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Guest Article

(Reprinted from The 401(k) Handbook, published by Thompson Publishing Group, Inc.)

Pension Reform Secures Retirement for All


by Martha Priddy Patterson

The most recently released national savings rate numbers reported a U.S. savings rate of negative 1 percent. With numbers like these, the Portman-Cardin pension reform legislation, which would substantially raise the limits for pretax retirement savings for 401(k)s and other pension plans, would appear to be both necessary and good fiscal policy. Among many changes, the measure would also permit an annual 401(k) catch-up provision of an additional deferral of up to $5,000 per year for those over age 50. While the bill has passed the House seven times, most recently with 407 votes out of 435 members, opponents say that it only benefits the "rich."

Certainly, anyone being paid $160,000 to $200,000 is well-paid, and might even be considered "rich." But the desire-- indeed the necessity-- of saving more than $10,500 to a 401(k) or similar plan per year for retirement is not simply limited to the rich, however they may be defined. The data indicates that Americans have been under-saving, and need to catch up.

For example, the data for those 50 and older show that unless that age group hyper-charges its saving, they will need to be working well past age 65, because they won't be able to retire. In the 2001 Employee Benefit Research Institute's Retirement Confidence Survey, respondents age 45-54 reported an average or $36,740 for all retirement savings. Those age 55 and over reported only $33,980 in retirement savings.

There are several reasons why the catch-up provision is important for lower paid families, as well as middle and high-income families. First, even modest earners can afford to save a much greater portion of their income later in life when the mortgage and college bills are paid-- or at least nearly paid. The catch-up provision is also important because of well-established, existing rules for 401(k) plans that prevent highly compensated employees from making disproportionately higher contributions to those plans. Those rules will continue to limit higher paid employees' contributions under Portman-Cardin.

For example, currently, 401(k) contributions are limited by a number of provisions, and an individual's contribution cannot exceed the lowest of those limits. No individual may contribute annually more than the lowest of $10,500 or 25-percent of compensation.

Additionally, individuals making more than $85,000 in 2001, presumably, the "rich," are subject to nondiscrimination test limits amounts unique to each plan. The annual nondiscrimination test is a calculation based on the comparing average contributions as a percentage of pay by all employees earning over $85,000 with the average for all other employees. Some of last year's versions of the bill had exempted the catch-up provisions from the nondiscrimination rules. But that nondiscrimination rule exemption is not included in the 2001 version of the bill that passed the House. The exemption was dropped precisely in an effort to quell objections that claim the bill benefits only the rich.

The application of the nondiscrimination rules ensures that the catch-up cannot be more heavily used by those earning over $85,000 annually than by other employees.

Many lower-paid employees currently are limited by the 25-percent of compensation rule that permits deferrals or contributions to defined contribution plans exclusion, and this limit applies before the $10,500 is reached. The Portman-Cardin bill would eliminate this 25-percent of compensation limit, but opponents of the catch-up indicate that they are opposed to the removal of this limit, as well as other limit increases.

Today's 50 Year-Old Missed the Best Years for DB and DC Plans

When today's 50-year-olds entered the workforce, ERISA, the basic pension law, was still in the drafting stages. Enacted in 1974, the Employment Retirement Income Security Act (ERISA) provided for 10-year vesting. Defined benefit plans, for which employers provide all the funding and assume the risk of investment and mortality, were the primary pension plans. Even if today's 50-year-old had a defined benefit plan for a time, the primary value of defined benefit plans accrues in the last point of one's career. Many of those under 50 will never see those build-ups because their defined benefit plans were terminated and later replaced by defined contribution plans, such as 401(k) plans.

Today's average 50-year-old worker did not have the benefit of a 401(k) plan or funding an Individual Retirement Account (IRA) until 1981. While 401(k) plans were introduced in the early 1980s, they were not widely available and publicized until the late 1980s. To put the $5,000 catch-up in perspective, consider this comparison. The $2,000 in 1975 that might have funded an IRA, had they been available, would have the same buying power today as $6,340. A $5,000 catch-up contribution does not cover even one lost year of IRA funding. Invested at 8 percent back in 1975, that same $2,000 would be worth almost $14,000 today.

Catch-Up Especially Important for Baby Boomer Women

Women in or nearing their 50s are the first generation of outside the home, career-long women workers. When they entered the workforce in record numbers in the 1970s, they stayed with only brief "time outs." Some took time away from the workforce for having a family and getting the children established and, more recently, possibly even time out of work to care for elderly relatives. But basically, those women increased the workforce, helping to create today's unprecedented prosperity, and remain a steady and significant part of the workforce.

Most of these women are far behind in their savings for retirement for a number of reasons not of their making. For example, the Fidelity account database indicates that men age 50-59 have an account balance of $128,000 on average, compared to $66,000 for women. But many of these women have now progressed to a point in their career of earning a little more than the amount needed to cover living expenses, which frees up more money to save for the first time. So, it is realistic to think that women can use both the higher 401(k) deferral limits and even the catch-up provision in some cases.

Families will still need two retirement incomes, just as they have relied on two working incomes since the early 70s. Under today's Social Security system, families with two workers earning similar amounts during their careers will receive considerably lower Social Security benefits than the one-income family earning the same amount. Because employer-provided retirement benefits have shifted from defined benefit plans to defined contribution plans since the 70s, if working women have a retirement plan at all, it is likely to be a 401(k) type plan. The catch-up provision will be crucial to both men and women age 50 and older if they are to have adequate retirement savings. It is, in many ways-- to use the ubiquitous phrase-- a "family values" issue.

But the catch-up provision is likely to be more important to women for some very basic reasons:

  • Women live long than men. Therefore, they will likely spend more time in retirement and, consequently, need more money.

  • Women have been more likely to take time out of the workforce than men, thus losing income, seniority and retirement benefit accruals during that time.

  • Women earn less money than men-- this was especially true in the early years of female baby boomers' careers, but it is still true. (The Fidelity data also show that women defer about the same percentage of pay as men, but that same percentage generates a lower dollar amount.) In 1973, women working full-time, year-round earned $0.57 for each $1.00 earned by men. In 1999 they earned $0.77.

  • Until relatively recently, women were less likely to be working for an employer that offered a retirement plan.

Capping Carol to Rein in Ross

While some in Congress may be concerned about giving taxpayer Ross undue tax cuts, capping taxpayer Carol's retirement savings hardly seems the best way to do it. Suppose Carol, now 50, earns $35,000. By law she has not been able to contribute the full $10,500 to her 401(k) plan in past years because the 25 percent of compensation rule limits her to $8,750. She well may not have been able to afford that high a deferral in the past. But now she could finally make a significant contribution to her 401(k) plan because the children are out of the house and the mortgage is paid. She is married and the family can now afford for much of her income to go to building her retirement savings. She needs to-- and is willing to-- sacrifice to build her retirement savings. With the catch-up, Carol could contribute $13,750 or as much as $15,500, if the 25 percent of compensation limit is dropped. Yes, Carol would get an incredible tax break-- $15,500 of tax-deferred savings for retirement. But she's going to need it, because she has only 15 years to boost her retirement savings.

Using the assumptions that she can save $15,000 every year and earn a steady 10 percent on those savings-- quite optimistic in today's market-- she will have $477,000 at age 65. Sounds like a lot of money. But Carol is likely to live for another 30 years after retirement and that amount will pay her $42,300 a year, assuming a steady 8-percent return (which may also be a very optimistic assumption). That is still more than she earns now. But at retirement 15 years from now, at even a modest 4-percent inflation rate, her annual payment of $42,300 will have the buying power of only $23,500. Since Carol has been in the workforce, inflation averaged 7 percent in the 70s, 5.5 percent in the 80s and 2 percent in the 90s. By age 75, Carol's buying power will be only $15,900 annually. Even with a $5,000 catch up, Carol will have to be very lucky to make her savings last as long as she does.

Of course, Carol may not be able to save the extra $5,000 each year and many "Carols" might not be able to annually sacrifice that much in savings each year. But Carol and many of her colleagues, both male and female, would like to try. Because a person is willing to sacrifice to save for retirement does not necessarily mean that he or she is rich, but it may mean that he or she may want to be.

Martha Priddy Patterson is the director of employee benefits policy analysis with Deloitte & Touche LLP's Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.
Reprinted with permission from the June 2001 supplement to The 401(k) Handbook, ©Thompson Publishing Group, Inc., 2001. All rights reserved.

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