White Paper: Retirement Saving Plans’ Effects on the Growing U.S.

Wealth Gap

Stakeholder OrganizationProf. Jordi ComasBy: John Wattles

5/7/15

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Table of Contents

Executive Summary……………………………………………………………. 3

History of Social Security............................................................................ 4

History of 401(k)’s…………………………………………………………..… 6

The Question …………………………………………………………………... 9

Dividing Wealth Gap:

Social Security………………………………………………………. .10401(k)’s..........................................................................................12

Solutions:

Social Security……………………………………………………….. 13401(k)’s………………………………………………………………. 15

Recommendations…………………………………………………………… 18

Works Cited……………………………………………………………………20

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Executive Summary

The purpose of this paper is to examine both public and private retirement

saving plans in the United States and their effects on public policy and the growing

wealth gap. My aim is to argue that the development and failures of Social Security

and defined contribution plans like today’s 401(k)’s, both share progressive and

regressive elements that have influenced the dividing wealth gap we see in America

today. By focusing strictly on retirement planning and avoiding other causes of

wealth disparities like pre-retirement income levels, I have found that both systems

contain fundamental problems that must be addressed. My research has led to the

conclusion that Social Security is largely progressive and that a simple increase to

the payroll cap will greatly increase the volume of its income distribution. Defined

contribution plans are in need of much greater reform as the system is largely

regressive. A call to establish automatic 401(k) plans while expanding Saver’s Credit

as well as tax breaks for small businesses will greatly reduce the unfair benefits high

earners receive in this system.

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History of Social Security:

To start, one must study the history of Social Security to understand its

evolution and how the policy effects the elderly population. Social Security arose in

the United States due to different demographic changes beginning in the mid 1800’s.

These demographic changes were the industrial revolution, the urbanization of

America, the loss of the extended family, and the increase in life expectancy. Prior to

the industrial revolution, most families found themselves living in rural

environments engaging in different agricultural businesses. As the economy

modernized and transformed into an industrial dominated society, many

wageworkers moved to urban areas. This brought significant uncertainties and

fallacies especially in regards to recessions, levels of unemployment, and overall

population densities. In 1890, only about 28% of the population lived in rural areas.

In 1930, this number reached roughly 56%. This mass migration of people

introduced the next catalyst for the development of Social Security, the loss of the

extended family (Social Security, 2015). As families moved from rural to urban

areas, many newer generations left their elderly relatives. Those who did stay

together found that their offspring could not afford to take care of them in cities as

low-wage workers. In both cases, the elderly did not generate their own income, nor

were fortunate enough to have offspring that could provide for them.

Lastly, life expectancy rates increased faster then any other period in human

history. This increased the elderly population living in the United States by roughly

8 million people in 1930, resulting in a total population of 128 million, or about

5.4% of the population. According to the US Census Bureau, today there exist

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approximately 48 million people over the age of 65 in the United States, making up

about 15% of the population (Elderweb, 2015). With costs moving higher due to

longer life expectancy rates, as well as economic faults due to migrating populations

to urban areas, the elderly further found themselves in poverty.

Additionally, the idea of retirement became increasingly popular over the

last century, and therefore led to a greater percentage of the population becoming

retired. The graph below shows the percent of male participation in the labor force

based on age and time. Gary Burtless, demonstrates this idea when he says, “At the

turn of the twentieth century, retirement was relatively rare but not unknown; two

out of three men past age 65 were employed, but one-third were not. By mid-

century retirement was far more common: less than half the men 65 and older held

jobs in 1950” (Burtless, 8).

The final

catalyst

for Social

Security

to come

about was due to the stock market crash of 1929 and the start of the Great

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Depression. On October 24, 1929 the stock market lost 40% of its value and caused

over $26 billion of wealth to disappear. Over the next three years, unemployment

had risen from 3 percent to 25 percent, and total GDP was cut in half from $103 to

$55 billion. Wages paid to workers declined from $50 billion to $30 billion in 1932,

and the number of elderly in poverty exceeded 50 percent. (Social Security, 2015)

As a result, Social Security was established by the passage of the Social

Security Act of 1935. The act provided benefits in two ways, grants to states and

federal old-age benefits. Individuals would receive a check once a month, every

month until the individual passed away. Today, federal old-age benefits are

calculated based on the cost of living allowances, which include the costs of inflation

measured by the consumer price index. The working classes help fund the account

by paying the Federal Insurance Contributions Act (FICA) tax of 6.2 percent. The

individual’s employer then must also match that cost, amounting to a combined tax

burden of 12.4 percent. Any excess funds are then invested in a trust fund,

(government bonds) where the government insures the loan to finance other

government programs (Social Security, 2015). The fund returns roughly 3.5 percent;

however more recently due to lower interest rates have yielded closer to 2 percent.

History: 401 (k)’s

A defined contribution plan, or a 401(k), is a cash or deferred arrangement

under which a covered employee can choose to contribute of portion of his or her

income to a qualified retirement plan as a pre-tax reduction in salary. Assets may be

invested in an assortment of vehicles including but not limited to stocks, bonds, or

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varying alternative assets. The pre-tax contributions as well as earnings on an

account are taxed only when withdrawn, and employers have the discretion to

match any employee contribution (EBRI, 2015)

The developments of 401(k)’s were primarily due to failures in private

pension plans, as well as a change in the internal revenue tax code in 1978. The

main reasons companies have begun to switch from pension plans to defined

contribution plans is due to increasing globalized competition, a restructuring of

compensation due to rising healthcare costs, and volatile financial markets.

Over the past 30 years, many even financially healthy companies who have

historically paid pension plans have moved to 401(k) plans due to increased global

competition. During the 1960-1970’s, companies began to cut compensation costs

as moving to a defined contribution plan cut total costs from 8 percent to 7 percent

(Munnell, 4). Prevalent companies were forced to cut pension costs to better

compete with foreign companies where governments provided the bulk of pension

benefits, as well as to better compete with domestic companies who had already

frozen their plans. In addition, increases in the FICA tax forced employers to further

promote 401(k) plans. Between 1965 and 2015, the combined worker-employer

FICA tax rates increased from about 7% to 12.6% forcing higher costs on companies

providing defined benefit plans (Social Security, 2015). Following this trend, an

increase in health care costs have driven a restructuring in pension benefits. These

costs arise both from providing health insurance for current employees and post-

retirement health care benefits for retirees. For example, in 1970, employer

spending on health care benefits as a percent of total compensation was only about

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33 percent. Today, the percentage is closer to 50 percent. The graph below shows

the change in private sector retirement and health care benefits as a percent of total

compensation (Munnell, 8).

A third reason why pension plans failed is because market volatility put too

much pressure on company balance sheets. In bull markets, company’s often had

more then enough assets to cover their post-retirement liabilities. However, in bear

markets, like the Dot Com Bubble in the early 2000’s, companies were forced to use

their own cash to fund their post-retirement liabilities. Also, as expectancy rates

increased, companies struggled to accurately gage retirement costs and they felt like

defined or fixed benefits placed too much of a liability on them. A move to 401(k)

plans allowed employees to make their own investment decisions while

contributing to the fund themselves, and therefore the liability placed on companies

was greatly reduced (Munnell, 2015)

Lastly, and most importantly, the emergence of 401(k)’s is due to a provision

in the Internal Revenue Code Sec. 401(k), for which the plan is named. The new law

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sanctioned the use of salary reductions as a source of planed contributions. Further,

in 1986, Congress acted to replace the defined benefit plan for federal civilian

workers (CSRS) with a combination of a less generous defined benefit plan (FERS)

and a more generous 401(k)-type plan (TSP). This action by the government to

essentially endorse defined contribution plans gave confidence to companies about

the investment vehicle’s long-term stability (EBRI, 2015). Since that time, 401(k)

plans have become the fastest growing type of retirement planning in the United

States. According to the Investment Company Institute, there are currently 638,000

401(k) plans in place involving 89 million participants. This is an increase from

1995 where there were only 200,000 401(k) plans, and amounts to a current total

value of roughly $4.5 trillion (EBRI, 2015).

The Question

As the above background demonstrates, the creation of Social Security and

401(k) plans has been a result of economic needs, as well as legislative policy meant

to protect employees both during and after their working years. However, even

though in theory these policies are meant to redistribute, protect, and grow one’s

accumulation of wealth, does a flawed retirement system act to reverse their

benefits, creating a further divide in wealth, and inherently perpetuating the

nation’s wealth disparity? To answer this complex question, I will break down the

flaws of each retirement system, and analyze how the practice of each has helped to

reduce or increase fair wealth accumulation, and therefore further divide the

nation’s wealth gap.

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Dividing Wealth Gap: Social Security

Social Security is flawed and it is widely accepted that without reform, the

program is completely unsustainable as the program is paying out more benefits

then the current payroll tax accumulates in income. To reverse this trend, estimates

show the United States needs to either increase its payroll tax revenue by roughly

33%, or cut benefits by 25% (Mackrides, 10). However, the purpose of this paper is

to address how the program further divides the nation’s wealth gap and therefore I

will ignore this fundamental problem.

In general, Social Security is in fact a progressive policy, where more of the

benefits are distributed to the low-income earners who contributed less of the

overall fund. According to the National Bureau of Economics Research, low earners

earn a 5.19% internal rate of return on their contributions compared to high

earners who get just 0.54%. However, a fundamental problem exists because the

12.4 percent flat tax for income under $118,000 is regressive in nature. If one makes

more then that he or she pays a smaller amount as a percentage of income thus, the

marginal benefit of income faces diminishing returns. (Economist, 2015) Overtime,

as the flat tax has increased (and helped to push away defined-benefit pension

plans), in conjunction with the nation’s overall wealth disparity outside of causes

related to retirement saving like the growing gap in income distribution, the

marginal benefit has been diminished quite significantly.

This flat tax also creates two more problems, which lead to a widening

wealth gap. First, by forcing everyone to pay the same rate without considering the

cap or the percent of income that expense entails, the U.S. government allows the

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higher earners to invest in higher yielding assets, and forces low-income earners

and employers to invest 12.4 percent of their income in low-yielding government

bonds. Historically, Social Security investments have returned annually roughly 3-4

percent versus perhaps an all equity portfolio that returns closer to 8-9 percent.

Thus, the system creates a problem in which lower-income earners must invest a

larger percentage of their income in low-yielding bonds. Even though the majority

of funds are distributed progressively to the low earners, another problem arises. At

the current cap, the payroll tax applies to only 83 percent of total earned income,

compared to 30 years ago where it captured closer to 90 percent (Ourfuture, 2015).

As the wealthy get wealthier, the total trust fund actually receives on a percentage

basis less money from high earners. As a result, the low-earners not only invest

more of their wealth into low yielding government bonds, but the overall

redistribution of the program has been squeezed. Lastly, as researched by Jeffrey

Liebman of The National Bureau of Economic Research, complexities in

demographics as it relates to mortality rates, marital rates, and variations in the

earnings levels of secondary earners in married couples, causes faults in the

system’s progressive nature. He found that, “One in five individuals in the top 20

percent of the lifetime income distribution receive greater net transfers than the

average for people in the bottom 20 percent of the income distribution.” (Liebman,

3) Therefore, Liebman argues that Social Security, when looked at based on the

transfer of income distribution, is slightly less progressive then when looked at as

total benefits paid.

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The graph above shows that at current discount rates, one can only expect 5-9

percent or $23-42 billion of real transfer of wealth. Therefore, due to measurement

complexities, much less wealth is being distributed, and brings fault to the idea that

low income earners actually receive greater internal rates of returns on their

contributions.

Dividing Wealth gap: 401 (k)

The immense growth of defined contribution plans since the 1980’s have

given further transparency to the faults of the investment vehicle and its

involvement in widening the wealth gap. These faults stem from poor policy limiting

both employee and employer participation/contribution, and a regressive

framework that benefits high-income earners over their less financially successful

counterparts.

In regards to poor policy, private wage-and-salary workers do not participate

as much in 401(k) plans as workers do in defined benefit pensions. In 2013, of the

workers offered retirement plans, 87 percent were in defined benefit pensions

compared to only 71 percent in 401(k)’s. In addition, worker contribution was far

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below the maximum limit, with the median amount hovering $2500. John C. Bogle,

founder of Vanguard, noted the shortcomings of 401(k) plans highlighting excessive

Wall Street fees, misguided asset allocations, and failure for managers to deal with

longevity risk. Even despite withdrawal penalties, Bogle argues that it’s too easy to

take money out of 401(k)’s and how those policies greatly reduce long-term

compounding gains. (Greenhouse, 2015).

401(k) plans are also highly regressive. With over $80 billion in annual tax

breaks, roughly 60 percent of them go to the top 10 percent of earners. According to

the Urban-Brookings Tax Policy Center, 401(k) plans raise the after-tax income 1.4

percent for the top quintile, 0.7 percent for the middle quintile, and just 0.1 percent

for the bottom quintile (Benjamin, 2015).

Solutions: Social Security

As mentioned before, the most fundamental problem with Social Security in

regards to creating wealth disparities is the effect of diminishing returns due to the

current cap rate and flat payroll tax. Due to the country’s growing divide in income

distribution, the payroll tax only applies to 83 percent of total income earned. The

reason for this is because the working class earns less than they used to, therefore

contribute less to the trust, and as the wealthy become wealthier, there are more

and more people above the cap of $118,000.

Other then the obvious solution to increase earnings for the bottom half, one

solution would be to raise the percentage of income subject to the payroll tax.

According to Sen. Bernie Sander (D-Vt), increasing the cap to $250,000 (or even

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removing the cap entirely) would make Social Security solvent for the next 40 years

on top of the 18 years it’s solvent (Ourfuture, 2015). This isn’t good just for the

longevity of the program, but income distribution would increase and become more

progressive as internal rates of returns would be increased for the lower earners. By

raising the cap, the payroll tax would apply to more total income earned, and

therefore create more funding to be progressively distributed.

Another solution to Social Security as it relates to wealth distribution, would

be to privatize a portion of the trust fund. Instead of the trust strictly investing in

government bonds, which are illiquid and low yielding, a private investment in

higher yielding assets like equities could increase returns. Albeit controversial, this

would allow low earners the ability to invest a greater percentage of their income

into higher yielding assets like higher earners are able to. The progressive nature of

the trust would not change, as individuals do not have the power to opt out. This

would increase short-term risk and cause possible collapse similar to retirement

accounts during the 2008 financial crisis, however as the graph demonstrates

below, over a 30-year basis, equities provide higher returns at less levels of risk

then fixed income.

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Likewise, a similar solution would be to create personalized private

retirement accounts in which people could opt into. The government could approve

certain investment portfolios that contained a mix of stock and bonds and a portion

of the individual’s payroll tax would be used to fund those private accounts like we

see with 401(k)’s. These accounts would essentially be government sponsored

401(k) plans for individuals who are not offered defined contribution plans by their

employer. Liability would fall on the individual just like in a 401(k) and because it’s

optional, funds lost or generated are unique to that individual and are not

progressively distributed in any way (Mackrides, 17).

Solutions: 401(k)

401(k) plans are enormously skewed to enhance higher earners. A few

reasons for this have to do with poor tax policies that benefit high earners over low-

income earners, and a lack of educational resources that limit participation rates as

well as financial success.

One solution to combat low participation and contribution rates, which are

high amongst young, low-income earners, is to establish automatic 401(k) plans. In

this system, companies who offer 401(k)’s automatically enroll employees,

deducting a small portion of their income to the fund. Thereafter, a percentage of an

employee’s income would act as their yearly contribution. Employees would still

have the autonomy to decide their contribution levels and even their participation

at all. Often times, due to a lack of expertise about retirement savings and or

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investment decisions, employees procrastinate and waste years of compounding

gains.

Additional solutions must also provide incentives for small businesses to

offer 401(k) plans, which again are highly dominated by low-income earners. By

expanding tax breaks, or even reducing the FICA tax employer’s pay, small

businesses would be inclined to offer plans as well as offer matching contributions.

Those tax benefits could also go towards funding required employee and financial

manger meeting in which proper investment plans can be made. In a report

published by Charles Schwab, the company noted that, “among the retirement plans

we serve at Schwab, approximately 70 percent of participants that receive and

implement 401(k) advice make a change to their deferral rates, and we see those

savings rates nearly double on average as a result, jumping from five percent to 10

percent of pay” (Schwab, 2015).

The most substantial solution to the regressive nature of 401(k) plans is to

expand the Saver’s Credit. The Saver’s Credit helps offset part of the initial

contribution workers voluntarily make to 401(k) plans. The amount of the credit is

50 percent, 20 percent, or 10 percent of their annual retirement plan depending on

the participant’s adjusted gross income. Current credits are “nonrefundable”

meaning it only offsets a taxpayer’s income tax liability. Under Obama’s proposal,

credits would become “refundable” and would in effect turn it into a matching

contribution plan. Essentially the employee would no longer have to pay income

taxes in order to receive the credit (Stephen, 2015). This proposal will benefit

taxpayers in the bottom 80 percent of the income distribution with almost no

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impact on the top 20 percent, all while incentivizing saving (Benjamin, 2015). The

graph above shows how such a policy increases the after tax income of lower

quintiles while hardly effecting the top quintile.

Lastly, to reflect on John Bogle’s comments, 401(k) plans should shy away

from mutual funds, and move into lower fee, index funds. Mutual funds in theory

provide diversification, however the development of “growth” vs. “value” vs.

“income” funds actually concentrate risk more than an overall index fund would. In

addition, many investment funds charged around 2 percent in annual fees,

compared to index funds that charged one-twentieth of that (Greenhouse, 2015).

Recommendations:

The growing wealth disparity in the United States has increasingly been a

topic of political discussion, and if the government is serious about reducing the gap

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reforms must be made to retirement saving planning. I want to stress however that

levels on income distribution, before retirement, are widely responsible for financial

stresses after retirement, but looking strictly at Social Security and defined

contribution plans there exists both progressive and regressive elements that both

help and hurt the savings problem.

Therefore I recommend reforms to both programs. In regards to Social

Security, congress should greatly increase the cap limit of $118,000 to a minimum of

$250,000. As a result, a larger percentage of the nation’s taxable income would fund

the trust, and therefore a larger percentage of income would be distributed to the

lower and middle class who earn higher internal rates of returns from their

contributions.

Moving to defined contribution plans, congress must completely reverse its

regressive attributes as well as promote lower and middle class

participation/contribution. This would mean expanding tax breaks to small

businesses to further incentivize their 401(k) involvement, and expanding the

Saver’s Credit to further provide subsidies to low-income earners incentivizing

401(k) participation.

Congress must also mandate automatic 401(k) plans and mandate company

and government sponsored financial planning for employees. High returns can be

achieved safely as long as proper investments are made, and a proper amount of

time is allowed to accrue those gains. Potentially, increasing the 10 percent penalty

for early withdrawal would help in this area.

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Overall, American’s do not save enough for retirement. This lack of savings

results in the need for these programs to help reverse this trend, as well as to

immediately force the issue. In terms of battling wealth disparities, minor reforms

to Social Security and more major reforms to defined contribution plans will help to

combat this issue.

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Works Cited:

Burtless, Gary. “An Economic View of Retirement.” Brookings Institute. Web. 3 May 2015.

Feldstein, Martin.“The Optimal Level of Social Security Benefits.” The Quarterly Journal of Economics. Vol. 100, No. 2 (May, 1985). Pp. 303-320.

Greenhouse, Steven. “Should the 401(k) be Reformed or Replaced?” The New York Times. 11 Sept. 2012. Web. 3 May 2015.

Harris, Benjamin and Butrica, Barbara. “Flattening Tax Incentives for Retirement Saving.” Urban Institute and Brooking Institution. June 2014. Web. 3 May 2015.

“History of 401(k) Plans: An Update.”EBRI.com Employee Benefit Research Institute, 1 Feb. 2005. Web. 3 May 2015.

Liebman, Jeffrey. “Redistribution in the Current U.S. Social Security System.” National Bureau of Economic Research. Dec. 2001. Web. 3 May 2015.

Mackrides, Kyle. White Paper – Social Security. 2013. 10-17. Print. 1 May 2015.

Miller, Stephen. “For 2015, 401(k) Contribution Limit Rises to $18,000.” Society For Human Resource Management. 23 Oct. 2014. Web. 5 May 2015.

Munnell, Alicia, and Francesca, Golub-Sass. “Why Are Healthy Employers Freezing Their Pensions?” Center For Retirement Research at Boston College, Mar. 2006. Web. 3 May 2015.

Thompson, Lawrench. “US Retirement Income System.” Oxford Review of Economic Policy. Vol. 22, No. 1, Pensions (Spring 2006). Pp. 95-122

“Are Social Security taxes regressive?” The Economist, 14 Apr. 2009. Web. 5 May 2015.

“New Charles Schwab Data Reveals 401(k) Plan Trends.” Business Wire. 31 Mar. 2010. Web. 4 May 2015.

Social Security. “Social Security Tax Rates.” Social Security Online, 8 Mar. 2008. Web. 2 May 2015.

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“The Real Social Security Crisis Is Income Inequality.” Campaign for America’s Future. OurFuture, 26 Feb. 2015. Web. 4 May 2015.

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