Private Pensions: Low Defined Contribution Plan Savings May Pose Challenges to Retirement Security, Especially for Many Low-Income Workers
Published: 2007-11-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Over the last 25 years, pension coverage has shifted primarily from "traditional" defined benefit (DB) plans, in which workers accrue benefits based on years of service and earnings, toward defined contribution (DC) plans, in which participants accumulate retirement balances in individual accounts. DC plans provide greater portability of benefits, but shift the responsibility of saving for retirement from employers to employees. This report addresses the following issues: (1) What percentage of workers participate in DC plans, and how much have they saved in them? (2) How much are workers likely to have saved in DC plans over their careers and to what degree do key individual decisions and plan features affect plan saving? (3) What options have been recently proposed to increase DC plan coverage, participation, and savings? GAO analyzed data from the Federal Reserve Board's 2004 Survey of Consumer Finances (SCF), the latest available, utilized a computer simulation model to project DC plan balances at retirement, reviewed academic studies, and interviewed experts.
section_title: What GAO Found
paragraphs: GAO's analysis of 2004 SCF data found that only 36 percent of workers participated in a current DC plan. For all workers with a current or former DC plan, including rolled-over retirement funds, the total median account balance was $22,800. Among workers aged 55 to 64, the median account balance were $50,000, and those aged 60 to 64 had $60,600. Low-income workers had less opportunity to participate in DC plans than the average worker, and when offered an opportunity to participate in a plan, they were less likely to do so. Modest balances might be expected, given the relatively recent prominence of 401(k) plans. Projections of DC plan savings over a career for workers born in 1990 indicate that DC plans could on average replace about 22 percent of annualized career earnings at retirement for all workers, but projected "replacement rates" vary widely across income groups and with changes in assumptions. Projections show almost 37 percent of workers reaching retirement with zero plan savings. Projections also show that workers in the lowest income quartile have projected replacement rates of 10.3 percent on average, with 63 percent of these workers having no plan savings at retirement, while highest-income workers have average replacement rates of 34 percent. Assuming that workers offered a plan always participate raises projected overall savings and reduces the number of workers with zero savings substantially, particularly among lower-income workers. Recent regulatory and legislative changes and proposals could have positive effects on DC plan coverage, participation, and savings, some by facilitating the adoption of automatic enrollment and escalation features. Some options focus on encouraging plan sponsorship, while others would create accounts for people not covered by an employer plan. Our findings indicate that DC plans can provide a meaningful contribution to retirement security for some workers but may not ensure the retirement security of lower-income workers.

section_title: Letter
paragraphs: Employer-sponsored pensions represent an important component of  retirement income. Since the early 1980s, while the percentage of workers  participating in a pension plan has remained around 50 percent of the  private sector work force, pension coverage has seen a noticeable shift  away from “traditional” defined benefit (DB) plans, in which workers  typically accrue benefits based on years of service and earnings, toward  defined contribution (DC) plans, in which participants accumulate  balances in personal accounts. DC plans provide participants tax-preferred  savings vehicles, portability, and the transparency of known account  balances. However, they shift the responsibility of saving for retirement,  and certain key risks, from employers to employees. Under such plans,  workers often manage the investment of plan assets throughout their lives.  However, workers may receive limited or no contributions from their  employers, spend accumulated savings prior to retirement, or choose not  to participate in a pension plan at all, ultimately arriving at retirement with  insufficient savings to support themselves. Further, retirees usually must  manage their DC plan savings to make them last throughout retirement.  Possible reforms to Social Security to address that program’s long-term  solvency could reduce benefits for future retirees, possibly increasing the  future role of DC plans, as well as other personal savings, in providing  retirement income.
Based on these concerns, this report addresses the following questions: (1)  What percentage of workers participate in DC plans, and how much have  they saved in them? (2) How much are workers likely to have saved in DC  plans by the time they reach retirement and to what degree do certain key  individual decisions and plan features affect plan saving? (3) What options  have been recently proposed to increase DC plan coverage, participation,  and savings?
To analyze participation and savings in DC plans, we examined data from  the 2004 version of the Federal Reserve Board’s Survey of Consumer  Finances (SCF), the latest available SCF, and data published by other  government agencies, by private organizations, and from academic  studies.  To analyze how much Americans can expect to save in DC plans  by the time they retire and the factors that affect these savings, we utilized  a microsimulation model, PENSIM, that simulates demographic, working,  and pension patterns for a constructed sample over their lives. (See  appendix I for further details of our projections using PENSIM.) We also  reviewed similar studies to compare their methodologies and conclusions  (see app. II). To analyze policy options to increase DC plan coverage,  participation, and savings, we synthesized information gathered from  interviews of plan practitioners, financial managers, and public policy  experts, as well as from academic and policy studies on DC plan  participation and savings. We also researched current government  initiatives and policy proposals to broaden participation in account-based  pension plans and increase retirement savings. We conducted our work  from July 2006 to October 2007 in accordance with generally accepted  government auditing standards.
subsections: section_title: Background
paragraphs: Employer-sponsored pensions fall into two major categories: defined  benefit (DB) and defined contribution (DC) plans. In DB, or traditional,  plans, benefits are typically set by formula, with workers receiving  benefits upon retirement based on the number of years worked for a firm  and earnings in years prior to retirement. In DC plans, workers  accumulate savings through contributions to an individual account. These  accounts are tax-advantaged in that contributions are typically excluded  from current income, and earnings on balances grow tax-deferred until  they are withdrawn. An employer may also make contributions, either by  matching employee’s contributions up to plan or legal limits, or on a non- contingent basis.
Like DB plans, DC plans operate in a voluntary system with tax incentives  for employers to offer a plan and for employees to participate.  Contributions to and earnings on DC plan accounts are not taxed until the  participant withdraws the money, although participants making  withdrawals prior to age 59 ½ may incur an additional 10 percent tax. In  2006, the pension tax expenditure for DC plans amounted to $54 billion. In  addition, a nonrefundable tax credit to qualifying low-and middle-income  workers who make contributions, the saver’s credit, accounted for less  than 2 percent of the 2006 tax expenditure on account-based retirement  plans.
DC plans offer workers more control over their retirement asset  management, but also shift some of the responsibility and certain risks  onto workers. Workers generally must elect to participate in a plan and  make regular contributions into their plans over their careers. Participants  typically choose how to invest plan assets from a range of options  provided under their plan, and accordingly face investment risk. Savings  in DC plans are portable in the sense that a participant may keep plan  balances in a tax-protected account upon leaving a job, either by rolling  over plan balances into a new plan or an IRA, or in some cases leaving  money in an old plan. Workers may have access to plan savings prior to  retirement, either through loans or withdrawals; participants may find  such features desirable, but pre-retirement access may also lead to lower  retirement savings (sometimes referred to as leakage) and possible tax  penalties. Workers who receive DC distributions in lump-sum form must  manage account withdrawals such that their savings last throughout  retirement. In contrast, a formula, often based on preretirement average  pay and years of service, determines DB plan benefits, and workers are  usually automatically enrolled in a plan. The employer has the  responsibility to ensure that the plan has sufficient funding to pay  promised benefits, although the sponsor can choose to terminate the  plan. DB plans also typically offer the option to take benefits as a lifetime  annuity, or periodic benefits until death. An annuity provides longevity  insurance against outliving one’s savings, but may lose purchasing power  if benefits do not rise with inflation. Table 1 summarizes some of the  primary differences between DC and DB plans.
Over the past 25 years, DC plans have become the dominant type of  private sector employee pension. In 1980, private DB plans had 38 million  participants, while DC plans had 20 million. As of 2004, 64.6 million  participants had DC plans, while 41.7 million had DB plans. Further, over  80 percent of private sector DC participants in 2004 were active  participants (in a plan with their current employer), while about half of DB  participants had separated from their sponsoring employer or retired.  According to the Employee Benefit Research Institute (EBRI), while  overall pension coverage among families remained around 40 percent  between 1992 and 2001, 38 percent of families with a pension relied  exclusively on a DC plan for retirement coverage in 1992, while 62 percent  had a DB plan. In 2001, 58 percent of pension-participating families had  only a DC plan, while 42 percent had a DB plan. Assets in all DB plans  exceeded total DC assets as recently as 1995. As of 2006, DC plans had  almost $3.3 trillion in assets while DB plans had almost $2.3 trillion. In  addition, assets in IRAs, accounts that are also tax protected and include  assets from rolled-over balances from employer-sponsored plans,  measured over $4.2 trillion in 2006.
There are several different categories of DC plans. Most of these plans are  types of cash or deferred arrangements (CODA), in which employees can  direct pre-tax dollars, along with any employer contributions, into an  account, with assets growing tax deferred until withdrawal. The 401(k)  plan is the most common, covering over 85 percent of active DC  participants.  Certain types of tax-exempt employers may offer plans, such  as 403(b) or 457 plans, which have many features similar to 401(k) plans.  Many employers match employee contributions, generally based on a  specified percentage of the employee’s salary and the rate at which the  participant contributes. Small business owners may offer employees a  Savings Incentive Match Plan for Employees of Small Employers  (SIMPLE) or a Simplified Employee Pension Plan (SEP), two types of DC  plans that have reduced regulatory requirements for sponsors. Other types  of DC plans keep the basic individual account structure of the 401(k), but  with different requirements and employer practices. Some are designed  primarily for employer contributions. These include money purchase  plans, which specify fixed annual employer contributions; profit sharing  plans, in which the employer decides annual contributions, perhaps based  on profits, into the plan, and allocations of these to each participant; and  employee stock ownership plans (ESOPs), in which contributions are  primarily invested in company stock.
Building up retirement savings in DC plans rests on factors that are, to  some degree, outside of the control of the individual worker, as well as  behaviors an individual does control (see fig. 1). Factors outside the  individual’s direct control include the following:    Plan sponsorship—the employer’s decision to sponsor a plan, as well  as participation eligibility rules.
Employer contributions—whether the sponsor makes matching or  noncontingent contributions.
Investment options—the plan sponsor’s decisions about investment  options to offer to participants under the plan.
Market returns on plan assets—market performance of plan assets.
Key individual decisions and behaviors that may affect retirement savings  include the following:    Employee contributions—deposits into the plan account, typically  out of current wages.
Investment decisions—how to invest plan assets given investment  options offered under the plan.  balances, which usually incur a tax penalty. Similarly, taking out a loan  from a plan, if allowed, may reduce future balances if the loan is not  repaid in full and treated as a withdrawal, or by lowering investment  returns.
Rollover—upon separation from a job, a participant may transfer the  plan account balance to an IRA, which maintains most of the same tax  preferences on the balances, move it to a new tax-qualified plan, or  leave the money in the old plan. Alternatively, any cash withdrawal  would likely be subject to income tax and penalties.
Age at retirement—the decision as to when to retire determines how  many years the worker has to accumulate plan balances and how long  the money has to last in retirement.
There is little consensus about how much constitutes “enough” savings to  have going into retirement. We may define retirement income adequacy  relative to a standard of minimum needs, such as the poverty rate, or to  the consumption spending that households experienced during working  years. Some economists and financial advisors consider retirement  income adequate if the ratio of retirement income to pre-retirement  income—or replacement rate—is between 65 and 85 percent. Retirees may  not need 100 percent of pre-retirement income to maintain living  standards for several reasons. Retirees will no longer need to save for  retirement, retirees’ payroll and income tax liability will likely fall, work  expenses will no longer be required, and mortgages and children’s  education and other costs may have been paid off. However, some  researchers cite uncertainties about future health care costs and future  Social Security benefit levels as reasons to suggest that a higher  replacement rate, perhaps above 100 percent or higher, would be  considered adequate.
To achieve adequate replacement rate levels, retirees depend on different  sources of income to support themselves in retirement. Social Security  benefits provide the bulk of retirement benefits for most households. As of  2004, annuitized pension benefits provided almost 20 percent of total  income to households with someone age 65 or older, while Social Security  benefits provided 39 percent. Social Security benefits compose over 50  percent of total income for two-thirds of households with someone age 65  or older, and at least 90 percent of income for one-third of such  households. Table 2 shows estimated replacement rates from Social  Security benefits for low and high earners retiring in 2007 and 2055, as  well as the remaining amount of pre-retirement income necessary to  achieve a 75 percent replacement rate. These figures give rough  guidelines for how much retirement income workers might need from  other sources, such as employer-sponsored pensions, as well as earnings  and income from other savings or assets.
It is important to keep certain economic principles in mind when  evaluating the effectiveness of retirement accounts, or any pensions, in  providing retirement income security. First, balances accumulated in a DC  plan may not represent new saving; individuals may have saved in another  type of account in the absence of a DC plan or its tax preferences. Second,  evaluating worker income security should consider total compensation,  not just employer contributions to DC plans. All else equal, we should  generally expect more generous employer-sponsored pension benefits to  lower cash wages and that the split between current wages and deferred  compensation is largely a reflection of labor market conditions, tax  provisions, and worker and employer preferences.
section_title: Many Workers Have No Plan Coverage, and Most DC Plan Participants Currently Have Modest Account Balances
paragraphs: Many workers do not have DC plans, and median savings levels among  participants show modest balances. While it is worth noting that for  workers nearing retirement age, DC plans were not considered primary  pension plans for a significant portion of their working careers,  participation rates and median balances in such plans are low across all  ages. Only 36 percent of working individuals were actively participating in  a DC plan, according to data from the 2004 SCF. Further, workers aged  55 to 64 had median balances totaling $50,000 in account-based retirement  savings vehicles, including DC plans and rollover accounts. Leakage,  when workers withdraw DC savings before retirement age, can also  reduce balances; almost half of those taking lump-sum distributions upon  leaving a job reported cashing out their balances for non-retirement  purposes. Participation among lower-income workers was particularly  limited, and those who did have accounts had very low balances.
subsections: section_title: Most Workers Do Not Have a Current DC Plan, and Participants Have Modest Plan Balances
paragraphs: The majority of workers, in all age groups, are not participating in DC  plans with their current employers. Employers do not always offer  retirement plans, and when they do, plans may have eligibility restrictions  initially, and some eligible workers do not choose to participate.  According to our analysis of the 2004 SCF, only 62 percent of workers  were offered a retirement plan by their employer, and 84 percent of those  offered a retirement plan participated. Only 36 percent of working  individuals participated in a DC plan with their current employer   (see fig. 2). Data indicated similar participation rates for working  households, as 42 percent of households had at least one member with a  current DC plan.
For many workers who participated in a plan, overall balances in DC plans  were modest, suggesting a potentially small contribution toward  retirement security for most plan participants and their households.  However, since DC plans were less common before the 1980s, older  workers would not have had access to these plans their whole careers. In  order to approximate lifetime DC balances when discussing mean and  median DC balances in this report, our analysis of the 2004 SCF aggregates  the “total balances” of DC plans with a current employer, DC plans with  former employers that have been left with the former employer, and any  retirement plans with former employers that have been rolled over into a  new plan or an IRA. Workers with a “current or former DC plan” refers to  current workers with one or more of those three components. For all  workers with a current or former DC plan, the median total balance was  $22,800. For all households with a current or former DC plan, the median  total balance was $27,940 (see fig. 3).
For individuals nearing retirement age, total DC plan balances are still low.  Given trends in coverage since the 1980’s, older workers close to  retirement age are more likely than younger ones to have accrued  retirement benefits in a DB plan. However, older workers who will rely on  DC plans for retirement income may not have time to substantially  increase their total savings without extending their working careers,  perhaps for several years. Among all workers aged 55 to 64 with a current  or former DC plan, the median balance according to the 2004 SCF was  $50,000, which would provide an income of about $4,400 a year, replacing  about 9 percent of income for the average worker in this group. Among  all workers aged 60 to 64 with a current or former DC plan, the median  balance was $60,600 for their accounts. Markedly higher values for mean  balances versus median balances in figure 3 illustrate that some  individuals in every age group are successfully saving far more than the  typical individual, increasing the mean savings. These are primarily  individuals at the highest levels of income.
Leakage, or cashing out accumulated retirement savings for non- retirement purposes, adversely affects account accumulation for some of  those with accounts, particularly for lower-income workers with small  account balances. Participants who withdraw money from a DC plan  before age 59 ½ generally pay ordinary income taxes on the distributions,  plus an additional 10 percent tax in most circumstances. Participants may  roll their DC plan balances into another tax-preferred account when they  leave a job, and employers are required, in the absence of participant  direction, to automatically roll DC account distributions greater than  $1,000 but not greater than $5,000 into an IRA, or to leave the money in the  plan. As of 2004, 21 percent of households in which the head of household  was under 59, had ever received lump-sum distributions from previous  jobs’ retirement plans. Among these households that received lump-sum  distributions, 47 percent had cashed out all the funds, 4 percent cashed  out some of the funds, and 50 percent preserved all the funds by rolling  them over into another retirement account. Workers were more likely to  roll over funds when the balances are greater. Among households that had  cashed out all retirement plans with former employers, the median total  value of those funds was $6,800. For households that had rolled over all  retirement plans with former employers, the median total value of rolled- over funds was $24,200.
Some evidence suggests that pre-retirement withdrawals may be  decreasing. One study finds that those receiving lump-sum distributions  are more likely to preserve funds in tax-qualified accounts than they were  in the past. For example, data show that in 1993, 19 percent of lump-sum  distributions recipients preserved all of their savings by rolling them into a  tax-qualified account, compared to 43 percent in 2003. Further, 23 percent  used all of their distribution for consumption in 1993, declining to 15  percent in 2003 (see fig. 4). According to the same study, age and size of  the distribution are major determinants of whether or not the distribution  is preserved in a tax-qualified account. For example, the authors found  55.5 percent of recipients aged 51 to 60 rolled their entire distribution in a  tax-qualified account compared with 32.7 percent of recipients 21 to 30.  Additionally, 19.9 percent of distributions from $1 to $499 were rolled over  in tax-qualified accounts, as opposed to 68.1 percent of distributions of  $50,000 or more.
Additionally, some participants take loans from their DC plan, which may  reduce plan savings. One survey found that in 2005, 85.2 percent of  employers surveyed offered a loan option. Most eligible participants do  not take loans, and one analysis finds that at the year end 2006, loans  amounted to 12 percent of account balances for those who had loans.  Individuals may prefer to take out pension loans in lieu of other lines of  credit because pension loans require no approval and have low or no  transaction costs. Borrowers also pay the loan principal and interest back  to their own accounts. However, someone borrowing from a DC plan may  still lose money if the interest on the loan paid back to the account is less  than the account balance would have earned if the loan had not been  taken. Further, loans not paid back in time, or not paid back before the  employee leaves the job, may be subject to early withdrawal penalties. No  data have been reported on the rate of loan defaults, but it is expected to  be much lower where repayments are made by payroll withholding.  However, a loan feature may also have a positive effect on participation, as  some workers may choose to participate who otherwise might not,  precisely because they can borrow from their accounts for non-retirement  purposes at relatively low interest rates.
section_title: Low-Income Workers Have Particularly Low DC Plan Coverage and Plan Balances
paragraphs: Among workers in the lowest income quartile, only 8 percent participated  in a current DC plan, a result of markedly lower access as well as lower  participation than the average worker (see fig. 5). Only 25 percent of  workers in the lowest income quartile were offered any type of retirement  plan by their employer, and among those offered a retirement plan, 60  percent elected to participate, compared with 84 percent among workers  of all income levels. Workers in the lower half of the income distribution  with either current or former DC plans had total median balances of  $9,420.
Older workers who were less wealthy also had limited retirement savings.  Workers with a current or former DC plan, aged 50-59 and at or below the  median level of wealth, had median total savings of only $13,800. Workers  with a current or former DC plan, aged 60-64 and at or below the median  level of wealth, had median total savings of $18,000, a level that could  provide at best only a limited supplement to retirement income. If  converted into a single life annuity at age 65, this balance would provide  only $132 per month—about $1,600 per year.
Notably, workers with low DC balances were actually less likely to have a  DB pension to fall back on than workers with higher DC balances. Among  all workers participating in current or former DC plans, only 17 percent of  those in the bottom quartile for total plan savings also were covered by a  current DB plan. In contrast, 32 percent of those in the top quartile for  total DC savings also had DB coverage. Among all workers with a current  or former DC plan, the plan balances for those with DB coverage were  higher than for those without DB coverage. The median DC balance for  workers with a DB account was $31,560, while the median DC balance for  someone without a DB account was $20,820.
section_title: Projected DC Plan Savings Are Small for Most Workers, but Could Vary Widely Depending on Several Factors
paragraphs: Simulations of projected retirement savings in DC plans suggest that a  large percentage of workers may accumulate enough over their careers to  replace only a small fraction of their working income, although results  vary widely by income levels and depend on model assumptions. Projected  savings allow us to analyze how much workers might save over a full  working career under a variety of conditions in a way that analyzing  current plan balances cannot, since DC plans have become primary  employer-sponsored plans only relatively recently. Baseline simulations of  projected retirement savings for a hypothetical 1990 birth cohort indicate  that DC plan savings would on average replace about 22 percent of  annualized career earnings, but provide no savings to almost 37 percent  of the working population, perhaps because of different factors —  working for employers who do not offer a plan, choosing not to  participate, or withdrawing any accumulated plan savings prior to  retirement. Further, projected DC account balances vary widely by  income quartile, with workers in the lowest-income quartile saving enough  for about a 10 percent replacement rate, while those in the highest quartile  saving enough for a 34 percent replacement rate, on average. Assuming  changes in certain plan features, individual behavior, or market  assumptions, such as increased participation or account rollover rates,  increased projected average savings and increased the number of workers  who had some DC plan savings at retirement, especially for low-income  workers. Other scenarios, such as assuming higher contribution limits or  delaying retirement, raised average replacement rates, but with more of  the positive impact on higher-income workers and having little effect on  reducing the number of workers with no savings at retirement.
subsections: section_title: Projected DC Plan Balances Vary Widely by Income, with Many Workers Having No Plan Savings at Retirement
paragraphs: Our projections, based on a sample of workers born in 1990, show that  workers would save enough in their DC plans over their careers to  produce, when converted to a lifetime annuity at the time of retirement, an  average of $18,784 per year in 2007 dollars (see table 3). The projections  assume that all workers fully annuitize all accumulated DC plans balances  at retirement, which occurs sometime between age 62 and 70. Participants  are assumed to always invest all plan assets in life cycle funds, and stocks  earn an average real annual return of 6.4 percent. This $18,784 annuity  would replace, on average, 22.2 percent of annualized career earnings for  workers in the cohort. Savings and replacement rates vary widely across  income groups. Almost 37 percent of workers in this cohort have no  projected DC plan savings at retirement, which brings down overall  average replacement rates. Workers in the lowest income quartile  accumulate DC plan savings equivalent to an annuity of about $1,850 per  year, or a 10.3 percent replacement rate, and 63 percent of this group have  no plan savings by the time they retire. In contrast, highest income quartile  workers save enough to receive about $50,000 per year in annuity income,  enough for a 33.8 percent replacement rate. Even in this highest-income  group, over 16 percent of workers have zero plan savings at retirement.  In  all cases, our replacement rates include projected savings only in DC  plans.  Retirees may also receive benefits from DB plans, as well as from  Social Security, which typically replaces a higher percentage of earnings  for lower-income workers.
Projected household-level plan savings show a higher average replacement  rate of 33.8 percent, with about 29 percent of households having no plan  savings at retirement. When we assume that plan assets earn a lower  average real annual return of 2.9 percent, average replacement rates from  DC plan savings fall to about 16 percent for the sample. Under this  assumption, workers in the lowest-income quartile receive an average 7.1  percent replacement rate from DC plans, while highest-income quartile  workers receive an average 25 percent replacement rate. Lower rates of  return affect the percentage of workers with no accumulated DC plan  savings only slightly, perhaps because on the margins some participants  might choose (or have their employers choose) to cash out lower  balances.
Table 3 also shows savings statistics for sub-samples of the cohort who  have a better chance of accumulating significant DC plan savings, such as  those workers who have long-term eligibility to participate in a plan or  who work for many years. As expected, these groups have higher  projected savings; replacement rates also show more even distribution  across income groups, compared to those in the full sample. However, we  still see a significant portion of the workers with no DC savings at  retirement. First, we limit the sample only to those workers who are  eligible to participate in a plan for at least 15 years over their careers.  Average replacement rates for this group measure 33.5 percent, with rates  ranging from 21.7 percent for lowest income quartile workers to 42.3  percent for the highest quartile. Even with such long-term eligibility for  plan coverage, however, 15.6 percent of these workers, and almost one- third of lowest-income workers, have nothing saved in DC plans at the  time they retire. This could result from workers choosing not to  participate or from cashing out plan balances prior to retirement.
We also analyze the prospects of workers with long-term attachment to  the labor market, for which we use people who work full-time for at least  25 years, without regard to plan coverage or participation. Among these  workers, average DC plan savings at retirement account for a 26.5 percent  replacement rate. Still, almost 29 percent of these workers have no  projected savings. This suggests that while DC plans have the potential to  provide significant retirement income, saving may be difficult for some  workers who work for many years, even among those whose employers  offer a plan.
section_title: Universal Participation in Sponsored Plans and Universal Account Rollover Raise Projected DC Plan Savings Substantially for Lower- Income Workers
paragraphs: Our simulations indicate that increasing participation and reducing  leakage out of DC plans may have a particularly significant impact on  overall savings, especially for lower-income workers. Of the changes in the  model assumptions that we simulated, these had the broadest effect on  savings because they not only raised average savings for the entire sample,  but had a relatively strong impact on workers in the lowest income  quartile and on the number of workers with no DC plan savings at  retirement. While these assumptions represent stylized scenarios, they  illustrate the potential effect of such changes on savings.
We project DC plan savings assuming that all employees of a firm that  sponsors a DC plan participate immediately, rather than having to wait for  eligibility or choosing not to participate. In our baseline projections, 6  percent of workers whose employers sponsor a plan are ineligible to  participate, and 33 percent of those eligible do not choose to participate;  therefore, this assumption significantly raises plan participation rates  among workers. Accordingly, average DC savings rise by almost 40  percent, raising average replacement rates to 35 percent, and the  percentage of the population with no savings at retirement drops by half,  down to 17.7 percent (see table 4).
Assuming automatic eligibility and participation raises projected plan  savings significantly for lower-wage workers, more than doubling the  annuity equivalent of retirement savings for the lowest-income quartile.  Workers in the highest income group also increase savings under this  scenario, with plan savings rising by 30 percent. This change in projected  savings suggests that automatically enrolling new employees in plans as a  default could have a significant positive impact on DC balances, especially  for low-income workers whose jobs offer a plan, although this stylized  scenario likely describes a more extreme change in eligibility and  participation than plans are likely to implement under automatic  enrollment, and that higher participation and savings would raise  employer’s pension costs, perhaps leading to a reduction in benefits or  coverage.
Another stylized scenario we model assumes that all workers who have a  DC plan balance always keep the money in a tax-preferred account upon  leaving a job, either by keeping the money in the plan, transferring it to a  new employer plan, or rolling it into an IRA, rather than cashing out any  accumulated savings. Eliminating this source of leakage raises average  annuity income from DC plans by almost 11 percent and average  replacement rates from 22.2 percent in the baseline to 25.6 percent; it also  reduces the percentage of the cohort with no DC savings at retirement by  over 25 percent. As with the instant participation scenario, “universal  rollover” raises annuity savings and reduces the number of retirees with  zero plan savings by the biggest percentages among lower-income  workers, suggesting that cashing out accumulate plan savings prior to  retirement may be a more significant drain on retirement savings for these  groups. These results indicate that policies to encourage participants to  keep DC plan balances in tax-preferred retirement accounts, perhaps by  making rollover of plan assets a default action in plans, may have a broad  positive impact on retirement savings.
section_title: Changing Retirement Decisions or Contribution Limits Would Affect Savings Primarily for Higher-Income Workers
paragraphs: Other changes we make in our projections related to plan features or  individual behavior affect average replacement rates overall, but with less  impact on lower-income workers’ replacement rates and on the number of  workers with zero plan savings at retirement. These scenarios include  assumed changes in annual contribution limits and retirement decisions  (see table 5).
We model projected retirement savings assuming that annual DC  contribution limits for employees rise from $15,500 to $25,000, and the  combined employer-employee maximum contribution level rises from  $45,000 to $60,000, starting in 2007. Higher annual maximum  contributions affect projected savings almost exclusively among the  highest-income group, indicating that few workers earning less are likely  to contribute at existing maximum levels. The highest income quartile  replacement rises from 33.8 to 38.5 percent, while replacement rates  hardly change in the lower income groups. Similarly, this scenario has  almost no impact on the percentage of workers with DC plan savings at  retirement.
Finally, we model retirement savings in two scenarios in which workers  delay retirement by 1 or 3 years. Encouraging workers to retire later has  been suggested as a key element in improving retirement income security,  by increasing earnings, allowing more time to save for retirement, and  reducing the length of retirement. In our projections, delaying retirement  not only provides more years to contribute to and earn returns on plan  balances but also might raise annual retirement income because older  retirees receive more annuity income for any given level of savings,  holding all else equal. In our projections, working longer modestly raises  retirement savings in our projections. Working one extra year changes  projected annuity income by 5.8 percent, but has little effect on the  percentage of people with no DC savings in our projections. Delaying  retirement by 3 years raises annuity income from DC plans by 20.9 percent  on average, with replacement rates rising from 22.2 percent in the baseline  to 25.7 percent overall. The 3-year delay increases annuity levels  somewhat evenly across income groups, with higher-income workers  showing slightly higher increases. Overall, working an extra 3 years raises  average replacement rates about as much as universal account rollover  would, but with little reduction in workers with no retirement savings.  Thus, while working longer would likely raise workers’ incomes, and in  most cases retirement benefits from other sources such as Social Security,  our projections show that this change alone would have a modest impact  on retirement income from DC plans, particularly regarding lower-income  workers and those not already saving in DC plans in the baseline.
section_title: Recent Changes and Proposals Could Have Positive Effects on DC Plan Coverage, Participation, and Savings
paragraphs: Recent regulatory and legislative changes and proposals could have  positive effects on DC plan coverage, participation, and saving. The  Pension Protection Act of 2006 (PPA) facilitated the adoption of automatic  plan features by plan sponsors that may increase DC participation and  savings within existing plans. Proposals to expand the saver’s credit  could similarly encourage greater contributions by low-wage workers who  are already covered by a DC plan. Other options, like the so-called “State- K” proposal, in which states would design and partner with private  financial institutions to offer low-cost DC plans employers could provide  to employees, would seek to expand coverage among workers without  current plans by encouraging employers to sponsor new plans. Other  options would try to increase retirement account coverage by increasing  the use of IRAs or creating new retirement savings vehicles outside of the  voluntary employer-sponsored pension framework. Such proposals  include automatic IRAs, in which employers would be required to allow  employees through automatic enrollment to contribute to IRAs by direct  payroll deposit, or universal accounts proposals, in which all workers  would be given a retirement account regardless of whether they had any  employment based pension coverage.
subsections: section_title: Changing Default Plan Features and Reforming Saver’s Credit Could Raise DC Plan Savings, but May Have Limited Impact on Coverage
paragraphs: Changing certain traditional DC plan defaults may have a significant  impact on DC participation and savings. Research suggests that employees  exhibit inertia regarding plan participation and contributions, which can  reduce DC savings by failure to participate or increase savings over time.  To reverse the effects of these tendencies, some experts have suggested  changing default plan actions to automatically sign up employees for  participation, escalate contributions, and set default investment options  unless workers opt out. Some studies have shown that automatic  enrollment may increase DC plan participation. For example, one study of  a large firm, automatic enrollment increased participation from 57 percent  for employees eligible to participate 1 year before the firm adopted  automatic enrollment to 86 percent for those hired under automatic  enrollment. Another study finds that, prior to automatic enrollment, 26 to  43 percent of employees at 6 months’ tenure participated in the plan at  three different companies; under automatic enrollment 86 to 96 percent of  employees participated. Some also advocate automatically rolling over  DC savings into an IRA when employees separate from their employers to  further increase retirement savings. Our own simulations shows that  universal account rollover to a tax-preferred account, such as a new plan  or an IRA, would increase projected retirement savings by 11 percent on  average, with the biggest percentage increases for lowest-income workers.
Various regulatory and legislative changes have focused on default DC  plan features. In 1998, the IRS first approved plan sponsor use of  automatic enrollment—the ability for plans to automatically sign  employees up for a 401(k) plan (from which the employee can opt out),  and—subsequently issued several rulings that clarified the use of other  automatic plan features and the permissibility of automatic features in  403(b) and 457 plans. Accordingly, the percentage of 401(k) plans using  automatic plan features has increased in recent years. One annual study of  plan sponsors found that in 2004, 12.4 percent of 401(k) plans were  automatically enrolling participants, and this number increased to 17.5  percent of plans in 2005. The percentage of plans automatically  increasing employee contributions also rose from 6.8 percent in 2004 to  13.6 percent in 2005. Some experts have argued that initially, some plan  sponsors may have been hesitant to use automatic plan features because  of legal ambiguities between state and federal law. However, clarifications  relating to automatic enrollment and default investment in the PPA have  led some plan sponsors and experts to expect more plans to adopt  automatic plan features.
Automatic DC plan features, however, may create complications for  sponsors and participants that may limit any effect on savings and  participation. Auto enrollment may not help expand plan sponsorship; in  fact, sponsors who offer a matching contribution may not want to offer  automatic enrollment if they believe this will raise their pension costs.  Also, if sponsors automatically invest contributions in a low-risk fund such  as a money market fund, this could limit rates of return on balances.  However, choosing a risky investment fund could subject automatic  contributions to market losses. Some employees may not realize they  have been signed up for a plan, and may be displeased to discover this,  particularly if their automatically invested contributions have lost money.
section_title: Proposals Seek to Increase Plan Coverage and Savings, Particularly for Lower-Income Workers
paragraphs: Other proposals would target plan formation or increase participation and  retirement savings by expanding worker access to other account-based  retirement savings vehicles like IRAs. Some of these alternative retirement  savings proposals are voluntary in design, while others are more universal.
Gen. Assem., Reg. Sess. (Md. 2006). employee access to account-based retirement plans. However, it is unclear  to what extent employers would adopt such plans.
The Automatic IRA: The Automatic IRA proposal would make direct  deposit or payroll deduction saving into an IRA available to all employees  by requiring employers that do not sponsor any retirement plan to offer  withholding to facilitate employee contributions. To maximize  participation, employees would be automatically enrolled at 3 percent of  pay, or could elect to opt out or to defer a different percentage of pay to an  IRA, up to the maximum IRA annual contribution limit ($4,000 for 2007;  $5,000 for 2008). Employers would not be required choose investments or  set up the IRAs, which would be provided mainly by the private-sector IRA  trustees and custodians that currently provide them.  Employers also  would not be required or permitted to make matching contributions, and  would not need to comply with the Employee Retirement Income Security  Act of 1974 (ERISA) or any qualified plan standards such as non- discrimination requirements.  Employers, however, would be required to  provide notice to employees, including information on the maximum  amount that can be contributed to the plan on an annual basis.  One  congressional proposal would require employers, other than small or new  ones, to offer payroll deposit IRA arrangements to employees not eligible  for pension plans and permit automatic enrollment in such IRAs in many  circumstances. Participating IRAs would be required to offer a default  investment consisting of life cycle funds similar to those offered by the  Thrift Savings Plan, the DC plan for federal workers, or other investments  specified by a new entity established for that purpose.
Universal accounts: Similar to the automatic IRA, universal account  (UA) proposals aim to establish retirement savings accounts for all  workers, and vary slightly based on employment-based pension access.  Additionally, some proposals would have employers contribute to the  account, whereas other proposals would also have the federal government  match contributions. One proposal suggests a 2 percent annual  contribution from the federal government regardless of individual  contributions, while another would provide for individual contributions  only, capped at $7,500 per year. In 1999, the Clinton Administration  proposed a UA to be established for each worker and spouse with  earnings of at least $5,000 annually. Individuals would receive a tax credit  of up to $300 annually. Additionally, workers could voluntarily contribute  to the account up to specified amounts with a 50 to 100 percent match by  the federal government. This match would come in the form of a tax  credit, and total voluntary contributions, including government  contributions, would be limited to $1,000. Both the credit and the match  would phase out as income increases, providing a progressive benefit and  targeting low- and middle-income workers. Federal contributions would  have revenue implications, while requiring employer contributions could  increase employer compensation costs.
Other proposals would expand the size and scope of the saver’s credit to  encourage greater contributions by those low-wage workers who are  already covered by a DC plan that allows employee contributions.  Currently, the saver’s credit, originally proposed in 2000 as an outgrowth  of the 1999 UA proposal as a government matching deposit on some  voluntary contributions to IRAs and 401(k) plans, provides a  nonrefundable tax credit to low- and middle-income savers of up to 50  percent of their annual IRA or 401(k) contributions of up to $2,000.  However, according to one analysis, because the credit is nonrefundable,  only about 17 percent of those with incomes low enough to qualify for the  credit would receive any benefit if they contributed to a plan. Some  analysts think that expanding the saver’s credit, or creating direct  transfers such as tax rebates or deposits into retirement savings accounts,  could increase plan contributions specifically for low- and middle-income  workers. Making the saver’s credit refundable to the participant could  also provide a direct transfer to the tax filer in lieu of a retirement account  match, but offers no assurance that funds would be saved or deposited  into a retirement account. A refundable tax credit would also have  revenue implications for the federal budget.
section_title: Concluding Observations
paragraphs: The DC plan has clearly overtaken the DB plan as the principal retirement  plan for the nation’s private sector workforce, and its growing dominance  suggests its increasingly crucial role in the retirement security of current  and future generations of workers. The current DC-based system faces  major challenges, like its DB-based predecessor, in terms of coverage,  participation, and lifetime distributions. Achieving retirement security  through DC plans carries particular challenges for workers, since  accumulating benefits in an account-based plan requires more active  commitment and management from individuals than it does for DB   participants. Since workers must typically sign up and voluntarily reduce  their take home pay to contribute to their DC plans, invest this money  wisely over their working years, and resist withdrawing from balances  prior to retirement, it is perhaps to be expected that even those who have  the opportunity to participate save little. While our results on both current  and projected plan balances suggest that while some workers save  significant amounts toward their retirement in DC plans, a large  proportion of workers will likely not save enough in DC plans for a secure  retirement.
Of particular concern are the retirement income challenges faced by lower  earners. Many of these workers face competing income demands for basic  necessities that may make contributions to their retirement plans difficult.  Further, the tax preferences that may entice higher-income workers to  contribute to their DC plans may not entice low-income workers who have  plan coverage, since these workers face relatively low marginal tax rates.  Our model results suggest that other measures, such as automatic  enrollment and rollover of funds may make a difference for some lower  income workers. Should pension policy, as embodied by the automatic  provisions in PPA, continue to move in this direction, it should focus on  those workers most in need of enhanced retirement income prospects.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Department of Labor and the  Department of the Treasury, as well as to five outside reviewers.  Neither  agency provided formal comments. We incorporated any technical  comments we received throughout the report as appropriate.
As agreed with your office, unless you publicly announce its contents  earlier, we plan no further distribution until 30 days after the date of this  letter.  At that time, we will send copies of this report to the Secretary of  Labor, the Secretary of the Treasury, appropriate congressional  committees, and other interested parties. We will also make copies  available to others upon request. In addition, the report will be available at  no charge on GAO’s website at http://www.gao.gov.
If you have any questions concerning this report, please contact Barbara  Bovbjerg at (202) 512-7215. Contact points for our Office of Congressional  Relations and Public Affairs may be found on the last page of this report.  GAO staff who made major contributions to this report are listed in  appendix III.
section_title: Appendix I: Scope and Methodology
paragraphs: To analyze saving in DC plans, we examined data from the Federal  Reserve Board’s Survey of Consumer Finances (SCF). This triennial  survey asks extensive questions about household income and wealth  components. We used the latest available survey, from 2004. The SCF is  widely used by the research community, is continually vetted by the  Federal Reserve and users, and is considered to be a reliable data source.  The SCF is believed by many to be the best source of publicly available  information on household finances. Further information about our use of  the SCF, including sampling errors, as well as definitions and assumptions  we made in our analysis are detailed below. We also reviewed published  statistics in articles by public policy groups and in academic studies.
To analyze how much Americans can expect to save in DC plans over their  careers and the factors that affect these savings, we used the Policy  Simulation Group’s (PSG) microsimulation models to run various  simulations of workers saving over a working career, changing various  inputs to model different scenarios that affect savings at retirement.  PENSIM is a pension policy simulation model that has been developed for  the Department of Labor to analyze lifetime coverage and adequacy issues  related to employer-sponsored pensions in the United States.  We  projected account balances at retirement for PENSIM-generated workers  under different scenarios representing different pension features,  individual behavioral decisions, and market assumptions. See below for  further discussion of PENSIM and our assumptions and methodologies.
To analyze those plan- or government-level policies that might best  increase participation and savings in DC plans, we synthesized  information gathered from interviews of plan practitioners, financial  managers, and public policy experts, as well as from academic and policy  studies on DC plan participation and savings. We also researched current  government initiatives and policy proposals to broaden participation in  account-based pension plans and increase retirement savings.
We conducted our work from July 2006 to October 2007 in accordance  with generally accepted government auditing standards.
subsections: section_title: Methodology and Assumptions Using Survey of Consumer Finances Data
paragraphs: The 2004 SCF surveyed 4,522 households about their pensions, incomes,  labor force participation, asset holdings and debts, use of financial  services, and demographic information. The SCF is conducted using a  dual-frame sample design. One part of the design is a standard, multi-stage  area-probability design, while the second part is a special oversample of  relatively wealthy households. This is done in order to accurately capture  financial information about the population at large as well as  characteristics specific to the relatively wealthy. The two parts of the  sample are adjusted for sample nonresponse and combined using weights  to provide a representation of households overall. In addition, the SCF  excludes people included in the Forbes Magazine list of the 400 wealthiest  people in the United States. Furthermore, the 2004 SCF dropped three  observations from the public data set that had net worth at least equal to  the minimum level needed to qualify for the Forbes list.
The SCF is a probability sample based on random selections, so the 2004  SCF sample is only one of a large number of samples that might have been  drawn. Since each sample could have provided different estimates, we  express our confidence in the precision of our particular sample’s results  as a 95 percent confidence interval (e.g., plus or minus 4 percentage  points). This is the interval that would contain the actual population value  for 95 percent of the samples we could have drawn. As a result, we are 95  percent confident that each of the confidence intervals in this report will  include the true values in the study population.
All percentage estimates based on GAO analysis of 2004 SCF data used in  this report have 95 percent confidence intervals that are within plus-or- minus 4 percentage points, with the following exceptions described in  table 6 below.
Other numerical estimates based on GAO analysis of 2004 SCF data used  in this report have 95 percent confidence intervals that are within 25  percent of the estimate itself, with exceptions described in table 7.
Because of the complexity of the SCF design and the need to suppress  some detailed sample design information to maintain confidentiality of  respondents, standard procedures for estimate of sampling errors could  not be used. Further, the SCF uses multiple imputations to estimate  responses to most survey questions to which respondents did not provide  answers. Sampling error estimates for this report are based on a bootstrap  technique using replicate weights to produce estimates of sampling error  that account for both the variability due to sampling and due to  imputation.
The SCF collects detailed information about an economically dominant  single individual or couple in a household (what the SCF calls a primary  economic unit), where the individuals are at least 18 years old. We created  an additional sample containing information on 7,471 individuals by  separating information about respondents and their spouses or partners  and considering them separately. When we discuss individuals in this  document, we are referring to this sample. When we refer to all workers,  we are referring to the subpopulation of workers within this individual  sample. In households where there are additional adult workers, beyond  the respondent and the spouse or partner, who may also have earnings and  a retirement plan, information about these additional workers is not  captured by the SCF and is therefore not part of our analysis. It is also  important to note that the SCF was designed to be used as a household  survey, and some information could not be broken into individual-level  information. Where that was the case, we presented only household-level  information.
We defined “worker” relatively broadly and opted to begin with the set of  all those who reported that they were both working and some other  activity, including for example, “worker plus disabled” and “worker plus  retired.” We then excluded those workers who reported that they were  self-employed from our analysis. Our definition of DC plans includes the  following plans: 401(k); 403(b); 457; thrift/savings plan; profit-sharing plan;  portable cash option plan; deferred compensation plan, n.e.c.;  SEP/SIMPLE; money purchase plan; stock purchase plan; and employee  stock ownership plan (ESOP).
The SCF and other surveys that are based on self-reported data are subject  to several other sources of nonsampling error, including the inability to get  information about all sample cases; difficulties of definition; differences in  the interpretation of questions; respondents’ inability or unwillingness to  provide correct information; and errors made in collecting, recording,  coding, and processing data. These nonsampling errors can influence the  accuracy of information presented in the report, although the magnitude  of their effect is not known.
Our analysis of the 2004 SCF yielded slightly lower participation rates than  other data sets that consider pensions. For example, 2004 Bureau of Labor  Statistics (BLS) data indicate a somewhat higher rate of active  participation in DC accounts, 42 percent, compared with our finding of 36  percent. One possible factor contributing to this difference is that BLS  surveys establishments about their employees, while SCF surveys  individuals who report on themselves and their households; it is possible  that the SCF respondents may be failing to report all retirement accounts,  while BLS is capturing a greater proportion of them. Also, the SCF  considered both public and private sector workers, while the BLS statistic  is only for private sector workers. Differences may also be explained by  different definitions of workers and participation, question wording, or  lines of questioning. The SCF appears to provide a lower bound on the  estimation of pension coverage among 4 major data sets.
section_title: Methodology and Assumptions Using PENSIM Microsimulation Model
paragraphs: To project lifetime savings in DC pensions, and related retirement plans  with personal accounts, and to identify the effects of changes in policies,  market assumptions, or individual behavior, we used the Policy Simulation  Group’s (PSG) Pension Simulator (PENSIM) microsimulation models.  PENSIM is a dynamic microsimulation model that produces life histories  for a sample of individuals born in the same year. The life history for a  sample individual includes different life events, such as birth, schooling  events, marriage and divorce, childbirth, immigration and emigration,  disability onset and recovery, and death.  In addition, a simulated life  history includes a complete employment record for each individual,  including each job’s starting date, job characteristics, pension coverage  and plan characteristics, and ending date.  The model has been developed  by PSG since 1997 with funding and input by the Office of Policy and  Research at the Employee Benefits Security Administration (EBSA) of the  U.S. Department of Labor with the recommendations of the National  Research Council panel on retirement income modeling.
PENSIM sets the timing for each life event by using data from various  longitudinal data sets to estimate a waiting-time model (often called a  hazard function model) using standard survival analysis methods.   PENSIM incorporates many such estimated waiting-time models into a  single dynamic simulation model.  This model can be used to simulate a  synthetic sample of complete life histories.  PENSIM employs continuous- time, discrete-event simulation techniques, such that life events do not  have to occur at discrete intervals, such as annually on a person’s  birthday.  PENSIM also uses simulated data generated by another PSG  simulation model, SSASIM, which produces simulated macro-demographic  and macroeconomic variables.
PENSIM imputes pension characteristics using a model estimated with  1996 to 1998 establishment data from the BLS Employee Benefits Survey  (now known as the National Compensation Survey). Pension offerings are  calibrated to historical trends in pension offerings from 1975 to 2005,  including plan mix, types of plans, and employer matching. Further,  PENSIM incorporates data from the 1996-1998 Employee Benefits Survey  (EBS) to impute access to and participation rates in DC plans in which the  employer makes no contribution, which BLS does not report as pension  plans in the NCS. The inclusion of these “zero-matching” plans enhances  PENSIM’s ability to accurately reflect the universe of pension plans  offered by employers.  PENSIM assumes that 2005 pension offerings,  included the imputed zero-matching plans, are projected forward in time.
PSG has conducted validation checks of PENSIM’s simulated life histories  against both historical life history statistics and other projections.   Different life history statistics have been validated against data from the  Survey of Income and Program Participation (SIPP), the Current  Population Survey (CPS), Modeling Income in the Near Term (MINT3), the  Panel Study of Income Dynamics (PSID), and the Social Security  Administration’s Trustees Report. PSG reports that PENSIM life histories  have produced similar annual population, taxable earnings, and disability  benefits for the years 2000 to 2080 as those produced by the Congressional  Budget Office’s long-term social security model (CBOLT) and as shown in  the Social Security Administration’s 2004 Trustees Report.  According to  PSG, PENSIM generates simulated DC plan participation rates and  account balances that are similar to those observed in a variety of data  sets.  For example, measures of central tendency in the simulated  distribution of DC account balances among employed individuals is similar  to those produced by an analysis of the Employee Benefit Research  Institute (EBRI)-Investment Company Institute (ICI) 401(k) database and  of the 2004 SCF.  GAO performed no independent validation checks of  PENSIM’s life histories or pension characteristics.
In 2006, EBSA submitted PENSIM to a peer review by three economists.   The economists’ overall reviews ranged from highly favorable to highly  critical.  While the economist who gave PENSIM a favorable review  expressed a “high degree of confidence” in the model, the one who  criticized it focused on PENSIM’s reduced form modeling. This means that  the model is grounded in previously observed statistical relationships  among individuals’ characteristics, circumstances, and behaviors, rather  than on any underlying theory of the determinants of behaviors, such as  the common economic theory that individuals make rational choices as  their preferences dictate and thereby maximize their own welfare.  The  third reviewer raised questions about specific modeling assumptions and  possible overlooked indirect effects.
subsections: section_title: Assumptions Used in Projecting DC Plan Balances at Retirement
paragraphs: PENSIM allows the user to alter one or more inputs to represent changes  in government policy, market assumptions, or personal behavioral choices  and analyze the subsequent impact on pension benefits. Starting with a 2  percent sample of a 1990 cohort, totaling 104,435 people at birth. our  baseline simulation includes some of the following key assumptions and  features.  For our report, we focus exclusively on accumulated balances in  DC plans and ignore any benefits an individual might receive from DB  plans or from Social Security. Our reported benefits and replacement rates  therefore capture just one source of potential income available to a  retiree.
Workers accumulate DC pension benefits from past jobs in one rollover  account, which continue to receive investment returns, along with any  benefits from a current job.  At retirement, these are combined into one  account.  Because we focus on DC plan balances only, we assume all  workers are ineligible to participate in DB plans and do not track  Social Security benefits.
Plan participants invest all assets in their account in life cycle funds,  which adjust the mix of assets between stocks and government bonds  as the individual ages. Stocks return an annual nonstochastic real rate  of return of 6.4 percent and government bonds have a real return of 2.9  percent per year. In one simulation, we use the government bond rate  on all plan assets.  Using different rates of return reflect assumptions  used by OCACT in some of its analyses of trust fund investment.
Workers purchase a single, nominal life annuity, typically at retirement,  which occurs between the ages of 62 and 70.  Anyone who becomes  permanently disabled at age 45 or older also purchases an immediate  annuity at their disability age.  We eliminate from the sample cohort  members who: 1) die before they retire, at whatever age; 2) die prior to  age 55; 3) immigrates into the cohort at an age older than 25; or 4)  becomes permanently disabled prior to age 45.  We assume that the  annuity provider charges an administrative load on the annuity such  that in all scenarios the provider’s revenues balance the annuity costs  (i.e., zero profit).
Replacement rates equal the annuity value of DC plan balances divided  by a “steady earnings” index. This index reflects career earnings,  calibrated to the Social Security Administration’s age-65 average wage  index (AWI). PENSIM computes steady earnings by first computing the  present value of lifetime wages. Then, it calculates a scaling factor that,  when multiplied by the present value of lifetime earnings for a 1990  cohort member earning the AWI from ages 21 to 65, produces the  individual’s present value of lifetime earnings. This scaling factor is  multiplied by AWI at age 65, then adjusted to 2007 dollars. Using this  measure as opposed to average pay for an individual’s final 3 or 5 years  of working, minimizes the problems presented by a worker who has  irregular earnings near the end of his or her career, perhaps because of  reduced hours.
For household replacement rates, we use a combined annuity value of  worker-spouse lifetime DC plan savings and a combined measure of  steady family earnings.
Starting from this baseline model, we vary key inputs and assumptions to  see how these variations affect pension benefits and replacement rates at  retirement. Scenarios we ran include:  (1) Universal rollover of DC plan balances. All workers with a DC  balance roll it over into an Individual Retirement Account or another  qualified plan upon job separation, as opposed to cashing out the  balance, in which case the money is assumed lost for retirement  purposes.  (2) Immediate eligibility and participation in a plan. A worker who  would be offered a plan has no eligibility waiting period and  immediately enrolls. This does not necessarily mean that the  participant makes immediate or regular contributions; contribution  levels are determined stochastically by PENSIM based on worker  characteristics.  (3) Delayed retirement. Workers work beyond the retirement age  determined by PENSIM in the baseline run. In one scenario, workers  work up to one extra year; in another, they delay retirement for up to 3  years, although 70 remains the maximum retirement age.  (4) Raised contribution limits. We set annual contribution limits  starting in 2007 to $25,000 per individual, up from $15,500 under  current law, and $60,000 for combined employer-employee  contributions, up from $45,000 under current law. These limits rise  with cost of living changes in subsequent years, as is the case in our  baseline model.
section_title: PENSIM Cohort Summary and Cross-Sectional Statistics
paragraphs: Lifetime summary statistics of the simulated 1990 cohort’s workforce and  demographic variables give some insight into the model’s projected DC  savings at retirement that we report (see tables 8 and 9). The 78,045 people  in the sample who have some earnings, do not immigrate into the cohort  after age 25, live to age 55, and retire (or become disabled at age 45 or  older), work a median 29.4 years full-time and 2.1 part-time, with median  “steady” earnings of $46,122 (in 2007 dollars). Those whose earnings fall  in the lowest quartile work full-time for only a median 14.1 years, while  working part-time for 9.1 years, and 13.4 years for their longest-tenured  job; this group’s median annual steady earnings measure $16,820. In  contrast, those in the highest-quartile of earnings work for a median 34.8  years, including 19.5 years for their longest job, and have median steady  earnings of $126,380 per year. The results also show that pension coverage  varies somewhat across income groups. About 83 percent of workers in  the lowest income quartile have at least one job in which they are covered  by a DC plan throughout their working careers, and are eligible for DC  plan coverage for a median 9.4 years. In contrast, at least 90 percent of  workers in the highest three income quartiles have some DC coverage  during their careers. Those in the highest income quartile are eligible for  DC participation for a median 25.2 years throughout their career.
Cross-sectional results of the sample cohort also provide some insights  into the model’s assumptions, as well as some further insights into the  relatively low projected sample replacement rates (see table 10). These  statistics describe the working characteristics for each employed  individual at a randomly determined age sometime between 22 and 62 in  order to provide a snapshot of a “current” job for most of the sample.
Among those employed at the time of the survey, 61.8 percent had an  employer who sponsors a DC plan. Of these workers with a plan offered,  94 percent were eligible to participate, and among those eligible 67  percent participated. Taking all of these percentages together, this means  that at any one time only 38.9 percent of the working population actively  participated in a DC plan in our projections. Even among these  participants, only 56.9 percent reported making a contribution to the plan  in the previous year, while 45.7 percent had an employer contribution.  Median combined employer-employee contributions in the previous year  were 6.2 percent of earnings in our simulation.
section_title: Appendix II: Comparison of DC Plan Projections Based on PENSIM to Other Studies
paragraphs: Other studies have projected DC plan savings for workers saving over  their entire working careers. These studies generally find higher projected  replacement rates from DC plan savings than our simulations do.  However, each study makes different key assumptions, particularly about  plan coverage, participation, and contributions.
A 2007 study by Patrick Purcell and Debra B. Whitman for the  Congressional Research Service (CRS) simulates DC plan replacement  rates based on earnings, contributions, and the rate of return on plan  balances. CRS projects savings for households that begin saving at age 25,  35, or 45. The study estimates 2004 earnings using the March 2005 CPS as  starting wages, and assumes that households experience an annual wage  growth rate of 1.1 percent. Households are randomly assigned a 6 percent,  8 percent, or 10 percent retirement plan contribution rate every year from  their starting age until age 65. The study assumes households allocate 65  percent of their retirement account assets to Standard & Poor’s 500 index  of stocks from ages 25 to 34, 60 percent to stocks from ages 35 to 44, 55  percent to stocks from ages 45 to 54, and 50 percent to stocks from age 55  and above, with the remaining portfolio assets invested in AAA-rated  corporate bonds. A Monte Carlo simulation based on historical returns on  stocks and bonds determines annual rates of return. Replacement rates  represent annuitized DC plan balances at age 65 divided by final 5-year  average pay.
After running the simulations, CRS finds variation in replacement rates  depending on rate of return, years of saving, and earning percentile. In the  CRS “middle estimate,” the unmarried householder that saves for 30 years,  has annual household earnings in the 50th percentile, contributes 8  percent each year until retirement, and earns returns on contributions in  the 50th percentile would have a 50 percent replacement rate (see table  11). The projected replacement rate jumps to 98 percent at 40 years of  saving, and 22 percent at just 20 years of saving. Assuming a 6 percent  annual contribution reduces projected replacement rates by about 10 to 30  percent. For example, an unmarried householder at the 50th percentile of  annual earnings and the 50th percentile of returns saving for 40 years is  projected to have a replacement rate of 72 percent at a 6 percent annual  contribution (see table 12). All CRS estimates, however, exceed those we  report in projections in this report, in part because CRS assumes constant  participation in, and contributions to, a DC plan. In addition, CRS  calculated annuity equivalents of accumulated DC balances based on  current annuity prices; for younger workers retiring several decades into  the future, we would expect the price of a given level of annuity income to  be higher than today’s levels because of longer life expectancies. This  would lower the replacement rates for any projected lump sum.
A 2005 study, by Sarah Holden of ICI and Jack VanDerhei of EBRI,  simulates, as a baseline scenario, retirement savings at age 65 for a group  in their 20s and 30s in the year 2000. The baseline assumes workers are  continuously covered by a DC plan throughout their career, and that  workers will continuously participate. However, the authors also run the  model assuming this group will have participation rates similar to current  rates by allowing workers to not be covered by, participate in, or  contribute to a DC plan. Their model also incorporates the possibility that  a participant might cash out a DC plan balance upon leaving a job.  Replacement rates are calculated by earnings quartile for participants  retiring between 2035 and 2039 as the annuity value of age-65 plan  balances divided by final 5-year average pay.
The EBRI/ICI baseline projections, starting with a sample of plan  participants, show a median replacement rate of 51 percent for the lowest  earnings quartile and 67 percent for the highest. (See table 13). The  authors analyze the effect of other plan or behavioral assumptions. For  example, replacement rates fall significantly when the projections relax  the assumption of continuous ongoing eligibility for a 401(k) plan,  although they remain higher than our projections, perhaps because the  projections start with current participants and assume continuous  employment.  When the authors include nonparticipants and assume  automatic enrollment with a 6 percent employee contribution and  investment of assets in a life cycle fund, replacement rates rise  significantly from projections without automatic enrollment.  Although  they project a larger effect on replacement rates resulting from automatic  enrollment than our projections show, EBRI/ICI similarly shows a greater  increase in savings for lower-income workers.
A forthcoming study by Poterba, Venti, and Wise uses the Survey of  Income and Program Participation (SIPP) to project DC plan balances at  age 65. In order to project participation, the authors assume that DC plan  sponsorship will continue to grow, although more slowly than during  recent decades. They calculate participation by earnings deciles within 5- year age intervals. The authors assume that 60 percent of plan  contributions are allocated to large capitalization equities, and 40 percent  to corporate bonds, and assume an average nominal rate of return of 12  percent for equities and 6 percent for corporate bonds. In addition, the  authors run a projection assuming the rate of return on equities is 300  basis points less than the historical rate. They determine a person’s  likelihood of DC plan participation based on age, cohort, and earnings, as  well as the probability of cashing out an existing DC plan balance when  someone leaves a job. The authors simulate earnings histories based on  data from the Health and Retirement Study (HRS), and impute earnings for  younger cohorts for which data are not available. They assume an annual  combined employee-employer contribution rate of 10 percent for each  year an individual participates, and do not account for increases in annual  contributions or changes made to DC plans in the Pension Protection Act,  such as a possible increase in participation by automatically enrolling  employees.
The authors find retirement savings for individuals retiring by decade  between 2000 and 2040 by lifetime earning deciles. For workers in the fifth  earnings decile retiring in 2030 at age 65, the authors project a mean DC  plan balance of $272,135 in 2000 dollars, and $895,179 for the highest  earning decile (see table 14). Earners in the lowest and second deciles,  however, project average balances of $1,372, and $21,917. The projected  average DC plan assets for 2030 retirees fall to $179,540 for the fifth decile  of earnings, $614,789 for the highest decile, and $810 for the lowest decile  when the authors assume an annual rate of return 300 basis points below  the historic rate of return (see table 15).
Finally, a 2007 study by William Even and David Macpherson estimates  replacement rate for those continuously enrolled in a DC plan between 36  and 65 years of age. The authors simulate a sample using the SCF, and  generate an age earnings profile for their sample using data on pension- covered workers in the 1989 SCF. The authors also use the SCF to  generate annual contributions to DC plans, which are estimated using a  person’s earnings, age, education, gender, race, ethnicity, martial status,  union coverage, and firm size. The authors also create an artificial sample  for workers who are predicted to be eligible for a DC plan, but choose not  to participate. Finally, the authors assume three different rates of return  on pension contributions: a 3 percent rate of return based on historical  returns on government bonds; a historic returns portfolio based on an  account mix of 75 percent in stocks split between large and small capital  equities, and 25 percent split between long term corporate bonds, long- term government bonds, midterm government bonds, and Treasury bills; a  6.5 percent real rate of returns based on the average real rate of return on  DC plans from 1985 to 1994 for plans with over 100 participants. In  calculating annuity rates, the authors rely on mortality tables for group  annuitants as opposed to the population as a whole, and do not include the  charge the company makes for marketing and administrative expenses.
The authors find that replacement rates vary by income distribution. For  example, low-income workers who are continuously enrolled in a DC plan  at the median replacement rate distribution are estimated to have a 30  percent replacement rate. (see table 16) The average replacement rate for  such workers is 44 percent. Middle-income and high-income workers have  median replacement rates 31 percent and 35 percent respectively. The  authors’ estimates are likely higher than ours because the authors assume  continuous enrollment.
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact above, Charles A. Jeszeck, Mark M. Glickman,  Katherine Freeman, Leo Chyi, Charles J. Ford, Charles Willson, Edward  Nannenhorn, Mark Ramage, Joe Applebaum, and Craig Winslow made  important contributions to this report.