Chiseling Away at the 401(k)…

The drumbeat to “fix” the 401(k) seems to be starting a little earlier this year—though the cures seem more likely to kill the patient.

The latest ran in the Wall Street Journal recently—a column by Spencer Jakab innocuously titled: “Is America’s Favorite Retirement Plan Broken?” Ironically, in the print edition, it was more accurately titled “Chiseling Away at The Aging 401(k)”—for that is surely what the author has in mind.

To do so, he has to gloss over certain facts (that tax benefits encourage not only participant behavior, but the decisions of employers to sponsor plans), ignore some realities (that tax benefits encourage not only plan creation, but matching contributions, and that nondiscrimination rules keep those in balance), and embrace the accounting myopia of government scorekeepers (that under the current system taxes are deferred, not foregone). Buckle up.

He’s apparently been sold on (or wants you to buy) the notion that the tax benefits of the 401(k) go largely to the rich, and so, with the enthusiastic myopia of those who don’t seem to have any real appreciation for how the system actually works, he throws in with the “equalization” proposal recently (re)floated as something of a trial balloon by the Biden campaign. It’s a proposal that purports to “fix” the perceived inequities of the current tax incentives with a government tax credit. 

The notion is not simple, but its approach is simplistic; looking only at the tax benefits attributed to employee deferrals, the argument goes that the benefits of a tax deferral go primarily to individuals who pay taxes, and that those who have higher incomes (and pay higher taxes) benefit more than do lower-income workers. Instead, the argument goes, the government should just hand everyone a tax credit of an identical amount as a replacement—a flat credit that would, therefore, be proportionately of more value to lower income workers. This author even manages to get Alicia Munnell, director of the Center for Retirement Research at Boston College, on board for the “ride,” conceding (assuming she’s accurately quoted) that such an arrangement would be “more equitable.”

Really?

I’ve noted before the underlying myopia in the argument—that the incentives apply not only to the behavior of workers, but—and significantly—to the motivations of those who not only sponsor those plans, but who make matching contributions to those programs—employers who, spared the need to worry about counterweights like non-discrimination limits—might well rationally decide to forego or to cut back on those contributions. While proponents of the so-called “equalization” path discount or disregard out of hand such possibilities, those implications were captured a decade ago in a survey of employers, and the impact quantified by the non-partisan Employee Benefit Research Institute (EBRI).    

Deferred, But Not Forever

There are, however, more fundamental shortcomings in the so-called “equalization” argument. It ignores that the deferral of taxes is just that—a deferral, not a forbearance. While there is certainly a benefit to deferring the payment of taxes, only in the world of government accounting is the deferral of taxes the same as handing out a tax credit. Those trillions of dollars that Americans have set aside for retirement will, and in fact, are already, being withdrawn—and taxed—to fund retirement living. Presumably that “revenue neutral” tax credit is so only within the 10-year budget window that government beancounters use.

But working Americans aren’t just deferring taxes on pay they decide to set aside for retirement—they’re also getting the benefit of not only receiving matching contributions, but not paying taxes on those matching contribution dollars until they are withdrawn. Think about it—in 2019 the Plan Sponsor Council of America found that company contributions averaged 5.2% in 2018. Now, equalization proponents blithely (and naively) assume that those contributions would be unimpacted by their radical proposal—but the reality is that tax benefits of the current system extend there as well—benefits, both in the dollar value of the match, and the deferral (still only a deferral, mind you) that are completely ignored by equalization proponents in their “analysis.”

Match ‘Less?’

There’s another significant aspect of the current system that is overlooked by “equalization” proponents, not only the dollar value and the tax benefit of those matching dollars—but their very existence. Because of the non-discrimination rules that apply to contributions to employer-based plans, employees who are not “highly compensated” may get significant employer contributions even though they are not contributing on their own behalf. That’s right, and those contributions don’t show up on their W-2s—or in the “analysis” of the tax benefits of these programs. Those non-discrimination tests not only foster the level, the very existence, of those employer contributions, but also work to ensure that a certain balance is maintained between the contributions made by the non-highly compensated and the contributions allowed to the highly compensated. 

Indeed, if those “upside-down incentives” were the only forces at work, one might reasonably expect to find that the higher the individual’s salary, the higher the overall account balance would be, as a multiple of salary. However, drawing on the actual administrative data from the massive EBRI/ICI 401(k) database, and specifically focusing on workers in their 60s (broken down by tenure and salary), EBRI Research Director Jack VanDerhei has found that those ratios hold relatively steady. In fact, those ratios are relatively flat for salaries between $30,000 and $100,000, before dropping substantially for those with salaries in excess of $100,000. 

The article asks if America’s favorite retirement plan is broken—to which my response is, “not yet.”