‘Mad Money’s’ Mixed Bag

  Last week a reader brought to my attention an episode of Jim Cramer’s “Mad Money” — an episode wherein he referred to the 401(k) as a “mixed” bag. 

In it, he acknowledged the benefits of tax deferral, the benefit of compounding on returns, and — where it’s found, anyway — the “free” money of an employer match. In that, he was at least more honest about such things than many[i] who make their living offering investment advice (generally accompanied by a subscription fee to their services — which, to be fair, Mr. Cramer has and mentions in this show). 

In point of fact, Mr. Cramer would clearly prefer an IRA option — if the contribution limits were equal to the 401(k) — though they’re not even close (not to worry — he says he’s going to continue to fight to remedy that situation). Indeed, Mr. Cramer counsels that once you’ve gotten the full match in your 401(k), you should just put everything else into an IRA (though he doesn’t get into the “nuances” of contributing to both in the same year). 

But Mr. Cramer is also concerned about the “hidden” fees in a 401(k) — so much so that he counsels folks to “always” roll out of that 401(k) when they change employers. And little wonder — since he appears to think that your typical 401(k) is charging administrative fees in excess of 200 basis points — more than 2%, in other words. I’ve no doubt those can be found but would caution Mr. Cramer that those are not the “norm.”

That said, he told viewers they should be “skeptical” of a 401(k) plan that doesn’t let you buy individual stocks via a self-directed IRA — one that he maintains gives you “control” of your money. As he’s a stock picker (of sorts), it’s not surprising that he has an affinity for individual stocks[ii] rather than mutual funds (though he admitted that those who don’t have the time for the former might be well-served by investing in a low-cost index fund).

Indeed, as do most folks touting mass media investment advice, Mr. Cramer prefers the ability to go beyond the investment menu “constraints” of a 401(k) menu — and surely for individuals like him who have the time and expertise (or think they do) to make and track individual investments, that resonates.

Programs like “Mad Money” are ostensibly positioned for more experienced/engaged investors — though that did NOT seem to be composition of the callers to this particular episode. Just as well, because he wasn’t providing much more than high-level generic wisdom on basic tax deferral, compounding benefits,[iii] and a heavy dose of equities in your portfolio until you get to your 50s. 

The reality for most individuals, of course, is that without a workplace retirement plan, they don’t save for retirement, much less invest. The match may be “free” money for the individual, but it surely has a cost — one borne by their employer in support of their eventual retirement. The mutual funds Cramer rejects are — increasingly — a portfolio not only selected, but managed by professionals, either in a target-date fund or managed account. For most, it’s not “mad” money, after all — it’s about thoughtfully building a secure, reliable financial foundation.   

Those with “mad” money to spare might not need that kind of help — but plenty of “regular” people do.

• Nevin E. Adams, JD

 

---

[i] See Is the 401(k) Really a 'Horrible' Retirement Plan?, When You Assume, The 'Plot' Thickens

[ii] He did make an interesting argument for investing in stocks as a way to curb spending. Specifically, he noted that you’d have to sell your favorite stock in order to raise the cash to spend — and that you wouldn’t want to sell that favorite stock — so you wouldn’t spend the money.

[iii] One assumes that he’s more specific in his “investment club,” which came up several times during this program.

Do Roth and 401(k) Pre-Tax Holders Really Spend Differently?

An interesting—and somewhat counterintuitive—report came out last week, one that cast doubt on the “common wisdom” regarding Roth versus traditional pre-tax savings.

The assumption underlying the research[i] was that those who had not yet paid taxes on their savings (the traditional pre-tax savings) would be hesitant to tap into those savings and trigger taxes, certainly more so that individuals that had already paid those taxes. Instead, the research suggested that the opposite occurred; that individuals who had saved on a pre-tax basis actually withdrew more/sooner—but with a twist. 

This they hailed as good news. They noted that the research suggests investing in a CT (current-taxed, or Roth) plan could help ease concerns about outliving funds—because they spend at a lower rate (though they saw this as a negative for those who saved on a deferred tax (DT) basis).  They even managed to find a silver lining in the “cloud” of faster spending by the pre-tax crowd because those individuals appeared to be trying to adjust for the effect of taxes (with the caveat “despite our findings that they do not appear to adjust sufficiently, if at all”). And they saw as a positive this report’s contribution to the “accounting literature exploring the effectiveness and consequences of incentivizing behaviors through tax policy, by highlighting how past decisions motivated by taxes (e.g., retirement plan type) may continue to affect one’s quality of life long into the future.”

A few words of caution would seem to be in order, however. This wasn’t based on the patterns of actual people spending their actual money in the real world. Rather, and to their credit, they constructed a laboratory environment of sorts; they selected a group of volunteers, gave them certain criteria—basically a role they would “play” in the experiment—and set out a spending scenario. They then had them read about various spending choices—and, well—recorded how the individuals chose.

As for their conclusions, when you probe into the results more carefully, what you see is that even though those who had pre-tax accounts ostensibly feel the “pain” of taxes due on their retirement withdrawals—and that appeared to restrict their spending—it seemed to be offset by another reality. That, for reasons not understood/explained, those same individuals appeared to relish the expected benefits of consumption more than Roth holders. Said another way, their “reservations”— the cognizance of taxes—didn’t seem to constrain their spending because they were (more) enamored of the benefits of spending. Indeed, the researchers commented that those with “equivalent nominal balances” actually spent at the same rate.

I’ll just comment that it’s an interesting premise—and that the test environment created struck me as detailed and complex to map out, establish and execute. That said, I would be hesitant to draw any substantive conclusions on actual human behavior from this analysis. To me, all it seemed to “prove” is that people selected for an experiment tend to spend to the perceived “limits” of their hypothetical account, regardless of taxation. It didn’t strike me that Roth holders spent less (as many headlines covering the report suggested), but rather that pre-tax holders spent the same, even though they were going to have to deal with a tax bill at some point (hypothetically, of course).

And that, to me, isn’t a positive thing for Roths so much as it is a cautionary note for pre-tax savers—who may have forgotten that tax deferral is just that.

 - Nevin E. Adams, JD

---

[i] How Does Tax Timing Affect Spending in Retirement?  

Withdrawal Symptoms?

 There’s nothing like a global pandemic to fuel interest in, if not the need for, emergency savings. Indeed, there are a half dozen provisions[i] in the new SECURE 2.0 designed to make it easier for workers to tap into their retirement savings—two aimed specifically at emergency savings.

Though the financial impact of the pandemic (not to mention a series of natural disasters) has arguably been uneven, a report from Vanguard[ii] highlighted the longer-term impacts of the economic slowdown and inflation’s growing bite of the household budget. It's also widely acknowledged that concerns about the inability to fund an unexpected financial emergency is a source of stress for workers, undermining financial wellness.   

All that said, well before COVID-19, there have been concerns about Americans’ lack of emergency savings[iii] and, perhaps more broadly, that they were using their retirement savings accounts as that resource. Behavioral finance-types have counseled that a mental, if not physical, segregation of money by purpose is helpful, and at least one of the new SECURE 2.0 provisions seems designed to make that structure a reality by creating an emergency savings “sidecar” alongside regular retirement savings accounts. 

The first of these is found in Section 115 and, beginning in 2024 it says a participant may generally make a withdrawal of up to $1,000 per year from their retirement account for certain emergencies. The withdrawal may be taxable (unless drawn from Roth) and MAY be repaid within three years, but it will not be subject to the 10% penalty for early withdrawals. Only one withdrawal is permitted per the three-year repayment period—if the first withdrawal has not been repaid.

The other emergency savings provision (Section 127)—and the one that seems to be garnering most of the media attention is the (confusingly labeled) “Pension Linked Emergency Savings Accounts.” Beginning in 2024, it will ALLOW (not require) employers to create an Emergency Savings Account (ESA) as part of a defined contribution plan (401(k) or 403(b)). Only non-highly compensated employees may contribute to the account, though employers MAY auto-enroll such individuals in an EAS up to 3% of their compensation, and the EAS value cannot exceed $2,500[iv] (indexed for inflation). All employee contributions to this emergency savings account MUST be made on an after-tax basis—and each month participants may take withdrawals from the account (just to further complicate administration, the first four withdrawals for a year cannot be subject to distribution fees). 

Oh—and speaking of complications, those employee contributions must be treated as elective deferrals for purposes of any matching contributions. The matching contributions are treated by a plan no differently than matching contributions made on account of elective deferrals.   

Now this provision likely makes the behavioral science-types happy—it provides a separate mental (and notational) accounting—and one that doesn’t force the individual to choose between saving for retirement or saving for that “rainy day” emergency, at least in terms of foregoing a company match. 

But, aside from the obvious administrative complexities of this option (certainly for the plan sponsor/recordkeeper), it’s by no means clear that this kind of set up won’t create a kind of “Christmas club” account, with individuals withdrawing these contributions for just about any reason every year (just) long enough to get the match—and then the next year they could do it all over again. And again. The Treasury is authorized to issue regulations to prevent abuse, but there’s no telling if or when (or  what) those rules would be.  

It might be good mental “accounting”—but I’m not sure that it will be good for retirement. 

- Nevin E. Adams, JD 

---

[i] While I’m focusing on only two of those provisions here, the others are Section 314 (allows for up to $10,000 of withdrawals from plans and IRAs in cases of domestic abuse, effective 2024), Section 326 (exempts from the 10% excise tax withdrawals from plans and IRAs in cases of terminal illness, effective now), Section 331 (allows for withdrawals from plans and IRAs of up to $22,000 in federally declared disasters, effective retroactively to Jan. 26, 2021), and Section 334 (allows for up to $2,500 a year of withdrawals from workplace plans to pay for long-term care, effective three years after enactment (so generally not until 2026)).

[ii] In fact, that report, published last October, and amidst growing concerns about the above factors and volatile investment markets, noted that the share of workers taking cash from their employer retirement plans through new loans, non-hardship withdrawals, and hardship withdrawals were on the rise in 2022.  Called out for special note was the rise in hardship withdrawals, which Vanguard said had reached an all-time high—though that was only 0.5% of workers tracked by Vanguard (5 million participants in 1,700 employer-sponsored retirement plans administered by the firm).

[iii] The most widely repeated likely being the Federal Reserve survey asking Americans if/how they’d handle a $400 emergency (approximately 1 in 9 said they couldn’t, and while that’s a minority, the headlines have tended to highlight the impact)—but see https://www.minneapolisfed.org/article/2021/what-a-400-dollar-emergency-expense-tells-us-about-the-economy.

[iv] Though there’s been some question as to whether $2,500 is “enough” (there’s language in the bill calling for a study to see if it needs to be higher).

‘Might’ Makes… Wrong?

 Sometimes the motivations of those attacking the 401(k) are pretty obvious.

The most recent was an article by a Maurie Backman at the Motley Fool titled, “Why a 401(k) isn’t the wonderful savings tool you think it is.” I tried to ignore it when it first (to my eyes) appeared on Forbes (which seems to have a pretty low threshold for contributions these days), and I was no more inclined to read it when it showed up a couple of days later on Fox News. But then folks started sharing it on both LinkedIn and Twitter—some ostensibly to hold it up for ridicule,[i] others as an affirmation—and, with some reluctance, I finally clicked on the article. 

Oddly, considering the title (and, in fairness, editors have been known to tweak headlines such that they bear little resemblance to the article they are attached to), the article spent almost as much space outlining the virtues of the 401(k)—specifically that they are “easier to sign up for” than an IRA, and that they have (much) higher annual contribution limits, even for catch-up contributions.

So, what’s their beef(s)? Backman makes three points:

1. That investment choices in a 401(k) can be limited (specifically that you generally can’t buy individual stocks).
2. That fees in a 401(k) can be high (the issue here seems to be the inclusion of actively managed funds alongside index offerings—and an assertion that “401(k)s plan come with administrative fees that generally are not negotiable. The administrative fees you'll pay with an IRA are typically much lower”—an assertion that doesn’t align with my experience, but is offered without data).
3. That a Roth option isn’t guaranteed (this factual assertion despite the fact that the most recent data from the Plan Sponsor Council of America that more than two-thirds of 401(k)s do currently provide the option).

To sum up: According to the article that claims the 401(k) isn’t a wonderful savings tool, the suboptimal aspects of a 401(k) are: (1) the options might not include individual stocks; (2) the fees can be high; and (3) you aren’t guaranteed to have the ability to save for retirement on a Roth basis—even though, by the author’s own admission, 401(k)s have much higher contribution limits and are easier to access, and thus are much more likely to be used (recall that data indicates individuals are 12-15 times more likely to save in a 401(k) than in an IRA on their own). Oh—and there’s only a passing reference to the employer match, which arguably also isn’t “guaranteed,” but is certainly more likely to be found in a 401(k) than in a stand-alone IRA.  

Perhaps it should come as no surprise that an article penned by the Motley Fool—a platform that purports to help individuals make stock picks—thinks that you’d be better off utilizing a retirement savings plan[ii] that would more readily accommodate their services. 

Yes, sometimes the motivations of those attacking the 401(k) are pretty obvious. The motivations of those choosing to publish such silliness? Not so much.

- Nevin E. Adams, JD

---

[i] Memo to those who did—clicking on the article is the whole point; sharing it only exacerbates the problem.  

[ii] To add to the irony, the article sums up its advice thusly: “What you should do in that case is contribute just enough money to your 401(k) to snag your full employer match, if one is offered, but then put the rest of your savings into an IRA. Doing so could help you invest more appropriately, avoid high fees, and enjoy the perks of a Roth saving option.” 

'Tacts' Treatment?

Roth 401(k)s are more prevalent—and popular—than ever. But is that good—or bad—for retirement?

A recent op-ed[i] in The Wall Street Journal explored the potential implications—“What ‘Rothifying’ 401(k)s Would Mean for Retirees”— (subscription required), though the focus is on tax policy as well.

You’ll remember that so-called “Rothification”—essentially the elimination of the pre-tax treatment currently accorded 401(k) contributions—was quite the controversial issue back in 2017 when the Republican-controlled House of Representatives was looking for ways to raise revenue to help pay for tax cuts.[ii] And while it’s not been an active focus of late, it seems likely to resurface as the nation’s budget deficit widens, and the field of 2020 presidential aspirants seem determined to find ways to spend more or, in the case of the incumbent, collect less in taxes.

‘Out’ Comes 

As for the WSJ treatment, I’ll spare you the short read (longer if you actually check out the 36-page paper it was based upon), and summarize it thusly: later retirements (not by choice, but of necessity), less retirement income, and more wealth inequality. Though, at least in the short run, more tax revenue for Uncle Sam.[iii]

Now most of this comes from a key assumption; as the WSJ piece puts it, “Over their lifetimes, workers would accumulate one-third less in their 401(k)s under a Roth system. This is because, with no tax advantage from contributing to a 401(k), workers would save less and those lower contributions would earn less over the years.”

Said another way, without the tax break, the authors conclude that workers won’t save as much, and saving less means that they’ll have less invested, and that  means that they’ll have less retirement income. They also argue that, with Rothified savings, workers would tap into Social Security later—a year later, on average, they claim. They note that with their retirement savings already taxed, wealthier individuals would be inclined to defer taking Social Security (increasing their benefit), widening income inequality.[iv]

‘Less’ on Plan?

The concern about mandatory Rothification was always that workers would, in fact, save less—and this is a concern that employers have expressed, though this was in the context of the ability to save on a pre-tax basis being taken away. That, in turn, seems to be predicated on the notion that workers have a specific dollar amount in mind that they can afford to save, and that if some of that certain dollar amount goes to taxes, there is a dollar-for-dollar offset. Doubtless that’s true for some, particularly among lower-income workers. However, when I have seen savings data, what seems to be the norm is that individuals save a specific percentage of pay, one generally driven either by what’s necessary to earn the employer match, or perhaps that rate at which default contributions are set. In other words, people choose to save 3% of pay, not $50/paycheck.

Now, if that  perception is accurate (feel free to disagree in the comments below if you see things differently), then it seems to me that most individuals might actually save the same amount, regardless of whether it’s pre- or post-tax. And if they were to same at the same rate (and admittedly that’s a big “if”), their retirement outcome might actually be more  secure—because withdrawals (and taxation) wouldn’t be forced on them by RMD calculations, because they wouldn’t have to worry about those contributions—and the earnings that have accumulated on those contributions—being taxed, and, significantly, because the reduction in taxable income wouldn’t undermine (through “means testing”) Social Security benefits.

But key to the analysis is how participants would respond, and the study cited in the WSJ isn’t the only academic consideration on the subject; one in 2015 found no change in savings rates with a voluntary addition of a Roth feature, and in 2017, the non-partisan Employee Benefit Research Institute (EBRI) found that it might help—or hurt—retirement security—and this is key—depending on the response of participants.

It appears that more participants are being presented with that option. Nearly 70% of plans now provide a Roth 401(k) option, according to the most recent survey by the Plan Sponsor Council of America. Perhaps more significantly, that survey, reporting 2018 plan activity, finds that nearly a quarter of participants (23%) elected to contribute to a Roth when given the opportunity, up from 19.5% in 2017 and 18.1% in 2016—an increase of nearly 30% in just three years.

Academic studies notwithstanding, it’s worth remembering that retirement security isn’t just a matter of how much you have saved at  retirement; it’s how much you have available to spend throughout retirement.

- Nevin E. Adams, JD

---

[i]The authors of the WSJ article, Olivia S. Mitchell and Raimond Maurer, previously authored a research paper upon which the WSJ piece was based (albeit with a slightly different title, “How Would 401(k) ‘Rothification’ Alter Saving, Retirement Security, and Inequality?”). 

[ii]They weren’t, however, the first to propose such a shift. President Obama did so in 2015.

[iii]However, the authors state that the taxes collected on withdrawals of that money exceed the amount of additional income taxes that would be collected during people’s working lives under Rothification.

[iv]As a side note, the authors in the WSJ article note that not only would this be bad for Social Security funding, but they also conclude that the taxes collected on withdrawals would exceed the amount of additional income taxes that would be collected during people’s working lives under Rothification—ostensibly because of their previous assumption that it would be a larger accumulation of money to be taxed. 

5 Key Industry Trends You May Have Missed

The Plan Sponsor Council of America recently released its 60th Annual Survey of Profit-Sharing and 401(k) Plans, documenting increases in participation, deferral rates, target-date funds, automatic enrollment and advisor hiring, among other key trends.

Here are five key trends highlighted in the survey that you may have missed.

Automatic enrollment is still (mostly) a large plan thing.

One of the most celebrated plan design features of the 401(k) era is automatic enrollment. Nearly as old as the 401(k) itself, once upon a time (when it wasn’t as popular) it was called a “negative election.” Regardless of the name, the concept has been extraordinarily effective at not only getting, but keeping, workers saving via their workplace retirement plans. However, adoption of the design, after a surge in the wake of the passage of the Pension Protection Act of 2006, now seems to have plateaued.

A decade ago, only about a third (35.6%) of respondents to the PSCA survey offered automatic enrollment. Now more than half (60%) do – and that increases to 70% among plans with more than 5,000 participants. However, only a third of plans with fewer than 50 workers do.

For some potential explanations – see Why Doesn’t Every Plan Have Automatic Enrollment?

Auto-escalation is escalating.

An incredible three-quarters of plans with automatic enrollment auto-escalate the deferral rate over time, compared with less than half (49.7%) a decade ago, according to the PSCA survey.

However, only one-third do so for all participants.

As for the rest, one in eight do so for under-contributing participants, and a third do so only if the participant elects to do so.

Plans are curing a fault with the default.

While you see surveys suggesting that a greater variety of default contribution rates is emerging, the most common rate today – as it was prior to the PPA – is 3%. There is some interesting history on how that 3% rate originally came to be, but the reality today is that it has been chosen because it is seen as a rate that is small enough that participants won’t be willing to go in and opt out – and, after the PPA, we have some law to sanction that as a target.

Sure enough, the PSCA survey found that the most common default deferral rate remains 3% (36.4%). However, more than half of plans now have a default deferral rate higher than 3%. Indeed, the second most common default (22.2%) is now 6%.

Roths remain on the rise.

Nearly two-thirds of plan sponsors now provide a Roth 401(k) option. In fact, in just a decade, the percentage of plans offering such an option has more than doubled; from about 30% in 2007 to 63.1% now.

Pre-tax treatment has, of course, been the norm in 401(k) plans since their introduction in the early 1980s. On the other hand, the Roth 401(k) wasn’t introduced until the Economic Growth and Tax Relief Reconciliation Act of 2001, and even in that legislation wasn’t slated to become effective until 2006 (and at that time was still slated to sunset in 2010). Significantly, participant take-up, which just a few years ago hovered in the single digits, is now in the 15-20% range (18.1% according to the PSCA survey, somewhat higher among smaller plans).

While industry surveys during the tax reform debate (including a flash poll from PSCA) indicated a fair degree of employer concern about the potential impact of so-called “Rothification” on participation, that doesn't seem to be slowing the opportunity for individuals to take advantage of tax diversification.

It’s (still) what goes in, not what comes out that ‘matters.’

It’s said that what’s measured matters – and yet, despite all the buzz around financial wellness, and a growing emphasis on outcomes, the latter still has a way to go in terms of being an established plan success benchmark.

Consider that in this year’s PSCA survey, a whopping 89.6% of plans cite participation rate as a benchmark to determine plan success – and even more (93.2%) of the largest plans rely on that gauge. Deferral rates were a distant second (72.6%), and average account balances ranked third (55%).

What about outcomes? Only a quarter of plans used that as a benchmark, though a third of the largest plans (33.8%) did.
Industry surveys, particularly those with a broad range of plan types and providers, and with the perspective of decades such as the PSCA survey provide an invaluable sense not only of where we are, but where we have been.

However, their real value lies in helping us see where we need to be.

- Nevin E. Adams, JD

More information about the Plan Sponsor Council of America’s 60th Annual Survey of Profit Sharing and 401(k) Plans is available at www.psca.org.

NOTE: There will be a special workshop exploring the survey results and the implications for advisors at the NAPA 401(k) SUMMIT, April 15-17, 2018 in Nashville, Tennessee. If you haven’t registered, there’s still time (but the hotel blocks are filling) at http://napasummit.org.

Tax Reform – ‘Tricks’ or Treat?

A few weeks back, my wife and I went to see the updated version of It. Now, I’ve been a fan of King’s work ever since a friend shared a copy of Salem’s Lot with me, though his work doesn’t always translate as well to the big screen. “It” is a malevolent entity that emerges about once every 27 years to feed, during which period it takes on various shapes designed to lure its prey – generally children, and then it returns to a hibernation of sorts. “It”’s most notorious incarnation is, of course, Pennywise the Dancing Clown (the lovely visage below).

Ironically, tax reform too seems to be a once-in-a-generational thing. It’s been 30 years since the Tax Reform of 1986 cut tax rates1 – and cut into retirement plan saving and formation with the creation of the 402(g) limit (and its tepid COLA pace), not to mention the cost and timing issues associated with multiple iterations of the nondiscrimination testing that often produced problematic refunds for the highly compensated group. There’s little question that those changes (and others) did what they were designed to do – generate additional tax revenue by limiting the deferral of taxes. But what did those constraints do for retirement security?

Much of that damage wasn’t repaired until – well, 2001 with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) – which, somewhat ironically, introduced the concept of the Roth 401(k).

Rothification Response

While tax reform has wrought its damage on retirement savings before, this time around a new way to raise revenue has emerged – “Rothification,” loosely defined as the limiting or elimination of the current pre-tax contribution limits.

We don’t really know what workers would do confronted with that kind of change (the surveys that are available – though not completely on point suggest that the response might be modest) – though we do know that if current participants continued to save at the same rate, retirement readiness would likely improve. There are also signs that it would be seen as a big enough change that some, perhaps many, plan sponsors would want to rethink, if not reconsider, their current automatic enrollment assumptions.

We may not know with certainty those outcomes, but there are lots of reasons to be nervous, if not downright fearful of change to retirement plans, particularly one that seems likely to give plan sponsors – and plan participants – a reason to rethink their current savings rates. Granted, surveys show that most plans already offer a Roth option, and more recent surveys indicate that most plan sponsors would continue to offer a plan even if the current pre-tax option for 401(k)s was reduced and/or eliminated (and how sad would it be if a plan sponsor decided to walk away from offering a plan just because the pre-tax savings option was clipped).

We also know that more than half of current 401(k) contributors would be affected by a $2,400 pre-tax contribution limit, based on data from the non-partisan Employee Benefit Research Institute (EBRI), using their Retirement Security Projection Model® (based on information from millions of administrative records from 401(k) recordkeepers), and that the impact reaches down to some very moderate income levels.

That said, we don’t yet know – and this is significant – if the tax reform proposals that emerge this month will include some version of Rothification, nor at what level the Rothification restriction might be imposed (as it turns out, Rothification was NOT included in this first round!).

‘Pass’ Tense?

Consider the recent “unintended” consequence of a proposed tax break for pass-through entities (i.e., partnerships, S corps, and small business limited liability corporations). More than 320,000 of these entities sponsor a retirement plan (with the average size being 75 employees) – unfortunately, many of these businesses may reconsider adopting or maintaining a qualified retirement plan because of significant financial disincentives woven into the fabric of the tax reform proposal, which would establish a 25% maximum pass-through rate on that business income, versus the 35% top rate on ordinary income (as well as the favorable tax rate on capital gains income at 20%) that would be assessed when the money is withdrawn at retirement. In other words, the small business owner’s plan contributions and accumulated earnings will be taxed at 35% instead of the 25% pass-through rate and the 20% capital gains rate on accumulated earnings.

There are some things about tax reform proposals that we do know. One, that lawmakers – and sometimes regulators – often seem to operate on the assumption that employers will, and indeed must, offer a workplace retirement plan no matter what changes or cost burdens are imposed on plan administration. With an eye toward narrowing the benefit gap between higher-paid and non-highly compensated workers, limits are imposed that often outweigh the modest financial incentives offered to businesses, particularly small businesses, to sponsor these programs. This, despite the striking coverage gap among those who work for these small businesses, and the potentially burdensome administrative requirements and additional costs that the owner must absorb, alongside a pervasive sense that their workers aren’t really interested in the benefit (or, perhaps more accurately, would prefer cold, hard cash).

The debates about modifying retirement plan tax preferences – or the notion that these preferences are “upside down,” and thus may be dispensed with – are bandied about as though those changes would have no impact at all on the calculus of those making the decisions to offer and support these programs with matching contributions. In other words, while some attempt is made to quantify the response of workers to changes in their incentives, most studies simply assume that employers will “suck it up.”

Well, this week the GOP is slated to unveil its proposal for tax reform in the House of Representatives, and shortly thereafter we should see a separate GOP proposal emerge in the Senate. Those will have to be reconciled, and these days that’s no slam dunk.

It remains to be see what tax reform – with all its laudable objectives – might mean for retirement plans this time around. But here’s hoping that, if tax reform turns out to be “Pennywise,” it won’t be “pound” foolish.

- Nevin E. Adams, JD

Footnote

1. And the time before that was 1954… with the creation of the Internal Revenue Code.

Forseeable Consequences

It is all too common in human affairs to make choices that have “unforeseeable consequences.” And then there are those situations where people should have known better. Like the current rumors about capping employee pre-tax contributions at $2,400.

Having the opportunity to put off paying taxes is something that most Americans relish — even those whose tax bracket means they really don’t wind up owing taxes. While there’s plenty of evidence to suggest that it is the employer match, rather than the (temporary) tax deduction that influences worker savings, most are happy to get both. Indeed, the ability to defer paying taxes on pay that you set aside for retirement is part and parcel of the 401(k) (though cash or deferred arrangements predated that change to the Internal Revenue Code).

Enter the talk about “Rothification” — the limit, or perhaps even complete elimination, of pre-tax contributions to 401(k)s. While a definitive notion of how participants would respond remains elusive, recent industry surveys have indicated a great deal of concern on the part of plan sponsors about their response. I’ve little doubt that some people would reduce their savings (if only because they would have less take-home pay), but certainly those who are anticipating a higher tax bracket in retirement than at present (are you listening younger workers?), the ability to pay a low tax rate now, while gaining the tax-free accumulation of earnings, and the freedom from mandated RMDs, makes a lot of sense. Older workers too might appreciate the tax diversification moving to Roth affords.

In considering the potential impact, I also drew comfort from the reality that so many of today’s workers are being automatically enrolled in their workplace savings plan. They may well have contemplated the potential tax implications before allowing that deduction to take place, but I’d guess most had not. And thus, a switch to Roth as an automatic deduction seemed unlikely to me unlikely to raise more than a brief ripple in current savings rates.

There are, however, signs that reactions beyond that of plan participants could produce seismic shocks. There were reports that some plan sponsors were not comfortable simply “flipping” automatic enrollment to Roth from pre-tax, at least not without some affirmative participant direction. Moreover, in recent days, a number of providers have been heard saying that, if a provision that would limit pre-tax contributions to something like the recently rumored $2,400, that they would feel obliged to place that cap in the plans they recordkeep with automatic enrollment provisions — at least until plan sponsors told them otherwise. And if plan sponsors aren’t comfortable making that switch with their automatic enrollment programs — well, you can see how that Roth limit could in short order actually become a limit on retirement savings.

But perhaps the most remarkable thing about the most recent set of tax reform rumors is the $2,400 limit itself. If it strikes you as a pretty low threshold, you’d be correct. None other than the nonpartisan Employee Benefit Research Institute (EBRI) using their Retirement Security Projection Model® (based on information from millions of administrative records from 401(k) recordkeepers), found that more than half of current 401(k) contributors would be impacted by a $2,400 contribution Roth. Even at the lowest wage levels ($10,000 to $25,000), nearly 4-in-10 (38%) of the 401(k) contributors would be impacted by the $2,400 threshold, as would 60% of those in the $50,000-$75,000 salary range. Can you say “middle-income tax increase”?

Tax reform might not happen, and even if it does happen, it might not touch retirement plans, or the delicate balances that incentivize both workers to save, and employers to offer the programs that allow workers to save.

Those who craft such legislation would do well to heed the danger signs already emerging from constraining and/or undermining retirement savings. It’s one thing, after all, to implement change without understanding or appreciating those consequences that are unintended, and something else altogether to know full well that those changes will have a negative impact, and then plow ahead with them regardless.

Those “foreseeable” consequences might — and should — have foreseeable consequences of their own for those who choose to disregard them.

- Nevin E. Adams, JD

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.

5 Things You May Not Know About Roth 401(k)s

I made the switch to Roth for my retirement savings years ago – and I have long counseled younger workers, who were likely paying the lowest tax rates of their working lives, to do so as well.

Pre-tax treatment has, of course, been the norm in 401(k) plans since their introduction in the early 1980s. On the other hand, the Roth 401(k) wasn’t introduced until the Economic Growth and Tax Relief Reconciliation Act of 2001, and even in that legislation wasn’t slated to become effective until 2006 (and at that time was still slated to sunset in 2010).

Despite that late start, according to a variety of industry surveys (Plan Sponsor Council of America, Vanguard, PLANSPONSOR), roughly 60% of 401(k) plans now offer a Roth 401(k) option, and PSCA data shows that 28.6% of 403(b) plans already allow for Roth contributions. Participant take-up, which just a few years ago hovered in the single digits, is now in the 15-20% range.

Here are five other things you may not know about the Roth 401(k):

To allow designated Roth contributions, a plan also has to offer traditional pre-tax 401(k) contributions. 

A plan can only offer designated Roth contributions if it also offers traditional, pre-tax elective contributions. Oh, and they can be offered by either a 401(k), 403(b) or 457 plan.

You can auto-enroll designated Roth contributions. 

The plan must state how the automatic contributions will be allocated between the pre-tax elective contributions and designated Roth contributions.

You can “catch up” on a Roth basis. 

Individuals can make age-50 catch-up contributions as a designated Roth contribution to a designated Roth account.

You have to include Roth contributions in the 401(k) plan annual nondiscrimination testing. 

Designated Roth contributions are treated the same as traditional, pre-tax elective contributions when performing annual nondiscrimination testing. Moreover, just like other elective deferral, they must be included when calculating the top-heavy ratio each year. You cannot allocate forfeitures, matching or any other employer contributions to any designated Roth accounts.

You can take loans from designated Roth accounts. 

As long as the plan permits, you can identify from which account(s) in your 401(k), 403(b) or governmental 457(b) plan you wish to draw your loan, including from a designated Roth account.

Retirement plan education has long had as a basic tenet that individuals will be paying lower tax rates in their retirement future. Of course, tax rates – and future income levels – are hard to predict. Both can rise more than anticipated in the future – and a Roth option can provide some essential flexibility to diversify tax treatment, as well as investments.

- Nevin E. Adams, JD

For more information, see Retirement Plans FAQs on Designated Roth Accounts from the IRS.

Here We Go Again ...

What were you doing in 1986?

It was a big year in my life. I got married, hit one of those birthdays with a zero in it, watched my-then hometown Chicago Bears dominate Super Bowl XX, and picked up and moved my new bride (and our menagerie) several hundred miles south to take on a new job heading up a recordkeeping operation.

Before the end of that year, that recordkeeping operation (and, thanks to a recent bank acquisition, the seven different platforms it was running on) would be struggling to understand, implement and communicate a wide array of sweeping changes associated with the Tax Reform Act of 1986. Even though it came during a period when tax code changes (ERTA, TEFRA, DEFRA, REA), were being thrown at us about every 18 months, on average, it’s still difficult to absorb the scope and breadth of the work it took to implement the changes that came with TRA 86.

For all the work that had to go into complying with the new regulatory regimen that came with TRA 86, its real impact would come in the years that followed, via the newly established 402(g) limit (back then we simply called it the $7,000 limit), not to mention the multiple iterations of the nondiscrimination testing that often produced problematic refunds for the highly compensated group. There’s little question that those changes (and others) did what they were designed to do – generate additional tax revenue in the here-and-now by limiting the deferral of taxes.

Yes, the talk is all about tax reform, but the motivation is generally tax cuts, and with a $20 trillion debt, Uncle Sam will need to find some way to offset the projected loss in revenue – and that’s where the tax incentives to establish, fund and contribute to a workplace retirement plan inevitably find themselves in the budgetary crosshairs.

While those paying attention to such things realize that most of those tax preferences are temporary – that is, taxes will be paid on those employer, pre-tax contributions and the earnings thereon when they are withdrawn – the government bean counters look at revenues and expenditures within a 10-year window, and since the payment of most retirement benefits occurs outside that window, the amount of taxes postponed looks, from a budgetary standpoint, to be taxes permanently foregone. And, on that basis, even though the retirement preferences are completely different from other tax deductions, from a budgetary scoring standpoint, it’s a big, juicy target.

We saw what that might mean as recently as 2014 when then-Chairman of the House Ways and Means Committee Rep. Dave Camp (R-Mich.) put forth a proposal that would pay for tax reform (or at least some of it) by freezing the COLA limits that apply to defined contribution plans for a decade and limiting the annual ceilings on elective deferrals so that only half could be made on pre-tax basis (weirdly, this would have applied only to employers with more than 100 workers). The first part of the proposal was deemed to raise $63.4 billion in revenue over 10 years, the latter an additional $144 billion, by basically forcing workers who would otherwise have taken advantage of pre-tax savings to pay taxes on those contributions upfront. And let’s not forget that those burdens would have fallen particularly harshly on those who decide to offer these plans in the first place and to match employee contributions.

For those of us who remember 1986 – or perhaps the years in between that and EGTRRA – the references to TRA 86 as a model for Tax Reform 2017 are a bit chilling. Because when it comes to winners and losers in tax reform – and make no mistake, tax reform is all about winners and losers – more often than not, retirement comes out on the short end. And every time it does, it feels more than a little bit like having to bail out your brother-in-law with a loan from your 401(k) – again.

For months now we’ve been talking about tax reform, and the potential implications for retirement policy. It was a focus at this year’s NAPA 401(k) Summit, and it will be front-and-center at this year’s NAPA DC Fly-In Forum. The reason is obvious: If you’re going to lower tax rates and be revenue neutral, the money to offset those tax reductions has to come from somewhere. And traditionally, the tax preferences that foster the growth and expansion of retirement plans and retirement savings have been a “go to” source, perhaps never more so than a generation ago with TRA 86.

The road ahead could be rocky, particularly as it comes in the wake of the application of the Labor Department’s fiduciary regulation, whether delayed or not, and perhaps modified. It’s said that being forewarned is being forearmed, and we’ve certainly worked to do that over the last several months.
If you are not already, you’ll want to stay connected on these issues in the weeks ahead.

Get informed. Get involved. Before it’s too late.

- Nevin E. Adams, JD

A Pension Protection Perspective

It’s hard to believe, but the Pension Protection Act of 2006 will be a decade old next month. And it’s probably done more good for the nation’s retirement security than most realize.

The PPA drew its name from the portions targeted at shoring up defined benefit plans (and PBGC funding, I suppose), though at the time I remember most people thinking it was an ironic name, in that it may have been intended to secure the pensions that were already in existence, but might well accelerate the demise of some on the cusp, and in any event was unlikely to help spur any new growth in that area. Some went so far as to call it the Pension Destruction Act.

Indeed, at a recent panel session featuring the perspectives of a number of the Hill staffers who shepherded the at times controversial legislation through its passage, the emphasis was largely on the DB aspects that, though well-intentioned, had been overwhelmed (if not undermined) by the onset of the 2008 financial crisis and the “historically low” interest rate environment that continues to pressure pension funding to this day.

DC Developments

In contrast, the aftermath of the PPA on the defined contribution side has been nothing short of extraordinary. Sure it was all voluntary – the use of carrots like safe harbors for automatic enrollment, rather than the sticks that accompanied the DB provisions. And yet, seemingly overnight, and without a government mandate or regulatory imperative, the decades-old concept of “negative election” (now “rebranded” as automatic enrollment) became part of every credible retirement plan advisor’s toolkit.

Without relying on a mandate to impose its will, nearly overnight the paradigm on automatic enrollment shifted. Sure, it’s still far more common among larger employers than those downstream – and yet, those larger plans are where most participants are. And if the adoption of contribution acceleration has lagged behind automatic enrollment, it is nonetheless far more advanced than it would have been in the absence of the PPA.

For my money, the biggest long-term positive impact of all may have been the rapid expansion of the qualified default investment alternative (QDIA) as the plan default investment option. One need look no further than the millions of dollars in retirement savings that have been channeled into a range of professionally managed asset allocation solutions to appreciate the impact that change has had. All have significantly and positively moved the needle in helping enhance the ultimate financial security of thousands, if not millions, of American workers.

‘Staying’ Power

However, perhaps the most-overlooked, if not underappreciated, aspect of the PPA was that it made permanent the retirement savings incentives enacted under the Economic Growth And Tax Relief Reconciliation Act of 2001 (EGTRRA), including annual contribution limits for IRAs, Roth 401(k) plans, enhanced portability of retirement benefits, and reduced administrative burdens on plan sponsors. Without that support, all the gains made on those provisions would have fallen back. The PPA also made the Saver’s Credit permanent, as well as resolving legal uncertainty surrounding cash balance plans, and requiring DC plans to permit employees to diversify out of investments in employer securities if the securities are publicly traded.

The work is not done, of course. Innovative retirement income offerings continue to be introduced, but can’t seem to find traction, the focus on outcomes (these days generally under the banner of financial wellness) is still nascent, and the challenges of compliance with the DOL’s new fiduciary regulation lie ahead.

With so much progress made – and yet so much yet to be achieved – it may seem naïve in this exceedingly unusual election year to hold out hope that the nation’s legislative bodies could put their heads together and work together as constructively as they did just a decade ago.

But one can (still) hope.

- Nevin E. Adams, JD 

Connecting the Dots

One of my favorite works of art is “A Sunday Afternoon on the Island of La Grande Jatte,” by Georges-Pierre Seurat. I was introduced to this painting in college via an art appreciation class at the Art Institute in Chicago (it even makes a brief appearance in the film “Ferris Bueller’s Day Off”).

The subject matter isn’t really extraordinary―just a group of individuals scattered about a park taking in the scenery. But what amazed me the first time I got close to the painting―and does to this day―is that Seurat created these images, and the marvelous color shadings in these images, through the use of thousands (perhaps millions: the painting itself measures 7 by 10 ft.) of individual dots.

Individual retirement accounts (IRAs) are a vital component of U.S. retirement savings, representing more than 25 percent of all retirement assets in the nation, with a substantial portion of these IRA assets originating in employment-based retirement plans, including defined benefit (pension) and 401(k) plans. Little wonder that those accounts have been a focus of the pending fiduciary regulation re-proposal.

Despite IRAs’ importance in the U.S. retirement system, there is a limited amount of knowledge about the behavior of individuals who own IRAs, alone or in combination with employment-based defined contribution (DC) plans.

Consequently, the Employee Benefit Research Institute (EBRI) created the EBRI IRA Database, which for 2011 contained information on 20.5 million accounts with total assets of $1.456 trillion. When looking across the entire EBRI IRA Database, as of year-end 2011, 44.4 percent of the assets were in equities, 10.7 percent in balanced funds, 18.0 percent in bonds, 13.0 percent in money, and 13.8 percent in other assets―an allocation spread roughly comparable to that found for 401(ks) in the EBRI/ICI 401(k) database at a comparable point in time.

But when you look inside the IRA database, certain interesting aspects emerge. For example, the asset allocation differences between genders were minimal: bond, equity, and money allocations were virtually identical. Moreover, in looking across IRA types, the average equity allocation at each age group was higher for owners of Roth IRAs than for owners of other IRA types―this is perhaps not surprising when you consider that a separate EBRI analysis also revealed that individuals contributing to Roth IRAs tended to be younger. Additionally, as the most recent report reveals, balanced funds have by far the largest asset allocations among young (under age 45) Roth IRA owners.

One might not be surprised to discover that both genders’ average allocations to bonds increased with age (starting at age 25), although the average amount allocated to balanced funds decreased as the age of both genders increased after age 25―with the exception of men ages 75–84. And while equity allocations for genders peaked and then plateaued for those ages 45−54, it then proceeded to INCREASE for male owners age 85 or older.

Of course, an IRA could be only part of an individual’s portfolio of retirement assets: That’s why the goal of the integration of the EBRI databases is to be able to look at the two largest sources of retirement assets (IRAs and DC plans) to examine owner behavior across (as well as within) the accounts to provide a better understanding of the decisions Americans make with their retirement savings.

Because sometimes you need to see the big picture―and sometimes the better understanding of the big picture comes from connecting the dots.

- Nevin E. Adams, JD

The October EBRI Notes article, “IRA Asset Allocation, 2011” is online here. 

Also see “The Generation in Roth IRA Contributions,” online here. 

The Bigger Picture

Over the weekend, my daughter shared with us an insurance quote she’d received.  It had been a while since I had focused on such things, but I was struck first by how much it was.  It was for insurance in a different state, so we worked through the particulars, trying to be certain that we understood what was covered, matched that against her needs.  Ultimately, while much of the quote made sense, there were a couple of items that seemed too high.

As we probed those items, my daughter explained that the agent had made an effort to match those levels against her current coverage.  A logical enough inquiry and starting point, but one that (apparently) failed to take into account that her current coverage – as part of our family policy – would be quite different from what she needed on her own.  The agent got an accurate response to the question he asked – but it wasn’t the right question.

Individual Retirement Accounts, or IRAs, hold more than 25 percent of all retirement assets in the United States, which makes them a vital component of the nation’s retirement savings.  In fact, as an account type, IRAs currently hold the largest single share of U.S. retirement plan assets.  There are, however, different types of IRAs, and, according to a recent EBRI analysis[i], they differ in a number of ways.

For example, in the EBRI IRA Database[ii], which contains data collected from various IRA plan administrators on 20.5 million accounts, with total assets of $1.456 trillion, most of the new IRA contributions go into Roth IRAs, but most of the assets are held in traditional IRAs, where, as noted above, the money frequently originated from a rollover from other tax-qualified retirement plans (such as 401(k) plans).  In fact, the latest report from the EBRI IRA Database finds that 26 percent of Roth IRA owners contributed to their accounts in 2011, compared with just 6 percent of traditional IRA owners.

On the other hand, individuals with a traditional IRA originating from rollovers had the highest average and median (mid-point) balances ($110,918 and $31,944, respectively, compared with Roth average and median balances at $25,228 and $11,344) – and in the 2011 EBRI IRA Database, almost 13 times the amount of dollars were added to IRAs through rollovers as from new contributions.

Roth IRAs had a higher percentage of younger individuals contribute to them: 23.8 percent of the Roth accounts receiving contributions were owned by individuals ages 25–34, compared with 8.9 percent for traditional IRAs.  Moreover, Roth IRA owners were both more likely to contribute to their IRA and more likely to contribute in subsequent years – and those who are younger and own a Roth IRA were more likely to contribute to it than older Roth IRA owners.

While they account for nearly one in five of the accounts in the EBRI IRA Database, Roth IRAs represented only 7 percent of the $1.456 trillion in assets at year-end 2011.  Still, it’s easy to imagine how the trend differences highlighted above could, over time, impact key trends in terms of contributions, asset allocation, and withdrawal patterns[iii].

Research sometimes suffers from a tendency to extrapolate big conclusions from remarkably small samples.

On the other hand, the EBRI IRA database, with millions of individual account records drawn from multiple account providers, allows us to see the big picture, as well as the details that underlie, and perhaps shape, the longer-term trends.

Nevin E. Adams, JD

---

[i] See Individual Retirement Account Balances, Contributions, and Rollovers, 2011: The EBRI IRA Database.
 

[ii] The EBRI IRA Database contains data collected from various IRA plan administrators on 20.5 million accounts owned by 16.6 million unique individuals with total assets of $1.456 trillion. EBRI is building a database that will allow it to track the flow of retirement assets saved in 401(k) plans and other tax-qualified plans and transferred to IRAs and spent in retirement as people leave the work force.

[iii] The EBRI IRA Database is also unique in its ability to track people who own multiple IRAs, providing a measure of individuals’ consolidated IRA holdings. For instance, it shows that the overall cumulative IRA average balance was 24 percent larger than the unique account balance, providing a far more accurate picture of the assets held in these accounts by individuals.