As the debate rages over whether Americans should be allowed to "carve out" some of their Social Security payroll tax to create individual accounts (IAs) for retirement, one potentially volatile question has gone largely unasked: How would the existence of the private IAs affect participation in corporate 401(k) plans?
Severely, according to J. Mark Iwry, a nonresident senior fellow at The Brookings Institution. "The consequence of the carve-out approach is to undermine the employer systems by leading employees to divert their contributions away from 401(k)s and into the new accounts," he says. Such a diversion, he suggests, could lead plan sponsors to cut back on their own pension programs, or at least stop building them up.
The dire prediction, says Iwry, stems from his speculation about the cost-benefit analysis that will confront employees. Most of the proposals for installing IAs envision making the accounts attractive enough to entice employees to take the carve-out. But Iwry, a former Treasury official who oversaw retirement savings policy and regulation from 1995 to 2001, suggests that many employees —especially low-income ones—will weigh the government-sponsored IA against the cost of making a voluntary contribution to their corporate plan.
"In making that calculation, employees who have an opportunity to contribute to a 401(k) couldn't help but notice that the 401(k) contribution is coming out of pocket," notes Iwry. "It's a salary reduction that cuts their take-home pay." By contrast, the carve-out contribution to an IA would be money already earmarked for payroll taxes, and thus never a part of take-home pay. "The apparent cost of a contribution to a Social Security individual account will seem cheaper," he says, "far less than the apparent cost of the 401(k) account."
Accept No Substitutes
Amid the many vociferous objections raised to the idea of IAs—which even supporters agree wouldn't stop Social Security's slide—worries about a possible threat to 401(k)s have raised hardly a murmur. One member of the President's Commission to Strengthen Social Security, Prof. Olivia Mitchell of the University of Pennsylvania's Wharton School, says, "I can't recall any particular conversation on the President's Commission where this came up." But even Michael Tanner, director of health and welfare studies at the Cato Institute—a strong supporter of Social Security private accounts—concedes that the introduction of IAs "probably will have a small negative impact" on company-based retirement savings. And Mitchell points out that the possibility of such an impact "is certainly worth thinking about."
A February report by the Congressional Research Service (CRS), part of the Library of Congress, outlined the ways 401(k) participants might react to private Social Security accounts. Their actions "would depend on their perceptions of the potential for the accounts to increase their retirement income, their expectations about the future benefits they will receive from the traditional Social Security program, and their attitudes toward risk," the report said. The CRS noted that if employees believed that the reduced Social Security benefit and an IA would lead to adequate retirement income, some might choose to offset their individual-account saving by setting aside less in other programs, or borrowing more. Further, the report said, workers "might invest their 401(k) contributions more conservatively, seeking to reduce the increased investment risk that would result from replacing part of Social Security with IAs."
The report went on to say that the possibility of IAs leading to cutbacks in other retirement saving "would need to be carefully addressed in worker-education efforts." It added that 401(k) plan sponsors should be prepared for workers perceiving "the IA as a substitute for their employer-sponsored retirement savings plan rather than a complement to it."
"Call Me An Optimist"
How those education efforts would convince workers to stick with their 401(k)s in practice, of course, is uncertain. But the 35 millionmember, Washington, D.C.-based AARP—among the most vocal opponents of Social Security private accounts—is fully prepared to instruct employees on the pros and cons of retirement-investment choices, whatever they may be. "For us, education is almost a mandate," says CFO Rob Hagans, who adds that the AARP's own 401(k) plan covers 1,600 employees, offering a 100 percent match for the first 3 percent of pay that employees contribute, and a 50 percent match for the next 2 percent.
Personally, Hagans doesn't "think that the carve-out of private accounts would really compete with the 401(k)." Neither does Wendy S. Reitherman, vice president of human resources for Varian Medical Systems, a Palo Alto, California, medical-equipment and software concern. While for many companies the debate still "feels a little speculative," she says, her guess is that through company education efforts, "employees would be clear that Social Security is not going to be enough to retire [on]," even if they carved a personal account from their payroll taxes. "Call me an optimist, but I think the more education people get about the cost of retirement, the more they will realize how much they need to save." In Varian's case, says Reitherman, its 2,850 employees who are 401(k) participants—82 percent of those eligible—would continue to be drawn to the 100 percent match for up to 6 percent of pay, and by the ability to borrow against funds in the plan.
Still, in Iwry's view, any pressure on employees to cut back on their 401(k) contributions could significantly affect plan sponsors. For one thing, corporate pension plans would be pinched because they are dependent on volume to keep fees low. So a decline in plan participation could make a 401(k) program more expensive to maintain. For another, any exodus from the corporate plan would reduce the secondary benefit that companies get from their pension plans: the ability to raise the contribution limits of highly compensated employees by a specified higher percentage than exists for the entire plan, depending on how much the rank-and-file contributes. The formula is determined under the government's "nondiscrimination" provisions (see "A Benefit at the Top," 401[k] Buyers' Guide, April).
Varian's Reitherman concedes that "we'd have to review the plan if there were any major changes." But her suspicion is that any increased attention Social Security IAs might put on retirement-savings needs could actually lead to more 401(k) contributions.
Professor Mitchell also sees that possibility. "Just the mere fact of people having a sense of ownership could make them more likely to increase their savings" by participating additionally in a 401(k), she says. Cato's Tanner agrees. "There's some thought—and [Federal Reserve chairman] Alan Greenspan, among others, has said it—that savings is a habit. If they see their money grow, they may actually be encouraged to save more" in a 401(k), he says.
And those pro-IA views were echoed in one section of the CRS report, which noted that some employees might increase 401(k) contributions as a way of offsetting some of the additional risk the IAs introduce, while other employees "might develop a 'taste for saving' that would persuade them to save more for retirement through vehicles such as Individual Retirement Accounts (IRAs)."
Indeed, Zvi Bodie, a Boston University School of Management professor who has written extensively on retirement savings, sees the argument that 401(k) plans might suffer as "weird reasoning." Bodie, no fan of the Social Securityrelated IAs as proposed—for example, he suggests an initial step of investing IA funds in inflation-protected government bonds—believes the attraction of the employer-sponsored 401(k) match is still the biggest draw. "I think the way young people will think about this," he says, "is that it's saving for retirement that's subsidized by their employer."
Roy Harris is senior editor of CFO.