The limits of reforming the U.S. private-sector retirement system

Looking at the future of retirement in the United States doesn’t reveal a pretty picture. Life expectancies are on the rise as the personal savings rate falls. Participation in employer-sponsored savings plans are on the decline, and fewer households are approaching retirement with enough savings stashed away. Clearly, we need policy reforms that encourage greater retirement savings. A new paper from the Hamilton Project by John N. Friedman, an economist at Brown University, proposes important steps in reforming the current private retirement-savings system, but are they comprehensive enough given the depth of the problems?

Without a doubt, the current private savings system is inefficient and inequitable. The system depends on personal tax deductions to spur private savings in employer-sponsored plans, such as 401(k) plans. But, as Friedman notes, two-thirds of these tax benefits go to taxpayers at the top 20 percent of the income ladder, or those earning more than about $90,000 a year. Research by Friedman, Harvard University economist Raj Chetty, and others find that tax incentives for retirement savings are incredibly inefficient. And employer-sponsored plans are not portable from job to job.

Friedman’s proposal takes aim at those problems. The Hamilton Project provides a summary of the proposal, but here are the reforms in short: Friedman suggests the creation of new savings plans that are portable across jobs and encourage investments in low-cost index funds. Workers would be automatically enrolled in these plans unless they earn under a certain threshold. And to encourage employers to enroll employees, Friedman would introduce an employer-side tax credit that increases in value with each employee added to the plan. The increase in that credit, however, would decrease as more employees are added. For the first 10 employees, an employer gets a credit of $1,000 per full-time worker, but for the next 15 workers the extra credit is only $500, and the credit continues to decrease until it’s only $25 for every employee over 100.

This proposed employer-side credit would be paid for by limiting the personal retirement savings tax deduction for high-income earners, or those making more than $90,000 a year. According to calculations by Friedman, the distributional impact of the reform would be sizable as more of the value of all tax benefits for saving would go to low- and middle-income households. Yet among earners in the top twenty percent, some would also see an increase in the value of the benefits they receive because some of the value of the tax credit would be captured by the firms and therefore their shareholders. Still, the system would become more progressive as many more workers would presumably start to save more if encouraged to do so by their employers.

Friedman’s proposal would do quite a bit to improve the current private savings system. But a well-functioning and efficient private system would not be a cure all for the overall retirement savings problem. The reason: too many low- and middle-income households simply can’t afford to save while also paying for everyday necessities out of wages that are growing only slowly if at all.

Prior to the Great Recession, which began in December 2007, the personal savings rate was already on a steady downward trend. But there was–and still is– a lot of variation in the savings rate. In 2011, the average savings rate of the top 10 percent of taxpayers by wealth was 26 percent, according to research by economist Emmanuel Saez of the University of California-Berkeley and Gabriel Zucman of the London School of Economics, while the average rate for the bottom 90 percent was 0 percent.

So, some households are clearly saving. It just isn’t the vast majority of U.S. households. The concurrent rise of inequality in the savings rate and income leading to rising wealth inequality in the United States suggests that savings is very much a function of what workers earn. Declining savings rates for the segment of the workforce that has experienced falling-to-stagnant real wage growth (after factoring in inflation) shouldn’t be surprising. Reforming the system into which savings flow is important, but increasing income growth seems just as vital as a part.

But is that asking too much of the private-sector retirement savings system? Even if income growth picks up, the possibility that a low-interest rate future for savings plans means individuals would have to save more to meet their savings goals as they live longer. So again savers would have to tuck away even more of their income. This may be too much to ask of the vast majority of households today.

As Eduardo Porter points out in The New York Times, the federal government plays a major role in retirement savings via the Social Security program. The government has more resources to call upon through taxation to help provide an adequate retirement for an aging population that is going to grow in size and longevity in the coming decades. The program could be expanded and become a much stronger base on which private savings could rest.

Reforms along the lines Friedman proposes would be a big step forward for the private U.S. retirement system, but are unlikely to fully tackle the larger issue at hand.