President Bush has proposed, as part of his economic stimulus plan, allowing taxpayers to exclude from taxable income dividends paid by corporations. This would eliminate the "double taxation" of corporate dividends, which is good. But the approach the administration has taken creates some significant problems for pension plans and ultimately is inequitable.
Let's begin with the broad economic effects of excluding dividends from income. Because returns on stock would be more valuable as a result of such a change, stock values will go up and pre-tax returns will go down - in the same way that municipal bond returns are lower than returns on corporates. After-tax returns, of course, will also go up - for taxpayers. But pension plans aren't taxpayers, so returns on equities for pension plans will, in real life, go down.
Defined benefit plan sponsors will have to face the fact that lower earnings on equity investments will force them to put more money in the plans than they had anticipated or take more risk than they had been comfortable with.
Similarly, 401(k) plan sponsors will have to revise their asset allocation and participant education and advice models to take this new fact - lower equity returns - into account. The gap between how much money a participant needs to retire and what he or she will have at retirement (based on current savings and asset allocation) will widen. And participants, like defined benefit plan managers, either will have to save more or take more risk to achieve their goals.
Most lower- and middle-income Americans depend on an employer-sponsored retirement plan to meet their retirement goals - nowadays, typically, a 401(k) plan. This group will get nothing from the Bush proposal. Indeed, they will suffer a loss because the equity returns previously available to them will go down. But it gets worse: Because plan distributions are fully taxable to the recipient, participants will wind up being one of the few groups that continues to pay taxes on dividends. Thus, earnings on stock held in retirement plans will remain subject to double taxation - once at the corporate level and again when distributed to participants.
Let's note some mitigating factors. If the proposal were adopted, the transition to this new tax system would provide a one-time gain - in increased stock values - to all stockholders, including pension and 401(k) plans. Deprived of the tax advantages available to taxpaying stockholders, retirement plans will seek equity and risk premiums in other vehicles - junk bonds, limited partnerships and real estate. And perhaps crafty investment bankers will come up with ways to sell to taxpayers "dividend-only strips" on equities held in retirement plans.
The fact remains, however, that returns on plan assets will go down, and those participants whose only savings vehicle is a 401(k) plan - typically lower- and middle-income employees -will be one of the few groups continuing to pay taxes on corporate dividends. This cannot be the right answer.
Michael P. Barry is president of Plan Advisory Services Group, Chicago.