What the Nobel Prize and 401(k) Plans Have in Common

Left to their own devices, many people wouldn’t save enough (or at all) for retirement, no matter how attractive the 401(k) plan.

Statistically speaking, most Americans in their forties have saved an average of $63,000. But according to Fidelity, this may present a dangerous retirement savings gap if held to the conservative benchmark that a nest egg be three times a person’s annual salary.

Look closely, however, and you might notice participation and savings rates slowly creeping upward.

This may be due to the work of Richard Thaler, an economist and professor at the University of Chicago. He’s also the 2017 Nobel Prize winner for Economic Sciences.

Thaler is a pioneer in a field of study called behavioral economics. His research looks at the ways we, as human beings, are our own worst enemies when it comes to acting rationally and in our personal best interests. This is particularly true when it comes to saving and investing for the future.

For instance, a company may offer an employee the chance to participate in a tax-deferred retirement benefit, such as a 401(k) program. As an extra incentive to sign up and begin building financial security, the company may even offer to match the employee’s plan contributions up to a certain amount.

While you’d think that most employees would be jumping for joy and running to sign up, plan sponsors would likely tell you that this is not the case, and that getting people to participate in retirement savings programs is quite difficult, akin to pulling teeth.

Regardless of the reasons why people wouldn’t participate (Laziness? Lack of awareness or education? Misinformation?), the good news is that people can be influenced to act more rationally through mechanisms that Thaler calls “nudges.”

OPT OUT, NOT IN

An example of a nudge is when an employer automatically enrolls its employees into 401(k) plans from the start, and puts the onus on people to opt out rather than opt in. The results are uncannywith a much higher number of employees saving for retirement.

This insight kicked off an industry-wide trend toward auto-enrollment. The Plan Sponsor Council of America (PSCA) found that in 2016, 58% of plans were automatically signing up workers, up from just 8.1% in 2000.

Just getting people to participate was a big step forward, but Thaler also looked for ways to influence participants to save more.

AUTO-ESCALATION LOCKS IN HIGHER CONTRIBUTIONS

In his paper, “Save More Tomorrow,” Thaler proposed another “nudge” to increase contributions, called auto-escalation.

Participants would start at first by allocating 3% of income to retirement. Then, with every salary raise, their investment contributions would automatically increase.

Auto-escalation has taken hold among larger plan sponsors. Callan’s 2017 Defined Contribution Trends survey found that 63% of large and mega plans offer an auto-escalation feature, up from 46% in 2015.

Thaler’s insight into why people don’t save and how to get them to do better laid the foundation for a more stable, secure retirement system—and all it took was a little nudge.

 

How Tax Reform May Impact the Investment Industry

The Senate recently passed its version of the GOP’s tax reform legislation.

The legislation isn’t final, however, as the House and the Senate must hammer out a final version of the bill that reconciles their differences.

Until that happens, you should be aware of the major changes proposed, and how they may impact your clients.

Exemptions and deductions

Under both proposals, personal exemptions would be eliminated. Both proposals would also eliminate the state and local income tax or sales tax deduction for individual taxpayers, though the standard deduction will nearly double.

The deduction for property taxes will now be capped at $10,000 (as there was no federal cap before).

While the impact on individuals will vary by situation, this could result in many investors having less cash flow to invest in their 401(k) plans and elsewhere.

No changes to 401(k) deferrals

One provision that was discussed early on in the process was limiting employee pre-tax contributions to 401(k) retirement plans.

This ultimately was not part of the package, and the IRS has increased 401(k) contribution limits to $18,500 (with $24,500 for those 50 and over) in 2018.

For those who lose the ability to itemize deductions via the changes in the tax bill, such as the increase in the standard deduction, the ability to make pre-tax retirement contributions becomes even more valuable.

It is important to remind your clients and prospects to max out their contributions if they aren’t already doing so, if this is an appropriate strategy for their situation.

For small business owners who were on the fence about starting a small business retirement plan, the ability to contribute to one for themselves might be an even better incentive under the new tax rules.

Impact on the markets

While trying to predict the direction of the stock market is always a fool’s errand at best, part of the premise of the plan is to lower corporate tax rates in an effort to spur growth.

This could well be a stimulus for the markets, but of course there are many factors that come into play here.

Be a resource

Even if you aren’t a tax expert, become knowledgeable about the features of these new rules that will impact your clients and prospects. Incorporate more knowledge into your advice to existing clients and your marketing to prospects.

Vestwell does not offer tax advice, please consult your tax professional, as necessary, related to any tax-related topics.

The “Rothification” of the Investment Industry

Even before President Trump’s tax reform legislation was finalized, rumblings of limits to 401(k) contribution amounts gave credence to “Rothification” impacting the investment industry.

If such proposals had passed, this would have reduced the amount of pre-tax money that people could contribute to their 401(k) plans, while freeing up spending money for the government.

But the industry is already seeing a rise in the conversion from some or all traditional defined contribution plans to Roth-like plans, hence the movement being coined Rothification. The results have sparked a debate about the pros and cons of moving in this direction.

Pros

Proponents of the increased reliance on Roth 401(k)s and IRAs point to the tax benefits later in life for retirement savers.

These savers will sacrifice a tax break today, so that they can avoid paying taxes when the money is withdrawn from their savings in retirement.

There are also estate planning benefits, because there are no required minimum distributions (RMDs) on Roth IRAs. Roth 401(k) accounts rolled over to Roth IRAs would also receive such benefits.

Cons

Many financial advisors fear that Rothification would lead to reduced retirement savings at a time when Americans can ill-afford to do so.

The loss of the income tax deduction would cause worker’s take-home pay to be reduced.

This could, in effect, limit the cash-flow available for 401(k) contributions and other retirement savings.

Consider Taxes

Roth accounts certainly offer solid options for retirement saving. While the benefit of tax savings down the road in retirement can seem distant, the reality is that many retirees may find themselves in a higher income tax bracket in the future.

Many also see Roth accounts as a way for retirement savers to diversify their retirement accounts’ tax profiles, in efforts to be prepared no matter what tax rules are passed in the future.

In the Meantime

Financial advisors should consider how Roth accounts can make sense for 401(k) plan sponsors and their employees.

We haven’t seen the last of the Rothification movement, so it’s best to first be educated, and then be prepared for what’s next.

Vestwell does not offer tax advice, please consult your tax professional, as necessary, related to any tax-related topics.