Obama’s Retirement Cap Could Hit Middle Class
President Obama wants to limit America's retirement benefits.
In his State of the Union address, Obama indicated he will include in his 2015 budget proposal in March plans to limit how much Americans can put in tax-deferred retirement plans including their company-administered 401(k)s and Individual Retirement Accounts. The limits come at a time when firms such as Fidelity say Americans are already underfunded when it comes to retirement (See MarketWatch story here).
As it did last year, Obama’s plan envisions limiting contributions to prevent retirement savers from having more than $205,000 in annuity payments from all their retirement plans combined - 401(k)s, IRAs and pension benefits. This was part of the 2014 budget proposed last spring.
That would mean a 62-year-old could have no more than $3.4 million socked away in tax-advantaged retirement savings because that’s how much it would cost to buy an annuity yielding $205,000 a year for life, according to actuarial estimates made in the Spring of 2013. In his State of the Union Address, the President said he wanted Congress “to fix an upside-down tax code that gives big tax breaks to help the wealthy save, but does little to nothing for middle-class Americans.”
Tax Nightmare for Middle Americans
For an upper middle class earner who hopes to avoid bumping up against the limit, the President’s proposal, if enacted into law, would bring a nightmarishly complicated calculation each year when taxes are filed to determine what one’s contribution limit would be for the following year. It could limit contributions for employees early in their careers, critics charge, because young workers have many years left for existing balances to earn returns. Final balances could end up being closer to $500,000 than to the $3.4 million suggested last year by the Obama Administration.
That’s far below the amount of money experts say Americans need to fund their retirement. Fidelity estimates people need at least eight times their final salary to maintain the same standard of living they had before retiring. For someone earning $250,000 a year, that means at least $2 million in savings.
Not surprisingly, this has been a bit of a sleeper issue. Instead, it has been analyzed mostly by pension plan consultants, actuaries, economists and policy advocates.
Perhaps no one has done more to analyze the President’s proposal than Jack VanDerhei, research director of the Employee Benefit Research Institute, based in Washington, D.C. VanDerhei wrote an advisory last spring on the proposal with his colleagues Nevin Adams and Craig Copeland, and expanded his analysis into EBRI’s Issue Brief No. 389 in August 2013, titled “The Impact of a Retirement Savings Cap.”
Impossible to Implement
The first problem, VanDerhei says, is that it would seem to be almost impossible to actually implement the President’s proposal since the limit on tax-deferred contributions is based on the accumulated benefits across IRAs, 401(k)s and pensions.
“In the real world, please don’t ask me how they accomplish this because I have no idea,” he says. “In the real world you have to figure out not only the sum of all your IRAs and defined contribution balances are every year in time presumably for tax filings, but also go back and figure out your accruals on defined benefit plans of current and previous employers,” he says.
EBRI has a database of 24 million participants in the 401(k) system. However, there is no database that connects the defined benefit and defined contribution plans together, VanDerhei says.
The President’s proposal would have the greatest impact, VanDerhei says, on “people with generous defined benefit plans who have been saving close the cap on the defined contribution side.”
Low Balances for 35-year-olds
The $3.4 million provided by the Obama Administration last April “was high only because discount rates were at an all time low level,” says VanDerhei. In April of last year VanDerhei calculated the effective discount rate, or assumed rate of return on retirement assets, was 4%. Each year’s allowable contribution would be based on assumed rates of return, so in years when rates are high, the allowable contribution would be lower. And so would be the final balance in the retirement account.
Even with a low 4%, the President’s proposal would significantly limit the final balance that could be accumulated to $1.17 million for today’s 35-year-olds. Rates have already risen significantly since last year. If they should rise to 6%, it would limit annual contributions to levels for 35-year-olds that could bring the final tally in the account to only $569,000. At 8%, contributions would be further limited for an expected final balance of only $284,000. (See Figure 2, page 6 in the Issue Brief.)
The President’s plan might also lead small companies to discard their 401(k) plans altogether. VanDerhei also looked at the likelihood that sponsors might terminate small 401(k) plans with 100 employees or less because the owner of the small business bumped up against limits required by the cap on the final benefit and could no longer contribute to the plan.
Even at a 4% discount rate, which would allow for higher contributions, the retirement cap would start to seriously limit contributions in the plan. Depending on the size of the plan, with smaller plans facing less restrictions, between 18% and 62% of existing 401(k) plans would have at least one employee - presumably the owner or top executive - bump up against a contribution limit. The share rises to a range between 29% and 75% if the discount rises to 8%.
More Join the Debate
More analysts have joined the debate about the President’s proposal in recent months. The Winter 2014 issue of “Journal of Retirement” (article here; behind paywall) contained an article that offers a proposal to achieve President Obama’s original objectives but with a method that would be easier and less costly to implement. John Turner, director of the Pension Policy Center in Washington, D.C., wrote the article with David McCarthy, senior research at the Pension Policy Center and Norman Stein, professor of law at Drexel University.
Like the President, Turner and his colleagues express concern that some wealthy people are accumulating super high balances, even with existing contribution limits. The authors estimate that 176,000 households had combined defined contribution and IRA or Keogh accounts exceeding $3 million in 2010. Based on this, the authors estimate “there is likely more than $500 billion” in very large amounts held in these accounts.
As an example of balances that are too big, the authors single out the $87 million accumulated in an IRA by Mitt Romney, the Republican former governor of Massachusetts who ran unsuccessfully for President in 2012. The article also lists the top 10 plans with the largest reported average account balances in 2010. At the top of the list is a plan terminated in 2010, Chelsey Capital Profit Sharing Plan of New York, with only two participants with average assets of $253 million each. At number 10, Perry J. Radoff, P.C. Profit Sharing plan of Houston, Texas, had an average balance of $11.8 million for two participants.
Flat $5 Million
Turner and his co-authors recommend that there be a flat dollar $5 million limit on the final accumulation balances in defined contribution plans. Because the authors did not want to support a policy that could impact defined benefit plans, they wanted the limits to apply only to defined contribution plans. “We think public policy should be encouraging defined benefit plans,” explains Turner.
Turner and his co-authors are working on a follow-up paper that looks at how large a “tax subsidy” the plans get. Even though taxes are deferred and eventually paid when withdrawals are made, Turner argues that by sheltering the returns in the account, capital gains are unfairly sheltered from income and this constitutes a subsidy. If taxes are paid by wealthy savers when the amounts are withdrawn, “the tax is exactly the same as if he had invested after tax income and gotten a tax free rate of return on capital gains,” Turner contends.
The authors of an article in the forthcoming Spring 2014 issue of “Journal of Retirement” take issue with the claims of Turner and his colleagues. The article, titled “Proposed Lifetime Pension Limits: Less than Meets the Eye,” is authored by Sylvester Schieber, retired from Towers Watson and working as an independent consultant in New Market, Md., and Brendan McFarland, senior research associate at Towers Watson in Arlington, Va.
Schieber questions the value of focusing on very high balances in some accounts as the basis for policies that could ultimately harm middle level executives and upper middle income households.
“They’ve got these cases of people who have developed these fantastic accounts,” Schieber says of Turner and his colleagues. The people with very high balances were placing assets in tax-deferred plans, often when they were young at the start-up of a company. “Then they had these fantastic results and all of sudden these assets became worth a lot of money,” Schieber says.
“You can portray that as some kind of device to avoid taxes,” Schieber says, “and maybe there is something here I am not seeing in terms of how people can liquidate their accounts when they get to retirement age.” Even so, from his own analysis, Schieber disagrees with Turner and his colleagues that there is a tax subsidy for the wealthy.
Schieber makes his case by calculating the tax for distributions from an IRA or 401(k) account with $100 million in investments. The owner of the account, be it Romney or anyone else, would at age 70½ be required under current law to begin withdrawing an amount equal to the balance divided by 27.4. For this $100 million account, the amount of the first annual distribution would be $3,649,635 in tax year 2013, according to Schieber's calculations.
At the highest income tax bracket, the owner of this account would be taxed $1,455,255 for tax year 2013. If the money had been in a non-tax-preferred account instead, the tax in 2013 on the same $3,649,635 would have been only $729,927, based on the 20% capital gains tax rate. The government clearly comes out ahead in this example if the money were socked away in the IRA with the tax deferral rather than saved outside the IRA without the tax deferral.
“Romney’s situation looks to me like he is going to end up paying more taxes because he’s got this money sheltered than if he had just carried it as a regular investment,” he says. “So, maybe the government is not going to get its taxes when it wants, but it’s ultimately going to get more because he was foolish enough to shelter these assets that generated spectacular results,” he adds.
Schieber, in his forthcoming article, also looked at how people coming to retirement age today would have fared if they had the President’s proposed limit in place for their entire careers. His simulated results take into account the actual returns of a portfolio of 60% stocks and 40% bonds and each year’s discount rate over the last 40 plus years. Schieber found that instead of accumulating $3.4 million, a retiree at even the highest incomes would have accumulated no more than a $1.5 million balance.
Schieber also evaluated how the same retiree would fare if there had been a $2.5 million flat-dollar amount limits on the final balance. Then he assessed how a $5 million flat-dollar limit would impact the same retiree, the limit recommended by Turner and his colleagues. Schieber found that in the case of a flat dollar limit of $2.5 million , someone who began working at age 25 in 1976 and retired in 2013 at age 62 would have accumulated only $1.5 million, based on the inflation-adjusted value of $2.5 million in 1976. If the final limit had been $5 million, the same person would have accumulated $2.1 million, again based on the inflation-adjusted value of $5 million in 1976.
Schieber also ran simulations for careers starting in every year going back a century to see how the cap would have worked under historic conditions. "In no working career starting since the end of World War II would a worker under a $2.5 million cap with normal investment patterns been able to get a balance equal to the suggested regulatory cap at retirement," he says. Schieber says that policy makers should look at the broader picture of both Social Security and retirement savings to evaluate proposals that cap retirement benefits. Under Social Security, higher income workers pay into a system and receive a very modest benefit, receiving back in benefits an amount well below what they contributed, subsidizing the benefits of others. So, these same workers should not face limits that would prevent them from achieving an adequate income in retirement, Schieber says.
The Bottom Line
Schieber recommends that if policy makers wish to set a limit on retirement accumulations that the policy rely on a simple trigger applied when someone reaches retirement age. This would deal with the very high account balances of some wealthy retirees who achieve fantastic returns, while not harming the ability of employees earning $250,000 to achieve an adequate retirement income. Schieber suggests a trigger limit of $7.5 million, with the understanding that as early as Social Security normal retirement age the retiree would have to withdraw amounts above the $7.5 million balance.
Correction: An earlier version misstated the estimated amounts that could be accumulated under $2.5 million and $5 million flat-dollar limits.