Pensions: Financing and Regulation

This discussion has often used the term "sponsor." The pension plans discussed have involved an arrangement between a sponsor, usually an employer, and members, usually employees, to provide retirement income. There are two large, very different, classes of retirement programs that do not fit into this framework.

Standard advice is to save for old age and the inevitable rainy day. The advice remains good, but it has also become embedded in tax policy. To encourage self-employed individuals and workers whose employers do not provide a formal pension plan to save for retirement, Congress has created several sections of the Internal Revenue Code, for different types of workers, that provide for the creation of special savings accounts for retirement purposes. These accounts are special in that income diverted to the account and the investment earnings of the account are not subject to income taxation until withdrawn. These tax-sheltered retirement savings vehicles have become popular. The question of whether they have generated new savings or diverted existing savings to tax shelters remains open.

Examples of these retirement programs will illustrate their history and variety. Individual retirement plans were authorized by ERISA in 1974. Originally these plans were limited to individuals not already participating in an employer sponsored tax qualified plan or other tax favored arrangement. Later the eligibility was broadened. These individual retirement plans are funded through Individual Retirement Accounts (IRAs). Tax Sheltered Annuities have an even longer history and can be sponsored by tax-exempt entities organized for religious, educational, or research activities. Keogh plans were authorized in 1962 and are designed for self-employed individuals. Section 401(k) plans are named for the section of the Internal Revenue Code that regulates them. They are designed for employees and are typically funded through salary reductions and matching contributions by employers.

Roth retirement accounts, named for their sponsor in Congress, are a recent addition to this list of individual retirement programs. Roth accounts are fundamentally different in that contributions are subject to income taxation but withdrawals are not.

The high rate of poverty among the elderly during the Great Depression was among the forces that moved the Congress to create an almost universal Social Security program in 1935. Social Security includes several types of benefits, but the old-age income part is a DB plan with replacement ratios that decline as career average indexed wages increase. Social Security has been funded primarily by a payroll tax on a modified current-cost basis. The modification has been the existence of a trust fund that stabilizes results across economic cycles.

In the early 1990s there were approximately three taxpaying workers for each beneficiary. By 2020 it is likely that there will be approximately two taxpaying workers for each person receiving benefits. The resulting financial crunch for a current-cost system is forcing political consideration of increasing the normal retirement age, shifting the system partially to a DC program, and actions to increase productivity by the time the crunch occurs.