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With Washington targeting incentives that have made workplace retirement plans so popular, investors may be left asking, Is this smart policy?
With the political season upon us, it’s raining proposals on both sides of the aisle, some of which would change our retirement system if enacted. A few of these proposals suggest further limiting retirement accumulations and deductions as a way to help reduce the federal deficit. Under these scenarios, corporations would lose tax deductions for retirement contributions and individuals’ maximum retirement accumulations would be capped.
Perhaps such proposals have merit; however, before the debate begins, let’s make sure we remember how our retirement system works, and the incentives upon which it is built that encourage employer and employee participation. It is my view that policy makers often lose sight of these fundamental elements as they formulate retirement proposals.
Unlike some other countries that mandate workplace retirement contributions, our retirement system is voluntary, with the exception of the Social Security safety net. What, then, are the carrots that motivate private-sector business owners to establish and maintain workplace retirement plans?
Contributions by business owners are tax-deductible
Contributions to qualified retirement plans are fully tax deductible, with no cap on eventual accumulations. This incentivizes business owners to make qualified retirement plan contributions because they receive deductions on their tax returns for contributions they make on behalf of themselves and employees. Of course, federal tax rules impose deduction limits, and there are strict nondiscrimination rules that require all eligible employees receive the contributions, not just the business owners. But the bottom line is the more employers can set aside for their employees, the greater their motivation because it means more money they can set aside for themselves.
A safe harbor from onerous testing requirements
Another carrot cropped up as a result of the Small Business Jobs Protection Act of 1996, namely, the special safe-harbor rules for 401(k) plans. Essentially, in return for mandatory employer contributions made to employees within a safe harbor 401(k) plan design, employers benefit from less stringent compliance testing. Safe harbor plans were later expanded by the Pension Protection Act of 2006 by adding an automatic enrollment option. The safe-harbor option was a huge success with tens of thousands of businesses adopting them, resulting in additional contributions for employees. 21% of 401(k) plans use some sort of safe-harbor contribution design according to the Plan Sponsor Council of America's 58th Annual Survey of Profit Sharing and 401(k) Plans.
Unintended consequences of changing workplace retirement plans
With these carrots in mind, let’s evaluate some of the recent proposals within the framework of how our retirement system actually operates.
- What if Congress and the president eliminated the ability to deduct retirement plan contributions from taxes? Well, there goes one carrot. Most businesses would not be inclined to make nondeductible contributions. That means less money going into workers’ retirement accounts.
- What if the administration capped retirement accumulations at a certain level? My guess is, if business owners couldn’t continue to grow their own retirement accounts, they would be less likely to contribute to their employees. There goes another carrot.
Reduced employer contributions, less access to retirement programs at work and worse retirement outcomes: These are the unintended consequences when policy makers overlook the fundamentals of the U.S. retirement system. The more we know about how our retirement system works, the more easily we can recognize whether proposed changes represent good policy or a potential threat.