The federal government's appetite for more revenue to feed an expanding federal budget threatens to jeopardize retirement income security.
President Barack Obama's budget proposal and the ambitious tax-code restructuring proposed by Rep. David Camp, R-Mich., have some common ground in limiting retirement savings.
Both would target high wage earners and high retirement plan savers. Both also would undermine the goal of expanding retirement plan coverage and the accumulation of retirement assets.
Mr. Obama's proposal, similar to one he introduced last year without success, would aggregate each participant's retirement plan assets — defined benefit, defined contribution and individual retirement account — and limit the combined tax-exempt accumulation to one that would allow a maximum annual retirement benefit equivalent of an annuity payable at $205,000. Based on current annuity rates, that would allow for a maximum combined accumulation from all plans of $3.4 million.
In addition, the president's proposal would limit the rate at which taxpayers can reduce their tax liability for retirement-related contributions to 28%. That limit would affect a participant or couple earning, respectively, more than $183,000 or $225,000.
Mr. Camp seeks to steer contributions to bring in more federal revenue upfront from defined contribution plans and IRAs.
One part of his proposal would subject all contributions to defined contribution plans by people in the 35% tax bracket to a 10% surtax, as well as continuing to tax retirement plan distributions.
The 10% surtax would give participants an automatic loss on their contributions, requiring them to earn back an even larger amount in investment return — an 11.1% return — just to break even on their contributions before they can start to build the assets based on them.
That return is quite a hurdle to overcome, higher than the historical rate of return on the equity market and higher than the assumed rate of return on defined benefit plans. That financial burden would have caused a devastating setback in the last few years of the last decade as participants tried to climb back from investment losses during the financial crisis that wiped out some 30% or more of their defined contribution assets.
In addition, Mr. Camp's proposal would allow up to $8,750 — half the current contribution limit — to be contributed to either a traditional or Roth plan, whether an IRA or defined contribution. Any larger contribution would have to be dedicated to a Roth plan. Roth plan distributions would continue to be tax free during retirement. The change would affect few participants, according to Mr. Camp, whose figures show almost 85% of plan participants contribute less than $8,750 to retirement.
The greater tax attention directed at the high wage earners serves the federal government's goal to raise more revenue but does nothing to bolster retirement assets of participants below the upper bracket wage level. At the same time, it adds to the administrative complexity of employer-sponsored plans, subjecting all participants, high and low earners, to the reduction in corporate resources and support for pension program contributions.
Down the road, the proposals could affect more than the small set of participants they are estimated to affect now, especially as interest rates and incomes rise.
In a 2013 study of the president's previous proposal, the Employee Benefit Research Institute, Washington, estimated more than 10% of 401(k) participants, assuming no defined benefit accruals, “are likely to hit the proposed cap sometime prior to age 65, even at the current historically low discount rate of 4%.”
At a higher discount rate closer to historical averages, “the percentage of 401(k) participants likely to be affected by these proposed limits increases substantially,” the study notes. With the addition of 401(k) participants who also have defined benefit plans, nearly one-third could be affected by the proposed limit at an 8% discount rate.
Participants who have built retirement assets did so by following rules, not through any abuse. They were doing what the government wanted them to do. In addition, defined contribution and other retirement programs are tax-deferral plans, not tax-avoidance plans. Taxes that are deferred now will be paid by participants as defined benefit pensions are paid out and as assets in defined contribution plans are withdrawn.
Mr. Camp's surtax would impose a double taxation on contributions, going into the plans and coming out.
In calling for the tax-favored treatment of $200,000 in annual retirement income, Mr. Obama in his proposal states the amount is “substantially more than is needed to ensure a secure retirement.”
The National Associate of Plan Advisers, an affiliated organization of the American Society of Pension Professional and Actuaries, points out Mr. Obama's own presidential pension value is $5 million, more than 40% higher than the total allowed for private-sector participants.
Mr. Obama's proposal would add to administrative complexity of aggregating all retirement programs and coordinating contribution limits. That complexity also would add to employer and IRA trustee expenses. That cost would likely be passed down in one form or another to participants through lower contributions or higher fees.
Mr. Obama, Mr. Camp and Congress should focus on the challenge of bolstering pension plan coverage and retirement asset accumulation.
Mr. Obama's MyRA retirement plan takes a step in that direction for employees without coverage. It should, however, provide an opportunity for participants to earn a better return. His proposal now provides for no risk of loss but offers no chance for gain above a small percentage. It would earn the same return as the Thrift Savings Plan's government securities investment fund, which was 1.89% last year. Participants should be conditioned for the risk-and-return trade-off, which provides a better chance to build assets for retirement. The president also should map allocations to low-cost index funds like those available in the Thrift Savings Plan.
Mr. Camp should leave the retirement plan tax benefits unchanged in his tax-reform efforts. Strengthening retirement savings will help the economy by providing money for capital investment. It will ultimately ease some of the strain on the Social Security System, and if it is strong enough, it would make Social Security reform politically possible. n