Trump gets it right on 401(k)s
Rarely do tweets from the 45th president of the United States have a calming effect on virtually anyone, but it happened this week. In the midst of tweets about NFL players kneeling, fake news stories, and “Wacky Congressman Wilson,” Donald Trump managed to calm the investment community when he wrote, “There will be no change to your 401(k).” The early morning tweet on Monday continued, “This has always been a great and popular middle class tax break that works, and it stays!”
The president was reacting to a Republican proposal that would lower the maximum annual pre-tax 401(k) contribution from $18,500 to just $2,400. Now, there are a lot of bad ideas that come out of Washington, but this one truly leaves me scratching my head. It is the wrong policy at the wrong time.
{mosads}Arguably the biggest economic crisis facing the country today is the profound lack of retirement savings. Simply put, Americans aren’t investing enough for retirement and Social Security will not be able to provide enough retirement income for those who fail to save. We desperately need more retirement savings, not less.
The magnitude of the problem cannot be overstated. A 2015 survey conducted by the National Institute on Retirement Security showed that in the world’s richest nation, the median retirement savings amount was a mere $2,500. For households with any kind of a retirement account, the median amount of savings was $50,000. Nearly half of households didn’t have any retirement savings at all.
Individuals are not the rational actors that traditional economics theory assumes. We should be able to properly plan for retirement and set aside the correct amount of money periodically to achieve that goal. But investing for retirement is an incredibly difficult mathematical problem with a great many variables. We also tend as human beings to tackle much easier problems that provide us with short term gratification.
The average American has great difficulty focusing on the long term. People need to be encouraged with economic incentives to forego current consumption in favor of consumption in the distant future. That trip to Aruba sounds much better than a contribution to my retirement plan.
Richard Thaler recently won the Nobel Prize in economics for his work in behavioral finance, work that recognizes that people need to be “nudged” into making the right long run decisions. Tax deductibility of retirement contributions nudges people into making those good, long term decisions because individuals receive an immediate reward in the form of lower taxes today.
My big fear is that if Congress lowered the 401(k) cap to $2,400, millions of Americans would hit that limit and simply stop contributing. They would interpret the amount that is tax deductible as an explicit recommendation or guide. Thaler would suggest that Americans need a nudge in the form of tax deductibility of a larger amount to do what is best and save more.
The decades long trend away from defined benefit pension plans to defined contribution retirement plans means that individuals, who are largely unqualified and financially illiterate, are now responsible for their own retirement planning decisions. In the defined benefit world, investment professionals managed retirement plan assets collectively for many individuals.
With the move to defined contribution plans, people must plan for the longest possible retirement, as one isn’t pooling assets with other future retirees. The basic issue is that people need to accumulate more assets collectively than they would in the defined benefit environment.
In other words, you can’t plan for an actuarial expected lifespan, you must plan for the longest lifespan possible. In that environment, we simply can’t have government reducing the incentive to save. The bottom line is that President Trump got this one right.
Robert R. Johnson, PhD, CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed and Investment Banking for Dummies.