but Composition Has Shifted Households with working head age 55 to 64; excludes top and bottom 1 percent of the income distribution, 1989 2010 Retirement assets only Both DB benefits and retirement assets DB benefits only 80 82 82 84 82 85 77 81 55% 25 31 26 37 37 41 41 40 60% 35 36 34 33 33 32 31 31 41% 20 15 16 12 14 9 13 10 71% 1989 1992 1995 1998 2001 2004 2007 2010 Note: Retirement assets include DC plan accounts and IRAs. Source: Investment Company Institute tabulations of the 1989 2010 Survey of Consumer Finances 20

Near Retiree Wealth Has Increased Over Time Comparison of average household wealth by cohort, in constant 2010 dollars. Excludes top and bottom 1 percent of the wealth distribution in each survey year. Other Net house and real estate value IRA assets Pension value Social Security $764,211 $712,384 $682,466 135,181 122,978 138,410 189,390 163,584 151,131 25,930 45,728 45,350 163,529 $189,460 $227,718 $226,717 181,990 181,367 206,445 195,124 212,923 Ages 51 to 56 in 1992 Ages 51 to 56 in 1998 Ages 51 to 56 in 2004 Source: Gustman, Steinmeier, and Tabatabai (2010) 21

Wealth Trend Affected By Recession, but Retirement Accumulations Up Comparison of average household wealth by cohort, in constant 2010 dollars. Excludes top and bottom 1 percent of the wealth distribution in each survey year. Other $894,000 $848,000 $848,000 Net Housing Plus 166,000 Real Estate 156,000 132,000 DC + IRA DB Social Security 162,000 206,000 154,000 114,000 130,000 165,000 $279,000 $283,000 165,000 153,000 141,000 $306,000 251,000 239,000 256,000 Age 57 to 62 in 1998 Age 57 to 62 in 2004 Age 57 to 62 in 2010 Source: Gustman, Steinmeier, and Tabatabai (2012) 22

Switch from DB Plans to DC Plans No evidence to date that switch in private sector from DB plans to DC plans has reduced retirement preparedness On the contrary, the value of employer plan and IRA assets have grown for each successive wave of preretirees 23

The Future of the U.S. Retirement System The U.S. retirement system has successfully provided financial resources to generations of Americans The shift of private-sector retirement plans toward DC plans is unlikely to reduce retirement preparedness The real risks to retirement security are unrelated to the design of private-sector retirement plans 24

Primary Areas of Concern Early retirement due to poor health Individuals with limited work histories Healthcare costs Social Security solvency Government-employee retirement benefits Low-interest rate environment 25

Summary The U.S. retirement system works well No evidence that private-sector shift to DC plans will reduce retirement preparedness Risks to retirement security unrelated to plan design 26

References Brady, Peter, Kimberly Burham, and Sarah Holden. 2012. The Success of the U.S. Retirement System (December). Washington, DC: Investment Company Institute. www.ici.org/pdf/ppr_12_success_retirement.pdf Brady, Peter, and Kevin Pierce. 2011. Using Panel Tax Data to Examine the Transition to Retirement. Presented at the National Bureau of Economic Research (November). Congressional Budget Office. 2013. The 2013 Long-Term Projections for Social Security: Additional Information. http://www.cbo.gov/publication/44972 Gustman, Alan L., Thomas L. Steinmeier, and Nahid Tabatabai. 2012. How Did the Recession of 2007 2009 Affect the Wealth and Retirement of the Near Retirement Age Population in the Health and Retirement Study? Social Security Bulletin, 72, no. 4. http://www.ssa.gov/policy/docs/ssb/v72n4/v72n4p47.html Gustman, Alan L., Thomas L. Steinmeier, and Nahid Tabatabai. 2009. What the Stock Market Decline Means for the Financial Security and Retirement Choices of the Near-Retirement Population. Michigan Retirement Research Center Working Paper WP2009-206 (October). Haveman, Robert, Karen Holden, Barbara Wolfe, and Andrei Romanov. 2005. Assessing the Maintenance of Savings Sufficiency over the First Decade of Retirement. CESIFO Working Paper, no. 1567 (October). www.cesifo-group.de/portal/pls/portal/docs/1/1188496.pdf. 27

References (continued) Haveman, Robert, Karen Holden, Barbara L. Wolfe, and Andrei Romanov. 2006. The Sufficiency of Retirement Savings: Comparing Cohorts at the Time of Retirement. Redefining Retirement: How Will Boomers Fare? Edited by Brigitte Madrian, Olivia S. Mitchell, and Beth J. Soldo: 36 69. New York: Oxford University Press. Hurd, Michael, and Susann Rohwedder. 2008. The Retirement-Consumption Puzzle: Actual Spending Change in Panel Data. RAND Labor and Population Working Paper, no. 563 (April). www.rand.org/pubs/working_papers/wr563.html. Love, David A., Michael G. Palumbo, and Paul A. Smith. 2008. The Trajectory of Wealth in Retirement. Center for Retirement Research at Boston College Working Paper, no. 2008-7 (February). crr.bc.edu/wp-content/uploads/2008/02/wp_2008-7-508.pdf. Poterba, James, Steven Venti, and David A. Wise. 2007. The Changing Landscape of Pensions in the United States. NBER Working Paper, no. 13381. Cambridge, MA: National Bureau of Economic Research (September). www.nber.org/papers/w13381. Poterba, James M., Steven F. Venti, and David A. Wise. 2012. Were They Prepared for Retirement? Financial Status at Advanced Ages in the HRS and AHEAD Cohorts. NBER Working Paper, no. 17824. Cambridge, MA: National Bureau of Economic Research (February). www.nber.org/papers/w17824. 28

References (continued) Scholz, John Karl, Ananth Seshadri, and Surachai Khitatrakun. 2006. Are Americans Saving Optimally for Retirement? Journal of Political Economy 114 (August): 607 643. ssrn.com/abstract=941137. Scholz, John Karl, and Ananth Seshadri. 2008. Are All Americans Saving Optimally for Retirement? Michigan Retirement Research Center 2008-189 (September). www.mrrc.isr.umich.edu/publications/papers/pdf/wp271.pdf. Scholz, John Karl, and Ananth Seshadri. 2012. The Interplay of Wealth, Retirement Decisions, Policy and Economic Shocks. Michigan Retirement Research Center 2012-271 (September). www.mrrc.isr.umich.edu/publications/papers/pdf/wp271.pdf. 29

Tax Deferral Compared with Typical Tax Treatment Deferral changes taxes at three points in time: Upfront deduction ( ) Tax-free inside buildup ( ) Tax upon distributions (+) Benefit is not the upfront reduction in tax liability Instead, benefit is roughly equivalent to getting a zero rate of tax on investment income 0

Tax Benefit of Deferral More Related to a Worker s Age Than to a Worker s Marginal Marginal Tax Rate Present value of the tax benefits (inclusive of federal and state income tax) of a onetime contribution of $1 of compensation by age at the time of deferral; deferral invested in mix of stocks and bonds; payouts based on life expectancy begin at age 70 $0.50 Federal marginal income tax rate: 10 15 25 28 33 35 $0.40 $0.30 $0.20 $0.10 $0.00 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 Age of employee at the time of deferral Source: Brady, The Tax Benefits and Revenue Costs of Tax Deferral (September 2012). 1