Are mandatory IRAs on the way?

Republicans and Democrats are starting to battle in earnest over how to cut federal discretionary spending. Eventually the ominous arithmetic of entitlements and tax revenue will require the focus to turn to the Social Security benefit formula (as well as Medicare).
While much of the attention is on benefits paid or taxes raised, the solution may lie in reviving an idea with a venerable history in the U.S. and lessons to draw on from other countries: Mandatory individual retirement savings accounts.
The demographics of an aging nation are inexorable while living standards for future retirees are increasingly uncertain. A mandatory savings plan would bring greater financial security in old age.
The basic outline of the pension scheme is widely shared, while the details of various proposals differ. For instance, the typical plan has all workers setting aside a portion of their wages, with targets ranging from 3 percent to 10 percent. The savings are invested in a well-diversified portfolio with razor- thin fees.
Some proponents would limit worker choice, with the accounts administered by a government agency (such as Social Security) and the money directed into a broad market index, 60 percent in stocks and 40 percent in bonds.
Others prefer giving workers greater choice, perhaps by allowing everyone into the Federal Thrift Savings Plan, a defined-contribution pension overseen by an independent agency and invested by private managers. The Thrift plan offers participants a limited number of broad-based funds with an expense ratio of 0.028 percent, compared with a 401(k) average of about 1 percent.
No Tax
Workers would own the accounts, much like an IRA. Unlike the George W. Bush administration’s controversial proposal to partially privatize Social Security by redirecting a portion of payroll taxes into private accounts, mandatory savings plans would supplement Social Security. It’s savings, not a tax.
That said, once the system is up and running it opens up the possibility of tweaking the overall retirement system for the better. For instance, the mandatory savings requirement could be gradually increased to offset the widely anticipated Social Security benefit reductions. The move could shore up the soundness of the Social Security safety net and boost everyone’s retirement savings.
Another advantage of mandatory savings is that it frees up management to focus on innovating for profits and markets in an intensely competitive global economy, while providing increasingly mobile workers with greater financial security in their dotage.
Participation Rate
The big knock on the current voluntary retirement system is its limited scope. In 2009, 59 percent of workers over the age of 16 had access to an employment-based pension or retirement plan and just 45 percent participated in such plans, according to the Employee Benefits Research Institute.
The value of promised benefits is also suspect.
Governors and mayors are in a mud-wrestling match with public employees over a gap between pension assets and obligations that may reach $2 trillion. The Pension Benefit Guarantee Corp., a federal agency that backstops private pensions, estimates it’s at risk to the tune of $170 billion from underfunded defined benefit plans at companies with a below investment-grade credit rating. Another $20 billion in exposure comes from multi-employer plans.
Under 401(k) plans the burden of creating retirement portfolios shifts to workers and research suggests that many are doing a poor job of it.
Pressure to Act
The call for pension reform is not new. President John F. Kennedy’s Committee on Corporate Pension Funds and Other Private Retirement and Welfare Programs recommended a central clearing house that would, among other things, keep accounts for workers at small companies. In 1981, the President’s Commission on Pension Policy suggested a mandatory universal pension system. In 2002, then-House Minority Leader Richard Gephardt, a Democrat from Missouri, proposed the Universal and Portable Pension Act.
Now, an aging population increases the pressure for action.
Jonathan Barry Forman, a University of Oklahoma law professor, and Adam Carasso, chief economist on the minority staff of the House Budget Committee, created a mandatory savings plan model that covers all workers, including the self-employed. Their simulation starts on Jan. 1, 2007, with each worker putting 10 percent of pay into an individual account.
The model assumes the accounts earn a 3 percent annual return over inflation and that the workers’ real wages rise 1.1 percent a year. (These are in line with Social Security trustee assumptions.) The savings accounts are annuitized at age 65.
Couple at 65
A high-earning two-income couple retiring in 2045 at 65 would have a combined income from Social Security and mandatory savings of $89,466 in the first year of retirement, replacing 45 percent of pre-retirement income. A comparable average-income couple would receive $64,187, replacing 51 percent of pre- retirement earnings, and a low-income household would get $36,705, or 65 percent of pre-replacement income.
The mandatory savings become more critical when Social Security benefit cuts are assumed in their model.
The word “mandatory” sets off alarm bells. It should. Mandated solutions are often no panacea. The transition to a new savings system won’t be easy. Nevertheless, the goal of greater retirement security is worth a mandate (as was Social Security). The risk is too great that the alternative for future retirees is to make do with less. We’d all be worse off then, not just the elderly.
(Chris Farrell is a Businessweek.com columnist. A version of this column appears on Businessweek.com. The opinions expressed are his own.)