Policymakers should focus on improving participation rates in retirement plans

A recent report titled “The Missing Middle – How Tax Incentives For Retirement Savings Leave Middle-Class Families Behind” from the National Institute on Retirement Security (NIRS) makes the argument that the country’s approach of providing tax deferral as an incentive for retirement savings may be working for higher-income individuals but not so well for lower- and middle-class workers. The analysis tackles a broad range of tax and benefit policy shortcomings and provides the following major conclusions:

• Social Security does a lot to prevent old-age poverty but could do more to protect the middle class.
• Tax expenditures and incentives for retirement savings are heavily skewed toward those at higher income levels, with the middle class having relatively weak tax incentives.
• Geographic and racial inequities in retirement savings are exacerbated by the inequality of tax expenditures and incentives for higher income levels.

The Missing Middle report proposes solutions it says are needed to combat the inequalities it suggests. For example, the report proposes higher Social Security income replacement rates for the middle class, eliminating the income tax deduction approach for incentivizing retirement savings and replacing it with refundable tax credits, improving access to retirement plans through state-facilitated “Secure Choice” type retirement savings plans for private-sector workers who are not offered an employer-based plan, and general curbing of so-called retirement savings abuses that allow individuals to transfer wealth between generations – e.g., when the SECURE Act of 2019 increased the start age for required minimum distributions from 70.5 to 72.

The report’s focus on tax expenditure differences between the income classes leads to an “inequality” and “unfairness” discussion that ignores several points.

First, high-income cohorts are being cast as benefitting unfairly under a tax system that takes more from them both in dollars and as an effective tax rate, even after all tax deductions are considered.

Second, the report ignores that individuals can and do move between income tax brackets through their working years, with many choosing to backload their retirement savings when they are older and earning more income. Shouldn’t it be good to provide tax incentives to help that happen? 

Third, the analysis ignores that tax incentives provided for retirement benefits are capped under the Internal Revenue Code (IRC). For 2022, IRC Section 415 limits defined benefit pension benefits to $245,000 in 2022, and defined contribution plan annual contributions are limited to a maximum of $61,000. These caps effectively limit the amount of tax benefits that can accrue to any individual from retirement plans.

Fourth, the analysis ignores the fundamental purpose of a retirement plan is to provide an appropriate amount of income replacement during retirement years at all income levels, which are typically defined in the retirement industry as being between 70% and 90% of pre-retirement income. The federal tax incentives for both defined benefit and defined contribution plans allow these employer plans to provide different retirement benefits for different compensation levels to help achieve these income replacement targets. Essentially, these plans are doing what they are designed to do. Should we abandon this concept?

Lastly, the NIRS report’s focus on tax expenditure inequality distracts from more critical actions that can be taken to improve financial security in retirement, the most important of which is increasing the level of meaningful participation in available employer and individual retirement benefit and savings plans.

The Bureau of Labor Statistics reported in 2021 that 68% of private industry workers had access to retirement benefits through their employer, with 51% choosing to participate. In contrast, 92% percent of workers in state and local governments had access to retirement benefits, with 82% participation. The take-up rate—the share of workers with access who participate in the retirement plan—was 75% for private industry workers and 89% for state and local government workers. Why the difference? 

The most significant factor is mandatory participation. Most state and local government plans do not give employees a chance to not participate in their retirement. Another key design feature is that most state and local government plans require mandatory pre-tax employee contributions. Private sector employers generally are not eligible to offer 414(h)(2) contribution features. Instead, most use pre-tax 401(k) options for voluntary employee savings. The voluntary nature of employee retirement savings accounts for most of the participation gap in our retirement security policy in the private sector. 

To try to rectify the participation gap, the U.S. has already added multiple complex layers of tax and Employee Retirement Income Security Act (ERISA) provisions to try to create incentives for increasing voluntary participation in retirement plans, including useful auto-enrollment and automatic savings plan design solutions. And yet, we still have the participation gap noted previously.

The use of tax expenditures as a tool for shaping the behaviors of individuals can reasonably be questioned. It is a blunt instrument that often does not work well to further desired results. However, taking away tax incentives is not likely to help lower- and middle-class workers, and providing more tax incentives through refundable tax credits would further distort an already distorted tax system. Focusing on tax expenditure differentials distracts from some of the more effective approaches policymakers could take for improving retirement security, such as incentivizing participation, auto-enrollment, and automatic savings solutions.