Sunday, January 16, 2005

How to Retire Rich

The New York Times
January 16, 2005

How to Retire Rich

If you are like most people, your sadness over losing, say, $1,000, would be twice as great as your happiness at winning $1,000. That all-too-human tendency to feel the pain of a loss more deeply than the joy of a gain is called "loss aversion" and is one of the central discoveries of behavioral economics - a branch of the dismal science that recognizes that when it comes to money, people are motivated by various impulses that are measurable and even predictable, but seldom rational.

Behavioral economics has vital implications for retirement savings. But in his zeal to privatize Social Security - a quest which is itself driven more by ideology than economics - President Bush is obscuring better approaches to a comfortable retirement for all Americans.

We all know that the benefits from Social Security do not provide enough income for a comfortable old age. But they do provide a guaranteed basic level of financial stability for all old people and, in so doing, enhance the socioeconomic well-being of everyone. And for the large majority of old people for whom Social Security makes up more than half of income, it is the difference between destitution and the ability to live with dignity. Clearly, the reliability of the income stream is critical. Mr. Bush does not want you to believe that such social and financial stability is possible. In a forum last Tuesday aimed at persuading "younger folks" to support privatization, he said that Social Security would be "flat broke" in the coming decades. That is false. The system's trustees expect that even if nothing whatsoever is done, the current system will be able to pay full benefits until 2042, when it will be able to pay 70 percent of the promised benefits. The independent Congressional Budget Office is even more optimistic. Of course, no one is suggesting that no reforms be made. But modest, straightforward tax increases and benefit cuts, phased in over generations, are all it would take to bolster the current system.

As the Social Security safety net is strengthened, it is also essential for government and business to work together to make it easier for everyone in the work force to increase personal savings. Unfortunately, the coming fight over the president's plan for privatization will very likely draw attention away from the simple and uncontroversial changes that would help people prepare on their own for their retirement years, including:

Automatic enrollment
About half of employees work for employers who provide 401(k) retirement savings plans. But only three-quarters of eligible employees participate, and of those, participation is steeply skewed toward high earners.

The evidence from research is overwhelming that participation increases significantly if employees are automatically enrolled in the 401(k), rather than being required to sign up, as is usually the case. (Employees would be free to opt out if they did not want to participate.) One typical study - by Brigitte Madrian, an economist at the Wharton School, and Dennis Shea, compensation and benefits specialist at Aetna - analyzed a Fortune 500 company that switched to automatic enrollment in early 1998. By mid-1999, overall participation increased to 86 percent from 36 percent. The jump was especially striking among low-income workers, with participation rising to 80 percent from 12 percent for people making less than $20,000 and to 83 percent from 24 percent for those making $20,000 to $30,000. Participation also soared among younger workers. Studies show that participation rates stay high once employees are enrolled.

Automatic enrollment overcomes procrastination, a natural response to something deemed painful, such as giving up some take-home pay to save for retirement. It also overcomes "status quo bias," which tends to keeps nonparticipants from opting into a plan once they've passed up a chance to do so.

Automatic allocation
The next obstacle for would-be savers is the explosion of choices within 401(k)'s and other retirement plans. A typical plan now lets employees choose among 15 stock, bond and cash accounts. Too much choice leads to paralysis, a response that is especially common among low- and middle-income savers. As a result, employees in the lowest 25 percent of earners generally invest most of their accounts in low-yielding money market or bond funds. An easy solution is to offer employees an option to have their contributions automatically invested in balanced, prudently diversified, low-cost funds.

Automatic escalation
Over all, only 5 percent of employees contribute the maximum allowed by their plans. Status quo bias makes it unlikely that an employee will change a contribution later. Loss aversion deters an employee from increasing the percentage even after a raise, because an increased payroll deduction may be perceived as a pay cut. The fix is to enroll employees in a program that automatically increases the percentage of pay whenever they get a raise.

The Bush administration has put forth two fine ideas for increasing personal savings outside of Social Security, but has not pursued either to the fullest. One would let taxpayers instruct the Treasury to split their tax refunds, which average about $2,000 a year, between a checking account and a savings account. Alas, the administration has not enacted the proposal, even though it requires no new legislation.

The other positive initiative was enacted in 2001 and offers a matching tax credit for retirement savings by low- and middle-income taxpayers. Unfortunately, the credit suffers from several design flaws. For instance, only people who earn enough to have a tax liability qualify for the credit. That requirement eliminates 80 percent of the 60 million lowest-income filers. Expanding eligibility to that group would cost the government about $5 billion a year, bringing the total annual cost of the credit to a relatively small $7 billion.

For the most part, however, the administration's savings initiatives, such as the retirement savings account, are totally off the mark. Their main feature - lofty new upper limits on the amount of savings that can be tax-sheltered - has little or no effect on the vast majority of families and individuals. In 2001, the Government Accountability Office found that raising the contribution limit on 401(k) plans benefited fewer than 3 percent of participants, most of whom were making more than $75,000 a year.

Social Security privatization and tax incentives for the affluent have another major drawback that endangers everyone's retirement security. Neither would add to national savings - the sum of government and individual savings that is a key determinant of the nation's overall standard of living. Privatization would not add to national savings because every dollar that goes into a private account would be offset by the government borrowing needed to establish the private system. Tax incentives for the rich do not add to national savings because they simply induce wealthy people to shift current assets from taxable to tax-free accounts.

Put more simply, with privatization and continued high-end tax breaks, the few would get richer as the many fall behind. Preserving Social Security while increasing savings outside Social Security is a better way to achieve a prosperous retirement.