Tax reform efforts put retirement plans at risk

As Washington policymakers turn their attention to tax reform, plan sponsors and retirement lobbyists are becoming increasingly concerned that the tax advantages of retirement savings are in real danger.

"My biggest concern is that they just reflexively look at the retirement system as a way to pay for it. Anybody who assumes they won't ignores history and ignores practical reality," said Lew Minsky, president and CEO of the Defined Contribution Institutional Investment Association, Washington.

While this latest tax reform effort might not be as dramatic as the 1986 overhaul that capped tax deductions for employee retirement contributions, negotiators will be looking "where they feel they have the​ least political pain," he said.

DCIIA is part of Save Our Savings, a broad industry coalition formed to prepare for the coming tax reform battle that congressional leaders have pledged will get underway in September.

When the White House unveiled a tax reform plan in April, National Economic Council Director Gary Cohn and Treasury Secretary Steven Mnuchin promised that deductions for retirement savings would be protected while other deductions would be sacrificed to pay for lower tax rates as well as tax code simplicity.

That mild reassurance has since been overtaken by growing alarm, with the White House and congressional leaders and staff members stopping short of echoing that promise. The most recent cause for worry were remarks at a July 31 Washington event by White House Legislative Affairs Director Marc Short, who said the tax advantage of retirement plan contributions is still under discussion.

Senate Finance Committee Chairman Orrin Hatch, R-Utah, a key player in tax reform talks who has promised a "robust" process with multiple hearings, is considered a champion of retirement savings but has declined to comment on specific approaches. Other tax reform players in the House and Senate "are very open to keeping everything on the table," warned one benefits lobbyist.

The trick will be keeping Republicans' pledge to make tax reform revenue neutral, instead of adding to the federal budget deficit. Reducing individual tax rates alone will cost $2.6 trillion over a decade, according to the Tax Policy Center in Washington, which estimates retirement contribution tax deferrals will cost $187 billion in 2017.

Congressional tax reform negotiators will use Joint Committee on Taxation projections that retirement contributions cost $584 billion in lost tax revenue between 2016 and 2020.

That makes big-ticket revenue drains like retirement savings — at least when they are counted within Congress' 10-year budget window — hard to resist. It is also a political calculation: In addition to being one of the largest tax expenditures, retirement plan contributions benefit higher-income workers the most, with 84.8% of the tax benefit going to the top 40% tax bracket, according to the Tax Policy Center.

Ideas now being considered to recoup some of that tax revenue range from freezing annual contribution levels and limiting the tax advantage to a small portion of contributions; a hybrid approach with a lower tax benefit for pre-tax and more for post-tax Roth accounts, to a mandate that all contributions be made to Roth accounts, where taxes are paid upfront.

"It is not unthinkable that it will lead to Rothification," said Ken Raskin, a partner at law firm King & Spalding in New York and board chairman of the Plan Sponsor Council of America. He also sees the possibility of a hybrid approach.

A PSCA employer survey released in June to help inform members of Congress found that if tax reform reduces pre-tax savings limits, as it did in 1986, 85% of plan sponsors are likely to continue offering plans. But if Congress switches to a Roth-only approach, that number would drop to 70%.

"I hope we never get there," Mr. Raskin said.

The tax revenue deferred from retirement savings is particularly attractive to tax reform negotiators, given the boom in automatic enrollment and auto-escalation following changes made to the 2006 Pension Protection Act.

"PPA tried to remove some of that complexity, and now it's back to more complexity," said Dennis Simmons, executive director of the Committee on Investment of Employee Benefit Assets in Washington, whose members are chief investment officers of more than 100 Fortune 500 companies managing $2 trillion in corporate retirement plan assets. "It's just a huge question mark that's been thrown into the mix. I think we are in uncharted waters," he said.

CIEBA members also worry about how plan participants will respond to any tax changes.

"At a minimum, there's going to be complexity. From a behavioral standpoint,whenever there is confusion, there is a real danger that participants throw up their hands and say, 'I am out,' " Mr. Simmons said.

About a fourth of CIEBA members do not offer Roth options.

If a tax deal shifts the focus to Roth contributions, the tax treatment will change for plan participants but not for sponsors' matches, so "it is on the backs of participants. The bigger question, is how do they respond?" Mr. Simmons said.

A shift toward Roth plans in whole or in part could also lead to more leakage of retirement assets from plans, said Mr. Minsky of DCIIA. "The Roth model has very little in the way of a backstop to keep people in the system, so I worry it could leak out."

Charlie Nelson, CEO of retirement for Voya Financial, New York, hopes that Congress will consider the impact on individuals saving for retirement before making major changes.

"A hybrid 401(k)/Roth will be complex for all constituents" and could make sponsoring retirement plans more expensive, he said. "We have a coverage issue in America. The government needs to look at how to promote coverage."

Will Hansen, senior vice president of retirement policy for the ERISA Industry Committee in Washington, said even if tax reform shifts the emphasis to Roth plans, individual tax advantages and employer matches still make an attractive benefit. But if it gets too complicated or less popular with employees, "companies may want to evaluate how they allocate their benefit dollars," and consider other benefits such as health savings accounts and student loan assistance.

Mr. Hansen, noting what happened to the tax advantages of retirement savings in 1986, added: "I think history shows that it's the most vulnerable out there."