State Programs to Solve the U.S.'s Retirement Crisis
The U.S. is facing a retirement crisis. About one third of Americans have no retirement savings, and most don't have enough savings to retire comfortably. One main cause of this financial shortfall: more than 60 million American workers have no retirement plan offered to them by their employer.
The U.S. Department of Labor (DOL) recently issued a rule proposal intended to encourage more employers to offer a retirement plan to their workers. Specifically, the DOL proposed to exempt from ERISA, the federal pension law, state-sponsored plans for individual retirement accounts (IRAs). These state plans would require employers that do not already offer any retirement program to forward to the plan a state-specified percentage of their workers' salaries. These monies would be invested as retirement savings, unless workers opted out of this state-sponsored plan.
The DOL proposal is an understandable response to the failure of Congress to pass federal legislation for a similar program called the Automatic IRA -- with regular contributions from workers without retirement plans unless they opted out. However, the DOL proposal gives too much leeway to the states in offering their own versions of the Automatic IRA.
Here is the background to the DOL proposal. Most employers without retirement plans run small businesses with fewer than 100 workers. These employers do not want the financial burdens of operating and contributing to a retirement plan.
Of course, their workers could apply and contribute to an IRA at a financial institution; that contribution would be excluded from their taxable income. Nevertheless, despite good intentions to save for retirement, most of these workers never get around to opening their own IRA.
By contrast, workers in firms above a certain size without retirement plans would be required to contribute to a state IRA plan -- unless they chose to opt out, initially and then annually. Such an opt-out procedure, as opposed to an opt in application, has been shown to dramatically increase worker participation in retirement plans.
Given the multiple opportunities for workers to opt out, the DOL proposal correctly characterizes state IRA plans as "voluntary." That is legally necessary for these plans to avoid violating ERISA's preemption of most state retirement laws. For the same reason, the DOL proposal narrowly confines the role of private sector employers to connecting their payrolls to state IRA plans; these employers are not permitted to make contributions to these plans.
On the other hand, the DOL proposal undermines a key purpose of ERISA: Congress did not want to impose different state requirements for retirement plans on private sector employers. For example, California requires any employer with more than 5 workers to connect its payroll to the state IRA plan, while Illinois requires such a connection for any employer with more than 25 workers.
To reinforce its position that state IRA plans are not preempted by federal law under ERISA, the DOL proposal further provides that a state must be "responsible for investing the employee savings or for selecting investment alternatives for employees to choose." This provision is based on the premise that state governments, rather than employers, will make administrative and investment decisions for retirement plans in the best interests of plan participants. Yet this premise could be questioned, since some states have not done a good job in running retirement plans for their own employees.
Under ERISA, pension managers are fiduciaries -- personally responsible to act prudently and solely in the best interests of plan participants. Unfortunately, the DOL proposal does not expressly subject state officials responsible for a state IRA plan to strict fiduciary standards or tough prohibitions against conflicts of interest. These ERISA standards and prohibitions should become express conditions of the DOL exemption.
The DOL should be particularly concerned by the serious discussions among certain state officials about offering "guaranteed" returns to workers in state IRA plans. There are few real guarantees in the financial world. That's why the Automatic IRA was designed at the federal level as a defined contribution plan, where retirement benefits would be based on investment performance. But "guaranteed" returns would turn state sponsored IRAs into defined benefit plans -- creating new fiscal challenges for states that already face large unfunded pension obligations.
Fortunately, most states seem ready to adopt a more sensible model for their IRA plans. They want to hire professional firms to process IRA contributions and invest them in appropriate funds. These funds would include default investments for workers who don't make any investment choice -- such as diversified balanced funds with a fixed mixture of stocks and bonds, or target date funds that gradually increase their bond over their stock component as a cohort of workers approaches retirement age.
In short, it would be optimal for Congress to adopt an Automatic IRA as a defined contribution plan with uniform federal rules. If that is not politically feasible, the DOL should try to minimize conflicts among state IRA plans and to constrain the role of state governments in investing worker contributions.
Most importantly, the ERISA exemption of DOL should include conditions requiring states to hire qualified financial professionals to invest worker contributions in diversified funds, independently managed with appropriate asset allocations. Those conditions would be designed to assure that state IRA plans would advance the best interests of participating workers.