Pursuing Universal Retirement Security Through Automatic IRAs€¦ · 7/6/2016  · The Retirement...

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The Retirement Security Project The Retirement Security Project Pursuing Universal Retirement Security Through Automatic IRAs J. Mark Iwry and David C. John Nº 2009-3

Transcript of Pursuing Universal Retirement Security Through Automatic IRAs€¦ · 7/6/2016  · The Retirement...

Page 1: Pursuing Universal Retirement Security Through Automatic IRAs€¦ · 7/6/2016  · The Retirement Security Project The Retirement Security Project Pursuing Universal Retirement Security

The Ret i rement Secur i ty Pro ject

The RetirementSecurity Project

PursuingUniversalRetirementSecurityThroughAutomatic IRAs

J. Mark Iwry andDavid C. John

Nº 2009-3

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Advisory Board

Bruce BartlettWashington Times Columnist

Michael GraetzJustus S. Hotchkiss Professor of Law,Yale Law School

Daniel HalperinStanley S. Surrey Professor of Law,Harvard Law School

Nancy KilleferDirector, McKinsey & Co.

Robert RubinDirector, Chairman of the ExecutiveCommittee and Member of the Officeof the Chairman, Citigroup Inc.

John ShovenCharles R. Schwab Professor ofEconomics and Director, StanfordInstitute for Economic Policy Research,Stanford University

C. Eugene SteuerleSenior Fellow, The Urban Institute

Commonsensereforms,real worldresults

www.ret i rementsecur i t yprojec t .org

1775 Massachusetts Ave., NW, Washington, DC 20036 ¥ p: 202.741.6524 ¥ www.retirementsecurityproject.org

The Retirement Security Project

is supported by The Pew

Charitable Trusts in partnership

with Georgetown University's

Public Policy Institute and the

Brookings Institution.

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IInnttrroodduuccttiioonn

Roughly half of all working Americans work for employers that offer no retirement plan. Thus about 78 million workers have no way to save on the job for the day when they stopcollecting a paycheck. This circumstance, combined with a national saving rate that hasbeen declining steadily for most of the past twenty years and the unlikelihood that SocialSecurity will be able to provide increased benefits, makes inadequate retirement saving amajor national problem.

This paper spells out an ambitious yet practical set of initiatives to expand retirementsaving dramatically. We propose making saving automatic—and hence easier, moreconvenient, and more likely. This strategy has been shown to be remarkably effective atboosting participation in workplace-based 401(k) retirement savings. We would extend thisstrategy to most employees who have no access to 401(k) plans by combining several keyelements of our current system: payroll-deposit saving; automatic enrollment; low-cost,diversified default investments; and individual retirement accounts (IRAs).

Automatic IRAs would not crowd out or compete with 401(k) plans. To the contrary, wewould hope that successful experience with the new, automatic IRAs would lead moreemployers to step up to 401(k)s and then to match employee contributions—if not dollarfor dollar, then perhaps fifty cents on the dollar or some other ratio. Automatic would bethe operative word for the new IRAs. Once all the automatic processes described in thisand other RSP publications have been developed and implemented, every step in theprocess, from saving for retirement to withdrawing the savings upon retirement, wouldoccur automatically unless the individual employee or employer stepped in andaffirmatively chose a different course.

HHooww PPeeooppllee WWoouulldd SSaavveeThe automatic IRA approach, which was touted by President Barack Obama in his firstaddress to a joint session of Congress, has been included in the president’s proposedbudget and has been endorsed by such diverse publications as the New York Times andthe National Review.1 It offers most employees not covered by an employer-sponsoredretirement plan the opportunity to save through the powerful mechanism of regular payrolldeposits that continue automatically. This is an opportunity now limited mainly to 401(k)-eligible workers. Under this approach:

—Employers above a certain size (at least ten employees, for example) that had been inbusiness for at least two years and did not sponsor any plan for their employees wouldallow employees to use their payroll system to channel their own money to an IRA.

—Employers would retain the option at all times of setting up a 401(k), a SIMPLE IRA, orother retirement plan instead of a payroll-deposit IRA. Those retirement plans offer employercontributions, much higher employee contributions, and larger tax credits for employers.

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Any employee declining to contributewould need to sign a waiver. If possible,the election form would be added orattached to IRS Form W-4, which newemployees complete to make electionsregarding payroll tax withholding. Evidencefrom the 401(k) universe strongly suggeststhat high levels of participation tend toresult not only from automatic enrollmentbut also from the practice of requiring eacheligible employee to decide explicitlywhether to participate.

A national website would give firms astandard notice for informing employees ofthe payroll-deduction IRA option. It wouldinclude standard employee election formsand enrollment procedures. The websitewould also promote best practices as theyevolve (about automatic enrollment, forexample, and, potentially, automaticannuitization) and employee educationregarding saving and investment. Finally,for employers that cannot find anacceptable IRA provider in their area, thewebsite would connect them withinterested IRA providers.

Employers that offer automatic payrolldeposit would be protected from potentialfiduciary liability for investment performanceand from having to choose or arrangedefault investments. Instead, whether theIRA provider was designated by employeesor their employer, workers’ contributionswould automatically be directed to adiversified investment (such as a life-cyclefund) unless the employees chose aprincipal-preservation investment alternativeor a different option. Initially, however, whenaccounts were very small, the automaticinvestment might be designed with a viewto simplicity and to avoiding short-termlosses (for example, using Treasurysecurities or special retirement bonds).Payroll deduction contributions would betransferred, at the employer’s option:

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—These employers, as well as smaller ornewer firms that voluntarily offeredpayroll deposit as a conduit for employeecontributions, would receive a small,temporary tax credit based on thenumber of employees who participated.

—For most employees, payroll deductionswould be made by direct deposit, similar tothe common practice of depositing paychecksdirectly into employees’ bank accounts.

—The arrangement would be market-oriented, with IRAs provided by thesame private financial institutions thatcurrently provide them.

—Each employer would send all depositsto a single IRA provider of its choice.

—As a fallback, individuals and employersthat could not find an acceptable IRA onthe market could use ready-made, low-cost, automatic IRA accounts through anonline clearinghouse that connectedemployers with financial providersserving as IRA trustees or custodians. Ifthat did not work, an IRA of last resortwould be made available by a financialservices industry consortium ornonprofit risk pooling arrangement, withinvestment management contracted outto the financial services industry.

—Enrollment would be automatic;employees would save a proportion oftheir pay in an IRA unless theyaffirmatively chose to opt out.

Employers not wishing to use this methodwith their employees could likewise opt outand instead have every employee make anexplicit choice. In all events, while noemployee would be required to participate,no employee could be left out simplybecause of inattention. Automatic enrollmentwould thus harness the power of inertia toincrease saving in sensible default investments.

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—To IRA providers designated by theemployer;

—To IRAs designated by employees (if theemployer allowed employees to choosetheir own provider in addition to theprovider that the employer had selected); or

—To a fallback collective retirementaccount if the employer or employeefailed to designate a provider.

The proposal is designed to minimize theemployer’s administrative functions andshould involve little if any out-of-pocketemployer cost. Many firms already offertheir workers direct deposit of paychecks.Many use automatic or electronic payrollarrangements (some of which are web-based)or payroll software, or they outsource to apayroll service provider. Virtually all makepayroll deposits to comply with income taxwithholding (federal and state) andwithholding for such things as SocialSecurity, Medicare, and unemploymentinsurance. Payroll deposit to IRAs wouldnot require much more effort fromemployers. They would facilitate employeesaving by forwarding employees’ contributionsto their IRAs without having to sponsor aplan; make any matching or other employercontributions; comply with federal planqualification or retirement insurancesecurity requirements; select investmentsfor employees; set up IRAs or otheraccounts for employees; or determineemployees’ eligibility to contribute to an IRA.

Many employers that still process payrollby hand would be exempted under theexception for very small employers. Firmsnot exempted could have the option ofpiggybacking the payroll deposits to IRAsonto the federal tax deposits they currentlymake online, by mail, or by delivery to thelocal bank.

The self-employed and other workerswithout employers would be encouraged tocontribute to IRAs by automatic debit.Professional and trade associations couldarrange the automatic debit and the IRAsthemselves. The self-employed could alsosend deposits to IRAs in conjunction withtheir quarterly estimated taxes or instructthe IRS to make direct deposit to IRAs ofpart or all of their income tax refunds.Independent contractors receiving regularpayments from a business could arrangefor automatic payroll deduction to an IRAin the same way as employees.

Automatic IRAs would be carefullydesigned to avoid competing with orcrowding out employer-based retirementplans and employer contributions foremployees. In fact, for several reasons,extensive use of automatic IRAs can beexpected to expand opportunities tomarket 401(k), SIMPLE, and other tax-favored plans to employers.

—The maximum permitted annualcontribution to IRAs (currently $5,000with an additional $1,000 for those age50 or older) exceeds employees’ average401(k) contribution but is not enough tosatisfy the appetite for tax-favored savingof business owners or decision makers.They would still have an incentive toadopt a SIMPLE plan, which allows tax-favored employee contributions of up to$11,500, or a 401(k), whose limit is$16,500. Together with employercontributions, which are allowed in the401(k) and required in the SIMPLE, totalcontributions to a 401(k) can reach$49,000 (and $5,500 higher foremployees 50 or older).

—The automatic IRA tax credit would besmaller than the tax credit smallemployers receive when adopting newretirement plans.

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—To encourage employer retirement plans,firms would not be asked (or allowed) tocontribute to automatic IRAs. Employersinterested in contributing for their employeesor saving more for themselves wouldhave to adopt 401(k)s or other plans.

Thus the proposal steers clear of discouragingemployers from sponsoring actual retirementplans. In fact, the intended indirect effectof the proposal is to draw small employersinto the private pension system bydemonstrating the power and convenienceof tax-preferred payroll deposit saving andwhetting employees’ appetite for it.

Within either the online clearinghouse thatlinks employers with IRA providers or, ifnecessary a fall-back investment platform,investment management, record-keeping,and other administrative functions would becontracted to private financial institutionsto the fullest extent practicable. Costs wouldbe minimized through a no-frills design relyingon index or other similarly low-cost investmentfunds, economies of scale, and maximumuse of electronic technologies. The ThriftSavings Plan for federal government employees

would serve as a model for some aspects ofthe proposal. The investment menu wouldbe kept simple: money would go to a low-cost,diversified, asset-allocated fund unless theindividual instead selected from among afew low-cost, diversified alternatives (probablyincluding Treasury inflation-protected securities).

In addition, a powerful financial incentivefor individuals to contribute might be providedby matching deposits to their IRAs. Employerscould offer no such match, but the privatefinancial institutions that maintain the accountscould deliver matching contributions andbe reimbursed through federal tax credits.Alternatively, the Saver’s Credit for voluntarycontributions might be expanded to providea match. Matching deposits are not, however,part of the basic automatic IRA proposal.

SSaavviinngg UUpp IIss HHaarrdd ttoo DDooMany American families, especially thosewith lower or middle incomes, find it hardto save, especially for retirement or otherlong-term needs. In 2004 half of allhouseholds headed by people aged 55 to59 had $13,000 or less in employer-based401(k)-type plans or tax-preferred savingplans.2 The personal saving rate in theUnited States has declined steadily over thelast two decades and in recent years hashovered around zero.3 Moreover, traditionalcorporate defined-benefit pension plans arebecoming rarer, and few expect SocialSecurity to provide increased benefits inthe future.

In general, those who tend to be in thebest financial position to confrontretirement are the 41 percent of theworkforce that participate in employer-sponsored retirement plans.4 About sevenor eight of every ten workers who areeligible participate in employer-sponsored401(k) plans, while the corresponding take-uprate for IRAs (which typically have noconnection to the workplace or payroll

The Power of Automatic Retirement Saving

Madrian, Brigitte, and Dennis, Shea. 2001. “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior.” Quarterly Journal of Economics 116(4):1149-87.And EBRI Notes, “401(k)-Type Plans and Individual Retirement Accounts (IRAs),”

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system) tends to be less than one in ten.Moreover, an increasing share of 401(k)plans include automatic features that, byapplying to all workers except those whoexplicitly choose an alternative, makesaving easier and raise participation to ratesoften exceeding nine in ten (figure 4-1).

Yet among 155 million working Americans,some 78 million—about half—work for anemployer that does not offer a 401(k) orany other type of employer-sponsoredplan. Another 16 million fail to participatein or are not eligible for their employer’splan. Among the approximately 94 millionfull-time, full-year wage and salary workersaged 21 to 64, 63 percent work for anemployer that sponsors a plan, and 55percent participate.5

These facts reveal a major gap between ourpublic policy goals relating to retirementsecurity and the market’s ability to meetthose goals. The major federal tax expendituresand associated regulation of private pensionsattest to a recognition of some need forpublic intervention to address this shortfall.

The causes of inadequate saving forretirement are several. Many people find itdifficult to plan for retirement and to deferconsumption. For many if not most, thenecessary financial sophistication and self-discipline do not come naturally or easily.Many people do not exercise the initiativerequired to save in an IRA.

Our approach is intended to helphouseholds overcome these barriers bybuilding on the successful use in 401(k)plans of automatic features that leademployees toward sensible decisions whileallowing them to make alternative choices.Since their inception, 401(k) plans haveencouraged contributions through payrolldeposits that continue automatically (“set itand forget it”) unless the employee takes

the initiative to stop or modify them.Starting in 1998, the U.S. TreasuryDepartment and the Internal RevenueService (IRS) have issued a series of rulingsdefining, permitting, and encouraging theautomatic initiation of those payrolldeposits (which they called “automaticenrollment”) and automatic rollover in401(k) and other salary-reductionretirement saving plans.6 Over time, the401(k) market has responded by moving toautomatic enrollment, automaticinvestment choices, and related automaticfeatures. In 2006 Congress added its voiceto this process by eliminating or reducingseveral barriers to the adoption ofautomatic 401(k) features.7

Although workplace saving throughemployer contributions or regular payrolldeposits tends to be the most effectivevehicle for building retirement savings, amajority of small employers do not offer aretirement plan. Many of them, unaware ofthe low-cost, simplified 401(k) andSIMPLE IRA plan options now available(often online), mistakenly perceive plansponsorship as a complex and costlyundertaking. 8 Small business owners maybe concerned that they have no one onstaff with the knowledge and time to sortthrough the options for plan adoption andto administer the plan on an ongoing basis.In addition, small businesses, unlike largerfirms, cannot spread fixed plan administrationand investment costs across a large numberof employees to make per capita costsmore manageable. They also lack theeconomies of scale and bargaining powerof a large employer when negotiating feesand expenses with financial services providers.

Our proposal is designed to reduce thetransaction costs for small employers thatadopt and maintain an automatic IRA fortheir employees by using the spare capacityfor saving that is inherent in employer

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payroll systems. By taking smalleremployers and their employees part of theway down the path toward plansponsorship and participation, theautomatic IRA approach would open upthis market more widely to the financialproviders, third-party administrators, andprofessionals who market, provide, andhelp administer employer plans.

Widespread use of payroll deposit tocontribute to IRAs would lay thegroundwork for a far deeper penetration ofthe small business market by 401(k) andSIMPLE plans. Either at the outset or aftera year or two, many small business ownerswill ask how they or a key manager cansave more for themselves than only $5,000a year, the general 2009 IRA limit. Somewill be interested in exploring how theycould make a very modest matchingcontribution for their employees, at least inyears when business has been good.

The answer to both questions is that theautomatic IRA is designed with a modestcontribution limit and no employercontributions to induce employers tograduate to a 401(k) or SIMPLE plan.Even when firms did not choose tosponsor 401(k)-type plans, however, theautomatic IRA proposed here would applythe key lessons learned from 401(k) plansso that more workers could enjoyautomated saving to build assets, withoutimposing any significant burden onemployers.9 Employers could help theiremployees save simply by transferring aportion of their pay to an IRA, preferablyby direct deposit, at little or no cost.

Another reason that employer plans areless prevalent in the small business marketis that many financial providers have foundit less profitable or unprofitable to serveplans with a small average account size.Many small workforces have lower-wageemployees with less ability or desire tocontribute, and it can be difficult to find

larger accounts to cross-subsidize the costsof servicing smaller accounts. However,many financial providers might beinterested in receiving rollovers from suchaccounts if and when they have grown to aprofitable size.

Our proposal seeks to address this concernby providing a backstop arrangementcontracted to the private sector that wouldgive an option to those employee groupsthat the financial services industry is notinterested in serving. As described below,pooling of contributions in a standard, low-cost, automatic investment and a limitednumber of investment alternatives wouldlower costs through economies of scale,standardization, and elimination of mostsales and marketing expenses. Onceaccounts had grown sufficiently, they couldbe automatically reinvested or could berolled over, substantially increasing thefinancial industry's assets under management.10

TThhee PPrrooppoosseedd SSoolluuttiioonnThe automatic IRA is a means offacilitating direct deposits to a retirementaccount, giving employees access to thepower of direct-deposit saving. In muchthe same way that millions of employeeshave their pay directly deposited to theiraccount at a bank or other financialinstitution, and millions more elect tocontribute to 401(k) plans by payrolldeduction, employees would have thechoice to have their employer to send anamount they select directly from theirpaychecks to an IRA. Employers generallywould be required to offer their employeesthe opportunity to save through suchdirect-deposit or payroll-deduction IRAs.

Payroll deposit to IRAs is not new. In 1997Congress encouraged employers not readyor willing to sponsor a retirement plan toat least offer their employees theopportunity to contribute to IRAs throughpayroll deduction.11 Both the IRS and theLabor Department have issued

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program was in operation. This automaticIRA credit would be designed to avoidcompeting with the tax credit availableunder current law to small businesses thatadopt a new employer-sponsoredretirement plan such as a 401(k) or otherqualified plan or a SIMPLE IRA. Undercurrent law, an employer with 100 or feweremployees can generally claim a tax creditof half the cost of establishing andadministering a new retirement plan(including educating employees about theplan) up to $500 a year for each of the firstthree years of the plan.

The automatic IRA tax credit could be set,for example, at $25 per employee enrolled,and it could be capped at $250 a year forits two years of availability. That wouldmake it meaningful only to very smallbusinesses. The larger credit forestablishing a new employer plan wouldstill favor 401(k) and SIMPLE plans overautomatic IRAs.

Employers could not claim both the 401(k)plan startup credit and the proposedautomatic IRA credit; otherwise, someemployers might exclude some employeesfrom a new 401(k) plan to earn anadditional credit for providing them withan automatic IRA. Employers also wouldbe ineligible for the automatic IRA credit ifthey had sponsored a retirement planduring the preceding three years forsubstantially the same group of employees.Employers that sponsor a retirement planfor their employees would generally beunaffected by the automatic IRA provision.But an employer offered the retirementplan only to employees in a particularsubsidiary or division or other businessclassification would be required to make anautomatic IRA available to the others(except for employees who may beexempted under qualified plan coveragestandards, specifically employees under age18, those represented by unions,

administrative guidance to publicize thepayroll-deduction or direct-deposit IRAoption for employers and to “facilitate theestablishment of payroll deduction IRAs.”12This guidance has made clear thatemployers can offer direct-deposit IRAswithout having the arrangement treated asemployer sponsorship of a retirement plan,which would subject it to federal EmployeeRetirement Income Security Act (ERISA)or qualified-plan requirements.13 However,it appears that few employers actually havedirect-deposit or payroll-deduction IRAs—at least in a way that actively encouragesemployees to take advantage of thearrangement. After some years ofencouragement by the government, payroll-deposit IRAs have simply not caught onwidely among employers and offer littleopportunity for employees to save.

OOuurr PPrrooppoossaall ffrroomm tthhee EEmmppllooyyeerr’’ssPPeerrssppeeccttiivveeOur strategy is designed to induce employersto offer, and employees to take up, direct-deposit or payroll-deduction saving. To thefullest extent possible, the arrangementwould be structured to avoid imposingcosts and responsibilities on employers.

Under our proposal, firms that do notoffer employees a qualified retirement plan,such as a defined-benefit pension, profit-sharing, or 401(k) plan, would receive atemporary tax credit if they let theiremployees use their payroll system to makepayroll-deduction contributions to IRAs.For the larger and more established smallbusinesses that would be required to offeremployees this opportunity, the tax creditwould represent a small recognition thatthe employer is being asked to institute anew procedure, albeit one that involveslittle if any out-of-pocket cost.

To help firms meet those costs, the taxcredit would be available for the first twoyears that its payroll-deposit saving

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nonresident aliens, and those who workonly a few hours a week or have notcompleted a year of service).

Thus the arrangement would be structuredto avoid, to the fullest extent possible,employer costs or responsibilities. The taxcredit would be available both to thosefirms that are required to offer payrolldeposit to all of their employees and to thesmall or new firms that are not required tooffer the automatic IRA but do so voluntarily.The intent would be to encourage, withoutrequiring, the smallest employers to participate.

For example, assume that Joe employs tenpeople in his auto body shop and does notsponsor a retirement plan for his employees.If he chooses to adopt a 401(k) orSIMPLE IRA plan, he and each of hisemployees generally can contribute up to$16,500 for a 401(k) or $11,500 for aSIMPLE each year, and the business mightbe required to make employer contributions.Joe can claim a start-up tax credit of half ofhis costs over three years, up to $500 a year.Alternatively, if Joe decides only to offerhis employees payroll deposits to an IRA,the business will not make employercontributions, and Joe can claim a tax credit foreach of the next two years of $25 for eachemployee who contributes out of his ownsalary (in this case up to the maximumautomatic IRA tax credit of $250 a year).

For many if not most employers, offeringpayroll-deposit IRAs would involve little orno cost. Unlike a 401(k) or other employer-sponsored retirement plans, the employerwould not be maintaining a plan but simplyacting as a forwarding agent for employeecontributions. Employer contributions topayroll-deposit IRAs would not be requiredor even permitted. Employers willing tomake retirement contributions for theiremployees would continue to be able to doso by sponsoring a retirement plan, such as

an SIMPLE IRA, 401(k), or pension plan.

Employer-sponsored retirement plans arethe saving vehicles of choice and should beencouraged; payroll-deposit IRAs are afallback designed for employees notfortunate enough to be covered by anactual employer retirement plan. They arealso intended to encourage more employersto decide, whether immediately oreventually, to sponsor a plan of their own.

Payroll-deposit IRAs also would minimizeemployer responsibilities. Firms would notbe required to

—Comply with plan qualification orERISA rules

—Establish or maintain a trust to holdassets (because the IRAs would receivethe contributions)

—Determine whether employees wereeligible to contribute to IRAs

—Select investments for employeecontributions;

—Select among IRA providers

—Set up IRAs for employees

Employers would be required simply toallow employees to make payroll-deductiondeposits to an IRA, with a standard noticeinforming employees of the automatic IRAsaving option and a standard form elicitingthe employee’s decision to participate oropt out. Employers would then implementdeposits elected by employees. Employerswould remit the direct deposits to theirIRA providers on the schedule they werealready following for federal payroll andwithholding tax deposits—usually biweeklyor monthly.

Thus a requirement to offer to forwardemployee contributions to an IRA by

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payroll deduction would not be onerousbut would dovetail neatly with whatemployers already do. The employee’spayroll-deposit IRA election might bemade on an attachment or addendum tothe federal income tax withholding form.Because employees’ salary reductioncontributions to IRAs would ordinarilyreceive tax-favored treatment, the employerwould report on Form W-2, the federalsalary and wage reporting form, thereduced amount of the employee’s taxablewages together with the amount of theemployee’s contribution.)

DDiirreecctt DDeeppoossiittOur proposal seeks to capitalize on therapid trend toward automated or electronicfund transfers. With the spread of new,low-cost technologies, employers areincreasingly using automated systems tomanage payroll. Many employers hire apayroll service provider to perform thesefunctions, including direct deposit ofpaychecks to accounts designated byemployees or contractors. Some keep theirpayroll-tax and related functions in housebut use readily available software or largelypaperless online means of making federaltax deposits and perhaps other fundstransfers, just as increasing numbers ofhouseholds pay bills and manage otherfinancial transactions online.

For the many firms that already offer theirworkers direct deposit, including many thatuse outside payroll providers, direct depositto an IRA would entail no additional cost,even in the short term, insofar as theemployer’s system has unused fields thatcould be used for the additional directdeposit destination. Other small businessesstill write their own paychecks by hand,complete the federal tax deposit andreporting forms by hand, and deliver themto employees and to the local bank orother depositary institution. Our proposal

would not require these employers to incurthe cost (if any) of transitioning toautomatic payroll processing or usingonline systems, although it might have thebeneficial effect of encouraging such transitions.

At the same time, we would not be inclinedto deny the benefits of payroll deductionsavings to all employees of employers thatdo not yet use automatic payroll processing(and we would not want to give smallemployers any incentive to drop automaticpayroll processing). These employeeswould benefit from the ability to savethrough regular payroll deposits at theworkplace whether the deposits are madeelectronically or by hand. Employees wouldstill have the advantages of tax-favoredsaving that, once begun, continuesautomatically, that is more likely to beginbecause of workplace enrollmentarrangements and peer groupreinforcement, and that need not cause avisible reduction in take-home pay if begunpromptly when employees are hired.

For employers that do not use automaticpayroll processing, we contemplate a three-pronged strategy. First, a large proportionof the employers that still process theirpayroll by hand would be exempted as verysmall employers. Our proposal would focuson employers that already offer theiremployees direct deposit of paychecks buthave not used that technology to provideemployees a convenient way to save forretirement.

Second, employers would have the optionof piggybacking their payroll deposits toIRAs onto their federal tax deposits. Theprocess, including timing and logistics, forboth sets of deposits would be the same.Accompanying the existing federal taxdeposit forms would be similar payrolldeposit savings forms enabling employersto send all payroll deposit savings to a single

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destination. Small employers that mail ordeliver their federal tax deposit checks andforms to the local bank would add anothercheck and form to the same mailing.

Third, the existing convenient, low-cost,online system for federal tax deposits couldbe expanded to accommodate a parallelstream of payroll-deduction saving payments.

The cost to employers making payrolldeduction savings available to their employeeswould be minimal. Employers would notbe required to make contributions or tocomply with plan qualification or federalrequirements with respect to thesearrangements. Implementing employeedecisions to participate or to opt out mightoccasionally require employers to addressmistakes or misunderstandings regardingpayroll deductions and deposit directions.The time and attention required of employerscould generally be expected to be minimizedthrough orderly communications, writtenor electronic, between employees andemployers, facilitated by the use of standardforms that piggyback on the existing IRSforms such as the W-4 used by individualsto elect levels of income tax withholding.

The requirement to offer payroll depositsto IRAs as a substitute for sponsoring aretirement plan would not apply to thesmallest firms (say, those with fewer thanten employees) or to firms that have notbeen in business for at least two years. However,even exempt firms would be encouraged toparticipate. A possible alternate approachto implementation of this program wouldbe to require payroll deposit for the first yearor two only by employers above a slightlylarger size. This tryout of the new systemcould identify improvements before broaderimplementation began.

Employees who do not work for anemployer that offers a payroll-deposit system

would be able to use other mechanisms tofacilitate saving. These include instructingthe IRS to deposit a portion of an incometax refund into an IRA, setting up anautomatic debit arrangement for IRAcontributions from employees’ bankaccounts (perhaps with the help of aprofessional or trade association), andmaking IRA contributions together withquarterly estimated tax payments.

TThhee PPrrooppoossaall ffrroomm tthhee EEmmppllooyyeeee’’ssPPeerrssppeeccttiivveeIn the case of an employer that does notsponsor a retirement plan, employeeseligible for payroll deposit savings mightbe, for example, all employees who haveworked for the employer on a regular basis(including part-time) for a specified periodof time (such as three months), whichwould exclude the highest-turnoveremployees and seasonal workers, As noted,if an employer sponsored a retirement plan,it would not be required to provide payrolldeposits to automatic IRAs unless its planexcluded a portion of the work force (suchas a division or subsidiary).

Like a 401(k) contribution, the amountelected by the employee as a salaryreduction contribution generally would betax favored. If channeled to a traditionalIRA, the contribution would be excludedfrom taxable income when it was made, butit—and whatever earnings it generated—would be taxed upon withdrawal from theIRA. A Roth IRA is quite different. Fundsdeposited into a Roth IRA are taxed, butwithdrawals—those representing earningsthat meet certain conditions as well asdeposits—are entirely tax free. The statuteauthorizing automatic IRAs could specifywhich type of IRA was the default.(Employees who did not qualify to make adeductible IRA contribution or a Roth IRAcontribution (for example, because theirincome exceeded eligibility thresholds)

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would be responsible for making theappropriate adjustment on their tax return.The firm would have no responsibility forensuring that employees satisfied theapplicable IRA eligibility requirements orcontribution limits.)

The choice between a traditional and aRoth IRA is another decision that canimpede participation. For many individuals,making this choice based on an informedand rational analysis would not be easy. Inthe interest of sparing households the needto make the decision, we strongly believethat one or the other type of IRA shouldbe automatically prescribed (with, perhaps,the choice to opt for the other). Manyhouseholds would simply go along with thestandard option, while others would try tofigure out the better alternative for them.

A reasonable case can also be made forsimply prescribing one or the other type ofIRA as the only available receptacle forcontributions to automatic IRAs. We aretentatively inclined to make the Roth IRAthe presumptive choice for automatic IRAdeposits, because the Roth may be morebeneficial for lower-income and moderate-income workers who lack sufficient taxableincome to take full advantage of the traditionalIRA tax deduction at the time of contributionbut who may expect to be in higher taxbrackets late in their careers. In addition,the Roth is often thought to be preferableby those who expect high federal budgetdeficits to eventually drive up future taxrates. All other things being equal, theRoth’s tax advantage for payouts wouldlikely be more valuable than the traditionalIRA’s tax deduction for contributions.

A number of other factors may militate infavor of defaulting to the Roth. First, formany, it comes as an unpleasant surprisethat the account balance they have accumulatedfor decades in a deductible IRA or a

traditional deductible 401(k) is worth farless than expected because it cannot bedrawn upon without losing a substantialportion to taxation. The Roth generallyavoids this unpleasant surprise, permittingthe individual to plan for retirementwithout having to adjust projected or actualsavings for an uncertain future tax bite.

Second, the Roth IRA, by producing lesstaxable income in retirement years, couldavoid exposing some individuals to a higherrate of income tax on Social Security benefitsin retirement. Third, while it is hoped thatfew participants would choose to withdrawfunds from their IRAs before they reach orapproach retirement age, those who dowithdraw from a deductible IRA not longafter contributing generally will be subjectto both income tax and a 10-percent earlywithdrawal penalty on the entire amountwithdrawn. In contrast, withdrawals from aRoth IRA within a few years after contributionsare made will not be subject to income taxor the 10-percent penalty on the withdrawalexcept to the extent that it consists ofearnings (which are likely to comprise arelatively small portion of the account ofthose who withdraw relatively soon).

Finally, the fact that all but very high-incomeemployees are eligible to contribute to aRoth IRA may make the automatic IRAprogram somewhat simpler to administerbecause virtually all of the target populationwould be eligible. Individuals saving in adeductible IRA may need to be mindful oftheir possible eligibility for a qualified planin another, concurrent job or of theirspouse’s eligibility. Some may be ineligibleto make deductible contributions butpermitted to make nondeductible contributionsto a traditional IRA, which could be viewedas an advantage or as a drawback becauseof the additional layer of complexity it entails.

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Once these decisions have been made, theindividual must still take the initiative to fillout the requisite paperwork to participate.Even in 401(k) plans, millions of employeesare deterred from participating becauseinertia prevents them from making theseimportant financial decisions or fromgetting around to enrolling.

These obstacles can be overcome by makingparticipation easier and more automatic, inmuch the same way as is being doneincreasingly in the 401(k) universe. Theemployer or other 401(k) plan sponsor setsup an account in the plan for eachparticipating employee, making a savingsvehicle ready to receive regular payrolldeductions from the employee. Once theemployee has elected to participate,deposits continue to occur automaticallyand regularly, without the need for anyaction by the employee. To get the ballrolling, an increasing percentage of 401(k)plan sponsors are using automatic enrollment.14

Automatic enrollment, which typically hasbeen applied only to newly hired employees,rather than to all nonparticipatingemployees, has produced dramaticincreases in 401(k) participation, especiallyby lower-income and minority workers.15 Inview of the basic similarities betweenemployee payroll-deduction saving in a401(k) and a direct-deposit IRA arrangement,federal law should, at a minimum, explicitlypermit employers to automatically enrollemployees in direct-deposit IRAs.16

The conditions imposed by the TreasuryDepartment on 401(k) automaticenrollment would apply to payroll-depositIRA automatic enrollment as well: allemployees who could potentially beautomatically enrolled must receive advancewritten notice (and annual notice) regardingthe terms and conditions of the savingopportunity and the enrollment, including the

AAuuttoommaattiicc IIRRAAss iinn CCoonnggrreessss::Hearings: The Automatic IRA proposal wasfeatured at a hearing of the House Subcommittee onSelect Revenue Measures held on June 26, 2008,concerning strategies for expanding pensioncoverage. See J. Mark Iwry and David C. John,"Pursuing Universal Retirement Security ThroughAutomatic IRAs," Testimony before SelectRevenue Measures Subcommittee of theCommittee on Ways and Means, United StatesHouse of Representatives (June 26, 2008) availableat www.retirementsecurityproject.org.

Bill: The automatic IRA proposal was introducedin the 109th Congress as the "Automatic IRA Actof 2006" (S. 3952) by Senators Jeff Bingaman (D-N.M.) and Gordon Smith (R.-Ore.), cosponsoredby Senator John Kerry (D-Mass.); as sections 101-104 of S. 3951 sponsored by Senators Smith,KentConrad (D-N. Dak.) and Bingaman, cosponsoredby Senator Kerry; and as H. 6210 sponsored byRep. Phil English (R.-Pa.).

In addition, another bill that takes an approachthat is very similar to most aspects of ourproposal has been introduced by the Chairman ofthe Senate Finance Committee, Senator MaxBaucus (D.-Mont.), S. 2431 (109th Cong., 2dSess.).

TThhee AAuuttoommaattiicc IIRRAAEven if employers were required to offerdirect deposit to IRAs, variousimpediments would prevent many eligibleemployees from taking advantage of theopportunity. To save in an IRA, individualsmust answer at least five key and oftenthorny questions:

—Should they participate at all?

—At which financial institution shouldthey open an IRA (or, if they have anIRA already, should they add to it oropen a new one)?

—Should the IRA be a traditional or a Roth?

—How much should they contribute?

—How should they invest their IRA money?

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procedure for opting out, and all employeesmust be able to opt out at any time.

It is not at all clear, however, whethersimply allowing employers to use automaticenrollment with payroll deposit IRAswould prove effective. A key motivationfor using it in 401(k) plans is to improvethe plan’s performance under the 401(k)nondiscrimination test by encouragingmoderate- and lower-paid (“non-highlycompensated”) employees to participateand to contribute as much as possible.That in turn increases the permissible levelof tax-preferred contributions for highlycompensated employees. This employerself-interest is absent from payroll-depositIRAs, which lack nondiscrimination standards.

Similarly, the absence of such standards inpayroll-deposit IRAs gives the employerless incentive than a 401(k) sponsor toprovide automatic increases in the initialcontribution rate. Gradual automaticincreases in 401(k) contribution rates havebeen found to make automatic 401(k)enrollment more effective. The automaticcontribution rate can increase, unless theemployee opts out of the increase, eitheron a regular, scheduled basis, such as 4percent of salary in the first year, 5 percentin the second, and so forth, or incoordination with future pay raises.17

A second major motivation for using401(k)-style automatic enrollment in manycompanies is management’s sense ofresponsibility or concern for employees’retirement security. Many executivesinvolved in managing employee plans andbenefits have opted for automaticenrollment and other automatic 401(k)features (such as asset-allocated defaultinvestments) because they believe far toomany employees are saving too little andinvesting unwisely and need a strong pushto “do the right thing.” Closely allied to

this motivation is the employer’s interest inrecruiting and retaining valuable employees.

There is reason to believe, however, thatemployers impelled by these interests tendto be those that have already chosen tosponsor a 401(k) or other retirement plan.By contrast, those that have not sponsoreda plan are more likely to be among thegroup of employers that have a morelaissez-faire approach. These include manysmaller employers that may not feel thatencouraging employees to save is their role.Some may offer health insurance, and bothemployees and employer might regardcontributions to employees’ share of healthpremiums as a higher-priority use foremployees’ limited resources than retirementsaving contributions, especially in view ofthe rising cost of health insurance.

Third, in the case of payroll-deposit IRAs,employers might have greater concernabout potential employee reaction toautomatic enrollment because there is noemployer matching contribution. With401(k) plans, the employer match gives theappearance of a high rate of return on theemployees’ investment. That gives confidenceto 401(k) sponsors that automatic enrollmentdoes right by their employees and that theyneed not worry unduly about potentialcomplaints from workers who fail to readthe notice informing them that they wouldbe automatically enrolled unless they opted out.

On the other hand, some employers mightbe more inclined to use automaticenrollment with payroll-deposit IRAsbecause greater employee participationwould not increase the employer’smatching costs. In addition our proposalprovides that the amount of the two-yeartax credit for employers using automaticIRAs would rise with the number ofemployees participating.

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A good case can be made for requiring,rather then merely allowing, employers touse automatic enrollment and automaticcontribution increases for their direct-depositIRAs. Automatic enrollment would probablyincrease participation sharply while leavingemployees the option to decline enrollment.But employers that do not offer a qualifiedplan or a match are unlikely to useautomatic enrollment voluntarily.

The arguments against such a requirementinclude the concern that a workforce whosedemand for a qualified retirement plan wastoo weak to get one might react unfavorablyto being automatically enrolled in directdeposit savings without a matchingcontribution. In addition, some small-businessowners who have only a few employeesand work with all of them every day mightregard automatic enrollment as unnecessarybecause of the constant flow of communicationbetween owner and employees.

It is noteworthy, however, that publicopinion polling shows strong supportamong registered voters for making savingautomatic: 71 percent of respondentsfavored automatic enrollment, investment,and contribution increases, with theopportunity to opt out at any stage.18 Avast majority (85 percent) said that if theywere automatically enrolled in a 401(k),they would not opt out. And 59 percentpreferred a workplace IRA with automaticenrollment to one without.

AAuuttoo EEnnrroollllmmeenntt oorr RReeqquuiirreedd RReessppoonnssee..Short of automatic enrollment in an IRA,employees could be required to explicitlyaccept or decline enrollment in an IRA.With 401(k) plans, evidence suggests thatthis approach can raise participation nearlyas much as automatic enrollment does.Requiring an explicit choice picks up manywho would otherwise fail to participatebecause they did not complete and return

the enrollment form either because theycould not decide on contribution levels orinvestments or because they just did notget around to it.

Accordingly, a possible strategy forincreasing participation in payroll-depositIRAs would be to generally requireemployers to obtain written or electronicnotification from each eligible employee—an explicit up-or-down election—eitheraccepting or declining the direct deposit toan IRA. Employers that chose to enrolltheir employees in the direct deposit IRAsautomatically would be excused from therequirement because all employees whofailed to elect would automatically participate.

What if an employer that opted for this up-or-down election procedure was unable forsome reason to obtain an election from aparticular employee? Under our approach,the employer would inform the employeethat failure to respond would lead toautomatic enrollment at the specifiedautomatic contribution rate and in thespecified investment and would give theemployee a final election opportunity.

This might be viewed as tantamount torequiring all employers to use automaticenrollment. After all, it carries out what isarguably the primary function of automaticenrollment: ensuring that mere inertia,procrastination, or indecision does notkeep anyone from participating. However,an up-or-down election procedure may notframe the choice for the employee in amanner that tilts in favor of participation,does not convey the same implicitemployer endorsement of participation thatautomatic enrollment does, and does notnecessarily steer individuals to an automaticcontribution rate and investment because itdoes not frame the choice around apresumptive package unless employeesinitially fail to elect.

PPuubblliicc ooppiinniioonn ppoolllliinngg

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aammoonngg rreeggiisstteerreedd vvootteerrss

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aauuttoommaattiicc......5599 ppeerrcceenntt

pprreeffeerrrreedd aa wwoorrkkppllaaccee IIRRAA

wwiitthh aauuttoommaattiicc eennrroollllmmeenntt

ttoo oonnee wwiitthhoouutt..

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This exemption—treating an employer’suse of automatic enrollment as analternative means of satisfying its required-response obligation—would add anincentive for employers to use automaticenrollment without requiring them to useit. Any firms that preferred not to useautomatic enrollment would simply obtaina completed election form from eachemployee. And under either approach,participation would likely increasesignificantly, perhaps even approaching thelevel that might be achieved if automaticenrollment were required for all payroll-deposit IRAs.

This combined strategy for promotingpayroll-deposit IRA participation could beapplied separately to new hires and existingemployees. An employer that automaticallyenrolled new hires would be exemptedfrom obtaining completed elections fromall new hires but not from existingemployees. An employer that automaticallyenrolled both new hires and existingemployees would be excused from havingto obtain elections from both groups.

Employers would not be obligated toobtain a new election from each employeeevery year. As in most 401(k) plans, theinitial election would continue unless theemployee chose to change it. Similarly, anemployee who failed to submit an electionform and was automatically enrolled bydefault in the payroll-deposit IRA wouldcontinue to be enrolled until the employeetook action to make an explicit election.

After some period of time, however,employees could be offered automaticincreases in their automatic IRA contributionrates, on terms similar to those applicableto the initial automatic contributions.Employers would be able to use flexibleautomatic enrollment with respect to theseincreases, either obtaining an election

regarding increases from each employee orproviding that employees who did notsubmit elections would be deemed to haveelected to increase their automatic IRAcontributions at a specified gradual rate.

To maximize participation, employerswould receive a standard enrollmentmodule reflecting current best practices inenrollment procedures. A national websitewould provide firms with standardemployee notice and election forms as wellas standard enrollment procedures. Thewebsite and the fallback automatic IRAplatform would promote employeeeducation and best practices as theyevolved, such as automatic enrollment and,potentially, automatic annuitization.Especially with the decline of traditionaldefined benefit pension plans, the need isincreasing for readily available, low-cost,guaranteed lifetime income—and forinnovative ways of delivering it—inindividual account saving vehicles. Thefallback automatic IRA account wouldprovide a national platform that couldfacilitate innovation and development ofannuity products suitable for IRAs andother account-based retirement vehicles.

The use of automatic enrollment would beencouraged in several ways. First, thestandard materials provided to employerswould be framed to present autoenrollment as the presumptive or perhapseven the default enrollment method,although employers would be able to optout easily in favor of simply obtaining anup-or-down response from all employees.In effect, such a “double-default” approachwould use the same principle at both theemployer and employee level, automaticallyenrolling employers into automaticallyenrolling employees.

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Second, as noted above, employers usingautomatic enrollment to promoteparticipation would not need to obtainresponses from unresponsive employees,and the ultimate outcome for an employeewho failed to submit a required electionwould be automatic enrollment. Finally, theemployer tax credit would give employers amodest incentive to encourageparticipation, which auto enrollment islikely to do.

CCoommpplliiaannccee aanndd EEnnffoorrcceemmeenntt..Employers’ use of the required elections byemployees would help solve an additionalproblem: enforcing compliance with therequirement that employers offer direct-deposit savings. As a practical matter, manyemployers might question whether the IRSwould ever really be able to monitor andenforce such a requirement. Employersmight believe that, if asked by the IRS whynone of its employees used direct-depositIRAs, they could respond that theiremployees were told about the option butwere not interested. However, if employershad to obtain a signed election from eacheligible employee who declined the payroll-deposit option, the IRS could audit theirfiles for each employee’s election. This byitself would likely improve compliance.

In fact, a single paper or e-mail notice couldadvise the employee of the opportunity toengage in payroll-deduction savings andelicit the employee’s response. The noticeand the employee’s election might be addedor attached to the IRS tax-withholdingform that new hires must complete. If theemployer chose to use automatic enrollment,the notice would also inform employees ofthat feature (including the automaticcontribution level and investment and theprocedure for opting out), and the employer’srecords would need to show that employeeswho failed to submit an election were in factparticipating in the payroll-deduction savings.

Employers would be required to certifyannually to the IRS that they were incompliance with the payroll-deposit savingsrequirements. This might be done inconjunction with the existing IRS Form W-3that employers file annually to transmit W-2forms to the government. Failure to offerpayroll-deposit savings would, if necessary,trigger an excise tax on the employer foreach employee affected by the violation.This sanction would be less than the oneemployers face if they violate the federalrequirement (known as COBRA) to offercertain employees who lose their healthbenefits to continue their coverage, andwould be subject to exceptions andopportunities for mitigation and relief thatare generally based on the correspondingCOBRA exceptions.

In addition, employees would be protectedfrom an employer’s failure to remit employeepayroll-deduction contributions by a complianceand enforcement regime substantially similarto the one that applies to an employer’sfailure to remit payroll tax deductions.

IRAs are inherently portable. Unlike a401(k) or other employer plan, an IRAsurvives and functions independently ofthe individual saver’s employment status.Thus the IRA owner is not at risk offorfeiting or losing the account or ofsuffering an interruption in the ability tocontribute when changing or losingemployment. As a broad generalization, theautomatic IRAs outlined here presumablywould be freely transferable to and withother IRAs and qualified plans that permitsuch transfers, although, as discussedbelow, there may be a need for somerestrictions on those transfers.

HHooww TThheeyy WWoouulldd IInnvveessttMost current direct deposit arrangementsuse a payroll-deduction savings mechanismsimilar to the 401(k); unlike the 401(k),

IIRRAAss aarree iinnhheerreennttllyy

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however, the employee does not have aready-made vehicle or account to receivedeposits. The employee must open arecipient account and must identify theaccount to the employer. However, wherethe purpose of the direct deposit is saving,it would be useful to many individuals whowould rather not choose a specific IRA tohave a ready-made fallback or defaultaccount available for the deposits.

Under this approach, modeled after theSIMPLE IRA, which currently is estimatedto cover some 3 million employees,individuals who wish to direct theircontributions to a specific IRA would doso. The employer would follow thesedirections as employers ordinarily do whenthey make direct deposits of paychecks toaccounts specified by employees. At thesame time, the employer could simplify itstask by remitting all employee contributionsin the first instance to IRAs at a singleprivate financial institution that theemployer designates.19 However, even inthis case, employees would be able totransfer the contributions, without cost,from the employer's designated financialinstitution to an IRA provider chosen bythe employee.

By designating a single IRA provider toreceive all contributions, the employercould avoid the potential administrativehassles of directing deposits to a multitudeof different IRAs for different employees,while employees would be free to transfertheir contributions from the employer’sdesignated institution to an IRA providerof their own choosing. Even this approach,though, still places a burden on either theemployer or the employee to choose anIRA. For many small businesses, the choicemight not be obvious or simple. Inaddition, the market may not be veryrobust because at least some of the majorfinancial institutions that provide IRAs may

well not be interested in selling newaccounts unless they seem likely to growenough to be profitable within a reasonabletime. Some of the major financial firmsappear to be motivated at least as much bythe objective of maximizing the averageaccount balance as by the goal ofmaximizing aggregate assets undermanagement. They therefore may shunsmall accounts.

The current experience with automaticrollover IRAs is a case in point. Firms arerequired to establish these IRAs as a defaultvehicle for 401(k) and other qualified planparticipants whose employment terminateswith an account balance of not more than$5,000 and who fail to provide any directionregarding rollover or other payout. Theobjective is to reduce leakage of benefitsfrom the tax-favored retirement system bystopping involuntary cash-outs of accountbalances between $1,000 and $5,000.20Because plan sponsors are required to setup IRAs only for “unresponsive”participants—those who fail to giveinstructions as to the disposition of theirbenefits—these IRAs are presumed to beless likely than other IRAs to attractadditional contributions. Accordingly,significant segments of the IRA providerindustry have not been eager to cater tothis segment of the market.

Automatic IRAs differ importantly fromautomatic-rollover IRAs, however. Even ifthey start small, they are likely to experiencecontinuing growth. In contrast toautomatic-rollover IRAs, whose ownershave failed to respond to the plan sponsor’snotices, there is no reason to expectautomatic IRA owners generally to beunresponsive or unlikely to continuecontributing. Accordingly, the automaticIRAs hold much more promise forfinancial providers.

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In addition, to benefit the financialinstitutions that serve as IRA trustees andcustodians, the fallback automatic IRAarrangement outlined below mightultimately serve as both a source ofrollovers to the financial services industryand a potential receptacle for their smalland inactive or orphan IRAs. The pathbetween industry and a collective standardIRA arrangement could be a two-waystreet. Pursuant to appropriate standards,IRA providers might be given theopportunity to “dump” a certain numberof very small IRAs that are unprofitablebecause they have been inactive (notreceiving contributions) for an extendedperiod (in some cases, because the owner isdeceased). These IRAs could be transferredto the central arrangement, which couldserve as a low-cost incubator of smallinactive accounts. At the same time,owners of IRAs within the arrangementthat have grown to a profitable size couldroll them over to private-sector providers.

AA SSttaannddaarrdd AAuuttoommaattiicc AAccccoouunnttThe prospect of tens of millions of relativelysmall personal retirement accounts with alikelihood of relatively meager growthsuggests that the market might need to beencouraged to develop widely available,low-cost IRAs. Otherwise, for small savers,fixed-cost investment management andadministrative fees might consume anunacceptably large share of earnings andeven erode principal.21

We believe that a strong case can be madefor a standard IRA that would be automaticallyavailable to receive direct-deposit contributionsafter either the employee or the employerhad a chance to choose among IRAproviders. We recognize, however, thatsome geographic areas or small businesssegments may be underserved by locallyavailable IRA providers. For that reason,we propose that one of two national

platforms be made available to any smallbusiness that has trouble finding anacceptable IRA.

The first and preferable approach would bethe creation of at least one national websitethat could match employers with IRAproviders interested in their business.Employers that went to the site wouldenter in basic information about theircompany and its workforce, and the sitewould connect the firm to providers willingto provide IRAs to the firm’s employees.Ideally, the site would then allow theemployer to set up accounts and a methodto transfer IRA contributions from itsemployees to their auto IRAs.

However, if it proved impossible to findIRA providers interested in serving allsmall employers that are required to offerauto IRAs to their employees, then (andonly then) the contributions would go tostandard IRAs in a platform maintainedand operated by private financialinstitutions under contract with the federalgovernment. To the fullest extent practicable,the private sector would provide the investmentfunds, investment management, record-keeping, and related administrative services.

Although this arrangement resembles thefederal Thrift Savings Plan (the 401(k)-typeretirement savings plan for federalgovernment employees) in certain respects,a standard account to receive direct depositsthat have not been directed elsewhere byemployers or employees need not bemaintained by a governmental entity. Givensufficient quality control and adherence toreasonably uniform standards, various privatefinancial institutions could contract toprovide the default accounts, on a collectiveor individual institution basis, more or lessinterchangeably—perhaps allocating customerson a geographic basis or in accordance withother arrangements based on providers’

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capacity. These fund managers could beselected through competitive bidding. Onceindividual standard accounts reached apredetermined balance (say, $15,000) sufficientto make them potentially profitable formany private IRA providers, accountowners would have the option to transferthem to IRAs of their own choosing.

CCoosstt CCoonnttaaiinnmmeennttBoth the direct-deposit IRAs expresslyselected by employees and employers andthe standardized direct-deposit IRAs wouldbe designed to minimize the costs ofinvestment management and accountadministration. It should be possible torealize substantial cost savings througheconomies of scale in asset managementand administration, uniformity, electronictechnologies, and investments in indexfunds or other low-cost funds.

In accordance with statutory guidelines forall direct-deposit IRAs, government contractspecifications would call for a no-frillsapproach to participant services in the interestof minimizing costs. By contrast to thewide-open investment options provided inmost current IRAs and the high (andcostlier) level of customer service providedin many 401(k) plans, the standard accountwould provide only a few investmentoptions (patterned after the Thrift SavingsPlan and possibly more limited). It wouldpermit individuals to change their investmentsonly once or twice a year and wouldemphasize transparency of investment andother fees and other expenses.22

Specifically, costs of direct-deposit IRAsmight be reduced by federal standards by,to the extent possible,

—Limiting the investment menu under theIRA to a standard default investmentand only two or three alternatives

—Allowing individuals to change theirinvestments only once or twice a year

—Specifying a low-cost automaticinvestment option and providing that, ifany of an individual's account balance isinvested in that option, all of it must be

—Prohibiting loans from the employee account(IRAs do not allow them in any event)

—Limiting, perhaps, pre-retirementwithdrawals

—Limiting access to customer service callcenters

—Contemplating moderate fees instead oflarge commissions

—Making compliance testing unnecessary

—Giving account owners only a singleaccount statement a year (especially if dailyvaluation is built into the system and suchvaluation reports are available throughsome other means to account owners)

—Encouraging the use of online, electronic,and other new technologies for enrollment,fund transfers, record-keeping, andcommunications among IRA providers,participating employees, and employers.Electronic administration has considerablepotential to cut costs.

The availability to savers of a major low-costpersonal account alternative in the form ofthe standard account may even help, throughmarket competition, to drive down the costsand fees of IRAs offered separately by privatefinancial institutions. Through efficienciesassociated with collective investment and greateruniformity, the standard account should helpmake smaller accounts more feasible by creatinga low-cost alternative to the retail-type coststructure characteristic of current IRAs. Itshould also help create a broad infrastructureof individual savings accounts that wouldcover most of the working population.23

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In conjunction with these steps, Congressand the regulators may be able to do moreto require simplified, uniform disclosureand description of IRA investment andadministrative fees and charges by buildingon previous work by the Labor Departmentand trade associations relating to 401(k)fees. Such disclosure should help consumerscompare costs and thereby promotehealthy price competition.

Another approach would begin by recognizingthe trade-off between asset managementcosts and investment types. As a broadgeneralization, asset management chargestend to be low for money market funds,certificates of deposit, Treasury bonds, andcertain other relatively low-risk, low-returninvestments that generally do not requireactive management. However, it appearsthat limiting individual accounts to thesetypes of investments, at least over the longterm, would be unnecessarily restrictive. Asdiscussed below, passively managed indexfunds such as those used in the ThriftSavings Plan are also relatively inexpensive.24

A very different approach to cost containmentwould be to impose a statutory or regulatorylimit on investment management andadministrative fees. One example is theUnited Kingdom’s limit on permissible chargesfor management of “stakeholder pension”accounts—an annual fee cap of 150 basispoints for five years that is scheduled todrop to 100 basis points thereafter.25 Anotherexample is the limit the U.S. Labor Departmenthas imposed on fees charged by providersof automatic-rollover IRAs established byemployers for terminating employees whofail to provide any direction regarding thedisposition of account balances of up to$5,000. These labor regulations provide afiduciary safe harbor for these IRAs thatpreserves principal and that does notcharge fees greater than those charged bythe IRA provider for its other IRAs.

Presumably, a mandatory limit would giverise to potential cross-subsidies fromproducts that are free of any limit on feesto the IRAs that are subject to the fee limit,a result that could be viewed either as aninappropriate distortion or as a necessaryand appropriate allocation of resources.The U.K. cost cap is widely considered tobe a major reason for the failure ofstakeholder pensions to attract supportfrom financial firms. It could have a similarimpact in the United States. We wouldview a mandatory limit as a last resort,preferring the market-based strategiesoutlined above.

AAuuttoommaattiicc IInnvveessttmmeenntt FFuunndd CChhooiicceeAutomatic IRAs would serve the importantpurpose of providing low-cost professionalasset management to millions of savers,presumably improving their aggregateinvestment results. To that end, all of theseaccounts would offer an automaticinvestment fund for all deposits unless theindividual chose otherwise. The standardautomatic investment would serve severalkey purposes. First, it would encourageemployee participation in direct-depositsavings by enabling employees who aresatisfied with the default to simplify whatmay be the most difficult decision theywould otherwise be required to make as acondition of participation—how to invest.Second, the automatic investment shouldencourage more employers to useautomatic enrollment (and thereby boostemployee participation) by saving themfrom having to choose a standardinvestment. This, in turn, would make iteasier to protect employers fromresponsibility for IRA investments,especially employers using automaticenrollment (as discussed below).

We would not fully specify the automaticinvestment by statute. It is desirable tomaintain a degree of flexibility in order to

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reflect a consensus of expert financialadvice over time. The advisability of suchan approach has become more evident inview of the nearly unprecedented fall inequity values and worldwide recession in2008–09, which has sparked freshdifferences of opinion concerning theprospects for realizing an “equitypremium” over medium- and longer-termtime horizons and the extent to which itmay be advisable to invest retirement fundsin diversified equities or in investments thatemphasize minimization of risk. Whateverone’s views on the merits of these issues,the fact that many 401(k) and IRAparticipants have seen a decade worth ofgains evaporate during the past year hasmade many U.S. households far more riskaverse than they were before the recession,leading to a general loss of confidence. Atleast for some time to come, many may bereluctant to contribute to an automatic IRAarrangement that does not guarantee areturn of principal. Accordingly, generalstatutory guidelines would be fleshed out atthe administrative level after regularcomment by and consultation with private-sector investment experts.26

At least initially, we contemplate that thisautomatic investment choice would be ahighly diversified “target asset allocation”or life-cycle fund comprising a mix ofequities and fixed-income or stable-valueinvestments and probably relying heavilyon index funds or other low-costalternatives. (The life-cycle funds that areoffered by the federal Thrift Savings Planare one possible model.) A portion or all ofthe fixed-income component could consistof Treasury inflation-protected securities(TIPS) to protect against the risk of lossand inflation.

The mix of diversified equities and fixedincome would be designed to reflect a degreeof consensus among personal investment

advisers for sound asset allocation anddiversification of investments, includingexposure to equities and perhaps otherassets that have higher risk and greaterpotential return. This strategy recognizesthe foundation of retirement incomealready provided by Social Security andwould apply to IRAs that will not shortlybe needed for expenses. The use of indexfunds would be one way to avoid the costsof active investment management whilepromoting wide diversification.27

This automatic investment would actuallyconsist of several different funds, dependingon the individual’s age, with the moreconservative investments (such as thoserelying more heavily on TIPS) applicable toolder individuals who are closer to the timewhen they might need to use the funds.Individuals who selected the automaticfund or whose contributions wereautomatically placed into it would havetheir account balances entirely invested inthat fund. However, they would be free toswitch at specified times to a differentinvestment option among those offeredwithin the IRA.

A variation on the automatic investmentfund may be worth considering. A temporaryguarantee of principal—as might beprovided by a bond similar to a Treasurysavings bond or TIPS—might ease somehouseholds, especially those that have noinvestment experience, into the process ofsaving and investing. Behavioral researchhas produced evidence that many smallersavers—the 2008–09 market downturnaside—are particularly averse to losses ofprincipal and weigh the risk of loss farmore heavily than the prospect of gain.

On the other hand, a “safe” investment,with no risk of loss but no significantpotential for growth over time, raisesconcerns about the adequacy of the likely

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long-term accumulation. Some evidencesuggests that favorable investment returnsover the long term are attributable not somuch to successful selection of individualstocks or other investments but tojudicious asset allocation—an appropriatelybalanced and diversified mix of asset typesand classes (including substantial exposureto diversified equities or other assets withgrowth potential) that have risk characteristicsdesigned to be uncorrelated with oneanother.28 Accordingly, we contemplate thatthe automatic investment could take theform of a balanced “asset-allocated” fundeither from the start or after a limitedtransition period, while giving risk-averseindividuals the ability to choose a principal-preserving investment as an alternative.

Another intriguing possibility might be tooffer a variation on the life-cycle fund thatguarantees that the investor will not losemoney on a nominal or even a partlyinflation-adjusted basis. This variation wouldbe intended to help induce participation bythose who are risk-averse but still hope forgrowth. The key question would be theextent of the limitation on the upsidepotential of the investment that would berequired by a guarantee of principal.

Yet another possibility worth exploringwould be the inclusion of some form ofannuity purchase as part of the life-cyclefund, perhaps as a replacement for thebond component. This option would allowsavers to ensure that their accounts couldprovide some level of guaranteed lifetimeincome, thus helping to address longevityand investment risks, regardless of the risesand falls of the stock market and of interestrates. Because balances in automatic IRAare likely to be smaller on average thanbalances in 401(k) plans, annuity purchasesmight have to be phased in as the accountgrew, or perhaps balances could be

transferred at regular intervals from thebond component into an annuity. Othertechnical and policy questions, such asportability of such annuities, would need tobe examined before such an approachcould be fully recommended.29

Certain IRA savers will have lower-than-average earnings and thus fairly lowbalances in their accounts. These accountswill be both less attractive to IRAproviders and more likely to be seriouslyeroded by administrative fees. A potentialstrategy for handling these low balanceswould be to place them in a short-termtransitional guaranteed investment, such asa government bond or a bank certificate ofdeposit (CD), until balances reached aspecified level, at which point they wouldbe automatically transferred into thestandard automatic investment option.

The transition account could be either astandard bank savings or short-term CDaccount, or it could begin as a principal-preservation fund in much the same waythat the federal Thrift Savings Plan beganwith the G (government securities) Fund.30In either case, the account would includethe same early withdrawal disincentives asany other IRA account. When the accountbalance reached a specified level, it wouldbe automatically rolled over into thestandard automatic investment option, withall future contributions going directly intothat standard option.

OOtthheerr IInnvveessttmmeenntt OOppttiioonnssAn additional, major design issue iswhether the standard, limited set ofinvestment options for payroll-depositIRAs should be only a minimum set ofoptions in each IRA, allowing the IRAprovider to offer any additional options itwished. Limiting the IRAs to thesespecified options would best serve thepurposes of containing costs, improving

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investment results for IRA owners in theaggregate, and simplifying individuals’investment choices. Behavioral researchhas suggested that eligible employees orother consumers who are confronted withnumerous choices often tend to avoid thedecision (here, participation in saving) orrevert to relatively arbitrary decision rules.31At the same time, such restrictions wouldconstrain the market, potentially limitinnovation, and limit choice for individualswho prefer other alternatives.

One of the ways to resolve this trade-offwould be to limit the prescribed array ofinvestment options to the “backstop”automatic IRAs, in which individualswould invest when neither the employeenor the employer had affirmatively electedanother IRA. While all automatic IRAswould be required to offer the defaultinvestment, the only ones constrained tooffer the limited list of other fund optionswould be the “backstop” automatic IRAs.Alternatively, all automatic IRAs could bemade subject to the limited list ofinvestment alternatives in addition to thedefault option.

In either case, no comparable limits wouldbe imposed on other IRAs, and owners ofthe default IRAs or all payroll-depositIRAs would be able to transfer or roll overtheir account balances between the variousclasses of accounts. Under this approach,the owner of an automatic or payroll-depositIRA could transfer the account balance toother unrestricted IRAs that were willing toaccept such transfers (but perhaps onlyafter the account balance reached a specifiedamount deemed sufficient to overcomeprofitability concerns for most IRA providers).While a system that permitted transfers toan unrestricted IRA would deprive theowner of the cost-saving advantages of theno-frills, limited-choice model, such asystem would still leave individuals free not

to make such a transfer and instead toretain the efficiencies and cost protectionassociated with the standard low-cost model.32

PPrrootteeccttiinngg EEmmppllooyyeerrssEmployers traditionally have been particularlyconcerned about the risk of fiduciaryliability associated with their selection ofretirement-plan investments. This concernextends to the employer’s designation ofdefault investments that employees are freeto decline in favor of alternative investments.In the IRA universe, employers transferringfunds to automatic-rollover IRAs andemployer-sponsored SIMPLE IRAs retaina measure of fiduciary responsibility forinitial investments.

By contrast, under our proposal, employersmaking direct deposits would be insulatedfrom such potential liability or fiduciaryresponsibility for the manner in whichdirect deposits are invested in automaticIRAs, regardless of whether the IRAprovider is selected by the employer or theemployee. Nor would employers be exposedto potential liability with respect to anyemployee’s choice of IRA provider or typeof IRA. This employer protection would befacilitated by regulatory designation ofstandard investment types, an approachthat would reduce the need for continuousprofessional investment advice.

ERISA protects plan fiduciaries fromliability for losses that result directly fromemployees’ investment choices. LaborDepartment regulations, in accordance withthe 2006 Pension Protection Act, extendedthis protection from fiduciary liabilityunder ERISA to certain types of employer-chosen investments that employees selectby default, without making an affirmativeelection. Regulatory designation of a life-cycle or balanced fund as the defaultinvestment for automatic IRAs would beconsistent with these ERISA fiduciary

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iinn aauuttoommaattiicc IIRRAAss,, rreeggaarrddlleessss

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regulations, which extend this type offiduciary protection to default life-cyclefunds, balanced funds and professionallymanaged accounts. The regulatory approachto the design of the automatic-IRA defaultinvestment could reflect any modificationsto these ERISA fiduciary regulations.

In addition, employers providing payroll-depositIRAs would be able to avoid fiduciaryresponsibility even for the selection of anIRA provider for their employees either byallowing each employee to designate apreferred provider or by specifying thegovernment-contracted default automaticIRA. An employer that wished to choosethe IRA provider for its employees wouldbe responsible for doing so prudently.Another possible alternative would be forthe regulators to specify an approved list ofproviders (based on capital adequacy,financial soundness, and other criteria)from which employers could choose if theywished to have another means of avoidingany fiduciary responsibility.

Public opinion polling has shown overwhelmingsupport for payroll-deduction, direct-depositsaving. Among workers surveyed in 2007who would be eligible for an automaticIRA, 86 percent said that it would be auseful way to save, and 83 percent foundthe proposal easy to understand.33

Another poll shows very strong supportfor a requirement that every company offerits employees some kind of retirementplan, such as a pension or 401(k), or atleast an IRA to which employees couldcontribute. Among registered voters surveyedin August 2005, 77 percent supported sucha requirement (and 59 percent respondedthat they were “strongly” in support).34

PPrrootteeccttiinngg EEmmppllooyyeerr PPllaannss.. Employer-sponsored pension, profit-sharing, 401(k),and other plans tend to be far more effectivethan IRAs in accumulating benefits for

employees. For one thing, pension andprofit-sharing plans, for example, arefunded by employer contributions that aremade automatically for the benefit ofeligible employees without requiring theemployees to take any initiative toparticipate. For another, essentially all tax-qualified employer plans must abide bystandards that either seek to requirereasonably proportionate coverage of rank-and-file workers and management or givethe employer a distinct incentive toencourage widespread participation byemployees. This encouragement typicallytakes the form of both employer-providedretirement savings education efforts andemployer matching contributions. Theresult is that the naturally eager savers, whotend to be in the higher tax brackets, tendto subsidize or bring along the naturallyreluctant savers in the lower brackets.

Employer-sponsored retirement plans alsohave other features that tend to make themeffective in providing or promotingcoverage. And our proposal seeks totransplant some of these features to theIRA universe. These include the automaticavailability of a saving vehicle, the use ofpayroll deductions, matching contributions(which could be provided by the saver’scredit, especially if expanded as proposedelsewhere), professional investmentmanagement, and peer groupreinforcement of saving behavior.

Our approach to providing for payrolldeposit contributions to IRAs is thereforedesigned carefully to avoid competing withor crowding out employer plans such aspension, profit sharing, 401(k), or SIMPLEplans. Business owners and others whocontrol the decision whether to adopt ormaintain a retirement plan for employeesshould continue to have incentives tosponsor such plans, which require thatcoverage for lower-income workers be

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IIRRAA,, 8866 ppeerrcceenntt ssaaiidd tthhaatt

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proportionate, to some degree, to coveragefor highly-paid employees. Payroll-deduction direct-deposit savings asenvisioned here would promote wealthaccumulation for retirement by filling inthe coverage gaps around employer-sponsored retirement plans. Moreover, asdescribed below, the arrangements wepropose are designed to set the stage forsmall employers to graduate from offeringpayroll deduction to sponsoring actualretirement plans.

Probably the single most importantprotection for employer plans is to setmaximum permitted contribution levels tothe automatic IRA so that they will besufficient to meet the demand for savingsby most households but not high enoughto satisfy the appetite for tax-favoredsaving of business owners anddecisionmakers. The average annualcontribution to a 401(k) plan by a non-highly compensated employee is less than$3,000 (7.5 percent of pay for a $40,000-a-year family, and 6 percent of pay for a$50,000-a-year family), and average annual401(k) contributions by all employees areon the order of 7 percent of pay.35

IRA contribution limits are already higherthan these contribution levels. Accordingly,at the most, payroll-deposit IRAs shouldnot permit contributions above the currentIRA dollar limits and could be limited to alower amount such as $3,000. (Only atincomes of $100,000 or more wouldemployees who contributed 3 percent ofpay bump up against such a ceiling.)Imposing a lower limit on the payroll-deduction IRA would reduce to somedegree the risk that employees wouldexceed the maximum IRA dollarcontribution limit because of automaticenrollment and possible othercontributions to an IRA.36 That is already arisk under current law, but automatic

enrollment increases the risk, especially incombination with automatic escalation ofcontributions. There is a trade-off betweenthe desirability of limiting the contributionamount (to reduce both this risk and thedanger of competing with employer plans)and the simplicity of using an existingvehicle (the IRA) “as is.”

In any event, employees, not employers,would be responsible for ensuring that alltheir IRA contributions comply with themaximum limit. The ultimate reconciliationwould be made by the employees in theirfederal income tax returns.

In addition, the automatic IRA is designedto avoid reducing ordinary employees’incentives to contribute to employer-sponsored plans such as 401(k)s. Ifworkers perceived a direct-deposit savingsto IRAs to be more attractive than anemployer-sponsored plan (for example,because of tax treatment, investmentoptions, or liquidity), they could bediverted from employer plans. This in turncould have a destabilizing effect by makingit difficult for employers to meet thenondiscrimination standards applicable to401(k)s and other plans and thereforepotentially discouraging employers fromcontinuing the plans or their contributions.

PPrroommoottiinngg EEmmppllooyyeerr PPllaannss.. Ourapproach is designed not only to avoidcausing any reduction or contraction ofemployer plans, but actually to promote them.Consultants, third-party administrators,financial institutions, and other planproviders could be expected to view thisproposal as providing a valuable newopportunity to market 401(k)s, SIMPLEIRAs, and other tax-favored retirementplans to employers. Firms that, under thisproposal, were about to begin offeringtheir employees payroll-deduction saving orhad been offering their employees payroll-

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deduction saving for a year or two could beencouraged to “trade up” to an actual plansuch as a 401(k) or SIMPLE IRA.

Especially because these plans can now bepurchased at very low cost, it would seemnatural for many small businesses tograduate from payroll-deduction savingsand complete the journey to a qualifiedplan in order to obtain the added benefitsin terms of recruitment. The results couldinclude improved employee relations andlarger tax-favored saving opportunities forowners and managers. Table 4-1 comparesthe maximum annual tax-favoredcontribution levels for IRAs, SIMPLE IRAplans. and 401(k) plans in effect for 2009.In addition, as noted, small employers thatadopt a new plan (including qualified plansand SIMPLEs) would for the first time beentitled to a tax credit of up to $500 eachyear for three years, while the automatic-IRA tax credit for employers would be halfthat amount for two years. This toomaintains the incentive for employers to gobeyond the payroll-deposit IRA and adoptan actual plan. (As noted, the tax credit fornew qualified plans could be increased,which would permit a larger automatic IRAcredit while still maintaining a substantialedge in favor of the qualified plan credit.)

EEnnccoouurraaggiinngg CCoonnttrriibbuuttiioonnss bbyyNNoonneemmppllooyyeeeessThe payroll-deposit system outlined thusfar would not automatically cover self-employedindividuals, employees of the smallest ornewest businesses, or certain unemployedindividuals who can save. But a strategycentered on automatic arrangements couldalso make it easier for these people tocontribute to IRAs.

For individuals who are not employees orwho otherwise lack access to payrolldeduction, automatic debit arrangementscan serve in its stead. Automatic debitenables individuals to make payments on aregular and timely basis by having themautomatically charged to or deducted froman account—such as a checking or savingsaccount or credit card—at regular intervals.The individual generally gives advanceauthorization to the payer that manages theaccount or the recipient of the payment, orboth. The key is that, as in the case ofpayroll deduction, once the initial authorizationhas been given, regular payments continuewithout requiring further initiative on thepart of the individual. For many consumers,automatic debit is a convenient way to paybills or make payments on mortgages orother loans without having to remember tomake each payment when due and withouthaving to write and mail checks.

Similarly, as an element of an automaticIRA strategy, automatic debit can facilitate

IRA tax-favoredcontribution limit

Retirement Plan Contribution Limits

Under age 50

Age 50 or older

2009 IRA Contribution and Deduction Limits: http://www.irs.gov/retirement/article/0,,id=202510,00.html401(k) Resource Guide: http://www.irs.gov/retirement/sponsor/article/0,,id=151925,00.html

$5,000

$6,000

$49,000

$54,500

$16,500

$22,000

401(k) contributionlimit (employee plus employer)

401(k) employeecontribution limit

$11,500

$14,000

SIMPLE IRAemployee contribution

limit

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saving while reducing paperwork andcutting costs. For example, households canbe encouraged to sign up online for regularautomatic debits that direct funds from achecking account or credit card to an IRAor other saving vehicle. With online sign-up and monitoring, steps can be taken tofamiliarize more households with automaticdebit arrangements and, through Internetwebsites and otherwise, to make thosearrangements easier to set up and use as amechanism for saving in IRAs.

Professional and trade associations couldfacilitate the establishment of IRAs and theuse of automatic debit and direct deposit tothem. Independent contractors and otherindividuals who do not have an employeroften belong to such an association. Theassociation, for example, might be able tomake saving easier for those members whowish to save by making available convenientarrangements for automatic debit ofmembers’ accounts. Association websitescan make it easy for members to sign uponline, monitor the automatic debit savings,and make changes promptly when they wishto. Although such associations generallylack the payroll-deduction mechanism thatis available to employers, they can helptheir members set up a pipeline involvingregular automatic deposits (online or bytraditional means) from their personal bankor other financial accounts to an IRAestablished for them.

Another major element of a strategy toencourage contributions outside ofemployment would be to allow taxpayersto deposit a portion of their income taxrefunds directly into an IRA by simplychecking a box on their tax returns.37Beginning in 2007 (tax year 2006), the IRSmade it possible to split refunds amongdifferent accounts. Allowing households tosplit their refunds and deposit a portiondirectly into an IRA could make saving

simpler and, thus, more likely. Federalincome tax refunds total nearly $230 billiona year (more than twice the estimatedannual aggregate amount of net personalsavings in the United States), so even amodest increase in the proportion ofrefunds saved every year could bring abouta significant increase in savings.

Millions of Americans are self-employed asindependent contractors. Many of theseworkers receive regular payments fromfirms, but because they are not employees,they are not subject to income- or payroll-tax withholding. These individuals might beincluded in the direct-deposit system byenabling them to request that the firmreceiving their services deposit a specifiedportion of their compensation directly intoan IRA.

Compared with writing a large check to anIRA once a year, this approach has severalpotential advantages to independentcontractors, which might well encouragethem to save. These include the ability tocommit themselves to save a portion oftheir compensation before they receive it(which, for some people, makes thedecision to defer consumption easier); theability to avoid having to make anaffirmative choice among various IRAproviders; remittance of the funds by thefirm by direct deposit to the IRA; and,where payments are made to theindependent contractor on a regular basis,an arrangement that, like regular payrollwithholdings for employees, automaticallycontinues the pattern of saving throughrepeated automatic payroll deductions.

In many cases, the independent serviceprovider and the hiring firm may not havea sufficient connection, or may beunwilling, to enter into a payroll-depositarrangement. In such instances, theindependent contractor could contribute to

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an IRA by using automatic debit or bysending the contribution together with theestimated taxes that the self-employedgenerally are required to pay quarterly. Matching Deposits. A powerful financialincentive for direct-deposit saving by thosewho are not in the higher tax brackets (andwho therefore derive little benefit from atax deduction) would be a matchingdeposit to their direct-deposit IRA. Onemeans of delivering such a matchingdeposit would be through the bank, mutualfund, insurance carrier, brokerage firm, orother financial institution that provides thedirect-deposit IRA. For example, the first$500 contributed to an IRA by an individualwho is eligible to make deductiblecontributions to an IRA might be matchedby the private IRA provider on a dollar-for-dollar basis, and the next $1,000 ofcontributions might be matched at the rateof 50 cents on the dollar. The financialprovider would be reimbursed for itsmatching contributions through federalincome tax credits.38

Recent evidence from a randomizedexperiment involving matched contributionsto IRAs suggests that a simple matchingdeposit to an IRA can make individualssignificantly more likely to contribute andmore likely to contribute larger amounts.39

Matching contributions, similar to thoseprovided by most 401(k) plan sponsors,not only would help induce individuals tocontribute directly from their own pay, butalso, if the match were automaticallydeposited in the IRA, would add to theamount saved in the IRA. The use ofmatching deposits, however, would make itnecessary to implement proceduresdesigned to prevent gaming—contributingto induce the matching deposit, thenquickly withdrawing those contributions toretain the use of those funds. Among thepossible approaches would be to place

matching deposits in a separate subaccountsubject to tight withdrawal rules and toimpose a financial penalty on earlywithdrawals of matched contributions.

CCoonncclluussiioonnAmerican households have a compellingneed to increase their personal saving,especially for long-term purposes such asretirement. This paper proposes a strategythat would seek to make saving moreautomatic, and thus easier, more convenient,and more likely to occur. Our strategywould adapt to the IRA universe the samepractices that have proven successful inpromoting 401(k) participation. In our view,the automatic IRA approach outlined hereholds considerable promise of expandingretirement savings for millions of workers.

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NNootteess1. Obama’s Republican rival, Sen. John McCain,also expressed support for the concept duringthe campaign.

2. Even among those households that had savingsin 401(k)s or IRAs, the median account balancewas only $69,000. Authors’ calculations usingthe Federal Reserve Board 2004 Survey ofConsumer Finance.

3. As measured in the National Income andProduct Accounts,www.bea.gov/national/nipaweb/index.asp.

4. Craig Copeland, “Employment-BasedRetirement Plan Participation: GeographicDifferences and Trends, 2005.” Issue Brief 299(Washington: Employee Benefit RetirementInstitute, November 2006), fig. 1, p. 7.

5. Ibid.6. Rev. Rul. 1998-30 clarified that automaticenrollment in 401(k) plans was permissible fornewly hired employees. Treasury and the IRSruled in 2000 that automatic enrollment wasallowed for current employees as well (Rev. Rul.2000-8). Later rulings also extend IRS-Treasuryapproval to 403(b) and section 457 plans.

7. William G. Gale, J. Mark Iwry, and SpencerWalters, “Retirement Saving for Middle- andLower- Income Households: The PensionProtection Act of 2006 and the UnfinishedAgenda,” Policy Brief 2007-1 (Washington:Retirement Security Project, 2007) and PensionProtection Act of 2006 (Public Law 109-280),Section 902.

8. The SIMPLE IRA is essentially a payroll-deposit IRA with an employee contributionlimit that is in between the IRA and 401(k)limits and with employer contributions, butwithout the annual reports, plan documents,nondiscrimination tests, or most of the otheradministrative requirements applicable to otheremployer plans.

9. See, for example, Alicia H. Munnell and AnnikaSunden, Coming Up Short: The Challenge of401(k) Plans (Brookings Institution Press, 2004).

10. The preceding discussion draws on Section1.02(3) J. Mark Iwry, “Growing PrivatePensions: A Supporting Role for the States,”Tax Management Compensation PlanningJournal 34 (Dec. 1, 2006).

11. In the conference report to the Tax ReformAct of 1997, Congress stated that “employersthat choose not to sponsor a retirement planshould be encouraged to set up a payrolldeduction [IRA] system to help employees save

for retirement by making payroll-deductioncontributions to their IRAs.” It encouraged theTreasury secretary to “continue his efforts topublicize the availability of these payrolldeduction IRAs.” See H. Rept. 220, 105 Cong.,1 sess., (1997), p. 775.

12. Department of Labor, “Interpretive Bulletin99-1,” 29 Code of Federal Regulations 2509.99-1(b) (June 18, 1999); IRS Announcement 99-2,1999-2 I.R.B. 44 (Jan. 11, 1999),http://www.irs.gov/pub/irs-drop/a-99-2.pdf

13. Neither the IRS nor the Labor Departmentguidance addressed the possible use ofautomatic enrollment in conjunction withdirect-deposit IRAs.

14. William G. Gale, J. Mark Iwry, and Peter R.Orszag, “The Automatic 401(k): A Simple Wayto Strengthen Retirement Savings,” Policy Brief2005-1 (Washington: Retirement SecurityProject, 2005).

15. Brigitte C. Madrian and Dennis F. Shea, “ThePower of Suggestion: Inertia in 401(k)Participation and Savings Behavior,” QuarterlyJournal of Economics 116 (November 2001),pp. 1149–87; James Choi and others, “DefinedContribution Pensions: Plan Rules, ParticipantDecisions, and the Path of Least Resistance,” inTax Policy and the Economy, vol. 16, edited byJames Poterba (MIT Press, 2002), pp. 67–113;Sarah Holden and Jack VanDerhei, “TheInfluence of Automatic Enrollment, Catch-Up,and IRA Contributions on 401(k)Accumulations at Retirement,” Issue Brief 283(Washington: Employee Benefit ResearchInstitute, July 2005); and Cass R. Sunstein andRichard R. Thaler, Nudge: Improving Decisionsabout Health, Wealth, and Happiness (YaleUniversity Press, 2008).

16. Any such statutory provision could usefullymake clear that automatic enrollment in direct-deposit IRAs was permitted irrespective of anystate payroll laws that prohibit deductions fromemployee paychecks without the employee’sadvance written approval. Assuming that mostdirect-deposit IRA arrangements are notemployer plans governed by the federalEmployee Retirement Income Security Act(ERISA), such state laws, as they apply toautomatic IRAs, may not be preempted byERISA because they do not “relate to anyemployee benefit plan.”

17. In 2004 the IRS affirmed that plans arepermitted to increase the automaticcontribution rate over time in accordance with a

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specified schedule or in connection with salaryincreases or bonuses. See letter dated March 17,2004, from the Internal Revenue Service to J.Mark Iwry. The idea of coordinating automaticcontribution increases with pay increases wasdeveloped by Richard Thaler and ShlomoBenartzi, “Save More Tomorrow: UsingBehavioral Economics to Increase EmployeeSaving,” Journal of Political Economy 112, no.1, pt. 2 (2004), pp. S164–87.

18. Between August 28 and 31, 2005, in a surveycommissioned by the Retirement SecurityProject, the Tarrance Group, in conjunctionwith Lake, Snell, Mermin/Decision Research,interviewed 1,000 registered voters nationwideabout retirement security issues. A full report ofthe survey findings can be found atwww.retirementsecurityproject.org.

19. Employers that sponsor a SIMPLE IRA planmay deposit all employee contributions in IRAsat a single designated financial institutionselected by the employer (IRS Notice 98-4,1998-2 I.R.B. 25).

20. Plan sponsors continue to have the option tocash out balances of up to $1,000 and to retainin the plan account balances between $1,000and $5,000 instead of rolling them over to an IRA.

21. Considerable challenges are involved inbuilding and implementing a workable universalsaving system based on employer directdeposits of contributions to IRAs. Thesechallenges include dealing with the contingentworkforce, with employees who have multiplejobs, work part-time, and tend to earn relativelylow wages, and with small employers. Asomewhat different and thoughtful approach todesigning such a system can be found in theevolving work of the Conversation onCoverage, a collaborative effort amongindividuals (including one of the authors) drawnfrom a diverse range of stakeholderorganizations. A final report from theConversation on Coverage was published in2007, seewww.conversationoncoverage.org/about/final-report/covering-the-uncovered.pdf. For ananalysis by a nonpartisan expert panel (includingone of the authors) of the issues involved indesigning arrangements for distributions fromindividual accounts, see National Academy ofSocial Insurance, Uncharted Waters: PayingBenefits from Individual Accounts in FederalRetirement Policy (Washington: 2005).Although various other efforts have been made

to design such systems or programs, this paperdoes not attempt to catalogue them.

22. For some years, the federal Thrift Savings Planhad five investment funds: three stock indexfunds (S&P 500, small- and mid-capitalizationU.S. stocks, and mostly large-capitalizationforeign stocks); a bond index fund consisting ofa mix of government and corporate bonds; anda fund consisting of short-term, nonmarketableU.S. Treasury securities. Effective August 1,2005, the plan added a set of life-cycle funds,each one of which is composed of a mix of theother five investment funds.

23. This was part of the impetus behind the 2001statutory provision to the effect that thesecretaries of Labor and Treasury may provide,and shall give consideration to providing,special relief with respect to the use of low-costindividual retirement plans for purposes ofautomatic rollovers and for other uses thatpromote the preservation of assets forretirement income; see Economic Growth andTax Relief Reconciliation Act of 2001, PublicLaw 107-16, 115 Stat. 38, Section 657(c)(2)(B).In a similar vein, one of the authors hasproposed a strategy for states to act as catalystsin expanding coverage under standardized, low-cost payroll-deposit IRAs, SIMPLE IRA plans,and 401(k) plans by facilitating the pooling ofsmall businesses to offer these vehicles. See J.Mark Iwry, “Expanding Retirement Savings atthe State Level,” written statement to theLegislature of the State of Washington (April2003). The proposal has been described in oraltestimony by Iwry to the Michigan Senate andto the Maryland House of Delegates, writtentestimony before the U.S. Senate Committee onFinance Subcommittee on Long-Term Growthand Debt Reduction (June 29, 2006), and ismore fully described in J. Mark Iwry, “State K:A New Strategy for Using State-Assisted Savingto Expand Private Pension Coverage,” NYUReview of Employee Benefits and ExecutiveCompensation (2006) and in “Growing PrivatePensions: A Supporting Role for the States,”Tax Management Compensation PlanningJournal (Bureau of National Affairs) 34(December 1, 2006).

24. The difference in expense between passivelymanaged index funds and actively managedmutual funds has been estimated to be, as abroad generalization, roughly 100 basis points(1 percent) a year; see William F. Sharpe,“Indexed Investing: A Prosaic Way to Beat the

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Average Investor,” Paper presented at theSpring President’s Forum (Monterey Institute ofInternational Studies, May 2002).

25. One of the authors has testified beforeCongress regarding the British retirement plansystem and has been critical of the UnitedKingdom’s attempt to impose a limit oncharges. See David C. John, testimony beforethe Subcommittee on Social Security of theCommittee on Ways and Means, U.S. House ofRepresentatives (June 16, 2005). See also DavidC. John and Ruth Levine, “National RetirementSavings Systems in Australia, Chile, NewZealand and the United Kingdom: Lessons forthe United States,” Policy Brief 2009-1(Washington: Retirement Security Project, 2009).

26. For example, some contend that a balancedfund reflecting the participant’s appetite for riskis preferable to a life-cycle fund because thelatter tends to transition to a relatively lowpercentage of equities by age 60 or 65, eventhough the participant might continue to holdthe investment for another three decades.However, for the presumably large numbers ofthe population who can be expected not to takethe initiative to adjust their asset allocation asthey age, some automatic adjustment might bepreferable to no adjustment. In addition, theprospect that participants will make explicitchoices may be far greater as they confrontretirement, when they might be able to focus ona one-time basis sufficiently to adjust a life-cyclefund to suit their preferences, taking into accountwhen they expect to draw down the funds.

27. As noted, the federal Thrift Savings Planconsists mainly of index funds, which are thebuilding blocks for the recently added life-cyclefunds. The Thrift Savings Plan informationalmaterials state that the life-cycle funds “providea way to diversify your account optimally, basedon professionally determined asset allocations.This provides you with the opportunity toachieve a maximum amount of return over agiven period of time with a minimum amountof risk. . . .” (see www.tsp.gov). A professionallyrun “managed account” that could achievesimilar results at no greater cost might beanother attractive option, and managedaccounts are growing in popularity as an optionin 401(k) plans. A question may be raised as towhether managed accounts are a better fit for401(k) plans than for automatic IRAs, because401(k)s tend to have more substantial accountbalances and greater flexibility to accommodate

individual preferences while allocating costs toindividuals who opt for costlier alternatives.

28. Gary P. Brinson, L. Randolph Hood, andGilbert L. Beebower, “Determinants ofPortfolio Performance,” Financial AnalystsJournal 42 (July/August 1986): 39–48.

29. For additional information about strategies forthe expanded use of annuities in connectionwith retirement savings, see William G. Gale, J.Mark Iwry, David C. John and Lina Walker,“Increasing Annuitization in 401(k) Plans withAutomatic Trail Income,” Policy Brief 2008-2(Washington: Retirement Security Project,2008). and J. Mark Iwry and John A. Turner,“Automati Annuitization: New BehavioralStrategies for Expanding Lifetime Income in401(k)s,” Policy Brief 2009-2 (Washington:Retirement Security Project, 2009).

30. The Federal Employees’ Retirement SystemAct of 1986 (Public Law 99-335) established theThrift Savings Plan as of January 1, 1987, with agovernment securities fund. The initiallegislation called for two additional funds—fixed income and stock index—to becomeavailable on January 1, 1988.

31. Particularly concerning 401(k) trading behavior,see, for example, Takeshi Yamaguchi andothers, “Winners and Losers: 401(k) Tradingand Portfolio Performance,” Working Paper2006-26 (University of Pennsylvania, WhartonSchool Pension Research Council, November2006) and Shlomo Benartzi and Richard Thaler,“"Naïve Diversification Strategies in DefinedContribution Saving Plans,” AmericanEconomic Review 91 (March 2001), pp 79–98.

32. The question of how best to fit direct-depositIRAs, with their improved and simplifiedinvestment structure, into the larger IRAuniverse is related to a broader issue: thepotential simplification of IRAs. We favorsimplification and revision of the current arrayof IRA options. However, the specifics of anysuch proposals are beyond the scope of this paper.

33. Prudential, “Saving for Retirement at Work:Employee and Business Reactions to theAutomatic IRA Concept” (Newark, N.J.:January 2008).

34. See Gale, Iwry, and Orszag, “The Automatic401(k)” for a full report of the survey findings.

35. Craig Copeland, “Retirement Plan Participationand Retirees’ Perception of Their Standard ofLiving,” Issue Brief 289 (Washington:Employee Benefit Research Institute, January2006), pp. 1–6, fig. A4.

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36. It is conceivable that the risk of exceeding theIRA dollar limit could be mitigated to somedegree by capping automatic enrollment at, say,$250 a month (for an annual total of $3,000) or$300 a month. However, because automaticenrollment would be administered at theemployer level and might be based onpaychecks provided weekly or every two weeks,the maximum dollar amount would need to beadjusted accordingly (say, $60 if weekly, $120 ifevery two weeks, or $250 if monthly).

37. J. Mark Iwry, “Using Tax Refunds to IncreaseSavings and Retirement Security” Policy Brief2006-1 (Washington: Retirement SecurityProject, January 2006).

38. Among the issues such an approach wouldneed to address is the means of reimbursingprivate financial institutions that have no federalincome tax liability to offset because they aretax exempt or in a loss position. A proposedalternative mechanism would convert theexisting Saver’s Credit (a federal income taxcredit to households with joint income below$55,500 for contributing to an IRA or employerplan) to a direct matching deposit to an IRA orother savings account. As currently structured,the Saver’s Credit reduces the household’sfederal income tax liability and isnonrefundable; thus, it is not automaticallysaved.) A variation would have such a directmatching deposit delivered by the financialinstitution that sponsors the IRAs or that servesas financial provider to the 401(k) plan to whichthe individual contributes. One of the authorswas involved in developing the Saver’s Creditand, in congressional testimony and writings,has advocated its extension and expansion. See,for example, William G. Gale, J. Mark Iwry, andPeter R. Orszag, “The Saver’s Credit:Expanding Retirement Savings for Middle- andLower-Income Americans” Policy Brief 2005-2(Washington: Retirement Security Project,March 2005). This proposal has been essentiallyincorporated in President Barack Obama’sbudget for fiscal 2010. Another significantasset-building approach targeted to lower- andmoderate-income households is reflected inindividual development accounts (IDAs). See,for example, Michael Sherraden, Assets and thePoor: A New American Welfare Policy(Armonk, N.Y.: M. E. Sharpe, 1992), and RayBoshara, “Individual Development Accounts:Policies to Build Savings and Assets for thePoor” Policy Brief (Brookings, March 2005).

39. Esther Duflo and others, “Saving Incentivesfor Low- and Middle-Income Families:Evidence from a Field Experiment with H&RBlock,” Quarterly Journal of Economics 121(November 2006), pp. 1311–46.

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JJ.. MMaarrkk IIwwrryy completedthis paper during his time asPrincipal to the RetirementSecurity Project. He iscurrently Senior Advisorto the Secretary and DeputyAssistant Treasury Secretaryfor Retirement and HealthPolicy, United States TreasuryDepartment.

DDaavviidd CC.. JJoohhnn isPrincipal to The RetirementSecurity Project and aSenior Research Fellowwith the Thomas A. RoeInstitute for Economic PolicyStudies at The HeritageFoundation.

The views expressed in this paper arethose of the authors alone andshould not be attributed to the PewCharitable Trusts, the RockerfellerFoundation, the BrookingsInstitution,, or any other institutionswith which the authors and theRetirement Security Project areaffiliated.

Copyright © 2009.

The authors thank Bill Gale andmany other individuals forhelpful comments and JaimeMatthews and Spencer Waltersfor outstanding assistance.

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