Texas Conservative Coalition Research Institute
House Committee on Pensions, Investments, and Financial Services
March 9, 2020
Regarding the Committee’s Charge:
Study pension plan and personal retirement savings options for small businesses in order to be competitive with state and larger employers.
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In the United States, employees’ options relating to retirement plan (and health insurance) coverage are unfortunately strongly constrained by the decisions of their employer. Rather than simply shopping in the marketplace and enrolling in the retirement plan that best fits their needs, employees are limited in their choices based on how (if at all) their employers decide to implement a retirement plan.
Texans who work in state government agencies or in public education are eligible to participate in the Employee Retirement System (ERS) or the Teachers Retirement System (TRS), respectively. These two pension funds help ensure that their participants will receive benefits when they are retired. Large employers in Texas often offer retirement plans to their employees, particularly 401(k)s. Employees of smaller companies, however, are less likely to have access to a retirement plan through their employer.
A resulting question is how small businesses can offer retirement plans to their employees which are comparable to the plans offered to employees of larger companies or of state agencies. A smaller business that offers a retirement plan to employees makes itself a more attractive place to work and can benefit by retaining talented employees. In addition, those employees are better able to save for retirement, potentially reducing their future reliance on the government social safety net after they retire. This testimony summarizes current retirement plan types, reviews the data on retirement plan participation in Texas, and makes several recommendations to increase the chances that employees save for retirement.
I. Overview of Retirement Plan Options
The types of retirement plans from which an individual may benefit are largely governed by federal law. Many types of retirement plans exist; while each type is subject to different rules, there is significant overlap in them. Contributions to non-Roth retirement accounts are generally tax-deductible by the employer or the employee, as applicable. Employees can direct how their funds are invested among the retirement plan’s investment menu options. When employees leave a company, generally their retirement account balances can be “rolled over” to a different retirement plan, most commonly an Individual Retirement Account (IRA). However, to discourage people from using 401(k) account balances for non-retirement needs, withdrawals before the age of 59.5 are subject to a penalty unless they meet a listed exception in the Code. Conversely, to ensure that people are using retirement accounts for retirement, retired people must begin making withdrawals from non-Roth retirement accounts by the April 1st of the year following the year turn age 72.
Retirement plans are attractive vehicles for saving for retirement because they offer employees tax-deferral on the growth in their investments. That is, investment earnings on funds contributed to a retirement plan are not subject to federal income tax each year, but only when those earnings are withdrawn (Roth accounts are an exception to this rule, as noted below). In addition, employees and employer generally receive a federal income tax deduction for contributions to a retirement plan (or in the case of a Roth, there is no deduction upon contribution but there is a tax-free withdrawal). Without these tax benefits of a retirement plan, workers will have a more difficult time saving for retirement.
Individual Retirement Accounts (IRAs)
Individual Retirement Accounts (IRAs) are the one type of retirement plan which does not necessarily depend upon an employer; eligible individuals can set one up on their own through banks or financial institutions such as Vanguard or Fidelity. Generally, people with earned income in a given year are eligible to contribute up to $6,000 ($7,000 if over the age of 50) to either a “Traditional” IRA or a “Roth” IRA for that tax year. Subject to income limits, an individual contributing to a Traditional IRA may claim a federal income tax deduction. The IRA funds grow tax-deferred until they are withdrawn. When the funds are withdrawn, the individual pays federal income tax on any invested funds which generated a deduction plus any earnings on the invested funds.
A Roth IRA works in similar fashion, except the individual making the contribution may not claim a deduction, but rather deposits after-tax money. Any withdrawals from a Roth IRA in retirement are generally exempt from federal income tax.
In the employer-employee context, there are two employer-linked variations of the IRA which differ from the “Traditional” and “Roth” IRAs described above: Simplified Employee Pension Plan (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs. Because these two types of plans are administratively less complex and less expensive than other retirement plans such as 401(k)s, Congress hoped that they would encourage small businesses to offer retirement plans to employees.
A SEP IRA is an account funded entirely by an employer. The employer may contribute up to 25 percent of an employee’s salary, but no more than $57,000. While the SEP IRA is very easy to administer, it is expensive to employers. In addition, employers generally must make contributions to all eligible employees pursuant to an IRS-approved formula that does not favor highly-compensated employees, if they contribute to any employee’s SEP IRA account at all in a given year.
Like a SEP IRA, a SIMPLE IRA is funded by employer contributions, but unlike a SEP IRA, a SIMPLE IRA can also accommodate employee contributions of up to $13,500 ($16,500 for employees age 50 or older). Only employers with 100 or fewer employees who received at least $5,000 in compensation in the preceding year may setup a SIMPLE IRA. SIMPLE IRA’s are funded by a matching contribution by the employer of up to 3 percent of the employee’s annual compensation (although matches as low as 1 percent are allowed in some years). Alternatively, the employer can choose to contribute 2 percent of that employee’s annual compensation to the account, but this 2 percent contribution is required even if the employee does not contribute in a given year. If a business sets up a SIMPLE IRA plan, any employee who is eligible to participate in it must benefit from any employer contributions. Unlike a SEP IRA, an employer generally must contribute to SIMPLE IRAs annually.
401(k) Plans
IRAs are easy to administer, but other retirement plans allow for greater annual contributions. Perhaps the best-known type of a retirement plan is the 401(k). Named after the corresponding section of the Internal Revenue Code (the “Code”), this type of account permits employees to make pre-tax contributions out of their salary or wages. Employers setting up a 401(k) must adopt a plan which governs the 401(k). The plan must adhere to federal requirements but can still provide considerable flexibility. For example, the plan may permit the employer to match a percentage of the funds an employee contributes. The employer may also offer a “401(k) Roth,” which permits employees to contribute after-tax funds; withdrawals from such an account in retirement are exempt from income tax. In general, 401(k) plans are more complex and expensive to administer than IRAs due to compliance with technical federal rules.
Employees may contribute up to $19,500 to their 401(k) accounts in a given year ($26,000 if they are age 50 or older). Employers can make matching or profit-sharing contributions to these accounts as well. Complex rules ensure that all employees with 401(k) accounts benefit from employer contributions if the employer contributes to an employee’s account in a given year, and that highly-compensated employees are not favored. The total employer and employee contributions to a 401(k) account for a given year may not exceed $57,000, although in practice very few 401(k) plans allow for large enough contributions to reach this figure.
A 401(k) is an example of a defined contribution plan, in which employees (and sometimes employers) contribute funds to their own tax-deferred retirement accounts. The distributions a person ultimately receives from a 401(k) depend on the amounts contributed to the account and the performance of the various investments in the account. Because the performance of investments can vary greatly, a defined contribution plan is subject to market risk. A defined benefit plan, in contrast, is a plan under which the benefit paid to the employee is determined by a formula; thus, the employer bears the risk of poor investment performance. Because of this guaranteed benefit to employees, and because defined benefit plans are funded primarily by employer contributions, they are not as popular with employer as defined contribution plans.
Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) is used by some small businesses, often in addition to another retirement plan. While ESOPs can be useful, they are not widespread because they involve significant employer contributions and also shift at least part of the beneficial ownership of a company to its employees. Because of their expense and complexity, defined benefit plans and ESOPs are not addressed in this testimony.
Table 1 below illustrates the primary retirement plan options a business may consider.
Table 1: Key Types of Retirement Plans
II. Data Concerning Employer Sponsorship of Retirement Plans and Employee Participation
A 2016 report by the Pew Charitable Trusts (the “Report”) offers a wealth of data on Texas employees’ access to, and participation in, retirement plans (other than standard IRAs). The report found that only 50 percent of full-time, private sector workers in the state (but excluding the self-employed) had access to an employer-based retirement plan, which was the third-lowest rate in the country. Of these workers, 84 percent participated in such a retirement plan, for an overall state participation rate of 42 percent. This participation rate was the fifth-lowest in the country. There was a pronounced relationship between employees’ compensation on one hand, and their access and participation rates on the other hand. The access rate was 72 percent even for those employees making over $100,000 annually, but only 26 percent for workers making less than $25,000. The size of a business (in terms of its number of employees) and the age of employees were also strongly correlated to both access and participation rates. For firms with fewer than 10 employees, 10 to 49 employees, and 50-99 employees, the access and participation rates were 17 percent and 14 percent, 29 percent and 23 percent, and 43 percent and 34 percent, respectively.
More than 3 million full-time, private sectors workers in Texas lack access to an employer-based retirement plan. Research indicates that most employees are aware of the importance of retirement plans. Indeed, the data described in the above paragraph shows that employees participate at high rates when they have access to an employer-based retirement plan. In a national survey of businesses that do not offer retirement plans and also have fewer than 150 employees, 67 percent of the businesses and 88 percent of the businesses’ employees said that a retirement plan is important in choosing a new employer. A full 87 percent of the employees said they would be likely to participate in an employer-based retirement program if one were offered. Another national study found that, among employers who offer a retirement plan, 91 percent believed it had a positive effect on employee performance, and 89 percent believed that it helped to attract and retain employees.
Given that both employers and employees recognize the benefits of retirement plans, a key question is why so many employers choose not to offer one. Several surveys of employers reveal recurring themes in their responses to this question. In a survey by Transamerica, employers were asked to provide reasons for why they do not sponsor retirement plans for employees. Of these employers, 58 percent said their company was not big enough; 50 percent expressed concern about the cost; 32 percent claimed employees were not interested; 27 percent said their company was simply not interested; 22 percent said their company was experiencing difficult business conditions; 19 percent expressed concern about administrative burdens; and 13 percent were concerned about fiduciary obligations which could accompany the plan. Notably, some of the above reasons may simply be re-statements of another reason. For example, if a company says it is not large enough to offer a retirement plan, or that it is going through difficult times, that could reasonably be interpreted as voicing concern about the cost of such a plan.
In a different national study that asked employers to provide a single reason for not offering a retirement plan, the most common answers were cost (37 percent), lack of resources (22 percent), and perceived employee disinterest (17 percent). Again, the “lack of resources” answer could simply be a different way of stating a concern about costs (and/or administrative complexity). Yet another study found that 66 percent of small business employers who do not offer a retirement plan state that the cost of a retirement plan is the most important reason for not doing so.
Overall, it appears from the above surveys that cost, administrative and legal complexity, and a perceived lack of employee interest play an important role in employers’ decision not to offer retirement plans. Consistent with this conclusion, when employers without a retirement plan were asked what would make them more likely to offer one, common responses included increased tax credits to defray the cost (60 percent), being able to obtain easy-to-understand explanations of available plans (58 percent), tax advantages for executives (55 percent), and reduced administrative requirements (53 percent).
Despite these concerns, there are indications that employers do not have a complete understanding of retirement plans. While 87 percent of surveyed employers were at least somewhat familiar with 401(k)s, 63 and 65 percent were “not at all familiar” with SIMPLE and SEP IRAs, respectively. In addition, the data above on employees’ views of retirement plans suggests that employers may be underestimating their employees’ interest in retirement plans. Moreover, 45 percent of employers admit to not spending time on researching retirement plans.
Employer concern with the cost of setting up a retirement plan is understandable. One 401(k) provider has estimated the typical 401(k) provider costs as follows: “[401(k)] Plans with less than $1 million in assets may cost $5,000-$10,000 per year: $800-$1,000 in administrative fees, quarterly per-participant charges of $15-$40, and an initial fee of $500-$3,000.” However, competition in the industry has increased in recent years. For example, the company Human Interest will set up a 401(k) for a business for a price of $120 per month plus $4 per employee per month, and a potentially-applicable $499 setup fee. In addition, employees who participate in the 401(k) pay an annual fee of 0.50 percent of their balances plus an average fund fee of 0.08 percent. Guideline, another discount 401(k) provider, charges a base fee of $39 per month, plus $8 per employee per month.
SIMPLE and SEP IRAs can be set up and maintained for even less, given their lesser complexity. For example, Vanguard charges no fee to set up a SEP IRA. It charges only its usual low fees for invested amounts (which can be lower than 10 basis points or 0.1 percent of invested assets) and a $20 annual service charge for Vanguard funds inside the SEP IRA which do not have a $10,000 balance. Given these offerings, employer concern about the cost of setting up and administering a retirement plan is probably a result of employer confusion about the offerings available. Of course, employers may be concerned about their contribution responsibilities under a retirement plan. In such a case, however, an employer could set up a 401(k) plan under which it is not required to make contributions.
III. Trends in Encouraging Retirement Plans
In looking at states which have taken steps to increase employees’ access to retirement plans, four approaches are evident: auto-enrollment IRAs, state-run 401(k)s, multiple-employer plans (MEPs), and marketplace listings. Each of these approaches is discussed below. It should be emphasized that in general these approaches are very recent innovations; therefore, it is difficult to evaluate their effects thus far.
Some states have passed legislation mandating auto-enrollment IRAs, which provide that a percentage of an employee’s salary is automatically deposited in an IRA. Employees have the right to opt out of this arrangement if they desire. Auto-enrollment IRAs are based on the idea that “forced” savings programs increase the percentage of people who save for retirement. Among other sources, the American Association of Retired Persons (AARP) Policy Institute estimates that people are 15 times more likely to save for retirement when they have a payroll deduction program. The states that have adopted this approach include California, Illinois, New Jersey, and Oregon.
A couple of states- Massachusetts and Vermont- have taken steps to set up a 401(k) for at least some workers in the state who do not have access to an employer-based retirement plan. In this arrangement, the state essentially assumes the place of an employer in sponsoring the plan. As a result, the state incurs fiscal costs, although the magnitude of the cost is difficult to predict given the uncertain enrollment. Notably, bills setting up a state-run 401(k) for private sector workers without access to a retirement plan have been proposed in each of the last two Texas legislative sessions (House Bill 4037, 86R and House Bill 3601, 85R), but have not progressed far through the legislative process. These bills would have set up auto-enrollment IRAs for workers without access to an employer-based retirement plan, as well as an MEP 401(k) to which they and employers could make voluntary contributions.
MEPs are arrangements in which otherwise unrelated employers band together to offer a 401(k) to their employees, with the goal being to reduce the costs an employer must bear. They have been permitted under federal law for some time, but until very recently they were often of limited use because they required employers to have a common nexus, such as being members of the same trade association. Federal legislation enacted in December 2019 and effective starting in 2021, however, greatly eases this requirement and permits employers in a given geographic area or industry to band together to form an MEP.
Finally, marketplace listings are currently used by only one state- Washington. This arrangement invites retirement plan providers to list information about their offered plans to the public through a website run by the state’s department of commerce. The state screens providers to ensure that they meet certain criteria, such as not charging excessive fees. To date, the marketplace listing in Washington has few offerings; nevertheless, several 401(k) options are available. The idea of a state-run marketplace listing bears some resemblance to Texas’s “Power to Choose” website for retail electric providers, which is maintained by the Public Utility Commission (PUC).
IV. Analysis and Recommendations
The state could consider the following measures to help employees without access to retirement plans save for retirement and to make smaller employers more competitive with large employers:
Educate the public about standard IRAs and federal tax credits for retirement plan participants. Standard IRAs are available to all Americans with earned income and should be a consideration for all employees without access to an employer-based retirement plan. They can be setup easily through various financial institutions without incurring any fees. Their main drawback is the relatively low cap of $6,000 on annual contributions ($7,000 if age 50 or older). This amount will increase over time due to inflation adjustments. Even ignoring future increases in the cap, though, a person who invests $6,000 a year for 40 years in an IRA and earns an annual return of 6 percent will have approximately $1 million at the end of that 40-year period. Such an amount should generate a meaningful source of income to a person in retirement. If a person invests in this manner with after-tax money through a Roth IRA, the $1 million can be withdrawn with no federal income taxes due. While Roth IRAs (and tax-deductible contributions to Traditional IRAs) are not available to those over a certain income level, a high-income person can nevertheless set up a Roth IRA very easily by first setting up a Traditional IRA and then shortly thereafter converting it to a Roth IRA.
Posting a simple statement such as the paragraph above on a state agency website (perhaps the Texas Workforce Commission’s) could help workers better understand how to prepare for retirement when they do not have access to a retirement plan. Additionally, the state agency website could provide a link to the IRS publication 590, which discusses IRAs in detail.
Furthermore, the state agency website could link to the IRS web page which discusses the retirement savings contributions credit. This federal tax credit is often overlooked by taxpayers, even though it can be as much as 50 percent of an employee’s annual contribution to an employer-based retirement plan.
Educate employers about the retirement plans and federal tax credits available to them. Similar to the first suggestion, a state agency website could provide a link to IRS Publication 560, which discusses retirement plan options for small businesses in detail. Perhaps more importantly, the website could alert employers that the SECURE Act, a federal law enacted in December 2019, which increases the Retirement Plans Startup Costs Tax Credit, a federal tax credit, from a maximum of $500 per year for three years to a maximum of $5,000 per year for three years. This credit is available to employers who set up a 401(k), SIMPLE IRA, or SEP IRA and who have 100 or fewer employees that each received at least $5,000 in compensation from the employer in the previous year. The amount of the annual credit, subject to statutory caps, is 50 percent of the costs the employer incurs in establishing the plan. In addition, the law provides for a federal tax credit of up to $500 for employers that establish 401(k) plans or SIMPLE IRAs with automatic enrollment for employees (this last incentive is inapplicable to SEP IRAs because employees cannot contribute to SEP IRAs). Thus, an employer setting up a retirement plan can qualify for up to $16,500 in federal tax credit overs three years. With this change in the law being just a few months old, the prudent course of action is to see how much it encourages employers to start retirement plans for their employees before making any drastic changes to state law.
Allow the private sector to work. The last decade has seen increasing competition in various financial industries, resulting in lower fees to consumers. For example, fees charged by investment funds inside 401(k)s have declined due to growing realization that low-cost funds generally provide consumers with better returns over long periods of time. Even hedge fund and private equity managers have felt the squeeze of competition in recent years; for example, the Teacher Retirement System (TRS), a state investment fund for teachers, has negotiated an arrangement with hedge fund managers under which they are paid the greater of one percent of assets managed or 30 percent or returns generated, which is generally less expensive than the standard 2 percent management plus 20 percent of returns generated. As noted above, companies such as Guideline, Vanguard, and Human Interest offer very affordable retirement plans. As competition continues to drive fees down, more employers can be expected to offer their employees the benefit of a retirement plan.
Avoid auto-enrollment IRAs. Auto-enrollment IRAs have the support of many commentators on retirement planning policy, such as the AARP. However, the Legislature should avoid embracing this approach because it cannot be reconciled with a conservative understanding of private property rights. While it is true that employees could opt out of auto-enrollment IRAs, permitting them in Texas sets a dangerous precedent that the government can direct the disposition of private property (i.e., wages) without an active objection by the actual owner of the property. Allowing an opt-out of such an arrangement would not change the fact that the government’s preferred use of funds has become the default or presumed use by the true owner of the property.
The Legislature should be mindful that it is the nature of government programs to grow once they are established. In this context, it is not difficult to imagine that this growth would manifest as an amendment to the law eliminating the ability to opt out. Alternatively, the government might start severing an owner’s possession of his or her property unless there is an opt out. For example, the government could provide for automatic payroll deductions to fund public charities, or to fund environmental cleanup, unless an employee takes action to request that that not be done.
While auto-enrollment IRAs are a well-intentioned idea to help people better save for retirement, a necessary aspect of liberty is that people exercise their freedom in ways that might not seem optimal to others. It is clear that the vast majority of employees are well aware of the importance of saving for retirement. Over the next few years, employers will hopefully gain greater awareness of the federal tax credits and the growing number of affordable retirement plan options available to them. In the meantime, the state’s role should be limited to directing employers and employees to information which educates them on their options.
Avoid a state-run 401k. The Legislature should reject any idea of a state-run 401(k) for workers without access to an employer-based retirement plan. Government intervention in the process of saving for retirement should be viewed skeptically when there are already numerous affordable options for employers. There is ample evidence indicating that many employers currently do not possess the knowledge to evaluate retirement plans and overestimate the cost and administrative burden of having one. It is not the proper role of government to set itself up as an actor in a private industry.
In addition to concerns about the role of government, a state-run 401(k) would raise fiscal concerns. The fiscal note for HB 3601 (85R), for example, indicated that the costs of the proposed measures were indeterminate, as they would depend on myriad factors, such as the number of participants, employer and participant contributions, investment activity and any potential fees charged to administer the plan. However, based on information from California and Illinois, the fiscal note estimated that the Texas plan would enroll about 7 million participants, and the bill would have required a General Revenue appropriation of about $3 million for fiscal year 2018 to get the overseeing board up and running. And, while the bill required any initial appropriations to be repaid to General Revenue, the fiscal note pointed out that it was “unknown whether the plan would generate enough earnings and fees to repay the initial appropriation by the required date.”
If the Legislature decides additional steps are needed, it could consider a marketplace listing.
If the Legislature determines that the above steps are insufficient, it could consider setting up a marketplace listing such as the one in Washington. The Power to Choose website – which helps electricity customers in the state compare plans – could serve as a model for this listing. The website could be designed such that business owners could compare costs and plans from various retirement plan providers. Additionally, beginning in 2021, employers could search for employers who have expressed interest in setting up MEPs with other employers.