David Harris, managing director, TOR Financial Consulting Ltd and David John, senior fellow, The Heritage Foundation discuss the challenges facing America's new president as he gets to grips with the retirement system
President Barack Obama faces an in-tray heavily laden with economic and social issues that are all stamped ‘urgent’. The speed and extent of the economic downturn has put enormous extra pressure on fiscal and monetary mechanisms already stretched by problems in the automotive, housing and financial services industries. Now, the economic crisis is spreading still further, and has hit commercial real estate, retailing, and a host of other areas. As in the UK, companies of all sizes are being denied important short and long term funding from US banks, who are hesitant to loan to any but clients with the highest credit ratings.
Although top priority will be given to helping homeowners facing foreclosure and the next stage of financial rescue, the Obama administration will also look at changes to social security (the US government-paid pension plan that covers most workers) and pension saving issues in its first six months. Pension savings plans such as the 401(k) remain very popular, but the recent financial turmoil has heightened concerns that they place all of the financial risk on individuals.
Targeting social security
A useful guide to what the Obama administration may tackle firstly on social security and pensions can be found in statements by the (then) Illinois senator during the US presidential election campaign. Unbiased actuarial experts have been warning for over 15 years that social security, which is funded by a dedicated payroll tax paid equally by workers and employers, will be unable to pay for all of the benefits that it has promised by around 2019. While the initial gap will be small, in less than 15 years, it will reach annual deficits of about US$300bn (in 2009 dollars).
President Obama declared in early January that Social Security will be repaired and protected but getting agreement on how will be difficult. The strong support from the union movement for the Obama campaign will make it extremely unlikely that he will suggest the kind of changes proposed by the Bush Administration after the 2004 elections. Instead of adding a savings element to Social Security as Bush advised, Obama is more likely to increase the payroll tax for wealthier taxpayers. This could be combined with raising the retirement age or making other changes to benefits, but important elements of the Democratic Party strongly oppose both. As a result, Obama is likely to approach the issue cautiously.
Much more attention will be focused on retirement savings issues. As in the UK, the proportion of workers covered by traditional defined benefit pension plans continues to shrink. At the end of 2008, Congress temporarily eased the more stringent funding requirements put in place in 2006 after employers and unions claimed that companies would have to lay off employees to fully fund pensions.
There remains an element within Congress that wants to reinstate DB pensions as the preferred retirement vehicle, but it is very unlikely that this will be successful. Even with the reduced funding requirements, employers who offer such a plan must include underfunding on the firm’s balance sheet as a charge against net worth. Firms that have fully funded their DB plans for many years are wary of the added volatility to the firm’s financials that stock market swings could cause to pension fund assets.
Private retirement savings plans grew during the 1990s assisted by generous tax incentives provided to employers and employees. There was a sharp rise in the amount of contributions into 401(k) plans, which are offered through the employer, and Individual Retirement Accounts (IRAs). However, this popularity took a hit when workers realised that if they made the wrong investments in a volatile market, the value of their retirement assets could drop substantially. Even before the market turmoil, Obama made it clear that the 401(k)-style DC plan required some substantial changes.
During the fall election campaign, Obama’s website was the only one that contained detailed proposals to improve the DC pension system. John McCain, his Republican rival, did endorse workplace retirement savings plans but it was only in the last few weeks before the vote that his campaign made specific recommendations.
The centrepiece of Obama’s thinking on retirement savings is the development of automatic workplace pensions for those employees whose employers do not currently offer any form of workplace pensions. Usually known as the Automatic IRA because of the underlying account mechanism, the proposal would be especially valuable to the roughly 50% of American workers without either a traditional DB pension plan or an employer-sponsored retirement savings plan. However, not everyone will be covered. The Automatic IRA would only apply to employers with more than 10 employees. Also, companies already offering some form of workplace pension would not be affected by the Automatic IRA.
This area interests Obama because workers without any form of pension plan tend to be younger, have lower incomes, and include a higher proportion of women and minority groups. These are the very people most unlikely to have sufficient resources in addition to Social Security to ensure a secure retirement.
The Automatic IRA had wide and diverse support even before the Obama campaign endorsed the concept. Initially developed by two researchers, one politically conservative and the other politically liberal, it has the support of groups ranging from the American Association of Retired Persons (AARP), a huge multi-million member organisation of older Americans and significant industry and interest group support. Legislation establishing the accounts was introduced into both the House of Representatives and the Senate in both of the last two congresses with the sponsorship of both Republicans and Democrats. In fact, at the end of the campaign, the Automatic IRA was also endorsed by the McCain campaign.
Automatic IRAs differ from stakeholder pensions because workers would be automatically enrolled at a set contribution rate that is invested into a lifestyle or target date fund. As senator, president Obama gave a legislative commitment towards passive fund management. Employers would be offered a temporary tax credit that should offset most of the costs of establishing the system. Employees would contribute to their accounts on a regular basis unless they took the step of opting out, something that studies suggest that only a minimal proportion would do. Further, because an IRA is an individual savings vehicle, according to US tax code, an employer contribution is not required but is in fact forbidden by law.
Financial groups are interested because the Automatic IRA offers them the opportunity to urge the employer to move up to either a full 401(k) plan complete with higher contribution rates for upper income employees or an intermediate accounts known as the IRA SIMPLE. Either option would generate significant fees over time. This is feasible as the Automatic IRA is also designed to give certain employers an incentive to eventually move up to one of the other retirement plans.
As Congress makes economic recovery its priority, consideration of the Automatic IRA will probably be delayed until later in 2009. Unlike the UK political system, the president cannot guarantee the support of the members of his party, so regardless of what the Obama administration proposes, it is likely to be somewhat altered during congressional debate.
Changes to tax rules
The new president is also expected to propose a change to the tax preferences for retirement savings contributions. Currently, workers can deduct these from their taxable incomes up to a certain amount. This ranges from $5,000 annually into an IRA to $16,500 into a 401(k). Another form of each account allows tax free withdrawals after retirement. In addition, there is a Savers’ Credit which refunds a set proportion of savings contributions to taxpayers within a set income range.
The real result of US tax incentives is that the vast majority go to upper income taxpayers who would probably save regardless of whether tax incentives exist or not. Since the Savers’ Credit is only paid as a refund of taxes if a worker has no taxable income after deductions and credits, there is no incentive to save. Unfortunately, the taxpayers most likely not to have taxable income are the people who most need to save.
To fix this, Obama proposes to make the Savers’ Credit refundable, meaning that it would go to all taxpayers below a certain income ceiling as a matching deposit into their account.
The challenges for the Obama administration are many and diverse. What is not debatable is the need for social security and pension solutions that generate confidence in the retirement system, security for retirees and solvency all round.
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