Obama's IRA Proposal: How to Make It Better

Tucked into the Obama financial reform package is a proposal to automatically enroll employees in IRAs if their employer doesn't have a retirement plan. It's a good idea, but it can be improved by equalizing the IRA and 401(k) contribution limits and removing the employer mandate from the plan.

No ERISA. First, the best thing about the proposal is that the automatic IRA would not be subject to ERISA (the Employee Retirement Income Security Act). The compliance costs and potential liability associated with ERISA are the main reasons many small employers don't want to be involved with retirement plans. So removing that barrier is huge, and a major step toward increasing retirement savings.

But the IRA proposal has problems when it comes to contribution limits and the automatic enrollment feature. I'll explain.

Equalize Contribution Limits. The contribution limits for 401(k) plans are much higher than they are for IRAs: $16,500 for a 401(k) vs. $5,000 for an IRA. There's no reason why the IRA contribution limit should not be equal to the 401(k) limit. Why are we penalizing employees who work for small employers? This would also make it easier for consultants and independent contractors to have the same tax benefits employees at big companies have. You can call it a 401(k) IRA.

By limiting IRA contributions, the Obama proposal is driving those who want to save more into higher cost 401(k) plans. 401(k) plans for small employers tend to be expensive because of the ERISA requirements. If you allowed employees to open IRAs at any institution they wanted (discount brokerage or index mutual fund companies for example) with contribution limits equal to the 401(k), you could easily drop the expenses on retirement savings by 1 percent or more.

That would make a huge difference in retirement security. Here are some numbers:

Assume you saved $10,000 a year for 40 years (the typical working cycle) and earned 7.5 percent on your retirement money. At the end of 40 years, your account would be worth $2,443,007. But if you deduct 1 percent for 401(k) costs, it drops the return to 6.5 percent, and the account balance is only worth $1,870,480. You end up with 30 percent more money if you can reduce your expenses.
Moreover, many small employers have 401(k) plan expenses in the 2 to 3 percent range. If you can cut the expenses by 2 percent, you would end up with 70% more in your retirement plan.

Reducing expenses is the main reason why small employers shouldn't be forced into 401(k) plans. So equalize the IRA and 401(k) contribution limits, and let them choose the most cost effective option.

Opt In. The Obama proposal mandates that employers open IRAs for their employees. And if employees don't want the IRA, they need to opt out of the plan. I recognize the benefits of making the IRA mandatory. We'll get more people to open up retirement plans. But it's a bad idea. Why? Because when you push people into financial transactions that they don't have any interest in or don't really understand, you usually get a bad result.

I remember not too long ago how home ownership was going to be the path to financial security for middle and lower income Americans. It sounded good and we had the academic theories to support it. So we shoved people into houses as fast as we could. What could go wrong? Well, now you know.

Putting money in a retirement plan comes with responsibilities, and it should require people to make an affirmative choice to opt-in to the plan. If you just toss them into an IRA and give them a disclosure, you'll end up with bad results.

And don't think that allocating their money into "lifestyle investment funds" will make it better, as the Obama proposal contemplates. There's no evidence that these funds did any better at managing risk than the average employee. See my recent post on why being smart won't save you from big declines.

Educate. There are risks associated with managing retirement money, whether you do it yourself or have someone else do it. And employees need to understand how to determine the amount of risk they want to take. That requires education and raising public awareness about how to manage risk. And that will take time.

Bottom line. The goal for the Obama IRA proposal shouldn't be more retirement plans; just like the goal for housing shouldn't simply be more home ownership. The goal should be to create more opportunities for simple and low cost ways to build wealth. And then educate people about how to responsibly manage what they choose to save.

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