Wednesday, May 1, 2013

The 401(k) world

There has been some real tough reflection on tax expenditures recently.  I have always seen 401(k) and IRA savings vehicles as being a better than average idea for using this approach.  It's sure better than tax advantaging investment income, which is very interesting in the abstract but in the real world seems to flow to the best off. 

But people are making some solid points about whether this is really a good idea or not.  If they don't work to incentivize the right behavior on the part of either consumers or vendors than maybe they are not an ideal retirement savings approach.

James Kwak:

The first is that they go overwhelmingly to people who don't need them -- like my wife and me. As two university professors living in Western Massachusetts, where the cost of living is low, we make more than we need to support our lifestyle. We max out our defined contribution plans every year, and because we're in a relatively high tax bracket (28%, I think), we save thousands of dollars a year on our taxes. This is the problem with most subsidies that are delivered as tax deductions. Their cash value depends on the amount you can deduct and on your marginal tax rate. In this case, fully 80 percent of retirement savings tax subsidies goes to households in the top income quintile. (See Toder, Harris, and Lim, Table 5.)

The second problem is that these tax incentives don't work. They don't cause people to save more. In my case, the amount we save is just our income minus our consumption, and our consumption isn't affected by the tax code. If there were no tax subsidy, we would save the same amount and just pay more in taxes. And it's not just us. A recent and widely discussed paper by Raj Chetty, John Friedman, Soren Leth-Petersen, Torben Heien Nielsen, and Tore Olsen looked at what happened when the Danish government reduced tax subsidies for retirement savings by rich people. The short answer is that decreases in retirement savings were almost perfectly matched by increases in non-retirement savings. The overall effect, they estimate, is that for every dollar in tax subsidies, total savings go up by one cent. The other ninety-nine cents is just a handout to people who would have saved anyway.

Matt Yglesias

Middle class retirement savings isn't like that. We know roughly how much people need to put away in order to retire with a standard of living they'll be comfortable with. And we definitely know what kind of investment vehicles are most appropriate for middle class savers. And we have abundant evidence that, left to their own devices, a very large share of middle class savers will make the wrong choices. What's more, because of the nature of the right choices it's obvious that the dominant business strategy for vendors of middle class investment products is to dedicate your time and energy to developing and marketing inferior products, since the essence of superior products in this field is that they're less remunerative.
The most convincing part is the whole question of how 401(k) plans are designed to reduce consumer choice and the resulting incentive to offer inferior products.  After all, the employer setting up the 401(k) has little incentive to make sure that difficult to spot fees don't eat up other people's money. 

The alternative, at this point, is social security.  I am very sympathetic to arguments that assets are just claims and that providing for the elderly ultimately turns into a resource sharing problem.  The difference appears to be that social security would divide the resources we put towards older adults more equitably than tax-advantaged savings plans do. 

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