Home > Library > Stable Times > Volume 6, Issue 2  

Guidelines for Pension Reform: Build on Success of the Voluntary System

Retirement income is often compared to a three-legged stool supported by Social Security, personal savings, and employer-provided pensions. However, for millions of seniors, the retirement stool is standing on one or more sawed off legs. According to the Employee Benefit Research Institute, the average middle-income senior receives 81 percent of his or her retirement income from Social Security. Only 7 percent is derived from pensions and 8 percent from personal savings.

Social Security is (and will always be) an important source of retirement income. However, strengthening the other two legs can make the difference between a barely adequate retirement and a secure retirement. Consequently, pension policy should focus on increasing pension coverage and encouraging workers to save more.

Last year, one of the most comprehensive pension reform bills was signed into law. Because of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), workers have more opportunities to save, portability has been improved and regulatory obstacles have been reduced. These reforms will have an important effect on pension coverage and savings. We now need to build on the success of last year's law, keeping several principles in mind as we move forward.

First and foremost is to do no harm. In an attempt to legislate in the name of "protecting" workers and "strengthening" pensions, a well-intentioned Congress can often create more problems than solutions. A recent survey shows that 41 percent of Americans believe that Congress starts out with good intentions, but ends up making things worse. The precipitous decline in the number of defined benefit plans is a prime example. Over the years, onerous regulations have made these plans difficult and expensive to administer, causing employers to abandon them in favor of less burdensome options. Pension policy should reflect the reality of a voluntary pension system. Employers will weigh the costs and benefits of sponsoring a pension plan. Any policies that tip the scales in the wrong direction will reduce opportunities for retirement saving. Accordingly, future policies should reduce regulatory burdens to the greatest extent possible, without sacrificing worker protections. In particular, several of the provisions that were dropped from EGTRRA because of procedural rules in the Senate would reduce regulatory burdens for small businesses and encourage them to adopt new pension plans. These provisions were included in the Pension Security Act of 2002 and should be enacted into law.

Second, any future changes to pension laws should minimize market interference. Every investor has a right to assess his or her investment goals and assume a level of risk that is appropriate and consistent with those goals. Attempts to insulate investors from market risk would be a mistake. For example, proposals to "insure" individual investment decisions would significantly drive up costs for plan participants, create severe moral hazard problems, and limit the possibility for upside gains. There are fundamental differences between the concept of insuring defined benefit plans and defined contribution plans. Defined benefit plans are insured primarily against the risk of the plan sponsor's bankruptcy - not poor investment decisions. Moreover, plan sponsors must comply with strict funding requirements, and poor investment performance often triggers additional contributions. This model could not be applied to defined contribution plans without imposing significant restrictions and costs on plan participants.

Third, an informed and educated investor is better able to make sound investment decisions in the best interest of his or her financial security. Research has found that many workers underestimate the amount they need to save each year to support a certain standard of living during retirement. Similarly, many workers are not informed about basic investment principles. The Pension Security Act of 2002 would ensure that employees have access to investment education. It would also allow service providers to offer investment advice to plan participants as long as all fees and potential conflicts of interest are disclosed. Employees who prefer to receive retirement planning services from a non-affiliated adviser would be allowed to pay for these services using pre-tax dollars.

Finally, tax provisions that discourage saving should be reformed. EGTRRA provided a good start by raising the contribution limits on individual retirement accounts (IRAs) and qualified pension plans, but more needs to be done. For example, the income limits on deductible IRA contributions create a significant impediment to saving among middle-income workers. The scheduled increase in the income limits should be accelerated, and the marriage penalty should be eliminated. Ultimately, all saving should be taxed in the same manner as 401(k) plans and deductible IRAs. This tax treatment would boost saving and encourage long-term economic growth.

Increasing pension coverage and encouraging workers to save more will even up the 3-legged stool of financial security. These adjustments will create true retirement security once Social Security is reformed and a fourth leg of stability is added through Medicare modernization.

Read Next: Close the Investment Advice Gap...