It is a strange twist of history that the primary way most Americans now save for retirement is through the 401K system, which in its beginning, was never supposed to provide a large percentage of retirement income for a large percentage of people. It's a bit reminiscent of the way employer-based health insurance coverage evolved in the country. If we had it all to do over again, we'd never consciously choose to do health insurance this way, and we'd never do 401Ks this way either.
The 401K system has many problems that prevent it from functioning as a solid retirement plan. It is too complex, is too fragmented, is not mandatory, has bad default options, allows too many loans, and has too many poor investment options. Most importantly, the fees are too high and there is not enough fee transparency.
The 529 Experimentthe 529 system. States and private companies compete for investor dollars with ever-improving tax breaks, ever decreasing expenses, and ever-improving investment options. Now the investor is left with the quandary of choosing between exceptional investment options such as the Utah 529 and the New York 529, both of which have excellent investments and total expenses less than 20 basis points. Even the worst 529s in the country are far better than most of the 401Ks out there.
If we could just make the retirement system similar to the 529 system, we'd have a much better retirement system. That improved system would provide an economic boost to the entire country. Here I offer 10 suggestions that would dramatically reform the system.
10 Reforms That Would Improve Our Retirement System
1) Get Rid Of The Numbers
One of the biggest difficulties in understanding the retirement system is that there are too many different types of accounts. There are 401Ks, 403Bs, two types of 457s, IRAs, 401As, SEP-IRAs, individual 401Ks, SIMPLE IRAs and many others. To make matters worse, most of these have a Roth option and a traditional tax-deferred option. Now I like Senator Roth as much as the next guy, but his name is not helpful in trying to figure out the difference between a traditional IRA and a Roth IRA. How about we have just two accounts –The Tax-Deferred Retirement Account (TDRA) and the Tax-Free Retirement Account (TFRA) and you can split your contributions between them in any way you see fit no matter what your income?
2) Standardize the Contribution Limits
Part of the difficulty is that there are all kinds of income and contribution limits for each type of account. Even financial advisers can't keep track of them all. Why not standardize them? How about every worker can contribute up to 30% of their gross income into their retirement plan with a maximum of perhaps $100K, indexed to inflation. Simple, yet sophisticated. No catch-up contributions. No income limits. No complexity. If you have a working spouse, they get their own $100K limit.
3) A Sensible Employer Match System
If employers wish to use retirement benefits to retain employees, they can offer a match of however much they like, up to 30% of the gross income of the employee. But every dollar the employer contributes is one less the employee can contribute, so the grand total is still 30% of gross income. Self-employed individuals use the same system, no additional benefit for being self-employed, but also no additional penalty.
4) Market-Based System
The 529 system demonstrated that the free market can provide low-priced and high quality investing options. States compete with private employers such as Vanguard and USAA to provide the best plans. The retirement system could work exactly the same way. Federal tax benefits are exactly the same with each plan, but states can offer an additional tax break for their own plans if they like. The Federal TSP could also be an option. You should also be able to change from one retirement account to another from time to time (perhaps once a year) with little hassle and reasonable fees. This preserves the competitive aspect of the system, encouraging providers to continually improve their products to compete for dollars.
When investors have a choice and are provided with transparency of fees, they will choose a plan with solid investments and low fees. Plans will compete by providing better options, perhaps even including a brokerage account for sophisticated, freedom-loving investors. The fiduciary requirements will be placed on the plans, instead of the employers.
5) Sensible Default Options
Studies have shown that if the default option for a retirement plan is to opt-out instead of opt-in, there is far more participation among employees. The default option should be that the employer has to send 10% of your gross income into the TFRA of your choice with each paycheck.
In addition, the plan itself should have a sensible default investing option. Some plans have a default option that is a money market fund. Better plans have a default option that is a target retirement fund based on your age. The problem with these is that they tend to be very aggressive (90% or more in equity) for younger employees who are just learning about investing. So when they see their retirement funds tank in their first bear market, they tend to bail out.
A much better option would be a sensible 50/50 strategy, perhaps 25% US Total Stock Index Fund, 25% International Total Stock Index Fund, 25% Total Bond Market, 25% Inflation-protected bonds. Each fund could design their own default within the regulations, but this would a much better default option than what is currently offered.
6) Mandatory Contributions
The default contribution is 10% of your paycheck into the Tax-Free Retirement Account (TFRA). You could change your contributions to the TDRA side if you like. You could also increase your contributions up to the maximum 30% or, or down to the minimum of say, 1-3%, but you can't stop them completely. Good retirement systems are mandatory retirement systems. Sometimes “free will” isn't all it's cracked up to be.
7) No Loans
Having a mandatory retirement system and then allowing employees to borrow the money right back out makes no sense at all. It was never very smart to take out a 401K loan, and IRAs don't allow them at all. I think that's a better model.
8) In-Service Conversions
You should be able to convert your TDRA dollars into TFRA dollars in any year you choose, no matter what your income, at your marginal tax rate.
9) Sensible Withdrawal Options
I see no reason that the government should be able to dictate the retirement age. You should be able to start taking withdrawals from your retirement accounts at any time after age 40 that you are working less than a certain number of hours a year. If you take a job later, you should be able to stop taking withdrawals and restart contributions.
However, the amount you can withdraw in any given year should be limited. Perhaps 5% a year in your 40s, 10% a year in your 50s, 15% a year in your 60s, and 20% a year beyond age 70. Obviously, that's not a sustainable safe withdrawal rate, but implementing a maximum withdrawal in any given year at least prevent someone from blowing the whole wad in the first couple of years of retirement.
Perhaps an exception could be made that with a physician certification of your life expectancy you could take out the balance of account divided by your life expectancy in years. So if you had two years to live with your cancer, you could take 50% of the amount out this year. Other sensible, but very limited, exceptions could be made, perhaps by an appeal panel you had to appear before.
It's a retirement account and should be used for retirement, not a first home, an education, a boat, or as disability insurance. Yes, some people will still abuse the system and start raiding their accounts at 40, but that's better than what's happening now (borrowing all the money out while working and spending whatever is left in the first couple of years of retirement.)
If this option isn't politically viable (too many people want access to their money at any given time), you could always leave things just the same as they are now, with a 10% penalty for withdrawals before 59 1/2.
National Single Premium Immediate Annuity (SPIA)
There should also be a national Single Premium Immediate Annuity (SPIA) clearinghouse, similar to the ideas for health insurance exchanges out there. You can go online, compare annuities, and purchase one at any time after 40 for your retirement account.
These should be insured by the federal government up to a certain reasonable amount, such as $1 Million in value, indexed to inflation. Many people complain that pensions are no longer available. Pensions are still available, you just have to purchase them yourself and you, instead of the employer, are responsible for investment performance up until the time of purchase, after which point your income is guaranteed.
Non-SPIA annuities could also be offered, but there should be only a few options (such as guaranteed payments that start in 5 years or 10 years) so that it is easy to compare plans and let market forces work.
10) No Required Minimum Distributions (RMDs)
Complexity can also be decreased by eliminating required minimum distributions. I know the government wants their share by the time you die, but it seems to me a much less complex way to do it is to take whatever is left when you die, and have it go into your spouse's account. If no surviving spouse, then what is left in your TDRA is liquidated, automatically converted to a TFRA at a federal tax rate of say, 25% plus state taxes, and distributed to your heirs tax-free, but outside of a retirement account. No RMDs and no stretch IRAs.
Implementing these reforms would dramatically improve our current retirement system. We would still need Social Security, and any changes to it could be completely separate from these. There would be a sensible mix of appropriate government regulation while allowing the free market to do what it does best — drive innovation, decrease prices, and improve quality.
What do you think? Agree? Disagree? How would you reform our retirement system? Comment below!