News Analysis -- Pension Reform: Making a Bad Situation Worse?

Journalists, in the words of Finley Peter Dunne's great social observer, Mr. Dooley, comfort the afflicted and afflict the comfortable. Here at Tax Analysts, we like to think that the time we spend afflicting the comfortable makes up for our shortcomings in comforting the afflicted. The multifaceted American pension system does the opposite. It provides further comfort to the already comfortable, and does not do much to comfort the afflicted in the forced departure from the labor force that is called retirement.

That the pension system has been doing a bad job, and doing it so very expensively, has been known for years, but not generally acknowledged because most of the people doing any thinking about the system were insiders -- people who worked for plan sponsors and consultants and who themselves were members of the comfortable class that has pensions. More than a decade ago, this correspondent attended an American Law Institute pension policy conference and wrote a scathing article about the bad job the pension system was doing -- using the same numbers that conference participants used to laud the system's ability to maintain the lifestyles of the better paid. (Tax Notes, Oct. 19, 1987, p. 235.) Some of the conference organizers are still not speaking to me.

But in recent years, the pension professionals' cheerleading for the system has been proven to be at least overstated, if not misplaced. A broader recognition of the failings of the colossally expensive system has become evident as the statistics come in.

Some 53 percent of currently employed workers have no pension coverage, and 48 percent of retirees have no private pension income. That is despite the fact that as a tax expenditure, private pensions cost $76 billion in fiscal 2000, making it the largest tax expenditure. That is hardly an efficient use of taxpayer funds. These dismal statistics came from the recent General Accounting Office report discussing the characteristics of workers with pension coverage. (For text of the GAO report, "Pension Plans: Characteristics of Persons in the Labor Force Without Pension Coverage," see Doc 2000-21993 (36 original pages); 2000 TNT 166-20.)

As if that were not bad enough, overlaying this dismal situation is the desire of the Republican Congress to raise the contribution limits for defined contribution plans, among other changes, in the name of pension reform. (For prior coverage, see Doc 2000-19549 (4 original pages), 2000 TNT 140-2, H&D, July 20, 2000, p. 609, or Tax Notes, July 24, 2000, p. 442.) A version of the House bill, called the Comprehensive Retirement Security and Pension Reform Act, will be marked up in the Senate Finance Committee on September 7.

The Clinton administration has complained that previous versions of the bill would primarily reward the already comfortable, but those complaints fall on deaf ears in a Congress that still believes in trickle-down economics. Ironically, trickle-down economics was the unstated basis for the ERISA nondiscrimination rules years before it became fashionable as national policy.

Who Has a Pension?

The people who run the company have pensions. The people who clean the toilets at the company do not.

The GAO, in the above-cited report, found that workers who do not have pensions are likely to be one or more of the following suspect characteristics: low-paid, young, temporary, and working for smaller enterprises. (Here we are using the word "pension" loosely to mean participation in a retirement plan, which is probably a defined contribution plan, not, strictly speaking, a pension plan in the defined benefit sense.)

More than half of workers, some 71 million people, did not have pension coverage as of 1998. Of the 53 percent of workers who have no pension coverage, 39 percent work for firms that do not offer plans, while 14 percent were ineligible to participate or chose not to participate in their employer's plan.

What about the 1986 rewrite of the pension rules, which was supposed to increase coverage? Coverage has increased by 5 percentage points from 1988 to 1998, but the GAO attributed that to the economic boom and the resulting labor shortage rather than to changes in the pension rules.

More than 80 percent of employees who either work for small firms or are lower-paid do not have pension coverage. The GAO defined small as tiny -- 25 or fewer employees, a category that nonetheless covers 22 percent of the labor force. Nearly 80 percent of part-time employees, and three-quarters of younger employees, lacked pension coverage.

The GAO defined "young" as under age 30, and suggested that some younger or part-time employees may have been willing to exchange pension coverage for shorter hours or more spending money. Maybe, but the GAO found that many of the uncovered had two or more of the four suspect characteristics. So three-quarters of the uncovered worker population consisted of the lower-paid employees of tiny businesses.

Pensions are a part of total compensation. So while 80 percent of lower-paid workers lack pension coverage, 34 percent of workers paid more than $20,000 annually lack pension coverage. The GAO suggested that the poorly paid may decline to participate in their employer's employee-funded defined contribution plans because they need the money for basic living expenses. But the GAO pointed out that the tax benefits associated with pension plans have little value to workers who may have little or no income tax liability. Only 4 percent of workers who were offered pension coverage declined it. (No surprise that employees were more likely to participate in defined contribution plans offering employer matches.)

The four suspect characteristics explain most of the uncovered worker population, but the GAO found other statistical correlations that make the total picture even less attractive. Education, for instance, correlates with pension coverage just like it correlates with income generally. Employees with longer job tenure are more likely to have pension coverage. And union members are more likely to have pension coverage. In the public sector, which is now the most heavily unionized sector, only 27 percent of employees lacked pension coverage. Still, the GAO did not attribute any pension coverage shortcomings to the decline of unions in the private sector.

Then, and more troubling, there is race and ethnicity as determinants of pension coverage. The GAO did not find a black/white dichotomy; rather, it found that Latinos and Asians are more likely to lack pensions than non-Hispanic white workers. Although the GAO gently suggests that the correlation is "not well understood," and that more research is needed, the suggestion is that people doing the society's scut work are not being taken care of.

Down the road, this does not make for a pretty picture. The GAO further found that most of the nearly 18 million current retirees living without any income from a private pension are single, female, nonwhite, and uneducated. This unattractive statistic has been known for years, and usually figures in discussions of social security as well.

The typical retiree who has no private pension or social security eligibility is an elderly black female former domestic servant. Workers who were not in the formal labor force were not eligible for social security, and it goes without saying that all but the most generous employers would not give those workers pensions. Even though social security has lifted the bulk of retirees out of poverty, the GAO found that 21 percent of retirees without private pension income had incomes below the poverty threshold, compared to only 3 percent of retirees with pension income.

The GAO maintains a posture of neutrality, but suggests in its concluding comments that perhaps reliance on tax incentives is not the best way to promote coverage of lower-paid workers. That is an understatement.

What the Bill Would Do

The chief feature of the so-called "pension reform" bill would be to increase contribution and benefit limits for a variety of plans. Money purchase pension plans, which are the most generous plans already, would see the greatest benefit from that increase.

The contribution limits for elective deferral plans under sections 401(k), 403(b), and 457, as well as simplified employee pensions (SEPs), would be raised and coordinated. The dollar limit for IRA contributions would be raised to $5,000 over three years, and then indexed for inflation thereafter. The annual benefit available under defined benefit plans would be raised, as would the ceiling on contributions to defined contribution plans. The limit on compensation that could be taken into account for purposes of the limits would be raised to $200,000.

The raising of the contribution limits is the most obvious and most discussed change in the bill. Other, more technical changes would make it easier for the owners of closely held businesses -- an important Republican constituency -- to stash away lots of pension savings for themselves.

The top-heavy rules would be seriously weakened by cumulative small changes (sort of like being nibbled to death by ducks). Repealing the family attribution rule would let family members put away more by treating individually. Allowing employers to disregard elective contributions for purposes of determining top- heavy status would also mean that the top could put away more, regardless of what the rank-and-file are doing. Moreover, the bill's annual rather than cumulative determination of top-heavy status would prevent many otherwise top-heavy plans from being treated as top heavy. Under present law, top-heavy status is something closely held businesses cannot easily avoid.

Other technical changes are less obvious. Allowing matching contributions to be considered in meeting the minimum contributions required for top-heavy plans would amount to double counting of those matching contributions. Then the so-called women's fairness provisions would be anything but.

The $5,000 catch-up contribution would be exempted from the nondiscrimination rules, and may still be when the Senate Finance Committee marks up the bill. Some observers believe that Finance may even raise the catch-up contribution to 50 percent of the elective deferral limit. Moreover, the House bill would create "Roth 401(k)s," which would perpetually exempt from tax the earnings on nondeductible contributions to section 401(k) accounts. (For discussion, see Doc 1999-12663 (8 original pages), 1999 TNT 64-3, or Tax Notes, Apr. 5, 1999, p. 10.)

A recent Urban Institute study, "The Limits of Saving," by Pamela Perun, who was trained as a pension lawyer, looked at the effects of the proposed changes to the contribution limits on the tax subsidies for two kinds of hypothetical savers, "maximizers" and "steady savers," in six different kinds of defined contribution plans. The study concluded that the proposals would do little to change the savings status quo in the private pension system.

The study found that the chief beneficiaries of the proposed increases in the contribution limits would be higher-income individuals and the "maximizers," who may or may not have high incomes but whose life circumstances allow to make the maximum contribution to a plan. A maximizer might be the wife of the owner of a closely held business who is on the payroll and saves the bulk of her salary.

Perun argues that the contribution limits contained in current law can easily accommodate plausible savings rates, such as the 5 percent of salary per year that she posits is contributed by "steady savers." The study questions the wisdom of increasing the tax expenditure for private pensions while leaving the distribution of the tax subsidy the same. Perun would like to see systemic reforms that would rationalize the multifarious plan types and provide more incentive to lower-income savers.

Like the GAO, Perun notes the paradox of using the income tax system to subsidize private retirement saving. The tax subsidy provides the most savings assistance to those who need it least, and vice versa. Because the tax subsidy is most valuable to workers with high incomes, it offers little or no incentive to save to those whose income tax liabilities are low or nonexistent.

The tax subsidy, Perun points out, has a tax bracket effect and a more important deferral effect. First, contributions are made with pretax dollars, a benefit that gets more valuable the higher the worker's current marginal tax rate goes. It is generally assumed that higher-paid workers face lower marginal tax rates in retirement, so that the greater the difference in present and future marginal rates, the greater the tax subsidy.

Second, earnings on plan contributions grow tax-free until the worker retires.

Third, contributions and earnings go untaxed until they are withdrawn during retirement. Deferral of tax reduces the present value of the worker's low future marginal tax rate even further. Not only would the proposed changes fail to alleviate those perverse effects, Perun concludes, they would exacerbate .

Constructive Ideas?

Much of the constructive thinking about the problem of pension coverage for lower-paid workers is nibbling around the edges of the present system while leaving the fundamental problems in place.

The large percentage of workers who choose not to participate in their employers' plans shows that there is something to be said for forced "negative" elections to compel lower-paid employees to contribute to defined contribution plans. (See Rev. Ruls. 98-30, 2000-8, 2000-33, 2000-35, and Ann. 2000-60.)

The Clinton Treasury has entertained ideas about asking for automatic enrollment legislation. A related point is the present-law design-based safe harbor for section 401(k) plans, which allows a 3 percent matching contribution to avoid nondiscrimination testing. Treasury worries that this safe harbor could discourage participation, so the administration's fiscal 2001 budget proposes a 1 percent across-the-board contribution that would be immediately vested. Employers hate that idea.

Then again, many workers are not paid enough to live on, let alone paid enough to be able to save for retirement. The GAO found that in 1998, 40 percent of employees earned less than $20,000 annually, and 81 percent of those poorly paid workers had no pension coverage.

The Clinton administration would address that problem through what it calls universal savings accounts (USAs), which would essentially mean that the government would create savings for lower- paid workers. Originally intended as a cynical ploy to soak up the alleged budget surplus and prevent the dismantling of social security, USAs were first floated in the president's 1999 State of the Union address and more fully described three months later. (See Doc 1999-13960 (4 original pages), 1999 TNT 72-1, or Tax Notes, Apr. 19, 1999, p. 329; also see 1999 TNT 74-2 or Tax Notes, Apr. 19, 1999, p. 331. For a related special report, see Doc 1999-19782 (14 original pages), 1999 TNT 108-94, or Tax Notes, June 7, 1999, p. 1487.)

As originally envisioned, the USA would be an automatic $300 annual refundable tax credit deposited into a private retirement account for the worker. Further, the government would match nondeductible voluntary contributions to the USA, also in the form of a refundable credit deposited directly into the account. The USA proposal has been further developed -- and the name changed to "retirement savings accounts" -- in the administration's fiscal 2001 budget.

The RSA proposal, in contrast to the USA proposal, requires the participant to save something to qualify for a nonrefundable tax credit. Thus the program would be a progressive matching program rather than a gift, and it would be privately administered. Finance Committee member Max Baucus, D-Mont., is expected to introduce a version of the RSA provisions in the Finance markup.

At a Bookings Institution-sponsored conference on pension policy last September, participants offered proposals for reform of the private pension system that assumed the present framework would be left in place. Harvard Law Professor Daniel Halperin, a former Treasury official, and economist Alicia Funnel of Boston College, a former Federal Reserve Bank of Boston economist, both despaired of getting the private pension system to provide adequate retirement income to low-income workers. They will not argue with economists who say that requiring pension benefits for lower-paid workers would reduce their cash wages.

The pair therefore made the radical suggestion that employers should be permitted to exclude lower-income workers from their plans, and that the government should take care of . In passing, they noted that government could increase social security benefits as replacement income, but suggested that the Clinton administration's USA proposal would be preferable. They proposed that employers be allowed to exclude employees earning less than $20,000 from their plans.

That group, as the GAO pointed out, is a whopping 40 percent of the labor force. Then Halperin and Funnel would impose a 5 percent tax on the earnings of private pension plans to partially finance the USA accounts. The cost of USA accounts is expected to grow geometrically once they go into effect.

The notion of spending the alleged budget surplus on USAs, a new private account scheme that would be an additional burden to administer, rather than beefing up social security, a program that is already in place, is strange. If, as Funnel and Halperin argue, social security benefits are inadequate at the low end, why not just use the alleged budget surplus to increase ? It would be rather sad to think that these two academics, who are Democrats, have already accepted the partial dismantling of social security and its replacement with private accounts that has mostly been advocated on the opposite side of the aisle.

Funnel and Halperin assume that the goal of pension policy is an annual pension of 80 percent of preretirement income, accepting the misguided premise that has colored the discussion for many years. The assumption that the government should continue to subsidize each according to his lifestyle has certainly made the folks at the top happy, but it has become absurdly expensive.

Perhaps Funnel and Halperin are being politically realistic about the likelihood that the government would cease subsidizing the retirement lifestyles of the most fortunate. The pair also appear to assume static income-earning ability in their proposed exclusion of the lower-paid, which is probably a safe assumption given the country's continuing failure to educate or train large chunks of the work force.

Funnel and Halperin would concentrate their efforts on ensuring that the private system provide adequate retirement income to middle- income employees. They would jettison the nondiscrimination rules and require employers to provide equivalent benefits to all employees, including part-time employees, in all of the employer's lines of business. (This correspondent suggested that in Tax Notes, May 4, 1992, p. 705.)

They would prohibit social security integration for middle- income employees, though what used to be called "integration out" (and is now prohibited) is basically what they advocate for lower- income employees. Pension benefits should vest after one year of employment, and cash-outs of benefits for departing employees, which have increased markedly in recent years, would be prohibited.

Why would businesses that are run by the class of persons who benefit most from the present system go along with these suggestions? Halperin and Funnel would trade massive increases in contribution limits for compliance with their proposals. Halperin, however, a veteran of the creation of section 401(k) accounts, opposes any increase in the contribution limits for those elective deferral plans, as well as section 403(b) and 457 accounts and IRAs, because it would encourage a further shift to those types of plans.

Halperin and Funnel would require that elective deferral plans offer lower-paid employees an employer-financed benefit rather than just offering the opportunity to contribute. They point out that 30 percent of private pension plan participants are covered only by elective deferral plans, which are generally inadequate providers of retirement income.

Bribing the owners and managers of businesses to set up retirement plans that would adequately cover employees other than the owners and managers has not worked, as the statistics show. And the offerings to the average employee get chintzier all the time. The participants in the Bookings conference seemed resigned to the stampede toward employee-funded defined contribution plans, and suggestions for dealing with the stampede were thin on the ground.

Halperin and Funnel meekly suggested that employers converting to cash balance plans keep their promises to long-standing employees. They have been keeping those promises, only just recently, thanks to energetic reporting by The Wall Street Journal and the attendant bad publicity. Converting employers have demonstrably not acted to keep any promises by virtue of any persuasion on the part of pension policymakers, who have stood by helplessly.

And these were the Democrats. The Republicans want to move halfway to a consumption tax and deregulate private pension plans, resulting in everyone fending for himself or herself, all on the taxpayer's nickel. Lower-paid workers would be left to social security, which would be partially dismantled so that better-paid workers could invest. It sounds horrible, but not much is being done to stop this social Darwinian trend.

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Documents

The full texts of the following documents are available from Tax Analysts:

H.R. 4843, the Comprehensive Retirement Security and Pension Reform Act. Doc 2000-19034 (110 original pages); 2000 TNT 138-44
Administration's statement. Doc 2000-19595 (2 original pages); 2000 TNT 141-26

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