Monday, December 15, 2008

Problems with Guaranteed Retirement Accounts

The New York Times calls Teresa Ghilarducci's proposal for Guaranteed Retirement Accounts one of the "ideas of the year." Here's some background, and then in later posts I'll look at a number of problematic issues regarding the proposal. The following summary of the GRA plan is pulled from this paper Ghilarducci wrote for the Economic Policy Institute:

How Guaranteed Retirement Accounts work

Structure. Guaranteed Retirement Accounts are like universal 401(k) plans except that the government, as befits a large and enduring institution, will invest and manage the pooled savings.

Participation. Participation in the program is mandatory except for workers participating in equivalent or better employer defined-benefit plans where contributions are at least 5% of earnings and benefits take the form of life annuities.

Contributions. Contributions equal to 5% of earnings are deducted along with payroll taxes and credited to individual accounts administered by the Social Security Administration. The cost of contributions is split equally between employer and employee. Mandatory contributions are deducted only on earnings up to the Social Security earnings cap, and workers and employers have the option of making additional contributions with post-tax dollars. The contributions of husbands and wives are combined and divided equally between their individual accounts.

Refundable tax credit. Employee contributions are offset through a $600 refundable tax credit, which takes the place of tax breaks for 401(k)s and similar individual accounts and is indexed to wage inflation. Eligibility for the tax credit is extended to part-time workers, caregivers of children under age six, and those collecting unemployment benefits. If an individual's annual contributions amount to less than $600, some or all of the tax credit is deposited directly into the account in order to ensure a minimum annual deposit of $600 for all participants.

Fund management. The accounts are administered by the Social Security Administration and funds are managed by the Thrift Savings Plan or similar body. Though funds are pooled, workers are able to track the dollar value of their accumulations, as with 401(k)s and other individual accounts.

Investment earnings. The pooled funds are conservatively invested in financial markets. However, participants earn a fixed 3% rate of return adjusted for inflation, guaranteed by the federal government. If the trustees determine that actual investment returns have been consistently higher than 3% over a number of years, the surplus will be distributed to participants, though a balancing fund will be maintained to ride out periods of low returns.

Retirement age. Participants begin collecting retirement benefits at the same time as Social Security, and therefore no earlier than the Social Security Early Retirement Age. Funds cannot be accessed before retirement for any reason other than death or disability.

Retirement benefits. Account balances are converted to inflation-indexed annuities upon retirement to ensure that workers do not outlive their savings. However, individuals can opt to take a partial lump sum equal to 10% of their account balance or $10,000 (whichever is higher), or to opt for survivor benefits in exchange for a lower monthly check. A full-time worker who works 40 years and retires at age 65 can expect a benefit equal to roughly 25% of pre-retirement income, adjusted for inflation, assuming a 3% real rate of return. Since Social Security provides the average such worker with an inflation-adjusted benefit equal to roughly 45% of pre-retirement income, the total replacement rate for this prototypical worker will be approximately 70%.

Death benefits. Participants who die before retiring can bequeath half their account balances to heirs; those who die after retiring can bequeath half their final account balance minus benefits received.

In following posts, I'll look at several aspects of the GRA plan that I think are worth considering more carefully before moving ahead.


Anonymous said...
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Rare Sense said...

Thanks for the most complete and most unbiased description I've read for GRAs so far. Two observations:
First, it describes the accumulation of excess returns in a 'balancing fund'. It doesn't describe how the accumulation of insufficient returns would be addressed... 3% ABOVE inflation is a pretty high target and doubtless some politicians will prefer that the only investment vehicle safe enough for retirement accounts is US Treasuries.
Second, it seems to transfer risk of outliving your pool of assets to those who don't by virtue of seizing at least 50% of the account at death. Is that a fair characterization?

Andrew G. Biggs said...

Thanks (and sorry for the delay in publishing your comments; spam monitoring is an issue, unfortunately). Both your points make sense. It's one thing to 'expect' a 3% real return by investing in equities, but another thing to guarantee it for everyone. That's expensive. Government bonds are an option, but I doubt you'll get a 3% real return on TIPS. One of the problems when government gets involved with this kind of stuff -- think public sector pensions, or the way the PBGC is managed -- is that there's no way to ensure that policies regarding benefits are kept in line with what markets say is affordable. This is another example of that, unfortunately.

Regarding annuitization and death benefits/taxes, it's not totally clear to me how the requirement to annuitize mixes with the ability to leave half your account to your heirs. If you've annuitized it (or 90% of it) at retirement, there isn't really anything to leave behind, unless I'm misunderstanding the policy.