The White House and Congress has been evaluating whether to reduce the pre-tax 401(k) contribution limit to potentially as low as $2,400 from $18,000. The move is a way to boost revenue as the government looks to cut taxes.
Economists and budget hawks call this a “budget gimmick,” since it would simply shift revenue that the federal government would collect to the future — essentially, a one-time cash boost.
While Rep. Kevin Brady (R-Tx), the GOP’s chief tax writer in the House, may be looking for immediate income, he told Yahoo Finance at the All Markets Summit that he wants to encourage people to save more — and was looking for alternative means, besides 401(k)s.
However, many consider the 401(k) to be crucial in retirement savings over the past half century making one question very important: What happens to saving behavior if the 401(k) changes?
People who are not financially literate might be hurt
“The average contribution last year was about $6,000. So limiting it to $2,400 would be a big whack,” Olivia Mitchell, a professor at the Wharton School of the University of Pennsylvania and executive director of the Pension Research Council, told Yahoo Finance.
Mitchell said the biggest impact will be on those who are not financially savvy, which could be many people.
“We know people are very financially illiterate so they tend to take what the employer puts in as the default, as advice,” she said. “Even if it’s not meant to be advice.”
So, for example, people who might be saving $6,000 — and probably should be saving even more — might take a new $2,400 cap as government-approved advice on what they should be doing. “That could have a big impact decreasing retirement savings,” said Mitchell.
Vanguard and Fidelity, titans of the retirement savings industry, share Mitchell’s analysis.
In an email, a Vanguard spokesperson noted that the company “is concerned over any legislation that would negatively impact investors’ ability or incentive to save for retirement.”
Looking at the issue with the benefit of significant data, David Gray, senior vice president of workplace retirement plan solutions at Fidelity, echoed Mitchell’s idea that a lower cap would be seen as advice.
Important nudging tools will lose their effectiveness
The 401(k) has been one of the most effective tools to get Americans to save because of auto-enrollment, Gray told Yahoo Finance.
“Plans that use auto-enrollment have 86% participation while plans that don’t leverage auto-enrollment are only at 51% participation rates,” said Gray. “We are concerned that if we have low tax threshold pre-tax, such as $2,400, employers may only auto-enroll [employees] up to that level. There would be real impact on retirement participation.”
Mitchell also noted that employer behavior also adds significant uncertainty into the mix. Would employers still match employee contributions? Would companies even participate? Would they even have 401(k)s if employee participation dropped? “We just don’t know because we haven’t seen any evidence,” said Mitchell.
The automatic nature of modern 401(k) plans has been a boon for savings, Fidelity has found. Automatic enrollment at default amounts of money has effectively nudged tens of millions of Americans into saving for retirement. Compounding that, many companies have auto-increases in the amounts set aside, as well as target-date funds that make investing further automated.
Changing to a Roth IRA structure in which less money is automatically taken out of people’s paychecks could be a tricky business. It could also lead to a special re-enrollment period instead of simply defaulting people to contribute to a retirement savings plan.
“If we have to go back and ask tens of millions of people to re-enroll, we are going to have people opt out or re-enroll at a lower savings rate,” said Gray. “We think that’s a real risk.”
Getting people to save for retirement is challenging, as Brady himself noted, and it could be dangerous to tweak the system — it could accidentally lead to even more underfunded retirements.
But the most important thing at play here, behaviorally, is inaction. Financial decisions are tough, complicated, and make a lot of people nervous enough to stick with the status quo. A change away from the automatic nature of 401(k)s could prove catastrophic if not handled well.
“It’d be taking some inertia out of the system,” said Gray. “And every study shows inertia is working as a benefit for individual retirement savers.”