Saving and Investing: A Challenge for Women

Policy Backgrounders | Retirement | Women In The Economy

No. 161
Thursday, April 15, 2004
by Celeste Colgan and John Goodman


Problems with Employee Retirement Plans

While defined contribution pension plans have solved some of the problems of the older system, they have created a new set of problems on their own. Let's take a closer look.

Problem: Vesting Requirements. The idea behind vesting is that employees must work for an employer for a certain number of years before they obtain full rights to the promised retirement benefits. Therefore, an employee who leaves before fully vesting in a defined-benefit plan will receive a smaller pension during retirement. In defined-contribution plans, employees are automatically entitled to whatever they have contributed. But they typically are not entitled to the full amount of an employer's matching contribution until they have logged a minimum number of years of service. At one time, it was not unusual for employers to require 10 or 15 years of service before vesting was complete. Today the law requires vesting periods to be no longer than seven years.23 But even a short, say, three year vesting requirement has a disparate effect on women24 and interferes with a dynamic, highly mobile workforce.

Figure III - Limits on Contributions to Tax-Favored Savings Plans in 2003

"Vesting requirements disadvantage women, who are more likely to switch jobs."

Why have vesting at all? One could argue that a vesting period makes sense. Vesting allows an employer to recover some of the administrative costs connected with employees who pop in and out of employment. In today's competitive job market for highly skilled workers, however, many employers have dropped vesting requirements altogether, choosing to match employees' contributions from their first day on the job. By contrast, other employers see long vesting requirements as a way to reward employees who are "loyal" (that is, who don't leave to work for a competitor), and to punish those who are not. Thus, vesting requirements remain an important recruitment and retention tool.

In a free labor market, employees and employers would be able to strike any compensation bargain to which both agree. If it makes sense to reward long-term employment, employers should be free to do that. Today's retirement plans, however, involve something more than voluntary exchange. The ability to build up funds tax-free involves a taxpayer subsidy, and the social purpose of that subsidy is to encourage the private sector to make private provision for retirement income needs.

"Individuals with no employer plan can deposit only $3,000 each year."

Employers who exact onerous vesting requirements are using a tax-subsidized vehicle created to achieve a socially desirable end in order to achieve a purely private, corporate end. In pursuing their own goals, these employers actually hinder the achievement of the social goal. Vesting requirements not only undermine the social goal of encouraging people to build a reasonable retirement income, they also interfere with the labor market mobility that our modern economy requires.

Problem: Arbitrary Limits on Contributions. One of the most remarkable characteristics of our retirement system is the arbitrary limits placed on tax-deferred saving opportunities. As Figure III shows,

  • Some people are able to deposit as much as $40,000 per year in tax-deferred savings plans.25 
  • Others are limited to the $12,000 maximum in contributions allowed to a 401(k) plan.26
  • Yet individuals who do not have access to an employer-sponsored plan, including those who are not in the labor market at all, are limited to an annual $3,000 maximum contribution to an IRA account.27

These limits are especially important to women for three reasons: (1) women are more likely to work in industries where employer-provided retirement plans are less prevalent; (2) even if their employer offers a retirement plan, they are less likely to qualify because they are part-time or temporary workers; and (3) women are more likely to move into and out of the labor market.28

Even a small break in employment can have a major impact on the assets that accumulate in a defined-contribution plan. Consider, for example, a woman who takes five years out of the labor force for child rearing, say, between the ages of 25 and 35. If she returns to the workforce and works until retirement, she is likely to find that her 401(k) accumulation at retirement will be 20 to 30 percent smaller due to her absence.29 Moreover, her absence would have significantly limited her ability to contribute to an IRA.

If it is socially desirable for some people to save for their own retirement, presumably it is just as desirable for others. There is no socially justifiable reason why the amount of tax-free savings a person is allowed should be conditioned on where or if he or she is employed.

Problem: Poor Investment Choices. Defined-contribution plans not only allow employees to make their own investment choices, they virtually require it. While many employees cherish this freedom, others view it as an unwelcome burden. Moreover, employees nationwide appear to do a very poor job investing their own money. A study of 503 employers by Watson Wyatt company found that from 1990 through 1995:

  • The defined-benefit plans averaged an annual rate of return 1.9 percentage points better than the 401(k) plans - 10 percent versus 8.1 percent.30
  • To illustrate the difference, consider investing $4,000 a year for 30 years: at 10 percent, the account will grow to about $690,880. At 8.1 percent, however, the account will grow to only $480,224 - a difference of $210,665!31

"Even employees of financialservices firms make poor investment choices."

One might suppose that investment results would be highly sensitive to the type of work employees perform; that is, more financially sophisticated employees would be likely to command better investment returns. But this is not necessarily the case. A study by the National Center for Policy Analysis examined the 401(k) performance of financial service firms' employees - who specialize in investing other people's money and/or giving investment advice. It found that over a four-year period ending in 1998, none of the financial service firms' own employees' average 401(k) earnings came close to matching the performance of the stock market as a whole or as a mixed portfolio of stocks and bonds.32

Figure IV - Sample 401(k) Plan%3A Asset Allocation by Income Quintile

Why is the performance of 401(k) plans so poor? There are a number of reasons, but the most important is that all too often unsophisticated investors make one or both of two bad investment decisions: (1) they invest in their employer's stock, and/or (2) they invest in what they perceive is "safe."

Enron's case, in which employees heavily invested in an employer's stock suffered large losses, is not unique. A recent survey found that in 40 of 105 larger public companies, more than half of 401(k) assets were invested in the employer's own stock.33 As the experience of Enron employees makes clear, putting all your financial eggs in one basket is a risky, unsafe strategy, even if the basket is your own trusted employer.

The other mistake employees make is to be too conservative. They invest in securities that are safe, but pay a low rate of return. This is especially true of lower-paid employees. Figure IV shows the 401(k) choices of the employees of a private company, grouped by the employees' incomes. As the figure shows:34

  • Almost two-thirds of the assets invested by employees in the lowest-pay quintile (bottom fifth) were in a money market fund or bond fund.
  • By contrast, about 85 percent of the assets invested by employees in the highest-pay quintile were in stocks.

"Lower income workers tend to make the most conservative investments, which lowers their retirement income."

To put this in perspective, compare two portfolios, one consisting entirely of stocks, the other of bonds. Based on historical averages, the all-stock portfolio will accumulate 10 times as much wealth as the all-bond portfolio over the course of a work life.35

Interestingly, other things equal, there are important differences in the investment behavior of men and women. On the one hand, a number of studies have found that women are more risk averse. Given a choice, they are significantly more likely to choose bonds over stocks.36 On the other hand, men are more likely than women to engage in frequent portfolio changes. Ultimately, such excessive trading reduces the net returns on men's investments by a full percentage point, relative to women.37 Part of the problem, according to a number of psychological studies, is that men are excessively confident in their own abilities. As one economist put it, "Men tend to think their successes are the result of their own skill rather than dumb luck."38

Problem: Getting Reliable Investment Advice. Surprisingly, a number of employees in 401(k) plans do not actually make an investment choice. For example, at least one-third of the lowest-paid employees depicted in Figure IV invest their funds in the "default" option, either by choosing it or by letting the employer choose for them. In these cases, the employees' investments are simply "defaulted" into a money market fund.39 Why don't employers "default" employees into portfolios that make more sense for retirement planning? The answer is simply that due to the fear of lawsuits, employers invariably choose the most conservative investment alternative. For the same reason, most employers refrain from giving their employees investment advice.40

Many books have been written on investing; indeed, an entire industry exists to give investment advice. But in fact, the nonprofessional investor doesn't need to read books or pay broker fees in order to make wise, long-term investment decisions. A mountain of economic research points to the simple conclusion that the best and most prudent strategy for the nonprofessional is to invest in the market as a whole. And one of the simplest, most efficient ways to do that is through an "index fund."

Take the 15-year period ending on December 31, 2001. Fifteen years ago, an investment in the Vanguard 500 Index would have averaged an annual rate of return of 13.56 percent. This rate of return is considerably better than the average in all other types of mutual funds. It is almost a point and a half better than the average equity fund's return. Dallas Morning News financial columnist Scott Burns calls this the "couch potato" approach to investing. His investments consistently do better than the mutual funds managed by professional analysts.41

It is very hard to beat the market. In fact, most people who try to beat the market, including most professional fund managers, do worse than the market as a whole. So an unsophisticated investor willing to settle for whatever return the market pays, will actually do very well over time. In fact, this untrained investor will do better than the vast majority of professionals!

For this reason, a simple change in the law would greatly improve the performance of the 401(k) plans for millions of Americans. The change would give employers a safe harbor against lawsuits if they:42

  • Default employees who do not make an investment choice into an index fund or similar broadly diversified portfolio.
  • Encourage employees who do make choices to make similar investments.

"Tax-deferred accounts are not the best option for lowand moderate-income families, who face higher tax rates when they retire."

Problem: Tax Deferral May Not Always Be A Good Idea. Before turning to solutions, we need to pause and consider the results of another recent study by the NCPA.43 Most people believe - and almost all investment advisers reinforce the belief - that deferring taxes through 401(k)s, IRAs and similar accounts will reduce their lifetime taxes. There are two reasons for this belief. First, tax deferral is like an interest-free loan. Instead of giving money to the government, the taxpayer is allowed to use it, invest it and pay the government much later in life. Second, most people expect that they will be in a lower tax bracket after they retire since their incomes will be lower. So tax deferral means shifting those payments from high tax bracket times (now) to lower ones (later, presumably in retirement).

The problem is that the second of these assumptions is wrong for most low- and moderate-income families. Why? The Social Security benefits tax. In order to address the dire financial prospects of Social Security, Congress has enacted a tax on Social Security benefits. This tax is confusing and often misunderstood, but regularly surprises current Social Security beneficiaries and will reduce the amount of benefits paid to large numbers of future beneficiaries.

This is nominally a tax on Social Security benefits, but as a practical matter it turns out to be a tax on other income. For example, seniors pay taxes on 85 percent of their benefits if their other income exceeds $34,000 (singles) or $44,000 (couples). And during the retirement years "other income" will mean income from pensions and savings accounts. This means that for every dollar of income earned over the threshold, seniors must pay taxes on $1.85. A retiree who is in the 28 percent tax bracket, for example, is burdened with an effective marginal tax rate of 52 percent.

Today only about one-fifth of seniors pay the Social Security benefits tax. But the impact of this tax will grow over time because the tax thresholds are not indexed to inflation and eventually will be paid by virtually all young people during their retirement years.44

Indeed, most people who are currently in their twenties, earning less than $100,000 a year, will be in a higher tax bracket during their retirement years than during their working years. Tax deferral in these cases means moving the payment of taxes from the time when they are in a lower tax bracket to a time when they are in a higher bracket. And the effect of being in a higher bracket during the retirement years can more than swamp the effects of the interest-free loan.

On the brighter side, researchers find that regardless of the amount invested, people almost always gain if they can invest through a Roth IRA.45 Like a regular IRA, Roth IRAs allow tax-free growth. However, deposits to the Roth IRA are made with after-tax dollars and withdrawals are tax free. For most people, the Roth IRA allows taxes to be paid at the time of life when the taxpayers are in the lowest tax bracket.

"Roth IRA funds can be withdrawn tax-free in retirement."

The Bush Tax-Cut Bill. President Bush's 2001 tax cut bill addressed a number of these issues. The act gradually raises the allowable contribution to IRAs and Roth IRAs from $2,000 to $5,000 per person by 2008. This will narrow somewhat the arbitrary difference between the maximum allowed contribution to 401(k) and IRA accounts. The act also will allow employers to offer a 401(k) plan that is taxed like a Roth IRA, beginning in 2006. However, all these provisions are scheduled to disappear and the nation will revert to the old tax rules after 2010!


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