funding your future

When it comes to building a truly secure retirement in this country, we face a historic challenge that has been growing for some time. For years now, people have described retirement security in America as a “three-legged stool”—representing Social Security, employers’ retirement plans and savings that individuals and families set aside on their own. Today, it is clear that for many workers and families, this stool is far from stable and safe. Most Americans earn only modest Social Security benefits. Some have pension coverage but only in certain jobs, covering pieces of their careers. Some save on their own but still need to do more.

Indeed, each element of the retirement security structure—Social Security, employer-sponsored retirement plans, and individual savings efforts—is showing signs of strain.

Social Security

FDR described Social Security “as a cornerstone in a structure which is being built but is by no means complete.” That’s as true today as it was when this landmark program was enacted in 1935. Social Security remains a cornerstone—a universal system that provides a floor benefit to millions of Americans who rely on it as their principal, and too often exclusive, source of retirement income. It is estimated that more than 90 percent of of Americans age 65 or older receive Social Security; and nearly two-thirds of those collecting Social Security report it is their predominant source of income.

Though policymakers disagree on the kind and extent of reforms needed, Social Security’s pay-as-you-go structure will soon run large annual budget deficits as Baby Boomers retire while the proportion of younger workers paying into the system continues to fall.

Employer-Sponsored Retirement Plans

Defined benefit plans

Traditional employer-sponsored pension plans—the old ‘defined benefit’ (DB) pension plan that promised a guaranteed benefit based largely on years of service and compensation—have become increasingly rare for today’s active workforce. Only 1 in 3 such plans survive today. Many of the plans that do remain have not yet recovered from economic setbacks in recent years that led to dramatic drops in the plans’ ability to fully pay all promised benefits. Several of the largest of these plans, sponsored by employers in troubled industries like airlines and steel, have been taken over by the federal agency that backs up such pension promises—the Pension Benefit Guaranty Corporation (PBGC)—as the employers that offered the plans filed for bankruptcy. For hundreds of thousands of people—maybe millions before this all shakes out—this has meant a big cut in promised benefits.

Defined contribution plans

As defined benefit plans were falling in number, defined contribution (DC) plans took off. From 1975 to 1999, the number of participants in defined contribution plans more than quintupled, from about 12 million to more than 60 million. The number of defined contribution plans more than tripled. And the assets held in these plans soared from a 1975 level of $74 billion to $3.2 trillion at the end of 2004, including $2.1 trillion in 401(k) plans. With the shift came a tremendous growth in individuals’ responsibility: in these plans, individual employees must decide whether to participate, how much to save, how to invest savings given the options provided, when to rebalance, when to withdraw, and how to withdraw.

How will workers fare under this system? We’ll see: those now facing retirement are the first generation to weather this transition. EBRI/ICI research suggests that employees who make full and consistent use of these plans, and other similar defined contribution plans such as the alternative versions offered to teachers, state and local government employees, or those working for non-profits, should find themselves fully prepared for retirement. But it’s also clear that many people who are offered the chance to participate in these valuable plans do not do so.

It is also common now for individuals to hold nine, 10 or more jobs over their adult working lives, and each job change can mean important choices. Often workers will leave a job before fully vesting in the retirement benefits offered by the employer. Those who withdraw benefits when leaving a job incur a tax penalty from early distributions. Leaving the money in the plan or rolling it over to an IRA allows benefits to continue to grow tax free.

Employees who do participate and stay involved in their plans also face challenges in understanding and appropriately using the investment options provided to them. Being too conservative—or taking too much risk—won’t get savers where they need to go.

Individual Savings

For all the attention given to pension plan reforms—for example, how to better fund plans, clarify rules governing their operation, and improve participation in them—it’s mportant to remember that just a little more than half of the 151 million American workers are offered a chance at retirement plan coverage on the job. For many millions of Americans, therefore, the third pillar of retirement security—private savings—is critical. This is especially so because people are living longer in retirement. Many are getting less and less in the way of health coverage from their former employers. And health care costs are rising. Making provisions for a longer life—over and above whatever Social Security and employer-sponsored plans can contribute—has never been more important.

The Growing Challenge: A Convergence of Pressures

Is this situation new? No, it’s been coming on for some time. What’s new and especially challenging right now is that all the elements of retirement security—Social Security, employer-sponsored pensions, individual savings—are so in need of attention and strengthening, all at the same time.

In 2004, the President of the United States launched a historic, nationwide debate regarding the future of Social Security. In the process, he illuminated something hugely important. The problem is far larger than Social Security. As important as it is to strengthen Social Security, it’s equally important to fulfill the promise of the other needed sources of retirement income.

Mutual Funds: An Integral Part of Retirement Savings

Mutual funds now make up roughly half of the savings that American workers have built up in 401(k) plans. In fact, many—perhaps most—of the people who own shares in mutual funds today do so because their employer’s plan offered them the opportunity to become investors. The mutual fund industry works with employers who offer retirement plans, workers who try to make the most of work-based retirement plans, savers trying to supplement retirement plans, individuals without access to retirement plans, and retirees deciding what to do with retirement savings. It’s a complicated landscape of life experiences and savings options—made more complicated by the fact that people work for many different employers over their careers.

The Investment Company Institute (ICI) is the organization representing more than 300 mutual fund firms that manage more than $8 trillion in assets. Today, more than 90 million shareholders—more than 50 million households—own mutual funds. ICI—along with the Employee Benefit Research Institute (EBRI)—has for nearly a decade tracked the experience of millions of workers as they participate in tens of thousands of different 401(k) plans of various sizes around the country. Separately, ICI also surveys households that are saving through IRAs—whether traditional, Roth, or employer-sponsored (e.g., SIMPLE IRAs). Based on this research, ICI can speak to the urgency of action needed to improve retirement readiness in this country.

The Retirement Outlook: Practical Action to Make a Real Difference

What concrete, practical action can lawmakers and policymakers take to make a real difference for the retirement outlook ahead? Below are some proposals to help Americans build savings for retirement, manage assets during retirement, and promote investor education and advice needed throughout.

Building Savings

Make Reforms Permanent

Let retirement savers know that recent enhancements to retirement and educational savings incentives, and reductions of dividend and capital gains tax rates, are here to stay.

Retirement and Education Savings

Congress took important action in 2001 to promote retirement and educational savings—action that is now showing demonstrable results. Specifically, Congress:

• Increased the annual IRA contribution limit, in steps, from $2,000 in 2001 to $4,000 today (and increasing to $5,000 in 2008);
• Increased income limits for the phase-out of the deductibility of contributions to traditional IRAs;
• Increased the annual contributions limits for employer-sponsored retirement plans such as 401(k) plans;
• Allowed individuals age 50 or older to make special “catch-up” contributions of $500 a year (increasing to $1,000 in 2006) to IRAs and $4,000 a year (increasing to $5,000 in 2006) to certain retirement plans, recognizing workers may not have been able to make adequate contributions earlier in their careers;
• Increased the ability of workers moving from job to job to transfer retirement savings, too, without encountering tax penalties;
• Allowed tax-free distributions from “Section 529” qualified tuition plans, so long as the funds are used to pay for certain higher education expenses; and
• Increased the annual contribution limit to Coverdell Education Savings Accounts from $500 a year to $2,000.

Congress should make permanent the enhanced 401(k), IRA, and educational savings incentives it provided in 2001.

Capital Gains and Dividends

In 2003, Congress again enhanced saving incentives by reducing capital gains and dividend tax rates. Specifically, Congress:

• Reduced the tax rates on long-term capital gains from 20 percent (for taxpayers facing tax rates of 25 to 35 percent on ordinary income) and 10 percent (for taxpayers in the 15 percent and 10 percent brackets) to 15 percent and 5 percent, respectively. The 5 percent rates will be reduced to zero in 2008.
• Reduced the tax rate on qualified dividend income, which was previously taxed at ordinary rates, to the 15 percent and 5 percent capital gains tax rates.

Since the provisions took effect in 2004, dividend increases have exceeded all increases between 1994 and 2002 combined—greatly helping seniors who receive almost half of all dividend income. The U.S. Treasury estimates that 24 million Americans saved an average of $950 on their taxes in 2004 as a result of lower capital gains tax rates. The provisions have also contributed to job creation, an enhanced tax base, and better corporate stewardship of investors’ capital. And they are vital to strengthening the ability of those without access to employer-sponsored retirement plans—tens of millions of working Americans—to save and invest on their own for retirement.

Just as employer-sponsored plans and individual retirement savings habits are best served by consistent and predictable retirement laws, corporations and individuals are also best served by consistent and predictable expectations. Both individual investors and the financial markets need certainty to plan for the future.

Congress should retain the improved tax treatment of dividends and capital gains enacted in 2003 to strengthen individuals’ preparation for retirement and bolster the economy.

The Need for Predictability

Most workers would probably be surprised to know that these important changes in the law are only temporary. Most expire at the end of 2010, some even sooner.

Most of us know that the key to retirement savings is starting early, even if you’re starting small, and allowing money to grow and work for you—harnessing the power of compounding. Steady and persistent wins this race. This is behavior that the laws should be encouraging.

Instead, working families and businesses around the country face repeated reminders that the tax treatment on retirement contributions and withdrawals is subject to change. The cost? The kind of unpredictability that discourages people from retirement planning, complicates their efforts to estimate needed savings, and discourages saving. That is a cost we can and should avoid.

Congress should make permanent the enhanced 401(k), IRA and educational savings incentives it provided in 2001.

Growth: Deferred Tax Treatment for Deferred Capital Gains

Give deferred capital gains deferred tax treatment; reward retention and reinvestment with common-sense tax timing, don’t punish it.

For millions of American savers one of the most frustrating aspects of the tax law is the requirement that long-term capital gains to mutual fund investors in taxable accounts be taxed every year, even if they are automatically reinvested. Fund shareholders, like other investors, should be taxed when they sell their shares—not before, while they are still building savings for retirement.

Modifying the tax law so that gains are allowed to compound for taxation when shares are sold rather than being nicked year-by-year would help the overwhelming majority of mutual fund investors saving for retirement. The savings will not be insignificant. According to a Congressional study conducted in 2004: “Over 30 years, a typical mutual fund investor could lose as much as $40,000 from this unfair aspect of the income tax.”

At a time when individual Americans are being called upon to contribute more to their retirement, the tax code needs to help, not hinder, the process. Legislation introduced by Ways and Means Committee Members Paul Ryan (R-WI) and William Jefferson (D-LA) would help. The GROWTH Act, for “Generating Retirement Ownership Through Long-Term Holding,” is a timely bipartisan proposal that would keep more retirement savings invested longer and growing longer by deferring taxation of automatically reinvested capital gains until fund shares are sold—rather than allowing these long-term gains, which generate no current income or cash in hand, to be taxed every year. Like making permanent the policies of 2001 and 2003, passing the GROWTH Act represents a long-term tax policy for long-term investors.

The GROWTH Act would assist tens of millions of American savers and “should-be savers” over the course of their working lives—and make a real difference in the retirement readiness of American families. It would encourage savings among middle-income taxpayers, especially those with less ability than high-income taxpayers to rearrange their portfolios; recognize the expectations of shareholders, who often do not anticipate being taxed annually when they invest in a fund; and recognize the unique nature of mutual fund investing, which is based on long-term investing through a balanced portfolio, rather than specific buy-or-sell decisions about each holding.

Millions of mutual fund investors are now saving on their own for retirement without access to the tax assistance of an employer-sponsored plan. Millions more are supplementing the limited benefits available under their employers’ plans—and often the years when no plan was offered—by putting additional savings into a mutual fund. Who are mutual fund investors? More than half of them make less than $75,000 a year per household. They are not the wealthy stereotype sometimes described. They are the middle-class, the squeezed generation, and they would appreciate and benefit from some common-sense tax treatment for their efforts to plan and save.

Congress should pass the GROWTH Act to encourage, not penalize, those who invest for the long term.

401(k)s and IRAs: Encourage Participation

Help expand participation in, and results from, 401(k) plans through broader use of automatic enrollment, better guidance on appropriate default investment, and more up-to-date access to investment advice.

Automatic Enrollment

There are valuable steps to take to draw more people into participation in employer-sponsored retirement plans and to increase the results they see from those plans. Right now, one in five individuals offered the chance to participate in a 401(k) plan does not do so. For many, that is the result of inertia that could very easily be overcome by automatically including in the plan all those who do not opt out, rather than only those who affirmatively opt in. Research shows that millions more would benefit from 401(k) plans if this practice of automatic enrollment could be expanded. A recent study conducted by the Institute and the Employee Benefit Research Institute (EBRI) showed automatic enrollment plans boost worker participation rates from about 66 percent to more than 90 percent, a substantial increase that can be expected to have a significant impact on retirement lifestyle for those remaining in a plan throughout their working lives. Employers who sponsor these plans and fiduciaries responsible for the investment options under the plan would welcome guidance on how best to include new enrollees in the plans’ design and to structure appropriate investment options for them.

Both Congress and federal regulatory agencies can and should take steps to expand the availability and effectiveness of automatic enrollment programs.

Investment Advice

Workers covered by 401(k) plans would also hugely benefit from additional assistance with the investment decisions these plans typically call upon them to make.

While the statistics indicate that, on average, 401(k) plan participants have appropriately diversified portfolios, it is also a fact that investors in retirement plans currently face an “advice gap.” The 1974 Employee Retirement Income Security Act (ERISA) severely limits the provision of investment advice to retirement plan participants. Financial institutions that provide investment options to retirement plans are effectively prohibited from offering specific, individually tailored advice to plan participants—no matter how prudent or objective the advice. Many participants are in plans that do not offer any investment advisory service.

Recent studies have shown that many 401(k) investors would like to be able to take advantage of financial counseling programs that offer personalized assistance, and that such programs could significantly increase plan savings and participation rates.

Regulations governing professional advice to retirement plan participants are based on laws more than 30 years old. During that time, the retirement plan landscape has undergone a sea change—as have the options available to workers in the plan, the services provided to workers, and the individual decisions they must often make. Investment advice rules and options available to these individuals should be updated to reflect that change.

Congress should update the rules governing 401(k) plans to make sure that participants have the kind of investment options and professional advice they need.

IRAs: Clarify and Simplify Eligibility Rules

Just as more modern rules would produce greater confidence and better results for 401(k) investors, use of IRAs likely would increase, too, if Congress restored simplicity and clarity to the rules on contributions and eligibility. IRAs were first envisioned as a savings vehicle for those without access to an employer’s retirement plan. In the early 1980s, Congress made IRAs “universal,” allowing any taxpayer under age 70 and a half with earned income to make a deductible IRA contribution, whether or not he or she was covered by an employer’s plan. IRA contributions soared.

In 1986, Congress reimposed coverage under an employer’s retirement plan as a limit on deductible IRA contribution eligibility. And although that limit has since been liberalized, annual IRA contributions remain far below the level they had reached in the mid-1980s. After all the changes in rules regarding who is eligible to contribute how much on what basis, it has become persistently true that only a fraction of those households eligible to contribute to IRAs do so. This remains true in spite of the growing attention to retirement costs and needs, attention to volatility in pension funding and security, and debate around Social Security.

If policymakers expect individual savings to represent a meaningful part of retirement income, then for a great many families the IRA rules need to be consistent over time, predictable in their application, and simpler. In other words, Congress must restore universal eligibility to IRAs.

Managing Assets in Retirement

Permit Investors to Make Retirement Income Last.

Delaying Required Withdrawals

Steady accumulation of retirement savings is one important phase of retirement security—steady withdrawal is the other challenge. Right now, the tax code effectively requires that savers begin withdrawing from IRAs and certain retirement plans at age 70 and a half. Given the length of time many will spend in retirement, and the fact that many may still be working full or part-time at age 70 and a half, this treatment needs to change. No doubt, reform would be costly, at least in the short term. From a federal budget perspective, delaying forced withdrawal means delaying annual taxation of those retirement dollars. But while from a short-term budget perspective, it’s expensive; from a long-term retirement security perspective, it’s the right thing to do.

Annuitized Retirement Income

Much has been written suggesting that annuitized retirement income is disappearing. Yet most people already have a significant portion of their retirement income “annuitized” and need some flexibility in the rest of their retirement savings. Currently, 76 percent of retirees receive two-thirds or more of their retirement income in the form of an annuity, through a combination of Social Security benefits, defined benefit plan income, and other annuities.

In addition, carefully tapping mutual fund investments allows retirees to use other retirement savings in a manner that lets them remain invested for the growth needed to fight inflation, to hold costs down, and to retain the flexibility needed to tap savings if health emergencies or other unanticipated needs arise, without incurring expensive debts or penalties. Systematic withdrawal programs—or periodic distribution plans or Lifetime Payment Accounts (LPAs)—have been around for a long time and are a common element in financial planning guidance.

No one savings plan is right for every individual needing to save for retirement, and no one approach to drawing down assets is right for every individual going through retirement. Congressional action intended to help retirees make retirement income last should keep this caution in mind. Different strategies make sense for different people in different circumstances. Special tax incentives that prejudge that decision and encourage any one form of distribution alone could operate as a dangerous distortion of retirement planning and must be avoided.

Promoting Investor Education

Help People Seize The Opportunity to Manage Their Future.

While we address sophisticated efforts to reform pension and tax laws, it’s imperative that we work on a parallel track that respects the fundamentals—American savers and investors of all ages need a wide range of skills and tools, including the basics of financial literacy, debt and credit management, and more.

Financial literacy is critical to individual wellbeing and, in turn, to finding solutions to many of the intractable domestic issues facing our nation’s policymakers. On a personal level, the consequences from a single bad financial decision (or indecision), such as the failure to diversify savings or the delay of saving until midlife or later, can directly, and perhaps permanently, affect one’s standard of living. Those with limited financial acumen are less likely to be able to meet long-term goals and are more vulnerable to fraud and to financial setbacks—up to and including personal bankruptcy.

But the impact of financial illiteracy extends far beyond individual well-being. When financial illiteracy is pervasive, the economy is also compromised: the aggregate decisions of uninformed or ill-informed consumers make financial markets inefficient and less competitive. Financial illiteracy can lead to the overuse of credit and can depress savings rates, thereby curtailing the availability of capital to fuel economic growth.

ICI Efforts

For several years the ICI’s Education Foundation has been participating in investor education initiatives such as the American Savings Education Coalition, the Alliance for Investor Education, the National Endowment for Financial Education, and more recently, the Financial Literacy Caucus, the Financial Literacy and Education Commission, and the White House Conference on Aging.

In addition, the Foundation partners with government agencies and other nonprofit organizations to develop, support, and distribute investor education programs for under-served communities. Currently, these include the Investing for Success program for African-American and Hispanic investors in partnership with the National Urban League and the Hispanic College Fund, the Stock Market Game™ program for secondary-school students with the Foundation for Investor Education, and money management seminars for students at Historically Black Colleges and Universities with the Society for Financial Education and Professional Development.

Government’s Role

The Federal Government has a significant interest in stimulating individual saving and investment because of the implications of such personal activities for a broad range of public policy issues, including education and health care, as well as retirement security. Accordingly, Congress should encourage financial literacy and investor education as national priorities. This support should include the Congressional Financial Literacy Caucus, the federal Financial Literacy and Education Commission, state initiatives to improve financial education requirements in schools, and innovative private and nonprofit programs.

A Work in Progress

The road ahead: research, analysis, education, advocacy.

To paraphrase FDR, America’s program to provide retirement security is a work in progress. And never has progress been more important. The challenge is made more urgent by the oncoming changes in America’s demographic profile, escalating health care costs, and longer life expectancies.

The President and Congress both recognize the need to debate this issue, and consider ways to help ensure that Americans are able to fund their future. The effort must strengthen all three legs of the retirement stool—Social Security, employer-sponsored retirement plans, and individual savings.

It is a challenge that requires research, analysis, education, and advocacy.

ICI stands ready to help.

September 7, 2005