401(k) Break at Risk as Policymakers Mull Retirement Shift

U.S. retirement programs could look different if a grand deficit-cutting bargain is struck in upcoming negotiations.

Among the ideas being floated are a replacement of the 401(k) deduction with a tax credit that would offer bigger benefits to lower earners, changes in the withdrawal choices that workers face when they retire and a shift in the way Social Security benefits are calculated. That is on top of the increase in the retirement age that has been mentioned several times in recent months.

A variety of economic pressures and demographic trends have come together to put these new ideas on the table. There's also some disillusionment within the Obama Administration and among people with close ties to the administration with the way the 401(k) system is operating. The Social Security program is projected by its own trustees to exhaust its trust fund in 2036. The so-called "retirement deficit" - the difference between what Americans have saved for retirement and what they should have saved - has been put at $6.6 trillion by Boston College's Center for Retirement Research.

At the same time, Congress and the White House are under pressure to cut federal deficits. And prominent members of both political parties have talked up the idea of loophole-closing, rate-lowering tax reform.

Of course, it may be that no big deal gets struck and retirement plans remain unchanged between now and the 2012 election. In that case, expect some of these themes to continue surfacing after the heavy campaigning is done.

"Any time they are looking at spending and revenue over the next 40 or 50 year, these issues will be on the table," Salisbury predicts.

THE 401(k) COMPLAINTS

The tax break for defined contribution retirement plans will cost the Treasury $212.2 billion between 2010 and 2014, according to the Joint Tax Committee. But the vast amount of that benefit - as much as 80% - goes to the top 20% of earners, according to estimates from the Tax Policy Center, a nonpartisan, but liberal-leaning, think tank.

For example, a person in the 35% tax bracket saves $35 in taxes every time he puts $100 in his 401(k), for a net cost of $65. Someone in the 15% bracket pays $85, after tax, for the same $100 contribution. The Pension Rights Center, which has favored traditional defined benefit pensions and other programs aimed at lower-income retirees, advocates rolling back the current $16,500 annual 401(k) tax-deferred contribution limit to the $10,500 level it was at before the Bush tax cuts, its director, Karen Ferguson, has said.

One way to address both the cost and the disparity is to change the deduction into a credit. William Gale, of the Brookings Institution, will present a plan like that to the Senate committee on Thursday. His plan would eliminate the deduction entirely and replace it with a federal match that would be deposited directly into workers retirement accounts. A match of 30% would be revenue neutral, he says.

If lawmakers instead opted to approve an 18% match, it would leave low-bracket workers unharmed, but would raise $450 billion in tax revenues over 10 years.

Gale's proposal is significant because he has close ties to current and former Obama Administration officials. An earlier version of the Gale plan was coauthored by Peter Orzsag, who was President Obama's first budget director and who continues to editorialize in favor of killing the deduction.

But those proposals would leave higher-income workers with less incentive than they currently have to stash money into a tax-deferred retirement account. "Quantitatively speaking, these proposals would appear to reduce prospective retirement well-being," says EBRI's Salisbury. He's raised the idea - that he says dates back to the mid-1990's - of putting all tax-favored savings (for items like retirement and college) into a single account that gave savers more flexibility.

NEW STATEMENTS AND MENUS

Mark Iwry, deputy assistant Treasury secretary for retirement and health policy, and another former Gale colleague, has voiced concern about the fact that workers may not be getting enough information about how much lifetime income their 401(k) account balances can support. And it's hard for individual retirees to understand how much they can afford to pull out of their tax-deferred accounts without running short in later years.

One approach to solve this would be a requirement that 401(k) sponsors put that kind of information in their statements. A bill proposed by a bipartisan group of senators led by Sen. Herb Kohl, chairman of the Senate Special Committee on Aging, would require that 401(k) statements show how much of an annuity the current account balance would provide.

A step beyond that would be the offering of more annuity and automated-withdrawal plans as alternatives to retiring workers who may believe their only option is to take the lump sum. That's an approach that, unsurprisingly, is favored by the insurance industry. But it also has fans in the Labor Department, which is currently working on some sort of policy encouragement for employers who give their workers flexible retirement income choices.

MAKE RETIREES PAY, JUST THIS ONCE

Though most officials repeatedly say they don't intend to "fix" Social Security by penalizing current retirees, several of the bipartisan, deficit-cutting proposals raised over the last two years have included a swipe at the cost-of-living adjustment that currently pegs benefits to the Consumer Price Index.

This "is one of the few ways to have current retirees contribute to restoring balance in the program," writes Alicia Munnell and William Hisey of the Center for Retirement Research in a new study.

But the most common proposal, which would switch the COLA from the CPI to a different (and slower-growing) measure called the "chained CPI" would set back retirees trying to keep up with the cost of elderly living by as much as 0.57% a year, the coauthors estimated. That's because the current CPI already understates the inflation rate that is actually experienced by retirees, and because the chained CPI would further understate that.

"Low-income elderly are not deciding whether to buy a watch or a bracelet," the two said. "They spend most of their income on essential amounts of necessities, like housing, food, health care and transportation."

Munnell and Hisey proposed a one-time delay in the inflation adjustment. That could help save the program money but also set all current beneficiaries back, but not to the same extent as an annual adjustment that understates inflation every year

Like all of the other retirement proposals floating around now, the COLA solution is a moving target. Workers and retirees should continue to watch that space.