Facts on Retirement Saving

June 2000

Background on Retirement Saving Plans

• IRAs and Roth IRAs: Individual Retirement Accounts (IRAs) were developed in the 1970s to encourage individuals to save for retirement. Under current law, individuals may contribute up to $2,000 annually to an IRA up to age 70¹/₂. For spousal accounts, the contribution limit is $4,000. Contributions to an IRA are fully tax deductible provided that the account holder does not participate in an employer-sponsored retirement plan, and taxes on funds accumulating in an IRA are deferred until the funds are withdrawn. If the account holder does participate in such a plan, contributions are still deductible provided that total income of the account holder does not exceed $32,000 for individual accounts or $52,000 for spousal accounts.¹ Individuals age 59¹/₂ and older can withdraw funds from an IRA without penalty.
  
  Roth IRAs, which were introduced in the Taxpayer Relief Act of 1997, are similar to ordinary IRAs but with a few important differences. The main difference is that contributions to a Roth IRA are never tax deductible. However, in contrast to an ordinary IRA, qualified withdrawals from a Roth IRA are entirely tax free, provided the account has been open at least five years. The annual contribution limit to a Roth IRA, $2,000, is reduced to the extent an individual makes contributions to any other IRA for the same taxable year. The maximum annual contribution that can be made to a Roth IRA is phased out for single individuals with adjusted gross income between $95,000 and $110,000 and for joint filers with adjusted gross income between $150,000 and $160,000.
  
  
• 401(k) Plans: 401(k) plans are employer-sponsored retirement programs designed to encourage personal saving and help raise the U.S. saving rate. They were first introduced in 1978, but did not become popular until clarified in 1981. Under the plan, employees can contribute up to $10,500 of their income to their 401(k) each year. These contributions are fully tax-deferred. Employers can also elect to make a separate "matching" contribution to the employee's plan. The combined employer-employee contribution may not exceed the lesser of $30,000 per year or 25 percent of compensation.

Why Retirement Saving Incentives Should Be Expanded

• U.S. Retirement Saving Is Inadequate. In order to support themselves in their retirement years, Americans need to save more aggressively. Many public finance experts agree that today"s saving rate is too low to ensure the retirement security of American families. According to Stanford University Professor Douglas Bernheim, a typical household would need to triple its rate of asset accumulation to finance its retirement. Other economists such as Mark Warshawsky, director of strategic research for TIAA-CREF, and John Ameriks, Ph.D. candidate in the department of economics at Columbia University; and Professor Olivia Mitchell and James Moore, Ph.D. candidate, University of Pennsylvania; have reached the same conclusion using different approaches. The current saving rate is simply not sufficient to fund the retirement of the baby boomer generation. In fact, the median household head would need to increase his or her saving by an additional 16 percent of annual gross income in order to have enough to live on after retirement.² Furthermore, while the conventional wisdom is that a 60 percent replacement ratio is adequate, recent research indicates that retirees need 80 percent to 100 percent of their working income while in retirement.
  
  In addition, saving makes possible productivity-enhancing investments, which in turn raise real wages for both skilled and unskilled workers. There is a widespread agreement among prominent economists and scholars that Americans are saving far too little. The U.S. personal saving rate dropped from 6.3 percent of GDP in 1960-1980 to 4.1 percent in 1991-2000 (first quarter). At the same time, net private domestic investment in the United States, which averaged 9.5 percent of GDP from 1960 to 1980, decreased gradually until 1991, reaching an average of 6.5 percent of GDP from 1991 to 2000. This downward trend should be reversed in order to ensure future growth in real income.
  
  
• Targeted Saving Vehicles Increase Saving. First, prominent public economists and scholars, including former Council of Economic Advisers chairman and now president of the National Bureau of Economic Research (NBER) Martin Feldstein, U.S. Secretary of the Treasury Lawrence Summers, David A. Wise of NBER, James M. Poterba of the Massachusetts Institute of Technology, Steven F. Venti and Jonathan Skinner of Dartmouth College, and Richard A. Thaler of University of Chicago, have concluded that IRAs and 401(k)s do result in new saving.
  
  In a number of studies using different approaches and data sets (such as the Survey of Income and Program Participation [SIPP], the Current Population Survey [CPS], and the Health and Retirement Study), Professors Venti, Wise, and Poterba have shown that the evidence strongly supports the view that contributions to targeted retirement saving accounts represent new saving.
  
  In early studies, William Gale of the Brookings Institution found that contributions to 401(k) plans did not represent new saving. However, in a recent paper, Dr. Gale, along with Eric M. Engen of the Federal Reserve Board (2000), shows that 401(k)s held by low-earning groups are more likely to represent new wealth than 401(k)s held by high-earning groups. This controversial finding about high-earning groups can be explained by the fact that the SIPP data used in the latter study lacks the over-sampling of high-income households needed to accurately measure their behavior.
  
  Another recent study by Karen M. Pence, a Ph.D. candidate at the University of Wisconsin-Madison, found evidence that 401(k) plans increase saving even after controlling for the fact that eligible households have a higher taste for saving than ineligible households.
  
  Second, there is a growing consensus among economists that pure economic incentives are not sufficient to explain saving behavior. This has lead a number of prominent scholars³ to examine whether behavioral theories can explain personal saving. One such theory is "self-control." According to Professor Thaler of the University of Chicago, 401(k) plans and IRAs cause people to save more by making it more difficult to "get to" the money than more traditional bank savings or checking accounts. This idea is related to the notion of "mental accounting" introduced by Shefrin and Thaler (1988), which emphasizes the mental allocation of funds into categories such as funds for current consumption (including cash or checking accounts) or funds for "rainy days" or "special occasions." Money in your wallet is more tempting to spend than money in a checking account, which in turn is more tempting than money in a savings account. The existence of penalties for early withdrawal of retirement saving makes tax-favored accounts less accessible, thus increasing long-term saving.
  
  Third, an important area of research is the role of "peer group" effects on saving decisions. As discussed in Bernheim (1999) of the Massachusetts Institute of Technology and Duflo and Saez (2000) of Harvard University, people may lack the information necessary to make contributions. The existence of IRAs, 401(k)s, and pension contributions may stimulate conversations between coworkers and lead to competition among contributors (individuals may want to maintain the same standard of living as their social group). Early studies of peer group effects on saving decisions, such as Duflo and Saez (2000), have shown that these effects are important and that there is a significant own-group peer effect on tax-deferred account participation.

Who Uses Targeted Saving Vehicles?

According to a survey of 1,181 households conducted by the Investment Company Institute between July and September of 1998,⁴ participants in 401(k) plans have a median age of 41 years. Contrary to popular belief, the majority of 401(k) participants are not wealthy but rather are middle-income Americans. Median household income among this group is $50,000, and households have financial assets amounting to just $45,000. Furthermore, most of their assets are held in employer-sponsored retirement plans.

In a December, 1999,⁵ survey of 3,576 representative households conducted by the Market Policy Division of the Investment Company Institute, the median age of individuals holding traditional IRAs was found to be 49 years, while the median age for Roth IRA owners was 44 years. Median household incomes and household financial assets were found to be $60,000 and $150,000 respectively for traditional IRA owners and $62,000 and $100,000 for Roth IRA owners (see Table 1). Fifty-six percent of traditional IRA participants and 58 percent of Roth IRA participants own 401(k) plans, while 33 percent of 401(k) plan participants own an IRA. For those who participate in a defined contribution or IRA plan, the average account balance was only $78,471 in 1999, a sum far too small to make a significant impact on retirees' living standards.

 

Table 1	Characteristics of Households Owning 401(k) Plans, Traditional, and Roth IRAs, 1999
	401(k) Plans	Traditional IRA	Roth IRA
Median
Age of Household	41 years	49 years	44 years
Household Income	$50,000	$60,000	$62,000
Household Financial Assets	$45,000	$150,000	$100,000
Source: Investment Company Institute

Is There Substitution Between IRAs, 401(k)s, and Taxable Financial Assets? Scholars have tried to answer this important question using a number of econometric analyses with different estimation methods and data sets. Led by Drs. Wise, Venti, Poterba, and Ms. Pence, a number of researchers have tested for substitution between targeted retirement saving assets and other financial assets. Most reached the same conclusion: there is little substitution. Tests for interaction between 401(k) assets and IRAs find similar results. Holding assets in one type of savings vehicle does not decrease holdings in another. In addition to these econometric analyses, an important fact suggests that there is no substitution between targeted retirement saving and other financial assets: American families simply do not have the money to keep shifting assets from IRAs or 401(k)s in order to reduce their tax liability. Pension Reforms Needed Many experts believe that pension reforms are needed to promote retirement income security and increase confidence in the pension system. A 1999 study by Dr. Sylvester J. Schieber, Richard Joss, and Marjorie Kulash of Watson Wyatt Worldwide, sponsored by the ACCF and the Association of Private Pension and Welfare Plans-The Benefits Association, found that pension reform and expansion would stimulate pension plan sponsorship, especially among small employers, and encourage greater saving among workers at companies of all sizes. For example, instituting "catch-up" provisions allowing workers over age 50 to make additional contributions would have a strong positive effect, especially for women returning to the work force after careers as homemakers. Also, another study by Stanford University Professor John B. Shoven and Dr. Schieber6 emphasizes that government policy toward pensions and pension saving has been very inconsistent over the last 30 years. While policies in the 1970s encouraged pension saving, many legislative steps in the 1980s discouraged it. Providing greater flexibility for retirement saving, simplifying and updating pension benefit rules, and reducing regulatory burdens are all measures that will increase incentives to save, thus promoting retirement security and U.S. economic growth. Notes 1. Beginning in 2005, the adjusted gross income phaseout for individual accounts will rise from $50,000 to $60,000. Beginning in 2007, the adjusted gross income phaseout for spousal accounts will rise from $80,000 to $100,000. 2. Olivia S. Mitchell, Brett Hammond, and Anna Rappaport, eds., Forecasting Retirement Needs and Retirement Wealth (Philadelphia, Penn.: University of Pennsylvania Press, 2000), p. 3. 3. Bernheim (1999), Madrian and Shea (2000), Bernheim and Garrett (1996), Bayer, Bernheim and Scholz (1996), Manski (1993), Duflo and Saez (2000). 4. Investment Company Institute, "401(k) Plan Participants: Characteristics, Contributions, and Account Activity" (Washington, D.C.: Investment Company Institute, Spring 2000). 5. Investment Company Institute, "IRA Ownership in 1999," Fundamentals 8, no. 6 (December 1999); and "401(k) Plan Participants," Investment Company Institute. 6. John B. Shoven and Sylvester J. Schieber, "The Aging of the Baby Boom Generation: The Impact on Private Pensions, National Saving, and Financial Markets" (Washington, D.C.: American Council for Capital Formation Center for Policy Research, February, 1997). Sources Bayer, Patrick, B. Douglas Bernheim, and John Karl Scholz. 1996. The effects of financial education in the workplace: Evidence from a survey of employers. Working Paper W5655. Cambridge, Mass.: National Bureau of Economic Research. July. Bernheim, B. Douglas. 1999. Taxation and Saving. Working Paper 7061. Cambridge, Mass.: National Bureau of Economic Research. March. Bernheim, B. Douglas and Daniel M. Garrett. 1996. The determinants and consequences of financial education in the workplace: Evidence from a survey of households. Working Paper 5667. Cambridge, Mass.: National Bureau of Economic Research. July. Duflo, Esther, and Emmanuel Saez. 2000. Participation and Investment Decisions in a Retirement Plan: The Influence of Colleagues' Choices. Working Paper 7735. Cambridge, Mass.: National Bureau of Economic Research. June. Engen, Eric M. and William G. Gale. 2000. The Effects of 401(k) Plans on Household Wealth. Unpublished mimeo. 2 June. Feldstein, Martin. 1999. Projecting Retirement Incomes. Testimony before the Senate Finance Committee, 16 March. Gale, William G. 1999. The Impact of Pensions and 401(k) Plans on Saving: A Critical Assessment of the State of the Literature. Washington, D.C.: Brookings Institution. September. Investment Company Institute. 2000. 401(k) Plan Participants: Characteristics, Contributions, and Account Activity. Washington, D.C.: Investment Company Institute. Spring. Investment Company Institute. 1999. IRA Ownership in 1999. Fundamentals 8(6)(December). Madrian, Brigitte, and Dennis Shea. 2000. The power of suggestion: Inertia on 401(k) participation and savings behavior. Mimeo. University of Chicago. Manski, Charles. 1993. Identification of exogenous social effects: The reflection problem. Review of Economic Studies 60: 419-431. Mitchell, Olivia S., Brett Hammond, and Anna Rappaport, eds., 2000. Forecasting Retirement Needs and Retirement Wealth. Philadelphia, Penn.: University of Pennsylvania Press. Mitchell, Olivia S. and James F. Moore. 2000. Projected Retirement Wealth and Saving Adequacy. In Forecasting Retirement Needs and Wealth. Philadelphia, Penn.: University of Pennsylvania Press. Pence, Karen M. 2000. 401(k)s and Household Saving: New Evidence From the Survey of Consumer Finances. Mimeo. March. Poterba, James. M., Steven F. Venti, and David Wise. 1997. Personal Retirement Saving Programs and Asset Accumulation: Reconciling the Evidence. Working Paper 5599. Cambridge, Mass.: National Bureau of Economic Research. January. Schieber, Sylvester J., Richard Joss, and Marjorie Kulash. 1999. Stretching the Pension Dollar: Improving U.S. Retirement Security and National Saving by Enhancing Employer-Based Pension Plans. Washington, D.C.: American Council for Capital Formation and Association of Private Pension and Welfare Plans. Shefrin, Hersh M., and Richard H. Thaler. 1988. The Behavioral Life-Cycle Hypothesis. Economic Inquiry 26(4): 609-43. Shoven, John B. and Sylvester J. Schieber. 1997. The Aging of the Baby Boom Generation: The Impact on Private Pensions, National Saving, and Financial Markets. Washington, D.C.: American Council for Capital Formation Center for Policy Research. February. Skinner, Jonathan. 1992. Do IRAs Promote Saving? A Review of the Evidence. Tax Notes 13 January 54(2): 261Ð85. Summers, Lawrence W. 1990. Stimulating Personal Saving. In The U.S. Saving Challenge: Policy Options for Productivity and Growth, eds. Charls E. Walker, Mark A. Bloomfield, and Margo Thorning. Boulder, Col.: Westview Press. Thaler, Richard H. 1994. Self-Control, Psychology, and Savings Policies. Testimony before the Senate Finance Subcommittee on Deficits, Debt Management, and Long-Term Growth, 7 December. Venti, Steven F. and David A. Wise. 1990. Have IRAs Increased U.S. Saving? Evidence From Consumer Expenditure Survey. Quarterly Journal of Economics, 661-697. August. Warshawsky, Mark J. and John Ameriks. 2000. How Prepared Are Americans for Retirement? In Forecasting Retirement Needs and Wealth. Philadelphia, Penn.: University of Pennsylvania Press.