Saturday, June 20, 2015

A Preference on ‘Preferences’?

A research paper finds that introducing a Roth 401(k) option doesn’t have much impact on current plan savings rates — but what does that have to do with their preference for tax preferences?

Well, according to “Does Front-Loading Taxation Increase Savings? Evidence from Roth 401(k) Introductions,” governments could actually increase private savings by taxing savings up front, rather than in retirement. This conclusion basically suggests that taking away the current 401(k) pre-tax contribution and replacing it with a Roth assumption would not only not decrease, but it might actually increase, retirement savings, and with no additional cost to the government.

For years a key education element touted about 401(k) plan participation has been the ability of the individual to put off paying taxes on their contributions and on the earnings attributable to those contributions (and those of their employer, if any) until retirement, at which point they would ostensibly find themselves in a lower income tax bracket. Moreover, by saving on a tax-deferred basis, the theory went that you could get more bang for your buck in leveraging the taxes deferred.

A Preference for Roths

The researchers look at that scenario a little differently — gauging that paying taxes upfront on the contributions and foregoing paying taxes on the accumulated earnings amounts to a better deal. They then anticipate that participants would shift their 401(k) contributions to Roths.

To test their hypothesis, the researchers drew on administrative 401(k) plan data from 11 companies that introduced a Roth 401(k) option between 2006 and 2010 to analyze the impact of a Roth option on savings plan contributions. They found no evidence of a change in total contribution rates between employees hired after a Roth option is introduced and employees hired before. In fact, they note that if anything, contributions rise slightly when a Roth option is available.

Having found no evidence of the anticipated shift to Roths, they seek to explain it.

To do so, they turn from actual data to a survey of participants who are asked to provide a savings recommendation to a couple of fictional participants — basically to come up with a recommended savings rate for a pre-tax 401(k) option versus one that allows for both a pre-tax 401(k) deferral and a Roth 401(k) contribution. Despite what the researchers see as obvious advantages with the Roth, the contribution recommendations (in terms of a total contribution) are almost identical.

No ‘Wonder’

While considering several possible explanations for why this occurs, they settle on one that seems fairly obvious: “ignorance and/or neglect of the 401(k) tax rules.” But since the introduction of the Roth 401(k) option didn’t lead to any major shift in contribution rates, the researchers conclude that this suggests that governments may be able to increase after-tax private savings (because participants will have more savings accumulated with the Roth) while holding the present value of taxes collected roughly constant (the government gets less money, but gets it upfront, rather than waiting for the individual to retire) by making savings non-deductible up front but tax exempt in retirement, rather than vice versa.

In other words, since the addition of the Roth option didn’t lead to any significant changes in contribution behaviors, policymakers could consider shifting those current tax preferences to a post-tax savings assumption without being worried that individuals would react negatively, and perhaps save less, in response.

What If?

While acknowledging that a Roth-focused savings design could be advantageous to some, perhaps many workers (especially younger workers who may currently be paying the lowest tax rates of their working lives), I’d like to posit an alternative perspective.

What if those workers didn’t shift to Roth just because they liked the notion of putting off paying taxes — that they appreciated the logic of getting a dollar’s worth of savings for 85 cents worth of paycheck (that might, however, even account for the small uptick in contributions for the Roth — trying to make up for that “gap”)? Or that, having contributed on a pre-tax basis for some period of time, they were simply disinclined to make a change. After all, if plan sponsors simply added a Roth contribution type to the play, without changing default assumptions or matching formulas, simply presenting it as an additional option, I think it’s fair to say that, under those circumstances, most participants wouldn’t have any reaction or response to the new option. Indeed, considering normal behavioral inertia, it would be surprising if they did.

Let’s face it — they didn’t save more, they didn’t save less. They pretty much held the status quo.

So, what does this non-response of participants to the addition of a Roth option tell us about their likely response to the elimination the ability to defer paying taxes on income they haven’t received?

Well, Newton’s First Law of Motion is that objects at rest tend to stay at rest unless acted on by an external force. If you wanted to really test the reaction of participants to losing their pre-tax deferral choice — their “preference” for tax “preferences” — it seems to me that you’d need to actually take that option away from them. And then perhaps consider Newton’s Third Law of Motion: that for every action there is an equal — and opposite — reaction.

There is, it seems to me, a big difference between participants ignoring an additional choice and having an existing choice taken away. And policymakers who ignore that distinction in effecting tax law changes for retirement plans do so at their peril.

- Nevin E. Adams, JD

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