The Oh-So-Golden-Years Pension Break

At great government expense, our tax laws subsidize very large company pensions for highly-paid employees. Yet most typical private sector workers receive only modest pensions or no pensions at all.

Question 6. Ask the Candidate:

Would you limit tax breaks for company pension plans to the funding of a basic pension for a typical worker. Would you also limit pensions for management to levels provided for typical workers?

Over the last 90 years, Congress has given trillions of dollars of tax relief to subsidize employer-based retirement plans (referred to here as “pension plans”). While this has handsomely rewarded management, the program has done little for most private sector workers, who must rely heavily on Social Security when they retire. It’s time to overhaul the system.

How the Tax Breaks Work

The Rules. Congress encourages the creation of pension plans by granting highly favorable tax treatment to employers and employees, and to the trusts that receive and invest all contributions:

All distributions are taxed as ordinary income, even if they include capital gains and dividends earned by the trust.

  • employers deduct their contributions to the trusts;
  • the contributions are exempt from Social Security and Medicare taxes, except for employee 401(k) contributions;
  • an employee does not owe an income tax on contributions for his pension to the trust or the earnings of the trust while the amounts accumulate in the trust;   
  • 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.

The Tax Savings. Some readers might assume that, because the IRS collects income 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. In fact, your right to defer the tax on all contributions and earnings, interest-free, until they’re distributed to you is what makes the plans so valuable.        

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 2011 through 2015, tax breaks for pension plans are estimated to reduce the government’s income tax revenue by about $718 billion, after subtracting the taxes collected on pension distributions. In addition, over these years, nearly $200 billion of Social Security and Medicare taxes will be forgone on pension contributions, and these are gone forever.[2]    

For example, they might not have been employed for at least one year or they might not work at least 20 hours per week, as required by most plans.

Why Benefits are Limited for Ordinary Workers. We would like to believe that, by granting these sizeable tax breaks, Congress expects that pension plans would significantly help to fill the considerable gap between the cash income needs of typical retired workers and the income they receive from Social Security and other savings they have accumulated. But Congress has long known that most pension plans haven’t come close to measuring up. Too few rank-and-file workers in the private sector—who represent about 85% of all workers--have participated in a pension plan, often because their employers haven’t adopted one. When employers have adopted a pension plan, many workers can’t satisfy eligibility rules. Also, many workers don’t participate in 401(k) plans because they can’t afford (or believe they can’t afford) to make their own contributions or because they lack the discipline to forego one or more personal discretionary expenditures.  

About three-quarters of public sector workers—representing about 15% of all workers-- participate in a pension plan.

For all these reasons, only about 44% of all private sector workers participate in a pension plan in any given year, and far less participate if employed by a small business. [3] And when rank-and-file workers do participate, their accounts 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 (see Question 7)

Medicare benefits and food stamps, for example, don’t count as cash income.

Pensions for most people are so small that about 40% of those 65 and older receive about 90% of their total cash income from Social Security.Even people in the middle quintile of seniors measured by their cash income receive over 75% 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 gone to middle- and upper-income workers.

You might think: Why shouldn’t employers be entitled to fund much larger pensions for key employees than for less-valued employees? Yes, they should, but other taxpayers shouldn’t pay higher taxes to subsidize them. Or put it this way: The government shouldn’t give tax breaks for large pensions for the top brass any more than it should give tax breaks for McMansions or deluxe health insurance policies.

The Two Traditional Private Pension Plans

Let’s take a moment to identify the two types of traditional private pension plans, to be distinguished from the modern 401(k) plan discussed shortly. In 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 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. 

If his highest average salary was $30,000, the maximum benefit would be $30,000 per year.

Consider Justin Malloy, long-time manager of a Fortune 500 company who has earned at least $200,000 over the last three years. If he retires today at age 65, the corporation’s defined benefit plan could pay him $200,000 per year for the rest of his life, the maximum benefit Congress allows this year. Think about it: Relatively few Americans ever earn $200,000 in a single year. But if Mr Malloy retires in a future year, that $200,000 annuity will be even higher because it is automatically adjusted for inflation.

To put this $200,000 “limit” in perspective: Many proposals in Congress today include cuts in programs for the poor as a means to address huge annual deficits. Yet no one is proposing to limit pensions like Mr. Malloy’s, which allow the tax-free accumulation of about $2.5 million in a defined benefit plan to guaranty that $200,000 per annum lifetime payment.

Defined contribution Plan. The other type of traditional pension plan—a “defined contribution plan”—adopts a formula to determine how much will be contributed for you each year but does not guarantee how much you’ll get when you retire. That amount will depend upon how well your contributions have been invested.

Having now learned about maximum defined benefits allowed by Congress, what ceiling do you think Congress imposes this year on contributions to a traditional defined contribution plan for highly-compensated employees? Did you say $50,000?And that’s just for one year.

Double Maximums.  Many employers may provide both defined benefit and defined contribution plans for their employees; and, if you earn enough—as in Justin Malloy’s case--you can receive the maximum allowed by Congress under each plan. That’s how mega-pensions are built.[6] 

The Traditional Right to Discriminate

The enormous gap between pension contributions for highly-compensated workers and for ordinary workers exists primarily because Congress allows contributions and benefits in ratio to salaries. In the case of a defined contribution plan, if someone makes five times as much as you, contributions for may be five times greater for her than for you. Again, there’s nothing wrong with employers funding whatever pensions they like for key employees, but--the government shouldn’t subsidize these much larger pensions through special tax breaks. 

Congress purports to limit this form of discrimination by forbidding plans to consider compensation above a certain level. Yet the level—$250,000 for 2012—earned by only about the top 2% of all employees—has little impact on the ways plans favor managers over rank-and-file workers, as demonstrated below.[7]     

Building the Mega-Pension with Government Dollars

To keep our example simple, consider contributions to a defined contribution plan for two of the hundreds of employees of Mortgage of America, Inc. (“Mortgage”), a successful mortgage lending corporation. (The outcomes here are typical for a large company that pays managers much more than rank-and-file workers.)

Mortgage employs Tina Terrific, a 35-year-old manager, and Laura Lamb, a 35-year old receptionist. Tina earns $250,000, Laura $25,000. Mortgage has adopted a contribution formula to provide the maximum contribution for people like Tina. That amount--$50,000 this year—can be reached if Mortgage contributes 20% of each participant’s salary: 20% of Tina’s $250,000 = $50,000. Laura will get a contribution of $5,000 (20% x $25,000).

Had Tina been taxed currently on the $50,000 at her 33% tax bracket, she would have owed over $16,500. Had Laura been taxed on her $5,000 at her 15% tax bracket, she would have owed only $750.

You get the picture: The contribution for Tina is 10 times larger than for Laura, but Tina’s tax savings this year are 22 times larger than Laura’s. So, Congress blesses this form of discrimination—and tax savings—greatly favoring highly-compensated workers.                  

And don’t forget: Mortgage also can offer a defined benefit plan that will guaranty Tina $200,000 per year when she retires at age 65 (a figure that may increase each year with inflation as Tina approaches retirement age). That’s in addition to her defined contribution plan.

Comparing Limits of 401(k) Plans

Now contrast rules for the old-fashioned defined contribution plan with rules Congress applies to 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, typically matched to some extent by the employer. A 401(k) plan also differs from traditional pension plans in two other fundamental respects. First, the combined contributions in 2012 by employee and employer--even for an executive who earns millions of dollars—cannot exceed $17,000, compared to $50,000 for a traditional defined contribution pension plan. (The average annual contribution by a participant to a 401(k) plan has been around $4,000.)[8]  Second, within the $17,000 limit, total contributions for managers (counting both employer and employee contributions) may not be significantly larger 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 and Medicare benefits, to allow that average worker to maintain the standard of living 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 discussing limits should be the 401(k) limit. Contributions of $17,000 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 most workers enjoy prior to retirement. Larger contributions (and tax breaks) could be allowed for workers who have insufficient pension accumulations and relatively few 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.

One alternative to the current treatment of defined contribution plans would be to tax them as wages and to allow a refundable credit of some percentage (such as 20%) of the amount contributed. Then, the tax relief would be far more equitable: Identical credits would be received for identical contributions, thereby eliminating the impact of marginal tax brackets on the tax savings. The credit should be refundable to assure benefits for participants who don’t owe any income tax.[9]

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 pension plans, particularly with the advantages of favorable income tax treatment for capital gains and dividends. Their personal savings could be supplemented 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 significantly reduce the amount higher-income workers save overall; and their lower level of saving could slow economic growth.[10] The most credible economic studies conclude, however, that tax breaks for saving have little impact on how much individuals save.[11] Even the economist Robert Hall, a great exponent of a 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.[12] 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 sharply curtailing contributions to traditional pension plans for higher-income workers. William Gale of the nonpartisan Brookings Institute, estimated, however, that by taxing all employee contributions to 401(k) plans and to IRAs, and instead providing participants with an 18% matching credit, Congress could increase tax revenues by $450 billion over 10 years.[13] The revenues would be considerably greater if comparable reforms were extended to traditional pension plans.

A Risk: Companies Might Shut Down Pension Plans

Some people argue that if Congress were stopped subsidizing much larger pensions for managers than for rank-and-file workers, many companies would stop offering pension plans, hurting millions of rank-and-file workers who now 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. Many companies already have moved in the direction of 401(k) plans, and more can be expected to even without the reforms suggested here.[14]

A Final Word

Certain candidates are likely to be particularly wary of these proposals, which might alienate the political and financial support they count on from highly-compensated workers. Candidates, and existing members of Congress, also may worry that limits on private pension plans would put large Congressional pensions in jeopardy.  We might also see resistance from union leaders because many are highly compensated and benefit from generous pension plans.

Readers interested in this issue might keep a notebook listing the different answers candidates give. The notebook is likely to become very 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 6% ($600) for the year, and that you will pay a tax of 25% on the entire $10,600 (or $2,650) in the subsequent year. You would be left with $7,950 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 6% on that $7,500, you would have earned $450; but it too would have been subject to a 25% tax, leaving $337. Your total after-tax savings: $7,837 ($7,500 + $337), or $113 less than in the tax-deferred example. If you continued this comparison for 30 years, your pension account would be several hundred thousand more, after the 25% tax on the distribution, compared to your personal account.

[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] “Preparing for Retirement in America,“ Retirement Conference Survey Fact Sheet #3, Employee Benefit Research Institute (EBRI), 2012.

[4] Estimates from the Current Population Survey for 2010, EBRI March 31 Supplement.

[5] An employee’s maximum benefit is reduced if he retires prior to normal retirement age (typically age 65) or has less than 10 years of employment..

[6]  Certain plans, such as for the self-employed or certain professional firms, may not able to provide maximum benefits under both defined benefit and defined contribution plans.

[7] 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 householdsconsume, and would be taxed on, a much smaller percentage of their income.

[8] Employee Benefit Research Institute Notes, October 2007, Vol. 28, No. 10, 6. The average contribution rate is around 7%– 8%. Fast Facts, EBRI, March 19, 2009, #117.

[9] William Gale of the Brookings Institute has proposed a somewhat similar reform of the tax treatment of 401(k) contributions. He would tax all contributions as wages, subject to federal income and FICA taxes. He then would provide a refundable tax credit of at least 18% of the amount contributed by the participant, and he would have the credit deposited directly into the participant’s 401(k) account. The difficulty with this approach is that many participants might struggle to come up with the money to pay the tax on the contributions, which would discourage them from making the contributions. William Gale, “Tax Reform Options: Promoting Retirement Security,” Testimony Submitted to United States Senate Committee on Finance, September 15, 2011.

[10] 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.

[11] See John O. Fox, If Americans Really Understood the Income Tax. Boulder: Westview Press, 2001, ch.9.

[12] Robert E. Hall, “Intertemporal Substitution in consumption,” Journal of Political Economy 96, no. 2 (1988): 339-40.

[13] See endnote 9.

[14] 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.


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