The Democrats’ Plan To Highjack Your 401(k)
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Economy Falling Fast Into Recession
2. Democrats Want To Highjack Your 401(k)
3. The Democrats’ 401(k) Replacement Plan
4. Socialism Du Jour – “Spread The Wealth Around”
5. Can We Afford This Nonsense? No, But So What
6. Conclusions – After Today, Anything Is Possible
On this Election Day that is expected to end with a win for Senator Barack Obama, I think it’s important to let you in on what the liberals in Congress are already discussing about your retirement planning options. Earlier in October, Congressional Democrats began discussing the possibility of eliminating the favorable tax benefits related to 401(k) plans, effectively killing the very popular retirement planning device.
In its place, the Dems propose to enact a government-sponsored plan that would transfer the role of total retirement security into its hands. The problem is, could the investment options be limited to only a special type of government bond? You know, the kind they use for the Social Security System where you can claim there’s a trust fund but the money’s all gone.
In any other circumstances, I would say that this proposal doesn’t have a snowball’s chance of becoming law. However, a year ago I would have told you it would be next to impossible for the Fed and Treasury to guarantee hundreds of billions in worthless bonds, force mergers of financial services companies, buy hundreds of billions in equity stakes in our largest banks or take ownership in a public corporation. If the Dems get a supermajority in both Houses of Congress, I won’t be surprised by any neo-socialist boondoggles that may well appear, especially if Obama wins the election.
I fear that the recent bailout maneuvers have started us on a slippery slope toward socialism. Where will it stop? Hopefully, today. If not then, we might see it get a lot worse before it gets better. Whatever turns out to be the case, you need to know what may be coming on the retirement account front, specifically for 401(k)s.
Before we get to that, I will quickly review the latest economic numbers which are grim. We are now in a recession, textbook definition or not, and I expect it will only get worse for some time to come. I will have a more detailed analysis on the economy and what we should expect in an upcoming E-Letter.
The Economy Falling Fast Into Recession
Last Thursday the Commerce Department announced that 3Q Gross Domestic Product fell at an annual rate of -0.3%. This was the “advance” report which relies on somewhat scant data for September, so the next GDP report late this month could well be revised downward. The much-watched ISM Manufacturing Index plunged from 43.5 in September to 38.9 in October, a 26-year low. The Chicago Purchasing Managers Index, a proxy for business spending, imploded from 56.7 in September to 37.8 in October.
Consumer confidence fell off a cliff in October, plunging from 61.4 in September all the way down to 38.0, an all-time low for the index. Personal consumption spending fell 0.3% and durable goods orders slumped 2.9% in September (latest data available). General Motors reported yesterday that car sales for October were down over 45% from yearago levels. Retailers are bracing for a very disappointing holiday season.
Our economy is in serious trouble, folks! And the credit crunch is far from over. I could see this recession lasting a year or longer. I will have more detailed economic analysis in the next week or so, depending on what new surprises we see in the days just ahead.
Democrats Want To Highjack Your 401(k)
By now, many of you may have read about a new Democratic proposal to eliminate the tax incentives provided to 401(k) retirement plans, and replace them with ‘government-guaranteed’ retirement accounts. On its face, this plan is being touted as a way to restore stock market losses incurred by 401(k) participants over the past couple of months. However, the real agenda is far more rooted in liberal ideology. If you read what follows, I think you’ll agree, and it should scare you!
Before getting into what has been proposed, let’s take a look at exactly what the Democratic proposal would do away with. Many Americans are not aware of all of the tax benefits available to help workers save for retirement in 401(k) plans, including plenty of people who actually have these retirement plans. The Democrats are no-doubt counting on participants not knowing what they are giving up to make the sale easier.
The Democrats’ proposal does not seek to do away with 401(k) plans. Instead, it places the tax advantages enjoyed by employers and employees in the crosshairs. Therefore, it would be beneficial to review just what those tax advantages are. Note that the following benefits pertain to traditional 401(k)s, but are not applicable to special “Roth” 401(k) contributions, which I will cover a little later on. Again, these are the current tax advantages for 401(k) accounts:
1. Employee contributions to the 401(k) are deductible for income tax purposes, but not for Social Security tax purposes;
2. Employer contributions are not taxed as compensation to participating employees for income tax or Social Security tax purposes;
3. Earnings (interest, dividends, capital gains, etc.) on employer and employee contributions are not currently taxed to the participant, but are allowed to accumulate on a tax-deferred basis. To illustrate, let’s compare the accumulation of a contribution of $300 per month on a taxable and tax-deferred basis. Assuming a 30-year time horizon and 6% earnings (which are for illustration purposes only and not guaranteed), the taxable account would grow to $172,453, while the tax-deferred account would grow to $227,146. You can see the results using other assumptions by going to the following website for a tax-deferral calculator:
4. Finally, assets grow tax-deferred in traditional 401(k) plans, not tax-free. Thus, withdrawals at retirement are taxed as ordinary income in the year in which they are actually withdrawn. Most retirees withdraw annually only what they need to supplement their other sources of retirement income.
I noted above that these tax benefits pertain to traditional 401(k) plans, but they do not apply to special “Roth-type” contributions and earnings. In Roth plans, contributions are not tax-deductible when made. However, earnings on all Roth contributions can be withdrawn tax-free IF they are held for a sufficient period of time. For younger 401(k) participants, this can be a huge advantage. Note, however, that these special rules do not apply to employer matching contributions.
As you can see, the tax benefits associated with traditional 401(k) plan contributions and earnings are not only favorable to the employer, but also to the employee. The ability to grow retirement assets on a tax-deferred basis is a huge benefit, and is part of the reason that these plans have gained so much in popularity over the last 20 years or so.
The Democrats’ 401(k) Replacement Plan
I have read a number of articles describing the alternative 401(k) plan being considered by some of the Democratic leadership. This plan was the brainchild of Dr. Teresa Ghilarducci, an economics-policy professor at the New School for Social Research in New York (where else?). However, I got so many different details from the various articles I read, I figured it would be best to review Dr. Ghilarducci’s own testimony and briefing paper rather than counting on hearsay.
It’s a good thing I did, because Dr. Ghilarducci’s original proposal is quite different in some respects than the plan she revealed in her Congressional testimony. However, either proposal would still likely result in the death of 401(k) plans and would put the government in the role of providing retirement security. Here are the details of her original briefing paper from November of 2007:
● As already noted, the proposal would not do away with 401(k) plans, but would eliminate all of the tax benefits as discussed above. I must assume that this also means the tax benefits associated with Roth-type 401(k) contributions as well. This would, in effect, kill 401(k) plans as the tax incentives for employers and employees are the main drivers for their adoption and participation.
● Instead of employer-sponsored 401(k) plans, the government would set up special Guaranteed Retirement Accounts (GRAs). Participation would be mandatory for all workers except for those who are covered by an equivalent or better defined benefit retirement plan.
● Required contributions of 5% of salary (equally shared by employer and employee) would be made to the GRA each year, and would be administered by the Social Security Administration. Contributions will apply only up to the Social Security earnings cap (currently $102,000 for 2008), and workers will have the option to make additional after-tax contributions to the GRA.
● To offset the loss of before-tax contributions in 401(k) plans, workers would receive an annual $600 refundable tax credit, indexed to inflation. Note that the “refundable” nature of this tax credit insures that workers receive it even though they may not pay any income taxes. For lower-paid workers, all or part of the $600 tax credit would be directed into the GRA to insure at least a $600 annual contribution for every worker.
● As noted above, the GRAs would be administered by the Social Security Administration and would be guaranteed at least a 3% annual return. However, the original proposal suggests that these contributions be managed by a unit of the government’s Thrift Savings Plan, and not placed into government IOUs. Independent trustees would direct the investment of contributions and have the authority to hire commercial money managers. While the government would guarantee a minimum return of 3%, it would also be possible to earn excess returns which could be credited to GRA accounts.
● Finally, at retirement, GRA account balances are converted to inflation-indexed annuities based upon the life expectancy of the participant. Even so, individuals will be permitted to take a partial lump-sum distribution equal to the greater of 10% of their account balance or $10,000, and will also be able to select among optional survivor benefits in exchange for a smaller monthly check.
The supposed benefits of this new retirement arrangement will be to provide a benefit roughly equal to 25% of the pre-retirement income of a full-time worker who works 40 years and retires at age 65. Noting that Social Security replaces approximately 45% of pre-retirement income of the average worker earning $40,000, the proposal states that the combined programs can replace 70% of pre-retirement income of such workers.
Of course, that only applies to workers earning their “averages” and working for the period of time they consider to be typical. The actual amount of replacement income will depend upon actual earnings. A table in Dr. Ghilarducci’s briefing paper notes that a “high earner” averaging $60,000 per year in earnings at retirement will replace only 61% of pre-retirement pay, while a “low earner” with only $20,000 of earnings at retirement will replace 89% of pre-retirement pay. Now that’s what I call spreading the wealth, but more about that later on.
There are many other details of this plan that space does not permit me to discuss. For more details of the original proposal, see Dr. Ghilarducci’s briefing paper for the Economic Policy Institute at the following web address:
Congressional Testimony Paints A Different Picture
It’s safe to say that Dr. Ghilarducci’s original proposal is not as bad as what we heard being proposed during her October testimony before the Committee on Education and Labor. This testimony provides some insights as to how the proposal has changed as the markets have wreaked havoc upon the account balances of 401(k) participants, and the government has moved to “bail out” various financial sectors.
For example, the original proposal didn’t spend much time talking about “trading in” existing 401(k) accounts for the new GRA, but Dr. Ghilarducci’s testimony notes that such a trade-in could occur based on “mid-August [stock market] prices.” In other words, the government would pony up the difference between participants’ current reduced account balances and what they had in mid-August before the latest stock market meltdown.
Other testimony given during the same Committee hearings stated that $2 trillion of value had been lost by participants in 401(k)s, IRAs and similar retirement plans over the course of the past 15 months. How much of this represented “lost” 401(k) balances is unknown, but whatever disappeared between mid-August and October would be restored by the government.
Also recall how Dr. Ghilarducci originally proposed a reasonable trustee-directed investment plan for the entire GRA. However, her recent Congressional testimony modified this stance. She now proposes that 401(k) accounts “traded in” to restore their mid-August values would be invested in a special type of government bond that earns 3%, adjusted for inflation. The testimony makes it clear that the government bond proposal would apply only to restored account balances traded in for GRAs, but who knows what Congress may decide.
Plus, we all know that these special bonds would likely be similar to those in the Social Security “trust funds.” It is a sad fact that money contributed to the Social Security trust funds is simply spent by the government in exchange for IOUs. I have written previously about how the Congressional Budget Office described the bonds in the Social Security trust fund back in 2002, but I’ll reproduce it below just to drive home the point:
“Trust fund holdings, as internal liabilities between government accounts, are not assets of the government. Nor do they represent money owed to program recipients individually; payments to Social Security recipients and beneficiaries of other social insurance programs are based on a variety of rules set by law unrelated to trust fund holdings. A federal trust fund is basically an accounting device that measures the difference between the income designated for a specific program and the expenditures made to its beneficiaries. The accumulated difference, or balance, often represents a reserve of future ‘spending authority’ for the program, but it is not a reserve of money for making payments.” [Emphasis added]
“In the future, when receipts for such programs as Social Security fall below their expenditures, the legal authority to pay benefits will exist as long as their trust funds have balances, but the government will have to generate cash to pay benefits either by running a surplus in the rest of the budget--which would probably require cutting other spending or raising taxes--or by borrowing from the public.”
Understand that the above described makeover plan for 401(k)s is just the starting point, especially under an Obama Administration and Democrat majorities in the House and Senate.
Specifically, Dr. Ghilarducci’s testimony also made it clear that she is not just aiming at 401(k) plans, but also various other types of “defined contribution” plans including profit sharing, money purchase pension plans, 403(b) plans and even IRAs. Perhaps we should christen this proposal “Social Insecurity 2.0.”
Other details are far less than clear right now, such as the tax treatment of 401(k) account balances transferred into a GRA, what would happen to workers who don’t fit the “average worker’s” 40 years to contribute to the plan, and many, many others. If this plan gains any traction in the new Congress, I’m sure we’ll hear more about these and other details yet to be disclosed.
Whatever the final form of an actual bill to introduce GRAs, if any, Dr. Ghilarducci’s proposals are still a major diversion from retirement planning law that has steadily evolved since the passage of the Economic Recovery and Income Security Act of 1974, otherwise known as ERISA. What would cause Congressional Democrats to trash over 30 years’ worth of retirement planning law? I’ll give you a hint: it starts with an “S.”
Socialism Du Jour – “Spread The Wealth Around”
The first hint at the real motivations behind the GRA proposal should come from the fact that Dr. Ghilarducci’s paper was published by the Economic Policy Institute, not exactly a bastion of conservative thought. Plus, the table of contents on the briefing paper was punctuated by the tagline “Agenda for Shared Prosperity.” Isn’t this just another way to say, as Senator Obama suggests, to “spread the wealth around?”
And don’t think this is just an over-the-top reaction from a conservative. Dr. Ghilarducci, the architect of the new plan, said the following during a recent interview:
And what’s amazing about this is that it’s actually, um, doesn’t cost the government anybody (sic). I’m just rearranging the tax breaks that are available now for 401(k)s and spreading -- spreading the wealth.
You would think that the Democrats would have coached her to not describe it in those exact words, but the bottom line is that spreading the wealth is exactly what GRAs are designed to do.
The carrot at the end of the stick is the restoration of accounts to their August 2008 values, before the latest market crash. Imagine how many Americans would jump at the chance to recoup the market losses of the last couple of months!
Free money, or so it would seem. That’s how socialism works: give ‘em a short-term benefit in exchange for a lifetime of bondage.
While a lot of Dr. Ghilarducci’s testimony dealt with enhancing retirement security, reducing investment-related fees and making up for losses incurred during the recent bear market, a quick review of her Congressional testimony reveals the real reason for this desire to change to a new government-sponsored universal retirement plan.
According to Dr. Ghilarducci, the current system of providing tax incentives to companies and workers for sponsoring and participating in 401(k)-type plans is inefficient. While you and I might define the term “inefficient” much differently, for purposes of the “spread the wealth” crowd, Dr. Ghilarducci defines it as having too much of the tax subsidies go to people who actually pay taxes (ie – higher income earners).
Her testimony notes that 6% of taxpayers with incomes over $100,000 per year reap 50% of the total tax benefits from 401(k) and related plans. Never mind that this 6% of taxpayers pay the lion’s share of all income taxes. I don’t have numbers for the top 6%, but in 2006, the top 5% of taxpayers paid 60% of all income taxes. Plus, approximately 1/3 of filers pay no income tax at all based on 2006 income tax statistics.
I would argue that it makes sense that people who actually pay taxes should be the ones receiving the lion’s share of any tax benefits, not those who pay no taxes at all. Demographics would also seem to dictate that high earners would get most of the benefits. My firm counsels workers to start contributing to their 401(k) plan early to allow compound interest to grow. Thus, it makes sense that those with larger balances are those who have been saving a long time, and who are most likely to have worked their way up into high-paying positions. This proves that working hard and saving early pays off in the long run.
However, the Democrats now want to say that those who worked hard to excel and who took advantage of tax incentives to save a sizeable nest egg should be punished and have their tax benefits given to those who have not been as industrious or mindful about saving.
The bottom line is that this whole proposal is nothing more than a way to redistribute wealth based on liberal ideology. It’s being sold as a way to restore balances, guarantee minimum future returns and reduce the uncertainty of market-based investments, but you can rest assured that it’s just another step on the road to increased government control of every part of our lives, also known as socialism.
A New Democratic Piggy Bank
I also find it very interesting that one of the new wrinkles that has appeared in Dr. Ghilarducci’s proposal between its original release and her recent testimony would allow 401(k) participants to have their account balance restored if they move their account into a new government bond. Considering that billions of dollars will be required to bail out Wall Street due to the subprime crisis, the future of social programs under a Democratically controlled Congress were in question. Where would they get the money?
Now we know one way they might try to get some cash in the coffers – highjack our 401(k)s and other tax-deferred retirement accounts.
Plus, it is currently unknown how much, if any, of the ongoing contributions would be allocated to these special government bonds. Since the whole matter is currently in flux, I could see a Democratic Congress mandating all or part of ongoing contributions be placed into government-guaranteed bonds. Sure, the Democrats will try to sell GRAs as a way to insure retirement stability, but it will really be a way to have access to a gigantic stash of cash.
Can We Afford This Nonsense? No, But So What?
This new 401(k) replacement proposal results in affordability issues at several levels. First, can the government afford to restore mid-August values for everyone in a defined contribution type of retirement plan? After all, the amount of money to do so would be gargantuan! Well, I guess it can as long as they keep the printing presses going at the Fed. However, that doesn’t mean it’s affordable.
The Congressional Budget Office has estimated that all types of retirement plans (IRAs, defined benefit, 401(k), etc.) have lost apprx. $2 trillion over the last 15 months due to stock market declines. I cannot find a statistic showing how much of that loss was in defined contribution plans like 401(k)s, but I would guess it’s in the hundreds of billions.
Plus, what about the defined benefit plans that are now going to be under-funded. It probably won’t be long until we see companies with at-risk pension plans asking for a bailout of their own. If we bail out 401(k) participants, can we justify not bailing out employers who may have no other choice than to terminate their plan if they can’t get a government handout?
Another level of affordability is in relation to the returns needed in a 401(k) to produce a meaningful retirement benefit. The proposed bond investments will guarantee 3% above inflation on balances “traded in” to the GRA. Since inflation historically runs about 3% per year, that means a 6% return. It will be hard for workers to build much wealth with such low returns.
Finally, we have to look at the effects on the stock market. We don’t know exactly how the money “traded in” to a GRA will be treated, but that giant sucking sound you’ll hear might be money flowing out of the equity markets and into government bonds. That will mean more downward pressure on stock market prices.
And what will the government do with the trillions of dollars it will be given? Three guesses and the first two don’t count: Spend it, of course. Maybe this is how Obama gets the money to fund his lavish new spending programs. It could happen.
What is really hard to understand is that Democrats continually grouse about the regressive nature of the Social Security tax, which is currently 7.65% of pay (matched by the employer). Self-employed individuals must pay both shares, so their tax rate is 15.30%. While Obama’s tax plan promises to rebate part of this tax, it would seem a contradiction to add yet another 5% mandatory contribution/tax/whatever for employees to pay. Plus, if employers have to pay half of this mandatory contribution, it will represent yet another expense during a period of recession. Not a good idea!
The entire idea of replacing employer-sponsored 401(k) plans with a government sponsored Social Security - II plan would have been considered ludicrous prior to August of this year. However, after banks, brokerage firms, insurance companies and car makers all lined up for a share of government’s largesse, it’s now not hard to imagine something this insane actually becoming law.
Conclusions – After Today, Anything May Be Possible
Considering that this proposal has been trotted out during a Committee hearing at a time when Congress is not even in session likely indicates that it’s no more than a trial balloon to gauge public reaction. Dr. Ghilarducci’s original proposal made no waves when it was released a year ago, likely because no one felt there was a snowball’s chance of it ever becoming law.
Now, however, times have changed. The recent market meltdown has many investors worried about their ability to retire with sufficient income. On top of that, lawmakers have seen that the major Wall Street bailouts have been passed without riots in the streets. This just might give them the ability to answer all of their constituents who have asked, “Hey, where’s my bailout?”
I want to think that this proposal has very little chance of ever becoming law. Over the last 2-3 decades, there has been a continual expansion of tax incentives to get workers to save for retirement, and for employers to help them do so, and there is no doubt this has been a good thing. Thus, I would hope this will not be dismantled in the next Congress.
But we should all understand that, if Barack Obama becomes our new president with supermajorities in Congress, anything is possible. A massive expansion of government and a rollback of our freedoms are not out of the question. Such an expansion of government has to be funded somewhere, and 401(k)s and other supposedly sacred retirement plans, including IRAs, may appear to be the low-hanging fruit to the liberals who will be in control in Washington.
Very best regards,
Gary D. HalbertSPECIAL ARTICLES
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