Hypothetically Speaking

A new academic study offers some insights on taxpayer preferences for pre-tax versus Roth savings – at least in certain conditions.

The study – which carries the somewhat unwieldy title “The Relative Effects of Economic and Non-Economic Factors on Taxpayers’ Preferences Between Front-Loaded and Back-Loaded Retirement Savings Plans” – takes a look at the various factors influencing preferences for paying taxes “up front” on retirement savings (this is termed “back-loaded by the researchers, in that the tax advantages come in retirement) versus pre-tax treatment as with a 401(k).

Writ large, and pretty much across the board, the researchers – Andrew D. Cuccia, associate professor and a Grant Thornton faculty fellow at the University of Oklahoma, and Marcus M. Doxey and Shane R. Stinson, both assistant professors at the University of Alabama – found that individuals preferred Roth (back-loaded) – even in circumstances in which they thought a rational determination would favor a pre-tax option.

“Consistent with prior research, our results suggest that individuals, on average, do not respond rationally to the relative economic incentives associated with alternatively structured plans,” they wrote. And while “at least part” of the “failure to connect relative tax rates – those paid now versus those in the future – was attributed to “a lack of awareness and/or understanding,” the researchers found individuals largely reluctant to embrace the pre-tax approach, even when education specifically designed to help frame that understanding was employed. Or, as the researchers explained, “… although errors can be reduced with increased awareness, our evidence illustrates that individuals systematically incorporate non-economic factors into their retirement plan choices, often leading to a preference for [pre-tax deferrals] even when such a choice is economically adverse.”

The researchers determined that “participants do not incorporate expected tax rate changes into their plan choice without an explicit explanation of the impact tax rate changes have on relative after-tax returns,” and “even when participants were educated about the tax rate change-return relation, 49% who reported that they expected their tax rates to be lower in retirement nonetheless elected to make their contributions to a back-loaded (Roth) plan.”

Now, in fairness the research wasn’t based on actual administrative data – rather they constructed several scenarios to test responses to various factors, and ran a group of online survey respondents through those scenarios to evaluate and weigh those responses. So, it was basically asking individuals about their (hypothetical) response to a variety of conditions regarding (hypothetical) tax rates, market conditions, as well as non-economic attitudes and preferences.

While they found a general preference for the back-loaded Roth accounts, they found “mixed evidence regarding whether individuals appropriately weight expected tax rate changes in their plan choices,” even though tax rates were seen as the primary factor driving the relative after-tax returns of front- and back-loaded plans. Indeed, the certainty of knowing the tax rate that would be paid, even if paid “now” seemed to outweigh the concerns associated with the uncertainty of future tax rates, though those who did expect to pay higher taxes in the future were – as one might expect – inclined toward the back-loaded (Roth) option.

If the researchers seemed puzzled about some of the preferences for the Roth option, they also found that a sense of urgency regarding saving for retirement was “positively associated” with savings rates, and that perhaps what they saw as “the current crisis in retirement preparedness” suggested to them that “current marketing and education campaigns are not sufficiently stoking investors’ sense of urgency.”

Those of us who work with retirement plans – and retirement plan participants – might not be quite so perplexed by the notion that individuals don’t always act in their financial best interest.  Additionally, while the researchers seemed to be quite thorough in outlining (and doubtless executing) their test scenarios, it is arguably one thing in a “laboratory environment” to make a choice with someone else’s money, and perhaps something else again to make those same choices with your own retirement savings.

Still, those concerned about a negative response by participants to the imposition of a Roth choice, might find some comfort in these findings.

Hypothetically speaking, of course.

- Nevin E. Adams, JD

Pay Me Now, or Pay Me Later

Many years ago, there was a commercial (for car oil filters, as I recall) that cautioned, “You can pay me now, or pay me later” – in other words, spend a little now on an oil filter, or pay lots later on to fix the damage done by not doing so. It’s a mantra that I’ve heard employed to encourage retirement savings – but these days it might have a new twist.

We now have a second survey of plan sponsors expressing concern about the impact that switch from the current pre-tax preferences accorded 401(k)s would have on participation.

That member survey by the Committee on Investment of Employee Benefit Assets (CIEBA) found that 78% of the 61 member respondents believed that a switch to an all-Roth system would negatively affect participation rates in their 401(k) plans. In that sense, it roughly mirrored the findings of a survey by the Plan Sponsor Council of America (PSCA) which found that more than three-quarters of the 443 employer respondents to the survey said they strongly agreed with the statement that eliminating or reducing the pre-tax benefits of 401(k) or 403(b) retirement savings plans would discourage employee savings in workplace retirement plans.1

While at least two other employer surveys are reportedly in the field and/or pending release, we (still) don’t know how participants will actually respond. However, it doesn’t require a massive leap of imagination to think that there might be a negative response of some magnitude to the federal government “taking away” the benefit of saving on a pre-tax basis that is, after all, what Section 401(k) of the Internal Revenue Code was all about.

Roth Rising?

Ironically, we find ourselves at a time when the availability of the Roth option in plans is at an all-time high, when providers like T. Rowe Price note that they have seen the biggest one-year increase in Roth contribution offerings in its clients’ 401(k) plans in 2016 – 61% of the plans for which it provides recordkeeping services – while Vanguard notes that two-thirds of the plans it recordkeeps now offer the feature, compared with 49% as recently as 2012.

Now, I realize that there is a difference between having the opportunity to contribute on a Roth basis, and having no option but to contribute on that basis. I’ve no doubt that there are individuals living paycheck-to-paycheck who would find the loss of the here-and-now tax preference to be a hardship. Individuals who, confronted with a Roth mandate, might indeed reduce their retirement savings in order to put food on the table, pay the rent, or put gas in the car so they can get to work.

Those concerns aren’t new, of course. For years they were – and in many cases still are – invoked as reasons to go slow, or go “low” on embracing automatic enrollment. Real as they may be, we also know what that means for retirement security.

Indeed, the surveys that have asked individuals about tax preferences – to the extent they are specific at all – nearly always focus on one particular aspect: deferring current taxes on contributions. The Roth advantages of not paying taxes on the accumulated earnings and the freedom from being forced to take RMDs aren’t even mentioned. Nor do most discussions about post-retirement drawdowns acknowledge that some large chunk of those retirement savings will be due Uncle Sam.

That said, it’s not as though the Roth doesn’t have its own set of tax preferences – and the closer one gets to retirement, the better they look. The odds that tax rates in retirement will be lower, particularly for younger workers, these days seems a quaint notion. Not surprisingly, Vanguard notes that nearly a third (30%) of Roth participants in Vanguard plans were in the age cohort of 34 or younger – and that’s without being defaulted in that direction.

Don’t get me wrong – like most of us, I’d rather have the choice than not. Nor would I diminish the communication challenge ahead if the long-standing 401(k) pre-tax preferences were capped or eliminated.

But of late, every time I see one of those reports about the average 401(k) account balances of those in their 60s, I can’t help but think that somewhere between 15% and 30%, and perhaps more, won’t go toward financing retirement, but will instead go to Uncle Sam and his state and municipal counterparts. And on a frequency dictated by the required minimum distribution schedules of the IRS.

And I can’t help but wonder how many plans for retirement don’t factor in that tax “cut.”

Nevin E. Adams, JD

1.  I draw comfort from the findings in both surveys that very few employers indicate that they would discontinue or diminish their current programs if a shift, full or partial, to Roth would occur.