Professor of Economics Proposes Retirement Reform

Mounting evidence suggests that reform of both the current structure and tax-code treatment of retirement accounts could stimulate greater savings for many Americans, a paper suggests.

In a new Hamilton Project discussion paper, John N. Friedman, Professor of Economics at Brown University, proposes two related reforms to the current system of retirement savings accounts.

First, Friedman calls for replacing the current multitude of retirement savings accounts with a single plan, the Universal Retirement Savings Account (URSA). Worker’s individual accounts in the plan would stay with them permanently, following them as they change jobs. This reform would both decrease confusion about different accounts and reduce retirement savings leakage that happens when workers change jobs and exercise the opportunity to cash out their employer-based plans, Friedman suggests.

Second, Friedman proposes redirecting part of the tax incentive aimed at individuals toward large tax credits for employers who help workers save through auto-enrollment and payroll-deductible contributions. He contends that firms are both more knowledgeable about and more responsive to tax incentives than individuals are, and this shift would increase the effectiveness and progressivity of such targeted tax incentives.

In his paper, Friedman says that since employer-sponsored plans are specific to each employer, individuals—especially if they change jobs—often must manage a large number of retirement accounts with varying rules for contributions, withdrawals, and asset management. The federal tax code currently provides for no fewer than thirteen different types of individually directed retirement savings accounts, he notes. This complexity, Friedman asserts, generates needless administrative burden and confusion for both employees and employers, resulting in lower-quality choices of savings and asset allocation. The administrative transition from one retirement plan to another that occurs when workers switch jobs also contributes to the large amount of early withdrawals from retirement accounts.

With Friedman’s proposal, Congress would replace the multitude of tax-preferred retirement savings accounts with a single tax-preferred URSA, which could function under either pre-tax or post-tax treatment. Existing retirement accounts would be rolled into the URSA as subaccounts, and account holders would have the option to convert assets into the main URSA account at any time.

Workers would hold their URSAs at account providers regulated under a framework similar to that currently governing 401(k) plans. Eligible assets would exclude speculative and overly risky investments and would ideally be restricted to low-cost index funds and lifecycle funds.

Fiduciary duty would shift from employers, who often lack financial expertise, to account providers. For bearing this responsibility, account providers would be allowed to levy an annual 0.01% fiduciary fee on account balances.

Despite the preponderance of tax-preferred retirement plans, which continue to grow rapidly in dollar terms, Friedman cites scholarly evidence suggesting that incentives based on income tax breaks are not effective at raising savings rates, especially among those who are most in need of additional saving. First, he says, research shows that roughly 80% to 85% of savers are unaware of or inattentive to the tax incentives and thus do not change their savings behavior. Second, savers who do respond to the incentives do not save more overall but instead shift money they would have saved anyway to tax-preferred retirement accounts.

Third, according to Friedman, research has shown the savers who respond the most to tax incentives tend to be wealthier individuals who are already saving enough for retirement. Two-thirds of the current tax break goes to households in the top 20% of the income distribution, and one-third goes to those in the top 5%. These inefficiencies suggest the current system can be reformed successfully to encourage more Americans to save more for retirement, Friedman says.

Under his proposal, by auto-enrolling their employees into low-risk, low-fee URSAs, at a set savings rate of at least 3%, employers would receive refundable tax credits against the employer share of the payroll tax. The savings rate would increase for workers by 1% annually, up to 8% of pay. The size of the tax credit would increase with the number of employees at a slowing rate.

The federal government would offset these employer tax credits by instituting new limits on tax-deductible contributions to employer-sponsored savings accounts, including URSAs. If Congress set up URSAs as pre-tax accounts (like today’s 401(k)s), the cap would be set at $35,000 and the share of income that can be deducted for tax purposes would be limited to 25% instead of the worker’s marginal tax rate.

If Congress set up URSAs as post-tax accounts (like today’s Roth IRAs), the cap would be set at $25,000 and withdrawals would no longer be tax-free but subject to capital gains tax of half the normal rate.

A policy brief summarizing Friedman’s proposals is available here, and the full paper is available here. He will discuss his proposals at an upcoming policy forum on Tuesday, June 23, at the Brookings Institution, where U.S. Secretary of Labor Tom Perez will deliver remarks.