How to Plan a Low-Income Retirement

Witnesses during a U.S. Senate subcommittee hearing shared issues and proposals policymakers should consider to ensure the retirement security of low-income workers.

Diane Oakley, executive director of the National Institute on Retirement Security (NIRS) in Washington, D.C., noted that with the disappearance of secure pensions, significant retirement security challenges face Baby Boomers and the upcoming generations of working families. “A sustained increase in retirement savings is needed to put all Americans on a path toward financial security,” she said.

She suggested that given Americans' low level of retirement-readiness, strengthening the Social Security safety net; expanding access to low-cost, high-quality retirement plans such as the recently announced myRA and other proposals designed to extend workplace retirement coverage at both the state and federal levels; and expanding incentives like the Saver’s Credit are important policy considerations.

NIRS data shows more than 38 million U.S. working-age households do not have retirement accounts, and most are in the bottom half of the income distribution. Among households with at least one earner, four in five have retirement savings that amount to less than their annual income. NIRS data also shows people of color face particularly severe challenges in preparing for retirement, Oakley added.

J. Mark Iwry, senior adviser to the Secretary and Deputy Assistant Secretary of (Tax Policy) Retirement and Health Policy at the United States Department of the Treasury in Washington, D.C., discussed details and the intent of the myRA proposal, noting it is a start for those who do not have access to a workplace plan (see “myRA Program Details and Intent”).

Under the myRA program, workers looking to start saving will be able to purchase a specially designed Treasury retirement savings bond held in a Roth individual retirement account (IRA). The bond will have an add-on feature, meaning that additional contributions will increase the value of a single security, instead of requiring the purchase of multiple securities. The Treasury intends to begin phasing in the myRA program by the end of 2014.

“Starting to save is only the first step toward a secure retirement, and Treasury and the administration want to help more Americans save for their future,” Iwry said.

During an initial phase, myRAs will be offered—only by payroll deduction—to employees of employers that choose to participate. According to Iwry, there is reason to expect that linking saving to an employment-based payroll deduction system could be an important step in boosting participation. He cited as an example that millions of employees bought U.S. savings bonds annually through the Treasury’s former payroll-deposit savings bond program, which for decades allowed employees to buy savings bonds through workplace-based payroll deductions.

However, Judy A. Miller, director of Retirement Policy and executive director for the American Society of Pension Professionals & Actuaries (ASPPA) and ASPPA College of Pension Actuaries in Arlington, Virginia, discussed the advantage current employer-sponsored plans have in the form of tax incentives.

Miller noted that in the Employee Retirement Income Security Act (ERISA), Congress decided to direct tax incentives for employer-sponsored plans toward coverage of substantially full-time employees. “Nearly 80% of full-time civilian workers now have access to workplace savings, so the incentives have been effective in providing coverage for the targeted group,” she said.

Miller argued the incentives are very effective at providing coverage to all income groups, due in large part to two features that set the retirement savings incentives apart from other individual tax incentives:

  • The retirement savings incentive is income deferral, not a permanent exclusion. Every dollar that is excluded from income this year will be included in income in a future year. “Unfortunately, that is not reflected in the cash basis measurement of the retirement savings ‘tax expenditure,’” she said, adding that the current methodology overstates the true cost by more than 50%; and
  • Nondiscrimination rules for employer-sponsored plans assure the plans do not discriminate in favor of highly compensated employees, and limit the amount of compensation that can be included in determining benefits and testing for nondiscrimination. “As a result, this tax incentive is more progressive than the current progressive tax code,” she contended.

Miller noted that IRAs share the incentive of tax deferral. However, if a small business owner makes a personal contribution to an IRA, there is no corresponding obligation to contribute to other employees’ IRAs. In addition, annuities purchased outside of a qualified plan share the benefit of “inside buildup”—the deferral of income tax on investment earnings until distributed from the arrangement—but have no limit on contributions or benefits, and no nondiscrimination requirements.

Citing Employee Benefit Research Institute (EBRI) data, Miller said the availability of a defined contribution (DC) plan at work is a key determinant in an individual's likelihood of having a secure retirement, regardless of his level of income. EBRI projections based on voluntary enrollment in 401(k) plans show a 76% success rate of achieving 70% income replacement for the lowest income quartile with more than 30 years of eligibility in a 401(k) plan. If automatic enrollment and auto-escalation are added to the projection, that success rate increases to 90%. The success rates for the top quartile are 73% and 81%, respectively.

“The success of lower-income workers with access to workplace savings relative to higher-income workers is due in part to the higher income replacement Social Security provides for lower income workers, and in part to the nondiscrimination rules and the limits on contributions that affect primarily higher-income workers,” Miller said. “The current system is working very well for millions of working Americans. Expanding availability of workplace savings is the key to improving the system. There is no need for dramatic changes, but measures should definitely be considered to make it easier for employers, particularly small businesses, to offer a workplace savings plan to their employees.”

In her testimony, Miller offered suggestions for how the framework for operating a small qualified plan could be simplified.

Stephen P. Utkus, principal and director of the Vanguard Center for Retirement Research in Malvern, Pennsylvania, encouraged policymakers to consider different levels of low-income workers when making proposals. Improvements in Social Security could be one way to address the concerns of workers with low lifetime earnings. For low-income workers with rising income prospects, automatic enrollment in the defined contribution system is gradually extending the benefits of these plans to workers who are covered by but not currently participating in their employer’s plan. For those with low incomes today but rising income prospects for the future, as their incomes grow, Social Security benefits will come to represent a smaller fraction of their retirement resources, and the need for private retirement savings will increase, Utkus explained.

According to Utkus, features such automatic enrollment, automatic deferral increases and automatic investments like target-date funds (TDFs) help. He added that Vanguard strongly believes all employers and workers have a third lever for influencing retirement outcomes, both when accumulating savings and in the drawdown or retirement phase—namely, costs.

“All other things equal, the lower the costs that workers bear in their retirement programs, the larger the nest egg they will accumulate during their working years, and the longer the money will last when it is spent in retirement,” Utkus stated. He noted that as a result of the plan sponsor fee disclosure regulations issued by the Department of Labor (DOL), combined with intense competition in the marketplace, both recordkeeping costs and investment costs are declining.

“On the administrative side, we are seeing substantial downward pressure on recordkeeping fees due to DOL disclosure regulations and competitive re-pricing efforts. On the investment side, we are experiencing a resurgence of interest in low-cost indexing strategies as sponsors look to ways to reduce DC plan investment costs and improve relative investment performance.”

Testimony from the hearing may be downloaded from here.