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Three Questions: Prof. James Choi on the Future of the 401(k)

Republican lawmakers are reportedly considering changing the way most 401(k) plans are taxed. We checked in with Yale SOM’s James Choi, the author of influential studies of how default options in retirement plans affect behavior, about how the proposed change might alter the way people save for retirement.

Your research helped make the case for automatic enrollment in 401(k) savings. As a result, the Pension Protection Act of 2006 was passed to encourage the adoption of automatic enrollment. What do we know now about the effect of that change? Are people saving more?

Vanguard reports that 45% of the 1,900 plans for which provides record-keeping services have adopted automatic enrollment, up from only 15% in 2007. Only 63% of eligible employees are contributing to opt-in plans, whereas 90% of eligible employees are contributing to automatic enrollment plans. As automatic enrollment has spread, the overall employee participation rate has risen from 68% in 2007 to 79% in 2016. The most important effect of automatic enrollment is that it increases 401(k) savings among those who would otherwise save nothing in the 401(k).

The impact on average contribution rates has been more modest because the contribution rate companies have chosen as their automatic enrollment default has typically been rather low. Low defaults drag down contribution rates of those who otherwise would have saved more. The average employer plus employee contribution rate (including those not contributing at all) was 7.9% in 2007, peaked at 8.9% in 2014, and was 8.2% in 2016.

The overall U.S. personal savings rate, which includes savings outside the 401(k) system, has been volatile over the past decade—starting at 3.0% in January 2007, peaking at 11.0% in December 2012, and ending at 3.6% in August 2017. Of course, there are a lot of things going on in the economy that are affecting savings rates besides automatic enrollment, so it's hard to know how much of the overall movements can be attributed to automatic enrollment.

What would be the effect of decreasing the tax-free threshold for contributions, as Republicans are considering?

The proposal seems to be that the annual before-tax 401(k) contribution limit would be decreased to $2,400, but that contributions above that amount would continue to be allowed on a Roth basis, so there would still be a tax benefit available for contributions above $2,400. (Before-tax contributions are fully deductible from income today, but both principal and capital gains are taxable upon withdrawal. Roth contributions are not deductible from income today, but neither principal nor capital gains are taxed upon withdrawal.)

My biggest concern, from a personal finance perspective, is that the $2,400 threshold will create a focal point that will drag people's contributions down toward $2,400. It would be better to completely Rothify the system than to create this low focal point.

The primary reason Republicans are considering this change is because they want to raise tax revenue in the near-term to pay for other tax cuts. Rothifying the retirement savings system helps them on this margin, but at the expense of future tax revenue. In effect, they would be borrowing from the future. There are fiscal implications that go beyond just the individual personal finance perspective.

Is there a retirement savings crisis? What’s the one policy change you’d make to help?

I think there's a consensus that at least 15-25% of Americans are not saving enough for retirement. How much beyond this population the undersavings problem extends is a matter of debate.

Half of American workers don't have access to a 401(k). I would like the federal government to facilitate the creation of automatic IRAs, where workers whose employer doesn't offer a 401(k) would be automatically enrolled into contributing to an IRA. Numerous states are already creating auto-IRAs, but because workers move across state lines so much, this really cries out for a federal solution.

Professor of Finance