Ten Steps to Reforming Baby Boomer Retirement
Thursday, March 23, 2006
by John C. Goodman, Devon Herrick, Matt Moore
Table of Contents
- Executive Summary
- Step 1. Improving Traditional Pension Plans
- Step 2. Improving 401(k) Plans
- Step 3. Expanding IRAs
- Step 4. Removing Penalties on Work
- Step 5. Repeal the Social Security Benefits Tax
- Step 6. Using the Roth Method of Taxation
- Step 7. Making Health Insurance Portable
- Step 8. Tax Relief for Post-Retirement Health Insurance
- Step 9. Creating Health Savings Accounts for Seniors
- Step 10. Paying for Long-Term Care
- About the Authors
As 77 million members of the Baby Boom generation begin to retire, America is about to experience one of the most dramatic economic, sociological and demographic changes in its history. The institutions we have relied upon in the past are completely unprepared for what lies ahead.
Politicians, the national news media and the general public have become increasingly aware that our federal entitlement programs are about to be swamped. Social Security, Medicare and Medicaid have made trillions of dollars of explicit and implicit unfunded promises. In fact, by 2030 (about the midpoint of the baby boomers' retirement years), we will have to double every tax rate or cut every benefit in half.
But our problems do not end there. Federal, state and local governments have made $5 trillion in promises (many of which are unfunded) to civil service workers. Corporate America owes about $450 billion in pension promises and $350 billion in post-retirement health care promises that are also unfunded.
To make matters worse, the instruments we have created to help individuals save for their own retirement - principally through 401(k) accounts — are also not working well. In general, people are not saving enough, and they are not prudently investing the funds they do save.
Behind our inadequate institutions are inadequate public policies. For example:
- On balance, the tax law encourages current consumption, but discourages saving for consumption during retirement.
- Even more important, the tax law encourages overconsumption of health care before retirement, but discourages saving for what are likely to be greater health needs later in life.
- The American answer to the European-style welfare state has traditionally been employer-provided benefits. Yet:
- Unwise public policies are encouraging large employers to abandon pension and post-retirement health care promises made to their employees.
- Other policies are preventing employers from helping employees make their own provision for income and health care during the retirement years.
- The policies that are most inadequate for the baby boomers' retirement years are those affecting early retirees. In general:
- People who retire early will find that their opportunities to save are much more restricted than those available to people still in the workforce.
- They will find that health insurance is not only more costly when purchased by individuals, but the insurance (unlike insurance obtained at work) must be purchased with after-tax dollars.
- Once they begin drawing Social Security, they will discover that if they earn additional income, say by working part-time, they will face draconian effective tax rates - taking as much as two-thirds of what they earn.
- And even if they don't work for wages, they will discover that the tax rates on their pension income and IRA withdrawals are much higher than the rates paid by younger taxpayers at the same income level.
What steps can be taken to secure the retirement of baby boomers and future generations of retirees? The following are 10 recommendations.
Step 1: Improve Traditional Pension Plans . The current system encourages employers to unload unfunded pension obligations on the federal government's pension insurance agency - resulting in smaller retiree benefits and potentially large burdens for taxpayers. Clearly, corporations should be required to fully fund their own pension plans. We also need to encourage immediate vesting and full portability of those benefits.
Step 2: Improve 401(k) Plans . More than half of all workers invest in a 401(k) or similar savings vehicle. But not enough people are investing appropriately for their future. They either do not invest enough or they pursue investment strategies that will not provide an adequate retirement income. To correct this problem, employers should be given a safe harbor against lawsuits and receive other regulatory relief if they automatically enroll employees, escalate the employees' contributions over time, invest in diversified portfolios, follow an investment strategy that becomes more conservative as the employee ages, and convert the funds into an annuity at retirement - unless the employee specifically opts out.
Step 3: Expand Individual Retirement Accounts (IRAs) . Current tax law penalizes those who do not have employer-sponsored savings plans. For example, participants in an employer-sponsored 401(k) plan can contribute up to $15,000 annually, while nonparticipants can contribute only $4,000 to a tax-advantaged IRA. This policy is particularly harmful to early retirees. We need a level playing field that treats all savers equally.
Step 4: Remove Social Security's Penalties on Work . For early retirees on Social Security, the earnings test is an arbitrary tax that imposes an effective tax rate as high as 50 percent on wages - in addition to regular income and payroll taxes. This policy hurts the elderly, reduces national output and serves no useful social purpose.
Step 5: Repeal the Social Security Benefits Tax . Although nominally a tax on benefits, this is really a tax on other income, and it imposes some of the highest marginal rates in the federal tax code. In fact, a middle-income couple living on IRA withdrawals can face a higher marginal tax rate than Warren Buffet and Bill Gates. If Social Security benefits must be taxed, they should be taxed as ordinary income.
Step 6: Use the Roth Method of Taxation . Unlike traditional savings vehicles, deposits into Roth IRAs are made with after-tax dollars and withdrawals are tax-free. Given the effects of the Social Security benefits tax, and the expectation that tax rates will be much higher in the future (in part to deal with the expenses of Social Security, Medicare and Medicaid), Roth taxation makes sense for many taxpayers. Yet Roth IRAs, like traditional IRAs, are discriminated against relative to employer-provided savings plans. Congress should level the playing field.
Step 7: Make Health Insurance Portable . Workers with employer-based health insurance enjoy an enormous tax advantage because, unlike wages, employer-paid premiums avoid income and payroll taxes. By contrast, early retirees and workers who buy their own insurance get virtually no tax break. The tax law should be equally generous to everyone who obtains private insurance - regardless of how it is purchased. Further, as President Bush has proposed, we should encourage employers to purchase portable insurance for their employees - insurance that travels with them from job to job and that they can keep after they retire.
Step 8: Provide Tax Relief for Post-Retirement Health Insurance . Although many employers provide post-retirement health benefits, the current system has two drawbacks: 1) employer coverage must generally be all or nothing, and 2) employees who do not receive benefits get virtually no tax relief if they purchase their own coverage. One solution is to move to a system of individually-owned, personal and portable health insurance with appropriate tax relief. Short of that reform, employers should be able to allocate pretax dollars to retirees, up to the amount spent on active workers - provided that the funds are spent on health care - and retirees should receive tax relief if they purchase individual health insurance on their own.
Step 9: Create Health Savings Accounts for Seniors . Despite coverage from Medicare, seniors pay half their medical bills out of their own pockets. And they have few opportunities to use tax-free savings to prepare for these expenses. Under current law, Medicare-eligible seniors cannot open or make deposits to Health Savings Accounts (HSAs), and opportunities for young people to make deposits are too restrictive. Clearly we need a more liberal HSA policy. Short of that, seniors should be able to turn IRA and 401(k) funds into Roth HSAs.
Step 10: Encourage Preparation for Long-Term Care . Although the tax law grants unlimited tax relief for current spending on employer-provided health care plans, it is quite stingy toward people who try to provide for their own long-term care needs. In addition to tax relief, seniors need to be able to protect their assets (from Medicaid) by buying long-term care insurance. For example, a $100,000 long-term care policy would shelter $100,000 of assets that would not be counted in determining Medicaid eligibility. This policy - successfully implemented as a pilot program in four states - should be adopted in the other 46 states.
These 10 steps would allow the baby boomers - and the generations that follow them - to better prepare for their retirement years.