Guaranteed retirement accounts

For most of the last century, American retirement income policy supported a combination of programs—Social Security and federal tax subsidies for traditional defined-benefit pensions and for voluntary personal retirement accounts—that enabled many people to stop working and to maintain their living standards in retirement, while reducing old-age poverty rates.

But the American retirement income security system is breaking down. If current trends continue, poverty rates among the elderly will increase and middle-class retirees will find that their retirement income will not pay for the lifestyle they achieved while working. This will be the first time since World War II that the standard of living of elderly Americans declines while that of prime- age workers increases.

This reversal is due to tax and regulatory policies that fail to promote retirement savings and penalize defined-benefit plans. Regulations favor, and tax subsidies increasingly go to, the wrong kinds of retirement programs. As a result, 401(k) plans and other defined-contribution plans1 that were designed to supplement, not replace, traditional pensions are growing at the expense of defined-benefit plans that provide secure supplemental income to Social Security.

Tax breaks for 401(k) plans amounted to $110 billion in 2006, most of which went to households in the top tax brackets. These tax breaks mostly cause wealthy households to shift savings to tax-favored accounts rather than increase overall savings (Chernozhukov and Hansen 2004; Engen and Gale 2000)—thus the paradox that taxpayers are giving up more and more revenue to promote retirement savings while retirement security declines.

In fact, the Urban-Brookings Tax Policy Center found that income tax expenditures for retirement plans were actually larger than personal savings in 2003, including contributions to retirement plans (Bell, Carasso, and Steuerle 2004). This occurred despite a confluence of factors that should have boosted savings growth, including a sharp increase in the amount of money people could shelter from tax in accounts that are intended for retirement savings, an older and more educated workforce, and an economy in which the wealthy, who tend to save more, have received the lion’s share of recent income increases.

This paper proposes a rescue plan for the American retirement income security system, based on a mixed system composed of Social Security, employer defined-benefit pension plans, and a new type of personal retirement savings account called a Guaranteed Retirement Account (GRA). This rescue plan will not work without a strong defined-benefit pension system and a strong Social Security system. Tax breaks for 401(k)-style plans and IRAs will be converted into flat tax credits to offset the cost of these new accounts, so the plan will improve the retirement security of most Americans without costing taxpayers more than the current system.

The plan calls for all workers not enrolled in an equivalent or better defined-benefit pension to enroll in a GRA, a plan that borrows the best features of defined-benefit and defined-contribution plans, including guaranteed retirement benefits that last a lifetime, low administrative costs, and steady contributions. With GRAs, workers will accumulate savings in investment funds that earn a rate of return guaranteed by the federal government. These funds will be converted to life annuities upon retirement. Along with Social Security benefits, these will replace approximately 70% of pre-retirement earnings for the typical retiree.

Guaranteed Retirement Accounts eliminate the regulatory and tax law favoritism that not only gives 401(k)-type plans wide discretion and little scrutiny, but does so at the expense of the defined-benefit system. Most defined-benefit plans yield a much higher benefit than even Guaranteed Retirement Accounts, though they typically also require average contributions of over 6% of payroll for sustainability.

The Guaranteed Retirement Account plan will help reverse the slide in employer-provided defined-benefit plans. Employers who are now considering converting their defined-benefit plans to 401(k)s to save money will find that option much less attractive without tax benefits, and will therefore be more likely to retain their defined-benefit plans. Meanwhile, employers currently offering 401(k)s as a recruitment and retention tool may switch to defined-benefit plans, since particular employers cannot distinguish themselves by offering Guaranteed Retirement Accounts (as with Social Security).

The first section of this paper describes GRAs. The second and third sections provide an overview of the current system and describe how it increasingly fails to meet 10 standards of a good retirement security system. The fourth section explains how the Guaranteed Retirement Account plan would address these failures, and the fifth answers questions about the plan. The final section compares the plan to other reform ideas, such as auto 401(k) enrollment and raising the retirement age.