Private Pensions: Issues and Options

William G. Gale, Peter Orszag

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

TPC Discussion Paper No. 9

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The Urban-Brookings Tax Policy Center

The Tax Policy Center (TPC) aims to clarify and analyze the nation's tax policy choices by providing timely and accessible facts, analyses, and commentary to policymakers, journalists, citizens and researchers. TPC's nationally recognized experts in tax, budget and social policy carry out an integrated program of research and communication on four overarching issues: fair, simple and efficient taxation; long-term implications of tax policy choices; social policy in the tax code; and state tax issues.

Support for the TPC comes from a generous consortium of funders, including the Ford Foundation, the Annie E. Casey Foundation, the George Gund Foundation, the Charles Stewart Mott Foundation, and the Open Society Institute.

Views expressed do not necessarily reflect those of the Urban Institute, the Brookings Institution, their boards of trustees, or their funders.

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Contents

Abstract

Introduction

A Brief Overview of Pensions and Tax-Preferred Saving
Aggregate Trends
Who Benefits from Pensions?

Evaluating the Pension System
Adequacy of Wealth Accumulation
Risk
Retirement
Complexity

Reform Options
The Groom-Shoven Plan
The Halperin-Munnell Plan
Incremental Reforms

Conclusion

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Abstract

This paper provides an overview of the U.S. system of pensions and tax-preferred saving, examines the effects of current policies, and evaluates proposals for reform. In light of lengthening life spans, earlier retirement, and projected financial shortfalls in Social Security and Medicare, the financial status of the elderly in the future will depend heavily on private saving for retirement. The central goal of the private pension system should be to encourage or provide adequate and secure retirement income in a cost-efficient and equitable manner.

The present system falls short of these goals. Pensions currently cost the U.S. Treasury almost $200 billion per year. Pension benefits are skewed toward more affluent households who would be more likely to be saving adequately for retirement even without pensions, and who disproportionately use pensions to divert other saving (rather than to raise their overall level of saving). Pension benefits are meager among lower- and middle-income households who more often are not saving adequately for retirement, but for whom pensions do serve effectively to raise retirement wealth. Pension rules often allocate financial risks to workers, the group least well equipped to handle these issues. Pension rules are unduly complex.

Reforms that raise contribution limits even further are unlikely to be helpful in promoting the goals noted above. Rather, pension reforms should focus on expanding benefits for lower- and middle-income households, improving incentives and opportunities to diversify investments, increasing financial education, improving the structure and rules regarding cash balance plans, and simplifying and strengthening non-discrimination rules.

Introduction

One of the most striking economic transitions over the past century has been the creation of a lengthy retirement period at the end of most working lives. In 1900, nearly two out of every three men aged sixty-five or older were in the work force.¹ By 2000, fewer than one in five among this age group was in the labor force.² An extended retirement is a historic advance in economic well-being, but it creates new challenges for public policy.

Over the past century, the United States has developed government programs and encouraged private institutions to ensure that elderly households have adequate income and health care during retirement. Social Security, established in 1935, covers more than 95 percent of workers. It provides basic, assured income support to retirees (and to the disabled and survivors), but was never intended to provide for all retirement needs.³

Other than Social Security, the primary saving vehicles for most households are pensions and saving plans favored by tax incentives, which form a second tier of retirement income.⁴ Tax incentives for employer-based pensions originated in 1921. Pensions expanded during World War II because pension contributions were exempt from wage controls and were deductible under the rapidly growing income tax. The spread of pensions continued after the war, and rules governing them have been modified repeatedly. The creation of Keogh accounts in 1962 and Individual Retirement Arrangements (sometimes called Individual Retirement Accounts or IRAs) in 1974 expanded eligibility for tax-sheltered saving plans beyond the employer-based system.

In 1998, pensions and tax-preferred saving plans covered more than 70 million workers. These plans received more than $200 billion in new contributions, had total assets of more than $4 trillion, and provided one-fifth of the income of the elderly.⁵ Relative to Social Security, pension coverage is less universal—only about half of workers are covered at any one time and about two-thirds are covered at some point in their career. Coverage is particularly low among lower earners. Because pensions are intended to replace earnings rather than meet basic needs, pension income is distributed less equally than Social Security.

Other financial assets, proceeds from businesses, and home equity constitute a third source of retirement income. Other than housing equity, however, ownership of these assets is concentrated among a few, relatively affluent retirees.

This multi-tier approach to retirement saving has enabled millions of retirees to enjoy a financially secure retirement. Poverty among the elderly, which was higher than among the non-elderly until 1994, has now fallen to roughly the same level as among non-elderly adults.

But retirement programs now face significant challenges. Social Security is projected to run a long-term deficit that will require benefit adjustments or new revenues. Even now Social Security replaces only a small fraction of earnings for most workers, and that fraction is destined to decline for retirement at any given age under current law (see table 1). Medicare faces equally serious financial challenges. These problems underscore the importance of private pensions and other tax sheltered saving plans in meeting the needs of tomorrow's retirees.

In light of these circumstances, the central goal of the private pension system should be to encourage or provide adequate and secure retirement income in a cost-efficient and equitable manner. To meet this goal, pensions must achieve several intermediate objectives.

First, they should increase households' saving for retirement. The central motivation for using the tax system to encourage pensions is the belief that without incentives, people would save too little to provide themselves with adequate retirement income.⁶ How many people save inadequately for retirement is controversial, but at least a significant minority of the population falls into this category. Some are myopic and do not plan ahead. Some with modest incomes may save little because they have little hope of saving more than the benefits they would receive under means-tested government income security programs for the poor elderly. Saving incentives succeed in any meaningful sense only if they increase the saving of those who would have saved too little in their absence.

Second, pensions should boost national saving—the sum of public and private saving. National saving contributes to economic growth, and increased growth would make Social Security and Medicare easier to finance. Pensions increase national saving, however, only to the extent that the contributions represent saving that would not have occurred anyway and only to the extent that the increase in private saving exceeds the reduction in tax revenues resulting from the tax incentives. Private saving is not increased when people shift assets into the tax-preferred pensions or reduce other saving that they would have undertaken.⁷

Third, pensions should induce efficient handling of risk. Long-term financial commitments, such as those represented by pensions, are inescapably risky. The recent stock market collapse and corporate scandals underscore those risks. While people are working and accumulating pensions, the risks include the possibility of unemployment, slowed growth of wages, a decline in asset values, unanticipated inflation, and disappointing yields. The final three risks persist during the payout stage, after the worker has retired. In addition, workers face the risk that they may outlive their assets in some pension plans.

Fourth, the increasing burdens on workers to support a growing retired population suggest that pensions should not promote early retirement and, in fact, should encourage continued work. Extended working lives are now feasible because of increasing longevity and improved health.

Finally, the pension system must be sufficiently simple and otherwise attractive enough to induce employers to offer pension plans and workers to participate in them. This is a considerable task because of inherent conflicts in the design of pension policy.

Considerable controversy surrounds the extent to which the current pension system attains these goals and, to the extent that it does not, how the system should change. In this chapter, we describe the current system of pensions and tax-deferred saving, evaluate its ability to meet the goals described above, and discuss options for reform.

Note: This report is available in its entirety in the Portable Document Format (PDF).

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1. Dan McGill, Kyle Brown, John Haley, and Sylvester J. Schieber, Fundamentals of Private Pensions 7th Edition (University of Pennsylvania Press, 1996), p. 5.

2. Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey, Series ID: LFU606501 (1). Available http://data.bls.gov/cgi-bin/srgate, accessed January 28, 2003.

3. Other programs also directly support the elderly. Medicare provides hospital insurance and the opportunity to purchase supplementary medical insurance. Supplemental Security Income and disability insurance provide benefits to poor elderly households and those with disabled individuals, respectively.

4. The tax advantage takes one of two forms. Under one approach, deposits are made from after-tax income, but investment earnings and withdrawals are not taxed. Under the alternative approach, deposits are made from before-tax income; investment earnings are untaxed when earned, but withdrawals are taxed as ordinary income. These two approaches are equivalent if the taxpayer is in the same tax bracket at all times, and if the before-tax amount contributed to the former approach is equal to the before-tax amount contributed to the latter approach (which means that the amount initially deposited in the account under the former approach, in which after-tax dollars are initially deposited, is smaller than the amount deposited in the account under the latter approach).

5. Department of Labor, Pension and Welfare Benefits Administration, Private Pension Bulletin: Abstract of 1998 Form 5500 Annual Reports, Number 11 (Winter 2001-2002), Table A1; and Employee Benefit Research Institute, "Income of the Elderly, 1998," January 2000.

6. Under a personal income tax, the tax rules applicable to pensions and to other "tax-sheltered" saving involve subsidies. Under the income tax, all income, whether it is currently consumed or saved, should be taxed as earned. Against this standard, pensions are "tax favored," in the sense that tax is not imposed at the time the worker's net pension wealth increases. Many analysts, however, favor a tax on consumption rather than income. For those who favor taxation of consumption, not income, the tax treatment of pensions and other sheltered income is not a concession, but rather a step toward a superior principle of taxation. It is not our purpose here to evaluate the various positions in this debate, but merely to point out that perspectives on the current tax system intersect with the partly independent debate about how best to design pensions.

7. Note that it is possible national saving would increase without improving retirement income adequacy if private saving increased by more than the reduction in public saving, but the private saving was undertaken only by those already well prepared for retirement.

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About the Authors

William G. Gale is the Arjay and Frances Fearing Miller Chair in Federal Economic Policy at the Brookings Institution and codirector of the Urban-Brookings Tax Policy Center. Peter R. Orszag is the Joseph A. Pechman Senior Fellow at the Brookings Institution and codirector of the Urban-Brookings Tax Policy Center.

Acknowledgments

From Agenda for the Nation, edited by Henry Aaron, James Lindsay, and Pietro Nivola (Brookings Institution Press, 2003). The authors thank Manijeh Azmoodah, David Gunter, and Matthew Hall for excellent research assistance, and Robert Cumby, Peter Diamond, Mark Iwry, Maya MacGuineas, Michael Orszag, and especially Henry Aaron and two referees for valuable comments and discussions. Any errors or opinions are the authors' and should not be taken to represent the views of the funders, officers, trustees, or staff of any of the institutions with which they are affiliated.