Fidelity Senior Vice President for Policy Development and Market Planning Pamela Everheart will speak on the subject of “The impact of financial guidance on plan participants.”  Sue Guerzon will also join us to provide a guided tour of some of Fidelity’s online educational tools.

If you plan on coming please RSVP. Coffee, juice, and pastries will be served. Please feel free to pass this along to others who you feel might be interested in attending.

The purpose of the Forum is to bring together academics, interested industry professionals, policy wonks, and government staffers who work on issues related to Social Security, pensions, savings, and general retirement issues for a monthly seminar and an annual half-day conference. More information is available at savingsandretirement.org.

Few previous studies have explored whether defined contribution retirement saving plans offer sufficiently diversified investment menus, though it is likely that these menus significantly shape workers’ accumulations of retirement wealth. This paper assesses the efficiency and performance of 401(k) investment options offered by a large group of US employers. We show that the majority of plans is efficient compared to market benchmark indexes. Three performance measures underscore the fact that these plans tend to offer a sensible investment menu, when measured in terms of the menus’ mean-variance efficiency, diversification, and participant utility. The key factor contributing to plan efficiency and performance is the particular set of funds offered, rather than the total number of investment options provided. We conclude that, in 401(k) arena, “more” is not necessarily “better.”

Link to Paper

Automatic 401(k) plans are beneficial to workers on several levels. First, they start workers on a saving path earlier than they otherwise would. With automatic enrollment, participation in 401(k)s increased
from 75 percent to as high as 90 or 95 percent of newly eligible employees (Madrian and Shea 2001); the change was highest among lower-income and minority workers. Second, workers will generally be
invested in more appropriate and diversified funds in automatic 401(k)s than if they invest on their own. Third, contributions to 401(k) plans are generally tax-preferred relative to saving outside of 401(k)s because contributions to 401(k)s are tax deductible.

This paper provides estimates of the effects – on federal revenue and the distribution of after-tax income – of a policy under which all 401(k) plans in the U.S. were converted to automatic 401(k)s. In recent years auto 401(k)s have become more prevalent, in part due to the passage of the Pension Protection Act (PPA) of 2006, which provided new incentives for automatic 401(k) plans and addressed several employer concerns regarding automatic 401(k)s. Between
2006 and 2007, the number of employers offering automatic enrollment
increased from 26 percent to 44 percent among surveyed employers.4 The paper should play an important role in helping policymakers, analysts, and pension administrators evaluate the merits of automatic 401(k)s.

Due to the preferred tax treatment of 401(k) contributions, federal income tax revenues are expected to decline with the increase in 401(k) participation – generated through higher enrollment rates and higher contribution rates. In addition, automatic 401(k)s will differentially impact workers at different income levels. Workers with higher marginal tax rates will receive a larger reduction in tax when they contribute to 401(k)s than workers with lower marginal tax rates.
On the other hand, in practice, automatic features in 401(k)s disproportionately increase enrollment for workers with lower-income, who face lower marginal tax rates. Furthermore, the default contribution rates were, for some workers, lower than what they may have chosen in the absence of automatic features, which lower both their level of tax benefit and the revenue loss.

We find the revenue costs to be modest over the ten-year budget window, particularly in relation to the revenue cost of providing saving incentives through employer-sponsored retirement saving plans. The revenue loss from making automatic enrollment in 401(k)s universal and implementing a default contribution rate is between $3.5 billion and $6.9 billion per year, and with losses between $35 billion and $69 billion over fiscal years 2008-17. The higher revenue estimates are associated with a model that includes the escalation of the
default contribution rate over time.

We find that the distributional effects of making automatic enrollment in 401(k)s universal and implementing a default contribution rate are progressive relative to the current system. Specifically, we find the proportion of the benefit going to taxpayers in the bottom four income quintiles – taxpayers in the bottom 80 percent range of the income distribution – is larger than their share of the overall tax burden.

Section I describes the Automatic 401(k) proposal. Our modeling procedure is described in Section II. Section III presents and discusses the central results. Section IV concludes.

Link to Paper

The Social Security benefit formula has incorporated some measure of progressivity almost since the program’s inception. As early as 1939, amendments to the original Social Security Act stipulated that monthly benefits replace a higher proportion of preretirement earnings for people with lower earnings compared with those with higher earnings (Martin and Weaver 2005). Throughout the program’s history, benefit adequacy—promoted through a progressive benefit formula—has been balanced with equity, the goal that benefits increase with contributions.

Although the Social Security retirement system is designed to replace a higher percentage of earnings for lower-income workers and their dependents,¹ the degree to which the program actually achieves progressive outcomes is less certain. To contribute to our understanding of this issue, this paper introduces a new measure—a progressivity index—to estimate the progressivity of the Social Security retirement program. Our purpose is to develop a comprehensive, easy-to-understand summary measure for evaluating the magnitude of progressivity under Social Security within cohorts and for assessing potential shifts in systemwide progressivity as a result of policy changes.

Social Security progressivity can be described in various ways. For the purposes of this paper, we define progressivity as the degree to which benefits are higher relative to lifetime payroll contributions for lower contributors than for higher contributors. This definition can be related to Musgrave and Thin’s note (1948) regarding the income tax:

It is generally agreed that a rate structure is progressive where the average rate of tax (i.e., tax liability as a percentage of income) rises when moving up the income scale; proportional where the average rate remains constant; and regressive where the average rate falls with the rising income.

Progressivity under the Social Security program, which both levies taxes and provides benefits, is necessarily more complex than for income taxes. While this paper’s definition of progressivity is just one approach, and others have merit, the definition used here appears to be consistent with Social Security’s program design.²

The progressivity index compares the distribution of the present value of lifetime benefits to the distribution of the present value of lifetime taxes. We apply this index to microsimulation data from the Social Security Administration’s (SSA‘s) Modeling Income in the Near Term (MINT) model and estimate progressivity under the program for those born between 1926 and 2017.³ Results indicate that Social Security is modestly progressive on a lifetime basis; currently, the program lies approximately halfway between paying a benefit directly proportional to lifetime taxable earnings and paying a flat dollar benefit to each retiree. Although the program’s progressivity has declined in recent decades, it is projected to remain roughly constant in the future, according to the index. Overall, the paper extends previous research by introducing a comprehensive, easy-to-understand summary measure that can evaluate Social Security’s progressivity among current and future retirees or as a result of policy changes.

The paper begins with a review of the methodological techniques often used to measure progressivity under the Social Security program. We then introduce the progressivity index, describing how the index is calculated and how results can be interpreted. Next, the progressivity index is applied to MINT data of the Social Security population. The magnitude of progressivity under the current Social Security program is estimated and compared with two stylized hypothetical programs with high and low progressivity. This is followed by an examination of progressivity for future retirees. To demonstrate the index’s potential utility in evaluating policy changes, the final section calculates the effects of several commonly cited Social Security policy changes on the system’s progressivity.

Link to Paper

by Petra Todd and Viviana Vélez-Grajales
WP 2008-193
Chile has been at the forefront of pension reform, having switched in 1980 from a pay-as-you-go system to a fully funded privatized accounts system. The Chilean system served as a model for reform in many other Latin American countries and has also been considered by U.S. policy makers as a possible prototype for social security reform. Some of the criticisms of the Chilean system are low coverage rates and contributions rates among certain segments of the population. In 2006, the Chilean government proposed some reforms aimed at increasing coverage and contribution rates and expanding the safety net provided by the system to poor households. This study evaluates how changes in pension system rules affect working behavior and pension contribution patterns using data from a new Chilean household survey administered in 2002 and 2004 linked with administrative data from the pension regulatory agency. It develops and estimates a dynamic model of decision-making about working in the covered or uncovered sectors of the economy and studies implications for pension accumulations. The estimated model is used to simulate behavior under different pension system rules, such as a change in the number of years of contributions required for the minimum pension or a change in pension plan fees.

Link to Paper

by Irena Dushi and Marjorie Honig
WP 2008-201
We use information from Social Security earnings records to examine the accuracy of employee reports of annual contributions to tax-deferred pension plans. As employer defined benefit pensions are replaced by voluntary contribution plans, employee understanding of the link between annual contribution decisions and post-retirement wealth is becoming increasingly important. We compare the accuracy of employee reports of annual contributions in a sample of respondents in the original HRS cohort and in a sample of two younger cohorts, the War Babies and Early Baby Boomers. Tax-deferred plans are more common among the younger cohorts and we expected that they would be better informed about their annual contributions. We find that, among respondents for whom SSA administrative records are available, those in the younger cohorts were more likely to report accurately that they were included in a tax-deferred plan. Contrary to our expectation, identical proportions (70 percent) of respondents in both the older and the younger cohorts accurately reported whether they made a contribution during the interview year. Furthermore, we find no significant difference between the older and younger cohorts in the degree of reporting accuracy of contribution amounts, with approximately one-half of respondents in each cohort reporting contributions within plus/minus 25 percent of the true value. Both cohorts’ self-reported contributions are systematically larger than the true values. Finally, both self-reported and W-2 contributions are significantly larger among respondents in the WB/EBB cohort.

Link to Paper

In recent years, the United States has seen a significant shift away from defined benefit (DB) pension plans to defined contribution (DC) plans. This shift may accelerate rapidly, as more large companies, even those with financially solvent plans, freeze their DB plans and replace them with new or enhanced DC plans.

This paper uses the Model of Income in the Near Term to simulate the effects of an accelerated shift from DB to DC pensions on boomers’ incomes at age 67. We compare a scenario under which employers freeze all remaining private sector DB plans and a third of all state and local plans over the next five years with a baseline scenario that incorporates all known pension freezes as of the end of 2006. Under this baseline, future changes in DB coverage reflect only projected changes in employment patterns. We project how the accelerated decline in DB coverage affects the level, composition, and distribution of income at age 67 by sex, education, marital status, race/ethnicity, number of work years, and quintiles of lifetime earnings and retirement income. We also project numbers and characteristics of winners and losers from the change in pension coverage. To understand better the differential impact of DB pension freezes on the retirement incomes of boomers, we compare outcomes for four waves of boomer cohorts born between 1946 and 1965.

The results show that the numbers of winners and losers and net income changes are much greater for boomers born between 1961 and 1965 (last wave boomers) than for earlier boomers. Younger boomers are most likely to have their DB pensions frozen with relatively little job tenure and to lose their high accrual years for DB pension wealth, but also to have relatively more years to accumulate DC pension wealth before retirement.

Key findings include the following:

• For boomers born between 1946 and 1950 (first wave boomers), the accelerated pension freezes produce virtually no change in DB or DC pension coverage and little change in income at age 67. These individuals are near or at plan retirement age when the first new plan freezes occur in 2007. Because they are likely to have their DB pensions frozen with lengthy job tenures, they do not lose much DB pension income. They also will have relatively few years to contribute to new or enhanced DC pensions before retirement to accumulate much additional retirement wealth.
• The freezes will also produce little change in pension coverage for last wave boomers, reducing their DB coverage rates from 44 to 42 percent while increasing their DC coverage rates from 77 to 79 percent. Only workers who are projected to start new jobs with DB pensions under the baseline will lose DB coverage under the simulated pension freezes; existing workers will maintain DB coverage, but have lower benefits. The freezes will reduce average income at age 67 by $700 per person. DB pension benefits will decline by $1,100, but new and enhanced DC plans will raise income from retirement accounts by $300 and delayed retirement will raise earnings at age 67 by another $100.
• The accelerated decline in DB coverage will produce more losers than winners. The new freezes will reduce income for 26 percent of last wave boomers by an average of $4,200 and raise income for only 11 percent of last wave boomers by an average of $2,800.
• Boomers in high socio-economic groups, who have the highest DB coverage rates and projected pension incomes, are most likely both to lose and win from the additional DB plan freezes and will experience the largest losses and gains. For example, 48 percent of last wave boomers in the top income quintile will lose an average of $8,000 in income at age 67, while 12 percent will gain an average of $5,800. In comparison, only 8 percent of last wave boomers in the lowest quintile will lose an average of $700 in income at age 67, while 6 percent will gain an average of $800.
• While most boomers will experience relatively modest changes in income from the additional DB freezes, some boomers (particularly those in the last wave) will experience large losses and gains. The freezes will lower average incomes by at least 5 percent for 10 percent of last wave boomers, and raise average incomes by at least 5 percent for 3 percent of them. Big losers will be concentrated in the top income quintiles. For example, 15 percent of last wave boomers in the top income quintile, but only 3 percent of those in the bottom quintile will see their incomes decline by 5 percent or more under the accelerated pension shift. In contrast, the share of large winners will be fairly evenly distributed among income quintiles.
• On average, winners will experience gains in DC retirement accounts ($2,100) and earnings ($1,300) that exceed their losses in DB pension benefits ($600). In comparison, losers will have small gains in retirement accounts ($200) that are insufficient to offset their large losses in DB benefits ($4,300). Losers are less likely than the winners to contribute to new or enhanced DC plans and, when they do contribute, are less likely to receive high returns.
• The net decline in retirement income from an accelerated shift from DB to DC plans is to some degree a transitory phenomenon. When workers switch from DB to DC plans in mid-career, they lose the high accrual years in their DB plans and have few years to accumulate DC wealth. Compared with retirement outcomes under this scenario, most workers would be better off participating in either a DB or DC plan for their entire career. More than any other birth cohort, the boomers cohorts will suffer the repercussions of this transition; those who come later may fare better depending on participation rates, contribution rates, and market returns.

Link to Paper

Link

Those problems have contributed to a broader collapse in confidence, leading to a general pullback from all types of risky lending. Financial institutions have become increasingly unwilling to lend to one another, creating stress in the interbank market for short-term loans that became particularly severe over the past several weeks. The issuance of corporate debt plummeted in the third quarter, and the commercial paper market has also been hit hard. Bank lending, which has thus far remained relatively strong, will likely be severely curtailed by the difficulties that banks are facing in raising capital. The general collapse in confidence is reflected in significant increases in risk spreads (or the difference between the interest rates charged on risky assets and those on Treasury securities). For example, the spread between the interest rate on corporate bonds with the lowest risk (AAA-rated bonds) and the interest rate on Treasury securities has risen by more than a percentage point since the middle of last year.

In sum, recent developments in financial markets represent a severe credit crunch, which could have devastating effects on the U.S. and world economies. In response, the Congress recently enacted a financial rescue package that, among other things, creates the Troubled Assets Relief Program (TARP), under which the Secretary of the Treasury is authorized to purchase, insure, hold, and sell a wide variety of financial instruments. The Congressional Budget Office (CBO) analyzed many aspects of that program in recent testimony before the House Budget Committee.

The turmoil in financial markets has affected many aspects of the economy, including pensions. The most direct effect on pensions is through the prices of financial assets such as corporate equities and bonds. The Standard & Poor’s 500 stock market index, for example, has fallen by more than 25 percent over the past year as the outlook for the economy and corporate profits has worsened.

Because the majority of pension assets are held in equities, drops in stock prices have had a significant adverse effect on pension plans. Data from the Federal Reserve suggest that the decline in the value of financial assets cost pension funds (private-sector and public-sector combined) roughly $1 trillion—almost 10 percent of their assets—from the second quarter of 2007 to the second quarter of 2008 (the latest period for which data are available), and there has been a significant further drop in asset prices since then.

Link to Testimony