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State-Run Retirement Plans Are Not a Complete Solution

Savings vehicles for private-sector workers are better than nothing, but they aren't a substitute for employer plans.

Note: This commentary from Morningstar director of policy research Aron Szapiro is in response to recent developments in retirement-savings efforts. 

California recently began setting up California Secure Choice, an effort to help millions of workers who don't have employer-offered retirement plans. California is on the vanguard, but it is being joined by at least five other states (Connecticut, New Jersey, Oregon, Maryland, and Illinois) that are trying to set up similar savings vehicles to increase retirement savings. The media (and the state governments) has described these savings schemes as 401(k)s for everyone. 

These retirement accounts are probably better than nothing, and they could move many people into having a savings account when they otherwise wouldn't. But they aren't a substitute for an employer plan. There will be no employer matches. The maximum contribution will be just $5,500 instead of at least $18,000 in an ERISA-qualified retirement plan. In California's plan, the contributions will be invested conservatively for the first few years in government bonds, which may well provide inadequate returns. Finally, these state plans may crowd out small businesses that might have offered a traditional plan, but will now conclude that the state-run plan is sufficient.

Additionally, although the California law does not specify that the IRAs will be Roth IRAs, for practical purposes they will have to be to make it easier for individuals to cope with tax rules. Roth contributions are probably a pretty good deal for lower-income workers, but Roth IRAs present three obstacles to saving for retirement.

The biggest problem with Roth IRAs is that the cost-basis can be removed without a tax penalty, so there is not much incentive to hang on to the money for retirement--particularly if a worker has a financial emergency today. Second, Roth IRAs cannot be rolled over into a 401(k). Workers without employer-sponsored retirement plans today may have them at their next job, and they will then be unable to move their state-plan savings into the employer-sponsored system. Third, as with all IRA money, the contributions and returns can be used for a host of nonretirement related purposes such as buying a first home or paying for college, making it easy to erode these accounts in advance of their intended purpose--retirement.

States have historically not been involved in private-sector retirement savings, which is regulated by the federal government under the Employee Retirement Income Security Act. Now, states are proposing to manage retirement savings for private-sector workers?

The key reason that states have decided to offer these plans is that about half of workers in the U.S. lack access to an employer-sponsored plan (like a 401(k) or 403(b)), and this low coverage level has been stubbornly stuck for years. States look at these coverage levels and worry about providing services to destitute seniors in the future, since people without workplace coverage rarely save for retirement on their own. In particular, California claims that 7.5 million of its workers don't have retirement plans at work. The architects of these state efforts know that there are problems with their approach, but they want to expand coverage in any way they can right now.

States think they have identified and can fix the reason workers lack coverage: small businesses often don't offer a retirement plan. (About 14 percent of small employers sponsor some type of plan for their employees to save for retirement, according to a 2012 U.S. Government Accountability Office report.) Furthermore, states know that this lack of coverage disproportionately affects low-income workers who are more likely to be employed by small firms. States like California have decided to compel employers to make it easy for their workers to contribute to a retirement account, and they are using the power of defaults to try to increase savings rates.

The federal government has stopped making serious efforts to increase retirement coverage. In 1996, Congress established the Simplified Employee Pension and the SIMPLE IRA. In 2001, Congress eliminated some of the regulatory requirements that small employers reported were a disincentive to offering plans.

Despite these efforts, most small employers still don't offer retirement plans, and many workers still go without. Now, with a deeply polarized Congress, the federal government doesn't seem to have the ability to act on big new programs that could enroll lots of people in new savings accounts, and states like California have chosen to act instead. Smaller, recent federal efforts such as the myRA program do not meet the "auto-IRA" standard that would enroll millions in retirement accounts and that the Obama administration has included in its annual budget eight consecutive years.

While these state plans are laudable in their goals, they should not be confused with real retirement plans. Instead, they will enroll people in IRAs and take a contribution out of their paycheck, unless the worker opts out.

As an alternative, states could have considered sponsoring multiple-employer plans, in which the state would sponsor a real retirement plan and let small businesses join. Such a plan could leverage higher levels of assets under management to get lower fees and better investment options. But no state is seriously working on such an effort yet. Perhaps these IRA-based savings plans will eventually lead to normal retirement plans for millions of workers. Perhaps successful auto-IRAs will in turn put pressure on national policymakers to create a universal retirement plan for people who don't have them. But for the moment, we shouldn't confuse these efforts with actually putting workers in true retirement plans.