The Oh-So-Golden-Years Pension Break
Highly-paid employees often benefit from much larger pensions, and much larger tax savings, through employer-based pension plans than do rank-and-file employees.
Question 6. Ask the Candidate:
Would you limit tax breaks for employer-based pension plans to the funding of a basic pension?
Congress encourages the creation of pension plans by granting highly favorable tax treatment to employers, employees, and the trusts that receive and invest all pension contributions. Employers deduct their contributions to the trusts; neither employers nor employees owe Social Security or Medicare taxes on the contributions except for employee 401(k) contributions; employees do not owe an income tax on the contributions, including any contributions by them, nor are they taxed on the earnings of the trusts while they accumulate; the trusts are exempt from tax on the contributions and earnings; employees are subject to an income tax on their pension accounts only when they receive them, which usually is decades after the contributions were made; and distributions are exempt from Social Security and Medicare taxes.
Some readers might assume that, because the IRS collects taxes on our pensions when we ultimately receive them, our right to defer the tax over decades doesn't really cost the government anything. Quite the opposite is true. Imagine how much more money you would have, and how much less money the government would have, if you could defer the tax on your wages for decades, without owing interest on the taxes you defer. But, of course, you can't. If you pay taxes on your wages one day late, you owe the IRS a day's interest on the taxes.[1]
No such interest accrues, however, on the deferral of the income tax on pension contributions and accumulations. That's why, from 2007 through 2011, tax breaks for pension plans are estimated to save participants about $660 billion of income taxes. In addition, over these years, several hundred billion dollars of Social Security taxes will be forgone on pension contributions, and these are forgone forever.[2]
We would like to believe that, by granting these sizeable tax breaks, Congress expects that pension plans would fill the considerable gap between the cash income needs of typical workers when retired and the income they receive from Social Security and other savings they have accumulated individually. But Congress has long known that pension plans largely have failed that calling. Too few rank-and-file workers have participated in a pension plan, often because their employers haven't offered one. When a plan is offered, many workers can't participate because eligibility rules exclude them. Also, many workers don't participate in 401(k) plans, which emphasize contributions by the workers themselves, either because they can't afford to contribute or because they are not sufficiently disciplined--living in the present instead of foregoing current consumption and planning ahead.
For all these reasons, only about half of all workers participated in a private pension plan in 2007, including only 37% of workers employed by a small business and 36% of workers earning less than $15 per hour.[3]
And when rank-and-file members do participate, their accounts too often are modest. One central reason: Employers contribute far greater amounts for higher-compensated workers than they contribute for rank-and-file workers. Another reason: Rank-and-file participants often forfeit a portion of their pensions when their employment terminates, as explained in Question 7.
Pensions for most people are so small that about one-third of all people who are 65 and older receive at least 90% of their cash income from Social Security, while two-thirds receive over half of their cash income from Social Security.[4]
To summarize, tax breaks for pension plans have proven to be an inefficient and costly strategy to help rank-and-file workers accumulate funds for a basic pension. Most of the tax savings have been for middle- and upper-income workers.
You might be thinking: Why shouldn't employers be entitled to fund much larger pensions for key employees than for employees they value less? They should, with one proviso: Other taxpayers shouldn't pay higher taxes to subsidize them. Or we might put it this way: The government shouldn't give tax breaks for large pensions for the top brass any more than it should give them tax breaks for expensive homes or deluxe health insurance policies.
The Two Traditional Private Pension Plans
Let's pause a moment to identify the two types of traditional private pension plans, to be distinguished from the modern 401(k) plan discussed shortly. For both types of traditional plans, contributions are made solely by the employer.
Defined benefit plan. The first type--a "defined benefit plan"--guarantees you an annual retirement income. The amount guaranteed will equal a specified percentage (such as 30%) of your highest wages (usually averaged over a 3-year period) by the time you reach normal retirement age (usually age 65).[5] For example, if by the time you reach 65, your highest average wage is $100,000, a 30% benefit formula would give you $30,000 (30% x $100,000) each year for the rest of your life.
Just so you're clear about maximums: For an employee who becomes 65 this year, a defined benefit plan may pay a benefit of as much as $185,000 per year, assuming the employee's average wage is at least that high. If he retires in subsequent years, the $185,000 figure is scheduled to increase with cost-of-living increases.
Defined contribution plan. The other type of traditional pension plan--a "defined contribution plan"--spells out a formula for determining how much will be contributed each year for you, but it does not guarantee what you'll get when you retire. Rather, that amount will depend upon how well your contributions have been invested.
You're wondering what the maximum contribution might be this year to a traditional defined contribution plan? It may be as much as $46,000 for an employee who earns at least $46,000 this year.
Doubling Up. Employers may adopt both defined benefit and defined contribution plans; and, if you earn enough, you can receive the maximum allowed by Congress under each plan. That's how mega-pensions are built.
The Traditional Right to Discriminate
The enormous gap between the size of pension contributions for highly-compensated workers compared to pension contributions for ordinary workers is directly related to the right of pension plans, explicitly granted by Congress, to discriminate on the basis of salary differentials. For example, in the case of a defined contribution plan, if someone makes five times as much as you, contributions for her may be five times greater than for you. Again, there's nothing wrong with employers funding whatever pensions they like for key employees, with one proviso: The government shouldn't subsidize these larger pensions through special tax breaks.
Congress "limits" this form of discrimination by forbidding plans to take into account compensation above a certain level. Yet the level--this year, it is $230,000, which only about the top 2% of workers earn--has little impact on the ability of plans to favor managers over rank-and-file workers, as will be demonstrated below.[6]
Now that we're clear about the rules, let's watch how they might play out.
Building the Mega-Pension with Government Dollars
To keep our example simple, let's look solely at a defined contribution plan for a company with two employees. Once you see the outcomes here, you can imagine the outcomes for the typical large company that pays managers far more than it pays rank-and-file workers.
Terrific Subprime Loans, Inc. employs Tina Terrific, the 32-year-old owner of the company, and Laura Lamb. Tina earns $230,000, Laura $23,000. Tina has arranged for Terrific to adopt a traditional defined contribution plan with a contribution formula geared to contribute the maximum for her. That amount--$46,000 for this year--can be reached if the plan calls for contributions of 20% of the salary of each participant: 20% of Tina's $230,000 = $46,000. Laura will get a contribution of $4,600 (20% x $23,000).
Had Tina been taxed currently on the $46,000 at her 33% marginal tax bracket, she would have owed over $15,000 a year. Had Laura been taxed on her $4,600 at her 10% marginal tax bracket, she would have owed only $460.
You get the picture: The contribution for Tina is 10 times larger than the contribution for Laura, but Tina's tax savings this year are almost 33 times larger than the tax savings for Laura. Remember, Congress blesses this form of discrimination in favor of highly-compensated workers.
Now let's see what happens if contributions for Tina increase with the cost-of-living index--which we'll assume is 3% per year--each year for 33 years, by which time she will turn 65, and if the plan earns 8% annually (well within the average growth rate of stocks over the last 50 years). Her pension account would then be worth a cool, and comfortable, $9,960,000; this would be equivalent to nearly $4 million, in today's dollars, for someone retiring this year. Still cool and comfortable.[7] Additionally, if Terrific also funded a defined benefit plan, Tina could be entitled to an annual pension of $185,000 (in today's dollars).
In theory, Laura could ultimately have an account, in today's dollars, of $386,000, a very respectable amount, if she remained employed for 33 years and her account grew proportionally to Tina's. More likely, she will leave her employment long before then. If she leaves voluntarily, or is fired with or without cause, she might even forfeit some of all of her account (see Question 7).
Comparing Limits of 401(k) Plans
Let's now contrast rules for the traditional defined contribution plan with rules Congress has fashioned for the modern 401(k) plan, also a defined contribution plan.
The 401(k) plan has become increasingly popular with employers because employees themselves make most of the contributions; employers typically choose to match a portion of the employee's contribution. A 401(k) plan also differs from traditional pension plans in two other fundamental respects. First, the basic contribution in 2008, by the employee and the employer combined, for any participant--even for an executive who earns millions of dollars--cannot exceed $15,500, compared to $46,000 for a traditional money purchase pension plan. (The average contribution by a participant to a 401(k) plan is just over $4,000.)[8] Second, within the $15,500 limit, total contributions may not be significantly larger for management than for rank-and-file workers.
What Congress Should Do
Set Basic Pension Limits. Congress should limit tax breaks for pension contributions for all workers, including management, to amounts necessary to achieve a basic pension for an average worker. This basic pension should be sufficient, when added to anticipated Social Security benefits, to allow that average worker to maintain the standard of living he has enjoyed prior to retirement. Plans also should be subject to the 401(k) rules that forbid discrimination in favor of management.
We won't try to define "average worker" or set precise pension limits here, but a good starting point for discussion of limits for defined contribution plans should be the 401(k) contribution limit. Contributions of $15,500 a year (increased for cost-of-living adjustments) until retirement would produce a retirement income, added to Social Security and Medicare benefits, more than sufficient to maintain the standard of living of most workers prior to the time they retired. Larger contributions (and tax breaks) could be allowed for workers who have insufficient pension accumulations and years to accumulate the desired amount by normal retirement age. A defined benefit plan could fill in any deficit if the defined contribution plan was falling short of the maximum allowed.
While these new limits would reduce the size of tax-favored pensions for higher-income workers, these workers are capable of building substantial pensions for themselves outside of these plans, particularly with the advantages of favorable income tax treatment for capital gains and dividends (both currently taxed at no more than 15%). Their personal savings could be supplemented (after taxes) by any additional wages employers paid to them to cover the difference between what previously could be contributed to pension plans and what would be allowed under the new rules.
Critics will argue that, by eliminating the tax relief for higher levels of pension saving, the proposal would reduce significantly the amount higher-income workers save overall, and their lower level of saving could slow economic growth.[9] The most credible economic studies conclude, however, that tax breaks for saving have little impact on how much individuals save.[10] Even the economist Robert Hall, a great exponent of the flat tax that exempts saving from tax, has written that "a detailed study of data for the twentieth-century United States shows no strong evidence" of a positive saving response to a reduced tax rate on saving.[11] In other words, higher-income workers are likely to increase other forms of savings to offset, for the most part, any savings that they may no longer be able to achieve through their pension plans.
Additional Revenue from Reforms. There are no current studies estimating the additional tax revenue that could result from these reforms. On the basis of earlier studies, we should expect that the revenue would at least be sufficient to fund all or most of the refundable credits suggested in this book for the child care credit (Question 3) and higher education tax credits (Question 8).[12]
A Risk: Companies Might Shut Down Pension Plans
Some people argue that if Congress were to stop subsidizing much larger pensions for managers than for rank-and-file workers, many companies would stop offering pension plans, which would hurt millions of rank-and-file workers who participate in these plans.
The risk of this happening on a large scale does not seem great. Most small companies don't have pension plans--and if they do, they are likely to be 401(k) plans, which already limit the advantages for managers. Most medium and large companies have pension plans, but the plans are so ingrained in the corporate culture that the companies are unlikely to forego pension plans altogether. Increasing numbers of these companies already have moved in the direction of 401(k) plans, and more can be expected to even without the reforms suggested here. Finally, limitations on discriminating in favor of managers might encourage some companies to contribute more to pensions for rank-and-file workers, which in turn would allow larger contributions for managers.[13]
A Final Word
Candidates are likely to be particularly wary of these proposals, which strike at one of the great opportunities today for highly-compensated workers (whose political and financial support the candidates need) to build up sizeable retirement accounts at the government's expense. Candidates, and existing members of Congress, also would worry that new limits on private pension plans would put large Congressional pensions in jeopardy. We might also see resistance from union leaders because many of them are highly compensated and benefit from generous pension plans. Readers who are particularly interested in this question might keep a notebook listing the different answers candidates give. The notebook had better be thick.
[1] Here's a simple example to show how you are better off deferring the tax, interest-free, on your pension contributions. Assume that you will defer the tax on a contribution of $10,000 for just one year, that the $10,000 will earn 8% ($800) for the year, and that you will pay a tax of 25% on the entire $10,800 (or $2,700) in the subsequent year. You would be left with $8,100 after taxes. On the other hand, if you paid a 25% tax on the $10,000 for the year it was contributed, you would have had $7,500 left; and had you earned 8% on that $7,500, you would have earned $600; but it too would have been subject to a 25% tax, leaving $450. Your total after-tax savings: $7,950 ($7,500 + $450), or $150 less than in the tax-deferred example. If you continued this comparison for 30 years, your pension account, after the 25% tax on the distribution, would be worth $918,000, while your personal account, after taxes, would be worth $629,000.
[2] For the income tax figure, see Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011. CS-3-07. Washington, D.C.: GPO, 2007, 34. The Social Security figure is my estimate.
[3][3] U.S. Department of Labor, U.S. Bureau of Labor Statistics, August 27, 2007, National Compensation Survey: Employee Benefits in Private Industry in the United States, March 2007, Table 1, 7.
[4] Congressional Budget Office. Baby Boomers= Retirement Prospects: An Overview. Washington, D.C.: GPO, November 2003, 4. See also National Institute on Aging and National Institutes of Health, Growing Older in America, The Health and Retirement Study. U.S. Department of Health and Human Services, June 12, 2007, Fig. 3-1, 58, and Fig. 3-2, 59.
[5] An employee's maximum benefit is reduced if he retires prior to normal retirement age.
[6] Consumption tax advocates favor unlimited exemptions for contributions to pension plans and other forms of saving. The arguments in favor of replacing the income tax with a consumption tax-a tax on spending, not saving--are beyond the scope of this short book. One likely outcome of a consumption tax would be to widen the enormous gap that exists between the wealth of high-income households and that of ordinary households. Most households consume, and would be taxed on, a high percentage of their income; high-income households consume, and would be taxed on, a much smaller percentage of their income.
[7] If you discount the $9,960,000 at 3% per year for 33 years, the rate of inflation used to calculate Tina's annual salary increase, the real value of the account in today's dollars would be $3,860,000.
[8] Employee Benefit Research Institute Notes, October 2007, Vol. 28, No. 10, 6.
[9] These modifications may have no negative impact on net national savings, defined as the sum of government saving plus private saving. Eliminating tax breaks for higher levels of pensions should increase federal tax revenue, and thus government saving; and this increase may be equal to, or even greater than, any decrease in saving by higher-income workers.
[10] See John O. Fox, If Americans Really Understood the Income Tax. Boulder: Westview Press, 2001, ch.9.
[11] Robert E. Hall, "Intertemporal Substitution in consumption," Journal of Political Economy 96, no. 2 (1988): 339-40.
[12] The Congressional Budget Office, in 2001, estimated that the government could collect an additional $27.4 billion from 2002-2011 by limiting tax subsidies for defined benefit plans to plans that provided a maximum annual benefit of $80,400 (down from a maximum annual benefit of $140,000 at that time), and by applying 401(k) limits-then $10,500-to defined contribution plans. The revenue would have been larger if the defined benefit limit were set at a retirement income for typical workers, which was then (and remains) far below $80,400. Congressional Budget Office. Budget Options, Washington, D.C.: Government Printing Office, February 2001, 414.
[13] While employers often contribute something to 401(k) plans to match a portion of contributions by employees, employers generally contribute far less not only for managers but also for rank-and-file workers than they contributed when the companies had traditional pension plans. For this reason, and also because rank-and-file members often are unable to afford contributions, the pensions of a typical rank-and-file worker are growing even less than they did in the past.