President Barack Obama's federal budget proposal to restrict accumulations in retirement programs would, if enacted, affect in a direct way only a very few participants, but would undermine the pension system and hurt all participants in it.
The proposal would, for the first time, aggregate each individual's retirement plan arrangements — defined benefit and defined contribution plans as well as individual retirement accounts — and limit the maximum combined tax-exempt accumulation to a currently estimated $3.4 million. That total is designed to permit, under current rates, a maximum annual retirement benefit equivalent to an annuity payable at age 62 of $205,000.
An administration analysis of the proposal reasons that at present “such accumulations can be considerably in excess of amounts needed to fund reasonable levels of consumption in retirement, and are well beyond the level of accumulation that justifies tax-advantaged treatment of retirement savings accounts.”
Once a participant reaches the limit, the proposal would prohibit further tax-exempt contributions or accruals.
The administration rationalizes the proposal by noting it will raise revenue to reduce the deficit and promote fairness in the distribution of the costs of government among different income levels.
Retirement programs, however, are tax-deferral plans, not tax-avoidance schemes. Taxes that are now deferred eventually will be paid as defined benefit pension benefits are paid out and assets in defined contribution plans are withdrawn.
Some participants pay income taxes now on their retirement contributions through their participation in Roth 401(k) plans, sponsored by their employers, and through Roth IRAs.
The proposal appeals to the administration because it provides a way to raise revenue without directly raising taxes. Pension plans and defined contribution plans, including 401(k) and 457 plans, attract attention as tempting, untapped sources of revenue because of the trillions of dollars in assets they have accumulated and the flow of billions of dollars annually in contributions into them.
The administration's restrictions would in no way bolster the retirement security of lower-income participants.
The challenge in retirement programs is not that employees are saving too much, it is that they are contributing too little, or not participating at all, while many employers don't offer retirement plans.
The administration should focus on bolstering the retirement security of lower-level income participants and employees who lack coverage. It should scrap its proposed restrictions on retirement-plan accumulations. It is a bad idea, and it is unlikely to get through the current Congress.
But with the administration offering this proposal, the question is how employers and participants will respond, and whether it might give some other Congress unfortunate ideas — ideas about raiding pension savings, as the government of Argentina has done.
The proposal puts more risk on to individual participants because it won't allow participants to build assets as a cushion against a market decline, economic downturn, job loss or sponsoring company financial trouble.
Adverse markets can devastate defined benefit and defined contributions plans. In the financial market crisis, many participants lost half or more of their 401(k) assets. If the limits had been in force in 2008, those close to retirement whose retirement accounts had reached $3.4 million and been capped would have had to retire on half the amount they expected.
In addition, the estimate of the assets needed for that $205,000 annuity is a moving target. Depending on interest rates, it would change. Interest rates are very low now. But as they rise, the amount of assets need for such a hypothetical annuity would decline, putting more participants above the accumulation limit.
The proposal will add to the complexity of administering retirement programs. Plan sponsor employers and IRA trustees would have to report each participant's account balances as of the end of every year, as well as any contributions to each accounting during that year. That year-end reporting would determine the ensuing year's contributions.
The proposal doesn't detail the complexity involved. Many participants have worked for a number of employers, participating in multiple defined benefit or defined contribution programs and often both. These participants have accumulations from a number of plan sponsors that would have to be taken into account in the aggregation.
It will be a challenge under the proposal to aggregate all retirement programs and coordinate contribution limits. That aggregation and coordination would add to sponsoring employer and IRA trustee expenses. Those cost likely would be passed on to all participants either through lower contributions or raised fees.
Added complexity was one factor that contributed to the decline of defined benefit plans. It could now contribute to some employers trimming their employee benefit packages, hurting participants. The administration needs to concentrate on expanding coverage and getting participants to save more, not save less.
In 1986, when Congress limited the tax-deferred pension that could be paid from a defined benefit plan, essentially cutting top executives out of such plans, a wave of defined benefit plan terminations ensued. A similar limit on total accumulations, which will affect top executives most, could cause those executives to fold their companies' retirement plans.
Despite the growth of defined contribution plans, many employees have been left behind. With about half of employees having no workplace retirement program, the administration should focus on addressing concerns about expanding pension program coverage — and encouraging participants to contribute more to their plans — rather than attempting to raise revenue early from tax-deferrals that participants eventually will pay.
The administration's budget proposal, to its credit, “would automatically enroll employees without employer-based retirement plans in IRAs through payroll deposit contributions at their workplace” and matched by a tax credit for eligible families. The proposal makes contributions voluntary, allowing employees to opt out. The proposal would provide tax credits to small employers to defray administrative costs in setting up these plans. In addition, the proposal would double the existing tax credit for small employers to set up qualifying retirement plans.
But that small positive does not offset the potential damage caused by the proposed retirement income cap. n