The "Magic" of Compounding

Some numbers were put in front of the Senate Finance Committee last week—numbers that even the chairman of that powerful body called “jaw-dropping.”

The numbers were 51 million and $6.2 trillion—the former the potential number of new retirement savers, the latter a separate projection of the potential new retirement savings (over a 10-year period) that could result if two pieces of existing retirement legislation were implemented, specifically the combination of some key provisions of the Automatic IRA Act and the Encouraging Americans to Save Act.

Those projections—presented in testimony by American Retirement Association CEO Brian Graff—were the work (and rework) of many late (and early) hours by a number of individuals over a period of months.

Key Assumptions 

Now, predicting the behavior of human beings decades into the future may seem like the stuff of science fiction, but it can be parameterized. However, the key to a projection that aligns with reality likes in the assumptions. Here the key provisions (and assumptions applied) were that:

• All employers with 10 or more workers that don’t currently offer a plan do so.
• All those new plans offer automatic enrollment (no employer contribution for a new plan).
• Those new automatic enrollment plans start deferrals at 6%, and auto-escalate to 10%. 

Oh—and with regard to those new participants, a 20% opt-out rate was assumed in the first year, similar (though actually somewhat less, because we assumed that the new Saver’s Match would dampen the rate of opt-outs) than that experienced by the state-run programs like OregonSaves. And yes, that’s higher (about double) the rate experienced by 401(k) plans in the private sector with automatic enrollment.  

As for the Enhanced Saver’s Credit (let’s call it the Saver’s Match for clarity), we simply assumed that everyone eligible would get it (except, of course, for those that opted out), in the amount(s) provided in the (then proposed) legislation. We even factored in self-employed and “gig” workers, a still small, but growing element in the economy.

Why it Matters

We’ve long highlighted the issue with access to a retirement plan at work—“coverage”—alongside data that supports the fact that even modest income ($30,000/year to $50,000/year) workers are 12-15 times more likely to save for retirement via a workplace plan than on their own. While a growing number of states have embraced the notion of a “mandate” on the part of employers to provide payroll deduction to a state-run plan, extending that concept on a national level is a real game-changer in terms of providing that opportunity. 

Doing so combined with automatic enrollment (also a provision of most of the current state-run plans) helps workers get off to a good start, and providing a Saver’s Match seems likely to encourage most to stay with it—and perhaps, particularly among smaller employers, without requiring the financial impact of an employer contribution. 

Moreover, not only do the expanded levels of eligibility for the enhanced Saver’s Match mean that more individuals will be eligible, making it refundable means that more will be able to claim it—and, with so many more having access to retirement accounts, they will now have a retirement-oriented place in which to put it.

In our business, we often talk about the “magic” of compounding, and when retirement savers see how that early contribution can grow and build on itself, it does truly seem magical. In fact, no less a personage than Albert Einstein is reputed to have said that “Compound interest is the eighth wonder of the world.”[i]

Indeed, taken together, the compounding impact of these two sweeping proposals look to produce a retirement result worthy of that accolade—if they can make it into law.

- Nevin E. Adams, JD

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[i] He went on to say: “He who understands it, earns it; he who doesn’t, pays it,” but that’s a story for another day.

The 'Cutting' Edge?

Are employers necessary for a successful retirement system? A new proposal suggests that their role be “jettisoned.”

Not one to simply “bash” the 401(k), and to his credit, Morningstar’s John Rekenthaler, who recently opined that the 401(k) had outlived its usefulness,[i] now offers an alternative that he considers to be a superior alternative, something he titles “the New American Retirement Plan.” Despite the shortfalls his previous column attributed to the 401(k), this proposal in most of its elements seems relatively modest, at least structurally. It’s (basically – in 25 words or less), a national DC plan for all employers, probably with mandatory employee contributions, no requirement for employer contributions, and tighter restrictions on withdrawals.[ii]
Make no mistake, though – the devil, and there’s mischief aplenty here – lies in the details.

Rekenthaler’s basic premise – one that he describes not only as “the first,” but the “most important” step – is to “jettison the employer’s responsibilities,” noting that “expecting companies to sponsor retirement plans is like demanding that a dog dance; it may comply, but neither well nor happily. Companies run businesses. That is what they are created to do.”

I get it. How much simpler would business be if you, as an employer, didn’t have to worry about the cost, aggravation, and yes – liability – associated with providing benefits? But let’s set aside for a moment the impact that benefits clearly have, in terms of not only job choice, but job retention.[iii] Let’s turn our attention to a program already in existence that, as Rekenthaler suggests, “jettisons” the employer’s responsibilities. Specifically, let’s consider for a moment the OregonSaves program – the longest running, and arguably quite successful – state-run programs for private sector workers. Two years in, and admittedly absorbing a part of the workforce – smaller businesses – that is perhaps lower paid, and less tenured – that program has a participation rate of approximately 70%, and an average deferral of 5.5%. 

Now, that’s 70% better than the participation rate of those individuals previously, and that 5.5% saved is almost certainly an improvement from the 0% these workers were likely setting aside from retirement before the advent of the program. Those results, however, pale in comparison with those reported in the 62^nd annual Plan Sponsor Council of America (PSCA) 401(k) survey. We’re talking record high contribution rates of 12.2% (5.2% of that from employers, by the way) and opt-out rates of generally less than 5%, compared to the 27% or so in the state-run program. 

And yet while Rekenthaler’s initial premise regarding the 401(k)’s “expiration” claims the current system has failed to deliver on its promise, here there’s not even an attempt to quantify what this “new” approach would produce in terms of retirement income adequacy, nor any notion of what level of mandatory employee contributions might be required to offset the loss of employer contributions. Could an unmandated employee contribution-only account produce “enough?”
Rekenthaler leaves open for “discussion” whether employee participation should, in fact, be mandatory, or mandatory only up to a certain level, and whether there should be a voluntary employer match or not. But adequacy of retirement funding isn’t even mentioned.

Despite the concerns raised (and acknowledged in a subsequent post) regarding the adequacy of the current system, he seems content to put forth a program he considers to be superior in design, apparently assuming it would also produce superior, if not sufficient, results – leaving it to the rest of us to work out – and presumably live with – the details.

Indeed, with as many opportunities for misuse, abuse, and underuse as the current voluntary system contains, it’s nothing short of amazing just how successful it has been in helping provide, in conjunction with Social Security and personal savings, the prospects for a financially secure retirement, nurtured by select tax incentives and bounded in by nondiscrimination rules and eligibility tests.

Sure, there’s still room for improvements in the current system – but mostly it seems to me that the problem with the current system seems to be that there’s not “enough” of it. As for the wisdom of cutting the support of employers from the current system – well, that seems to me like cutting off your nose to spite your face…

- Nevin E. Adams, JD

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[i]His columns are generally thoughtful and thought-provoking, his perspectives rational and well-reasoned, his commentary nearly always not only interesting, but entertaining. But on this one – well, let’s just say we disagree.

[ii]As for leakage – well, Rekenthaler’s solution there is a simple one: “Forget tax penalties; they do not sufficiently deter foolishness. Instead, ban early withdrawals outright. After all, retirement-plan investors receive a benefit from the government for deferring taxes. It is only fair that they give something back.” Only consider for a moment – if you knew as a matter of course when the money was being automatically deducted from your paycheck that you would never again be able to access it for anything pre-retirement – how might that affect your  opt-out decision? (My guess is you’d hold back some, if not all.)

[iii]Not to mention the widespread availability and applicability of Social Security, which, though technically an insurance, not an account-based program, ostensibly already has many of the attributes Rekenthaler prizes, while drawing 12.4% of all wages up through $137.700/year.

Half A Chance...

I’ve never played the lottery. But there are days…

I tell myself it’s because I know how remote the odds are, that the rules are too complicated, that they “feed” on the aspirations of people who should be spending their money on “better” things – and even that I don’t have enough “lucky” numbers to bet on consistently. But those are rationalizations.

The simple fact, despite the screaming billboards and nightly news reminders about the size of the latest “mega” jackpot, is that I simply find it inconvenient. Oh, it’s not like I never frequent the convenience stores or even grocery checkouts that these days beg for the cash/credit card that hasn’t yet been put away. I’ve never really regretted walking away from those “temptations.” And yet…    

As an industry, we spend a lot of time focused on a wide variety of considerations that impact the likelihood of having a financially satisfying retirement. But what about those who don’t have access to a retirement plan?

Now, even thoughtful industry insiders have been known to push back on the notion that people don’t have access to a retirement plan. And, in fact, you don’t have to be an industry insider (though it helps) to know that anyone who doesn’t have access to a retirement plan at work can stroll down to your local bank or financial services outlet and open an IRA – heck, these days you can just boot up your computer and do that online. And yet people don’t. This isn’t really a surprise – but even among modest income workers ($30,000-$50,000/year), we’ve seen that workers are 12 times more likely to save via a workplace retirement plan than to open that individual IRA.

Last week, we unveiled a state-by-state analysis that highlighted the coverage gap – that more than 5 million employers in the United States still don’t offer a workplace retirement savings benefit, a generation after the 401(k) plan design was first introduced. And what that means is that more than 28 million full-time workers don’t have an opportunity to save for retirement in a 401(k) – and that doesn’t include more than 23 million part-time workers who don’t have that opportunity.

That is, of course, the coverage “gap” that the so-called state-run automatic IRA programs are designed to close. And, though it’s still relatively early in that particular vein, they do seem to be having a positive effect. In Oregon (whose OregonSaves program has just commemorated its second anniversary), they’re reporting more than 6,856 employers now participating – who ostensibly didn’t offer a plan before – with some 95,704 employees – who, ostensibly, weren’t saving for retirement previously. And if the opt-out rate is high (approximately 30%) compared with the 7-9% rates typical of automatic enrollment plans administered in the private sector, well it not only lacks the support of an employer match (not to mention the support of workplace education or an advisor), but it also has a (still) relatively high 5% default contribution rate, though recent surveys suggest that the default rate standard is rising in 401(k)s.

There are, of course, issues with the emergence of multiple, and potentially contradictory, state-run versions – particularly for employers who draw workers from multiple states. But in just this last year, the program has begun offering traditional IRAs and has been opened to the self-employed, gig economy workers and cannabis businesses. The program is now more than halfway through its statewide rollout, which will be completed by mid-2020, with more new “features and improvements” in the works. Similar programs in Illinois and California are underway, or nearly so – and Rep. Richie Neal (D-MA), Chairman of the House Ways & Means Committee, has previously proposed a federal version. 

Much of the coverage gap can be laid at the door of smaller employers, which arguably have a different focus on such matters than larger organizations. And, sure enough, a 2013 analysis by the nonpartisan Employee Benefit Research Institute (EBRI) found that when you adjust for access to a plan – the percentage participating divided by the percentage working for employers that sponsor a plan – you find that participation rates between larger employers and smaller ones largely disappear. For example, while data indicates that just 16.9% of those full-time, full-year employees who work at smaller employers participate in a plan – that turns out to be about 86% of the 19.5% of workers in that category whose employer sponsors a plan. And that is nearly identical to the participation rate of private-sector employers with 1,000 or more employees.

A few years back I remember hearing a lottery motto, “Gotta be in it to win it.” That’s a motto that those worried about retirement finances should always take to heart.

But if they’re going to have (more than) half a chance, there’s something to be said for improving the odds – by having a chance to “play.”

- Nevin E. Adams, JD