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Employee Benefits Security Administration

Report of the Working Group on the Impact of Alternative Tax Proposals
on ERISA Employer-Sponsored Plans

November 13, 1996

I. The Working Group's Purpose and Scope

The 1996 Advisory Council on Employee Welfare and Pension Benefit Plans created a Working Group on the Impact of Alternative Tax Proposals on Employer-Sponsored Plans. The Working Group was charged with analyzing the issues and making recommendations based on its findings, prior to the next session of Congress.

The topic arose due to concerns among Council members regarding what appeared to them to be inadequate attention to issues surrounding employer-sponsored plans in the national debate over fundamental tax reform. Some council members noted that the debate over tax reform was reaching a depth and seriousness rarely seen in this century, with advocates of reform arguing not only for changes in the existing tax code, but for wholesale replacement of the current federal individual and corporate income tax in favor of some other system.

Such a far-reaching change would have the effect of eliminating the special tax preferences that now support employer-provided health benefits and employer contributions and maintenance of qualified retirement plans established under ERISA. The Council felt that such a dramatic change that could transform the existing universe of employee benefits under ERISA required analysis and attention, which was not occurring in the Congressional and other forums where fundamental tax changes were being debated.

The Working Group determined that its study would focus only on qualified retirement plans, and not include employer-provided health care. This was based on two main reasons. First, the Council recently had looked in depth at health care issues during the debate over the Clinton Administration's proposals for health care reform, and it did not seem timely to take up that range of issues again.

Second, several members said that if tax reform were to move forward, it might be early in the next Congress. Therefore, in order to assist in the debate, the Council needed to issue a report this year, and not make the Working Group on tax reform a multiyear project. At the same time, members agreed that the Group and the Council would not be endorsing any particular approach to tax reform, but would concentrate on raising issues and highlighting important questions.

Based on this discussion, the Working Group established parameters for this year's work. First, the Group would focus on qualified retirement plans, and not include health plans. Second, the Group emphasized that the Council would not make any endorsement of any particular approach to tax reform, but would instead concentrate on analysis and raising issues that have been given little attention in the overall debate over tax reform.

Third, the proceedings of the Working Group would not devote extensive time to detailed analysis of each competing plan for tax reform, although key differences among them would be noted where necessary. As Council member Edward Montgomery stated "there's a generic issue -- what happens when you remove the tax deductibility of contributions."

Fourth, because of the Council's statutory charge, the Working Group would devote special attention to issues flowing out of the ERISA statute that are not the focus of tax reform plans. Although ERISA and proposals for tax reform share a broad overall goal of increasing national savings, Council member Richard McGahey noted the wide range of "issues that are framed under Title I of ERISA...[that] are of critical importance...particularly questions about protections, enforcement, and how this potentially dramatic change in the tax system would feed back into the existing statutory and regulatory responsibilities of the Department [of Labor]."

Finally, the Working Group also wanted to focus on how overall savings and investment allocations patterns might change if the nation replaced employer retirement plans and moved to an exclusive policy of individual and household savings and investment for retirement. These concerns encompassed both whether individuals would invest in the long-term to provide for adequate retirement income, and what, as Council chair Judith Mares put it, "could happen to the capital base of America, the cost of capital and allocation of capital, from savings."

II. Working Group Proceedings

The Working Group received oral and written testimony and background materials at a series of public hearings, and through solicitation and submission of analyses and information on topics related to the Group's focus. (Summaries of the testimony can be found in Section IV below.)

At the meeting of May 8, 1996, the Working Group discussed its purpose and scope, deciding to focus on qualified retirement plans. Due to the short time available for gathering information and preparing a report, the Group decided to concentrate on several key questions (discussed in section I above), and also to look for research and background information that could be made part of the overall record and report.

Also on May 8, the group heard testimony from Professor Jonathan Barry Forman of the University of Oklahoma School of Law, analyzing the impact of moving to a consumption tax on employee benefit plans.

At the hearing on June 19, the Working Group heard a variety of testimony, both on the specific impact of tax reform on retirement savings and ERISA, and on the overall goals and potential problems with fundamental tax reform. The first witness was Kenneth Kies, Chief of Staff of the Joint Committee on Taxation of the U.S. Congress. Mr. Kies discussed both the broad issues related to overall tax reform, including why he thought that reform was eventually inevitable, and specific issues related to employer-sponsored pensions and how they might fare under tax reform.

Mr. Kies was followed by William Gale, a Senior Fellow at the Brookings Institution, who presented oral and written testimony based on his research on the effect of tax reform on private pensions, which he characterized as "one of the great sleeper issues in tax reform." Mr. Gale discussed statistical estimations of the impact on tax reform on savings, investment, and pensions, emphasizing that "all of these estimates are...shrouded in uncertainty," and pointing out where statistical biases and other factors could add to uncertain results when analyzing these issues.

The Working Group also heard from Paul Yakoboski, a Research Analyst with the Employee Benefits Research Institute (EBRI), and Ron Gebhardtsbauer, Senior Pension Fellow of the American Academy of Actuaries. Both discussed their analysis of what would happen if, in Mr. Yakoboski's words, "all forms of savings enjoyed the same preferential tax treatment currently reserved for qualified retirement plans." Both analyses focused on possible aggregate impacts of tax reform, and on possible distributional changes in coverage and levels of savings.

The final witnesses on June 19 were J.D. Foster, Chief Economist of the Tax Foundation, and Bradley Belt, Director of the Domestic Policy Issues Program at the Center for Strategic and International Studies. Their testimony and discussion focused on broad issues related to overall tax reform, and why shifting from the current income tax to an alternative method of taxation might be desirable for the economy and for savings and investment.

At the Working Group's next hearing on September 11, 1996, oral and written testimony was presented by three practitioners in the financial, pension, and investment area. The first witness was Kathryn Smith, an attorney with Bergman, Horowitz, and Reynolds of New Haven, Connecticut who specializes in tax law, estate planning, and employee benefits. Ms. Smith's testimony concentrated on practical issues of implementation, coverage, and distribution if tax reform made significant changes relating to qualified retirement plans.

Ms. Smith was followed by a panel with two witnesses with expertise in investment management: Patricia Chadwick, Chief Investment Strategist of Chancellor Capital Management, and John R. Serhant, Chairman of the Investment Committee of State Street Global Advisors. They focused on potential impacts of tax reform on overall savings and investment, the allocation of assets by individuals, households, and professional investment managers, and whether, in their view, tax reform would improve and harm the overall level of retirement savings and the distribution of saving and retirement income. Mr. Serhant put his testimony in the context of his advocacy of partial or full privatization of Social Security, arguing that fixing the private pension system should be done in the context of overall national retirement policy, and that some privatization of Social Security was an essential element of future policy.

III. Findings and Recommendations

The Working Group is explicitly not taking any position on overall tax reform, or on the merits or demerits of any particular reform proposal. But we are concerned at the lack of attention to the critical issues we have mentioned in this report, especially given the high degree of uncertainty that surrounds each of them. We heard that the effect of fundamental tax reform might be to increase overall national saving, but also that, under plausible assumptions, the net impact on savings could be close to zero, as pension savings fell while other savings rose. We heard that employers might reduce or eliminate pensions without the tax incentive, but also that they might maintain some form of pension for their employees. This was a particular concern in relation to small business. Some analysts argued that tax reform could lead to a less progressive distribution of retirement income and less coverage, especially for small businesses and lower income workers, while other experts disagreed with that scenario.

This high degree of uncertainty over the impact of tax reform on fundamental issues for the nation's retirement policy, and for ERISA, is perhaps our major finding, and our major concern.

The lack of attention to pension plan issues in the tax reform debate is perhaps not surprising, but somewhat disturbing. The debate over fundamental tax reform is shaping up as one of the most far-reaching debates over taxes in this century, with major public figures (including Congressional leaders) calling for wholesale replacement of the Federal individual and corporate income tax. Previous debates over tax reform, such as those in the 1980s, concentrated on reforming the existing income tax, not replacing it. Given the scope of issues raised by proposals to replace the income tax, it is not surprising that pension issues have not been given much specific attention.

However, the Working Group notes this lack of attention with concern. There are four major sets of issues that concern the group.

  • First, most of the tax reform proposals concentrate on ways to increase the nation's overall savings rate, but one way that the plans propose to achieve this goal is the elimination of any special tax preference for retirement savings, with an uncertain impact on the overall level of savings in the economy.
  • Second, there has been little attention to how changes in taxation and savings under tax reform might affect the coverage and distribution of retirement income for the entire population.
  • Third, moving from pension-based saving to individual and household-based saving raises questions about the investment behavior of those households, both to achieve long-term adequate rates of return on their savings, and the consequences of their investment behavior on the allocation of capital in the American economy.
  • Finally, there are a host of social policy goals and protections that are reflected in the current body of law and regulation regarding pensions; moving away from the existing private pension system could undermine many of those goals and protections.

The Working Group feels strongly that these and related issues have not been adequately considered to date in the debate over tax reform, which has focused almost exclusively on the overall national saving rate. Advocates of tax reform sometimes seem to assume that raising the savings rate for the nation as a whole will automatically lead to an adequate retirement income for most Americans, but testimony before the Working Group indicated substantial uncertainty about the effects of such tax changes. As one witness, Kathryn Smith, put it, there is a significant difference between "the nation's saving rate and a national retirement income policy."

One central goal of all tax reform proposals is to increase the level of national saving in the American economy, however that might be achieved -- through a shift to a consumption tax such as a VAT or a sales tax, a flattening of income tax rates and reducing or eliminating taxes on capital income, or splitting income between consumption and saving and only taxing the part consumed, as in a consumed income tax. As part of the overall reform design, all of these proposals would sharply curtail or end the existing special tax preference for employer contributions to qualified retirement plans. The net effect would be to treat pension and retirement saving in the same way as all other individual and household savings.

Testimony and materials presented to the Working Group indicate that many expert analysts view the tax preferences for qualified retirement plans are among the most significant positive incentives contributing to national savings. William Gale of the Brookings Institution, in written testimony submitted to the work group, reported on analyses showing that "from 1985 to 1992...pension contributions have averaged about 50 percent of personal savings." If total pension earnings and returns on investment are included along with contributions, Gale reported that "pension saving has represented 70 percent or more of personal saving since the mid-1980s." Based on this and other testimony, the work group feels that the tax reform debate needs a much more critical examination of the claim that elimination of existing incentives would not harm overall savings and would assist in national retirement policy.

A second major set of issues involves whether tax reform and elimination of the pension tax preferences could inhibit pension coverage and lead to a worse overall distribution of savings and retirement coverage, with employees of small firms and those with lower incomes on the losing end. Professor Jonathan Barry Forman of the University of Oklahoma testified on his concerns that tax reform and the elimination of the existing pension system " would have a tremendous impact on low and moderate income workers. They are going to get more cash, and they're going to spend it, and they're going to reach age 65 wanting to retire... and not having the money to do it, and making increasing demands on our governmental system." Other witnesses, including John Serhant of State Street Global Advisors, disagreed, arguing that "I do not think that tax reforms...will have a negative impact on the low income worker." As one goal of a national retirement policy under ERISA is expanding pension coverage to as many workers as possible, policy makers need to carefully consider whether tax reform might actually reduce coverage or tilt the distribution of pension benefits away from lower income people.

A third major set of issues that needs more attention is whether moving away from private pensions to individually-managed saving would result in inadequate returns on investment and shifts in investment patterns that would affect capital allocation in the American economy. Although it is often assumed that individuals will, on average, make suboptimal allocations of their savings in light of their long-term retirement needs, research presented to the work group by Council member Thomas Healey found broadly similar asset allocations between defined benefit and defined contribution plans. There was a good deal of speculation on this issue, but the Working Group feels that much more research needs to be done in this area.

1( Whatever tax system we have, there was universal agreement by the Working Group that more work needs to be done in educating individuals about the consequences of their long-term savings and investment decisions. This issue has been a long-standing one of the ERISA Advisory Council and of the Department of Labor.)

Finally, the Working Group has concerns about what impact tax reform might have on the broad social purposes of existing retirement policy. As work group member Kenneth Cohen noted, there is a great deal of "embedded social policy that requires the nexus of employer-provided plans," including reporting and disclosure requirements, fiduciary rules for investment and management, vesting and protections against fraud and abuse, retirement equity for women through joint survivor rules, and many other policy provisions. As tax reform could cause a sharp reduction or a wholesale elimination of existing pension plans, the issue of what would happen to existing law and social policy needs more analysis and attention.

The group heard testimony that moving away from employer-sponsored pensions under ERISA could create significant regulatory and administrative burdens for the Department of Labor and the Federal Government. If existing pensions and regulations were grandfathered under a new tax system, regulatory and enforcement activity would have to be maintained, while the nation's overall savings and retirement policy moved in a different direction. On the other hand, if existing pensions were phased out and transferred into some new overall pool of savings, very complex legal, regulatory, and enforcement issues would arise during a transition, and for some time afterwards.

In summary, the Working Group believes that the complex and far-reaching implications of fundamental tax reform for the nation's retirement and pension system have not been given adequate attention or analysis through existing policy channels, either in Congress or in the Executive Branch, especially given the complexity of the issues and the uncertainty that surrounds them.

Accordingly, the Working Group makes the following recommendations to the Secretary of Labor.

  1. As part of the Congressional debate over fundamental tax reform, the Secretary of Labor should encourage Congressional committees and leaders to actively seek out a wide range of views of how such reform might affect pensions and saving for retirement. Expert witnesses, including those from relevant executive branch agencies, should be called to testify and submit information to Congress, and organizations with significant expertise on these questions should be called upon to assist Congress in its deliberations. Congressional resources like the Joint Committee on Taxation should consider preparing a report for Congress on the implications of tax reform for pensions and retirement.

  2. The Secretary should raise issues relating to the impact of tax reform on the private pension system within the Administration, and with the public at large. A majority of the work group recommended formation of a national commission on retirement policy to study private pension and benefit issues. The Working Group is unanimous in the view that the issues facing private pensions and retirement policy need to be elevated to a much higher level of study and concern by all major political decision makers, and that the existing regular channels of policy debate are not paying adequate attention to this issue.

    A majority of the Working Group supported the idea of a national commission. While recognizing that any solution to the coming retirement of the "baby boom" generation must consider the availability of retirement income from all sources, including employee pensions, those in the work group who support a commission recommend that its charge be limited to the future of employer-sponsored retirement savings.

    The Secretary might also suggest forming a working group that would include other key executive branch agencies, such as the Department of the Treasury, the Pension Benefit Guaranty Corporation, and the Office of Management and Budget, to analyze the issues surrounding fundamental tax reform and pensions.

    Some Working Group members were concerned that the complex and critical issues surrounding retirement and pension policy will not get adequate attention through existing policy channels, either in Congress or in the Executive Branch.

  3. Within the Department, the Secretary should conduct an analysis of the regulatory and legal issues that would arise if tax laws are changed to eliminate the tax preference for employer contributions to qualified pension plans. Two scenarios need more attention: one in which existing plans, laws, and regulations remain in place while new policies come to govern future savings and retirement policy, and a second scenario where the existing body of law and regulation is phased out in favor of incorporating existing pension assets into a new overall national savings regime.

  4. The Secretary should also consider sponsoring research and public discussion, alone or in conjunction with academic experts and non-governmental organizations, on the many questions that have only partly been researched and analyzed. All of these are questions where there is some research, but where no consensus is apparent to the Working Group. Among these issues are:

    • Considering the significant impact of current pension contributions and earnings to national savings, how might tax reform affect total net national savings?
    • Would tax reform increase or reduce pension coverage and retirement benefits?
    • What might the distributional consequences be of such reform, especially for the self-employed, those working in small businesses, and lower-income workers?
    • If pension decisions were made by each individual rather than professional managers, would asset allocations and investment strategies change significantly? What might the consequence be of such changes, both for the distribution of capital investment among economic sectors, and for the long-term investment returns and adequacy of retirement funds for individuals?
    • What legal, regulatory, and enforcement issues might arise in changing to a new tax system that eliminated any special consideration for employer contributions to qualified retirement plans? How would the social policy goals currently embodied in law and regulation be achieved under a new tax system, and how difficult would it be to achieve those goals?
    • Would companies terminate or phase out their qualified retirement programs if there was no tax preference for them?

IV. Summaries of Testimony Received

The following are summaries of testimony received by the Work Group.

Meeting of May 8, 1996

Professor Jonathan Barry Forman,
University of Oklahoma College of Law

Jonathan Barry Forman is a Professor at the University of Oklahoma College of Law teaching tax and pension law. In addition to a law degree, Professor Forman holds a Master's Degree in Economics.

Professor Forman observed that most of the tax reform proposals before Congress will eliminate tax breaks for health care plans and essentially put qualified pension plans on the same level playing field with all other savings. In evaluating the impact of this, Professor Forman reviewed the implications of moving from our current income tax structure to a consumption tax structure. In his analysis, the following actions are likely:

  • Employers will no longer have an incentive to maintain pension plans and the plans will, therefore, wither and decline;

  • Employees will desire more cash compensation which may reduce overall savings;

  • Low and moderate income workers will be more inclined to spend their additional savings, placing higher burdens on the social security system as they retire;

  • There will be a shift from defined investment plans to defined contribution plans;

  • Individual investor may make different investment choices with their savings versus the long term orientation of company sponsored investment allocations; and,

  • Workers would be need to work longer as they would not be financially prepared for retirement.

  • Companies would loose an effective tool in managing their workforce.

  • Some recommended solutions to the potential change in savings rates and patterns are:

    • A mandated pension system or some form of mandated individual savings;
    • The creation of unlimited retirement savings accounts;
    • Relaxation of the mandatory retirement age;
    • Modifications to the Age Discrimination in Employment Act; and,
    • Putting constraints around money already saved for retirement as part of qualified plans.
  • Employers will no longer have an incentive to maintain pension plans and the plans will, therefore, wither and decline;

  • Employees will desire more cash compensation which may reduce overall savings;

  • Low and moderate income workers will be more inclined to spend their additional savings, placing higher burdens on the social security system as they retire;

  • There will be a shift from defined investment plans to defined contribution plans;

  • Individual investor may make different investment choices with their savings versus the long term orientation of company sponsored investment allocations; and,

  • Workers would be need to work longer as they would not be financially prepared for retirement

  • Companies would loose an effective tool in managing their workforce.

  • Some recommended solutions to the potential change in savings rates and patterns are:

    • A mandated pension system or some form of mandated individual savings;
    • The creation of unlimited retirement savings accounts;
    • Relaxation of the mandatory retirement age;
    • Modifications to the Age Discrimination in Employment Act; and,
    • Putting constraints around money already saved for retirement as part of qualified plans.

In conclusion, Professor Forman believes retirement income has now become a four-legged stool: Social Security, pension, individual savings and work. He encourages consideration of tax reform's impact on each of these segments.

Meeting of June 19, 1996

Kenneth Kies,
Chief of Staff
Joint Committee on Taxation,
United States Congress

Mr. Kies testimony focused on three issues that were germane to the Working Group. First, he suggested that tax reform was inevitable because of concerns over the level of saving in the economy. He noted that the U.S. has the lowest national savings rate of any of the major industrialized countries. Second, when this is combined with the prospect of the Baby Boom generation impacting Social Security and Medicare at the same time those systems are undergoing distress, concern for the adequacy of private saving becomes paramount. Third and perhaps more important for the political debate, is the fact that the inequities of the current system have generated widespread dislike or distrust of our current tax system. The complexity of the current system baffles even tax experts as reflected in the Money Magazine article in which even professional tax preparers could not agree on the tax liability of a sample tax return.

The pension system plays a substantial role in the tax system as the exclusion for pension contributions and earnings is the single largest deduction in the current tax system with the next largest being exclusions for employer provided health care. While it can be debated how much of pension savings is due to the tax system, there is no doubt that pensions plays an important role in level of private savings. There are a number of alternative tax systems proposals in front of Congress that range from fixing the current income tax system to moving to a consumption tax systems. While some of the plans retain the current filing requirements and include deductions for savings and other items, others do not and are collected like a sales or VAT tax. All of the plans give tax preference for savings but the distinction between employer sponsored plans and other savings would be lost under many of them. This could reduce employer incentives to sponsor plans and hence any forced saving that results from them could be lost. While putting all savings on the same plane may be beneficial it does carry risks to the degree employer paternalism or forced saving is important.

An end to employer plans might also carry some non-tax risks. Individuals may not select diversified portfolios because of the lack of fiduciary obligations that force employer plans to do so. Transition rule for pensions, protections for non-working spouses, and protections against creditors are issues that must be dealt with if the ERISA system is abandoned. While increasing savings, revenue neutrality and distributional fairness are important considerations in any redesign of the tax system these issues should not be ignored. Despite its critics, the current tax system does have elements of a consumption tax to encourage saving and is more progressive than commonly thought, as the top 10 percent of income earners pay 46.8 percent of all income and FICA taxes while the bottom 40 percent pay just 4.9 percent. Further, moving to a consumption tax is likely to have major macroeconomic effects that are not necessarily positive in the short run. The long-term benefits in terms of increased growth are still being debated by economists.

William G. Gale
Senior Fellow,
The Brookings Institution

Dr. Gale, an economist with expertise in taxation and employee benefit issues, testified that the principal potential benefits of adopting a new tax system are simplicity and a stronger rate of economic growth. However, whether these goals will be attained depends in part on how pensions are treated in the tax reform process and how savers will respond to tax policy changes.

Dr. Gale presented a statistical analysis showing that since 1986 more than 100% of the net personal savings in the U.S. has occurred in pensions or tax deferred life insurance products and therefore is currently occurring under "consumption tax principles", i.e., money is taxed only when it is withdrawn from the pension plan and spent.

Responding to questions, Dr. Gale noted that if the non-discrimination provisions of the current tax were eliminated, the proportion of low income workers with pensions might be reduced.

Asked to design his ideal tax program to enhance pensions, Dr. Gale said that he would try to make the tax system much simpler, particularly in the area of the non- discrimination rules.

Dr. Gale stated that pension, health, charitable contribution and mortgage deductions are unlikely to disappear in the tax reform process because they are reflective of social policy that has become ingrained in the tax code.

Ron Gebhardstbauer
Senior Pension Fellow
American Academy of Actuaries

Mr. Gebhardtsbauer presented testimony on behalf of the American Academy of Actuaries Task Force on Tax Reform. His oral and written presentation concentrated on outlining the Academy task force's case for simplifying, not overhauling, the tax code, based on an evaluation of the current system, its advantages and disadvantages, and a review of the various proposals for tax reform.

The central issues raised in the testimony were:

  1. Will removal of the tax advantage eliminate employee benefits, particularly for small plans?

  2. Will equal tax treatment encourage a shift toward non-qualified plans, discretionary benefits, lack of funding or no protection of participant rights?

  3. Will individuals opt for cash compensation and further erode their own retirement savings program?

  4. Will individuals save more and/or invest more wisely on their own, than if they were in employer-sponsored plans?

  5. Will the government ultimately take on greater retirement income burden, and be forced ultimately to mandate employer-sponsored plans?

Several issues arose in Mr. Gebhardtsbauer's oral testimony and in discussion with members of the working group. It was generally agreed that tax incentives are the primary reason for employer-sponsored, qualified pension plans. Such plans ensure broad coverage of workers at various age and income levels, provide an opportunity for cost- sharing and investment diversification, enhance national savings and retirement security and promote global competitiveness.

On the other hand, the current tax code is complex, seemingly unfair and a demotivator to personal savings. Unfortunately, the huge tax break granted to pension funds appears to be at cross purposes with the federal government's budget deficit reduction initiatives.

A new tax system, as under the various proposals, that gives the same tax advantages as other forms of savings, will greatly reduce employers' incentives for establishing and maintaining pension plans. There is need for careful deliberation of tax reform in light of national retirement policy issues.

Paul Yakoboski
Research Associate,
Employee Benefit Research Institute

EBRI has been examining what would happen to qualified retirement plans if the current preferential tax treatment currently reserved for them were to be extended to all savings arrangements. Would employers be willing to offer a retirement plan without a relative tax advantage; would employees want an employment-based retirement plan or would they prefer to make their own saving/spending decisions?

A recent survey of employers showed no consensus about whether or not to retain retirement plans. Decisions will probably be based on the size and profitability of the organization and whether a retirement plan is crucial to attracting and retaining the workforce. Defined benefit plans will probably survive because of their workforce management function. 401(k) plans, however, might wither away because workers could achieve the same tax advantages without pre-retirement withdrawal restrictions in other forms of savings vehicle.

In a separate survey of worker preferences, EBRI found that, given a choice a choice of contributing to (1) an IRA or 401(k) plan with pre-retirement withdrawal penalties, one third of respondents preferred the IRA/401(k) option, and 55 percent selected the other vehicle. Reasons for the surprising one third vote for IRAs/401(k) might include the discipline to save and retain assets imposed by the automatic payroll deduction and withdrawal penalties. However, when asked whether they would prefer to be responsible for any tax-free savings, 59 percent of respondents selected their employer, as opposed to 33 percent who said they would make their own decisions.

One of the motivations for a consumption-based tax is to increase the national savings rate. This could occur but most of the savings might be concentrated at the higher income levels. Many researchers hypothesize that in a situation where all savings mechanisms are treated equally from the tax point of view, 401(k) plans would disappear. Mr. Yakoboski said that it is not clear that workers would save as much as they currently do if the discipline of the 401(k) plan were not present.

J.D. Foster,
Chief Economist
The Tax Foundation

Mr. Foster began by describing the work of the Tax Foundation, which is a non- profit, non-partisan organization that analyzes a wide range of issues related to taxation and tax policy. He noted that he was not primarily a pension expert, and was appearing as part of a broader discussion over the issues related to fundamental tax reform.

He outlined the twin problems of low national savings rates and a low rate of capital formation and investment as two major reasons why fundamental tax reform might be desirable. To him, the main goal of tax reform is "getting the tax code out of the economic decisions of individuals and other words, coming up with a more neutral tax system."

Mr. Foster noted that the current American tax system is not a pure income tax, but a hybrid that contains consumption elements as well, including the existing tax preference for contributions to qualified retirement plans and other incentives that favor savings. These elements, however, are not well integrated, especially in regard to business taxation. This is why many tax reform plans focus not only on the personal income tax, but on corporate tax policy.

He agreed with some other analysts that, if the existing tax preferences were changed, "there's no question there's probably going to be less savings going on through pensions," but that lower tax rates overall would allow individuals to save in other ways, offsetting that reduction and perhaps increasing the total amount of savings.

While citing the work of several economists who have studied these issues, Mr. Foster cautioned against trying to extrapolate too much from studies based on the current system to project what would happen under an entirely new tax system. He also felt that the issue of potential changes in asset allocation that might be caused by tax reform was worthy of study and research, especially the question of whether individuals "will save and invest as wisely as professional pension managers."

Bradley Belt
Domestic Policy Issues Program
Center for Strategic and International Studies

Mr. Belt was part of a panel describing the goals and issues facing overall tax reform, with less emphasis on the particular impact on pensions and the retirement system. He first described the extensive and long-standing interest of the Center for Strategic and International Studies (CSIS) in tax policy. The most prominent effort by CSIS was the Strengthening of America Commission, chaired by Senators Sam Nunn and Pete Domenici, which called for replacement of the current federal tax code by a progressive, consumption-based income tax. This proposal later evolved into the USA (Unlimited Savings Allowance) Tax, although CSIS is not itself advocating any particular specific change, but providing the educational and intellectual foundations to make the case for broad and comprehensive tax reform.

Mr. Belt outlined his concerns over the low saving rate in the United States, and the changing demography of the American population, with a rapidly aging population and the coming retirement of the baby boom early in the next century. These concerns, along with slow productivity growth and the need for more investment, lead him to advocated replacing the current tax code. Although noting that the current code has some consumption tax elements, Mr. Belt argued that "there is no question that the income tax system, as currently constituted, is fundamentally biased against savings" in favor of consumption.

Mr. Belt was careful to note that savings and responses to incentives in the tax code and elsewhere are complex issues, where leading economists disagree on important analytic issues. And he noted the difficulty of moving to a new tax code, with problems in transition from the current system. The USA Tax proposal did outline transition rules, and it was noted that in so doing, it created a great deal of political controversy. Mr. Belt concluded by noting that, although Congressional advocates were proposing major tax reform, it would take Presidential involvement and leadership for such a sweeping reform to be enacted into law.

Meeting of September 11, 1996

Kathryn Smith,
Bergman, Horowitz, and Reynolds

Ms. Smith opened by asking how does one move people without savings to look towards a comfortable retirement.

Ms. Smith detailed how she was more of a "practical" tax attorney and said her emphasis would concern small companies that have very little in the way of retirement savings opportunities. In light of the discussion of the national retirement income policy, emphasis needs to be placed on how to get people to save towards retirement.

In addressing the complaint that taxes are too complex, Congress has suggested fundamental tax reform suggestions such as a flat tax, VAT tax, consumption tax and wage tax. These changes taken as a whole both undermine the private pension system and in general replace the entire existing tax code.

In speaking about the various tax reform proposals, Ms. Smith made the following points:

  • The consumption tax that taxes what one uses could be seen as a discretionary super IRA because taxes are only applicable to moneys withdrawn and/or consumed.
  • Elimination of individual income tax leads to application of a business or corporate level tax wherein companies are taxed on the value they add and pay in the form of wages or compensation/pension.
  • Loosening and simplifying the present tax code would be more beneficial. This could be achieved through elimination of some non-discriminatory taxes, minimum participation rules, etc.

Examining the role that voluntary employer-sponsored pension plans play in this tax reform environment, Ms. Smith observed a comfortable retirement requires three areas to be secure and used the three-legged stool comparison featuring personal savings, Social Security and the private voluntary employer system. Social Security is baseline and personal savings are almost a non-item in the U.S., which is more a nation of consumers than savers. Private pension plans have been the one area that has survived a long-term savings base.

In looking at the history of defined benefit plans and the impact of both tax reforms and additional regulation on small companies, Ms. Smith noted:

  • Plans became overfunded due to cutting of defined benefit limits, leaving an excess of assets that went to the federal government in the form of excise or income taxes. This caused defined benefit plans to drop in significant numbers.

  • The combination of Social Security integration rules, 415 limits and higher corporate tax rates made it more financially attractive to bonus out any superfluous funds rather than put them in a qualified plan.

  • Pension plans have become almost invisible in small companies because of changes in tax laws such as:

    • 415 limits (owner's benefits) were reduced,
    • 402(g) amounts (contributable to 401(k) ) dropped,
    • top heavy minimum benefits were introduced which are super costly for small businesses,
    • compensation limits were put in place,
    • family aggregation was removed and
    • because of complexity, costliness, yearly changes in pension laws and OBRA '87's change of full funding rules.

Ms. Smith said defined benefit plans are dying in small businesses due to IRS audits that disqualify plans for tiny defects. She concluded her testimony by noting the impacts of the proposed reforms as follows: The tax reform proposals are going to neutralize the benefits of 405 plans. Owners are not incentivized to set up the SIMPLE plan due to the 100 percent matching criteria and the $6,000 contribution cap on employer contributions in 401(k) plans. In the case of the consumption tax/super IRA, large companies are really not affected as the company gets a deduction regardless.

By loosening qualification rules, the results include a return to selective plans, weird vesting and forfeiture rules, no spousal protections, lack of fiduciary responsibility and an adverse effect on the retirement system.

Small businesses will react to the new tax reforms in a negative fashion. The 75 percent that do not have plans will definitely not be encouraged to initiate plans and the 25 percent that do have plans will suffer a large fallout. Implementing the new tax reform proposals will provide people who have money a great opportunity while the low income folks have no where to look to for investment incentives.

Patricia Chadwick
Chief Investment Strategist,
Chancellor Capital Management

Uncertainty in the investment markets was the starting point for Ms. Chadwick's testimony. Major changes to the U.S. Tax Code means uncertainty, and financial markets do not like uncertainty due to the unknown effects on corporations and their earnings. Reducing or eliminating tax deductions associated with pension plans could eliminate incentives for employers to offer those plans. Without incentives, most employers would spend the money on enhancing cash flow to please stockholders rather than being concerned with employees' retirement savings. Consequently, actual retirement savings may be reduced and many individuals left to make their own investment decisions. These individuals are not capable of investing wisely without additional investment education. Educational efforts to date have been insufficient and many individuals are not equipped to make decisions on their own.

The current tax system is supported by a complex system of deductions, exemptions and graduated tax rates. This complexity makes it difficult to predict the true economic impact of tax reform on retirement savings. As an example, Ms. Chadwick pointed to the 1986 luxury tax that was intended solely to produce revenue from the sale of luxury items, but in fact almost wiped out the U.S. luxury boat industry causing many blue collar workers to lose their jobs.

Currently, no sense of urgency exists for individuals to save for retirement. Many such individuals rely on employers to create and maintain pension plans to provide for their retirement needs. Changes in the tax laws could reduce or eliminate deductibility of pension plan contributions or act as a disincentive to corporations to fund and maintain their plans. Without corporate plans, individuals do not have the incentive or the necessary education to successfully save for their retirement. Lower or middle-income individuals would be hardest hit because of lower investment education levels, while at the same time having greater demands for day-to-day living expenses.

Ms. Chadwick suggested that instead of tax reform, an incentive plan be considered that would start individuals saving for retirement in their twenties and by age sixty-five have more than enough funds to retire comfortably without governmental assistance.

Key Points:

  • Current incentives for retirement savings must be maintained or even possibly increased.
  • Eliminating tax incentives for employer-sponsored pension plans would hurt lower and middle-income individuals the most. Lower and middle-income individuals do not have sufficient investment education necessary to invest wisely and under tax reform may not have adequate incentives to save.

John R. Serhant,
Investment Committee of State Street Global Advisors

Mr. Serhant was strongly in favor or encouraging retirement savings on all levels. He felt Congress should "do whatever it takes" to raise retirement savings above existing levels. Additional retirement savings may require tax reform that would reduce current regulations and remove limits on amounts individuals can save. Nationally, pension savings are substantial and should not be taken lightly. More study is needed in a "savings friendly" atmosphere. Existing tax reform proposals could balance individual savings with collective savings in employer-sponsored pension plans. However, tax reform could also take away incentives for pension plans which may result in a negative effect on overall national retirement savings.

Mr. Serhant strongly supports any reform of the current tax system which increases the national savings rate. He suggests this could be done by simplifying existing pension rules and expanding IRA eligibility. Loosening existing pension regulations would allow all individuals the freedom to save, including lower and moderate income level workers. Mr. Serhant put his testimony in the context of his advocacy of partial or full privatization of Social Security, arguing that fixing the private pension system should be done in the context of overall national retirement policy, and that some privatization of Social Security was an essential element of future policy.

Key Points:

  • Make whatever changes are necessary to increase the net national retirement savings rate.
  • Existing tax reform proposals might negatively effect the pension system. Therefore, Congress should first consider simplifying and reducing existing regulations as a first step while further studying potential effects of tax reform.

V. Testimony and Other Materials Received or Placed in Record

For the Advisory Council 1996 term:

May 8, 1996:

Suggested Issues for ERISA Advisory Council to Investigate by Kenneth S. Cohen, 5/6/96

Written Testimony from Jonathan Barry Forman, University of Oklahoma at Norman, "The Impact of Shifting to a Personal Consumption Tax on Pension Plans and Their Beneficiaries" presented originally to a panel on public policy perspective of the April 30, 1996 EBRI-ERF Policy Forum on Comprehensive Tax Reform: Implications for Economic Security and Employee Benefits.

Written Testimony from the Association of Private Pension and Welfare Plans on "Flat Tax Side-by-Side" dated 9/5/95.

June 19, 1996:

Written Testimony from Kenneth Kies, chief of staff of the Congressional Joint Committee on Taxation, which was a copy of the Selected Materials Relating to the Federal Tax System Under Present Law and Various Alternative Tax Systems, issued March 14, 1996.

Written Testimony by William G. Gale, senior fellow, The Brookings Institution, on "Effects of Comprehensive Tax Reform on Private Pensions and Savings"

Written Testimony submitted by the American Academy of Actuaries Task Force on Tax Reform as presented by Ron Gebhardtsbauer, senior pension fellow, on June 19, 1996.

Written Testimony from Bradley D. Belt, domestic policy director of the Center for Strategic Internal Studies (CSIS), on the topic of the impact of alternative tax proposals on the ERISA employer-sponsored pension system.

September 11, 1996:

Written Testimony from Kathryn H. Smith, Bergman, Horowitz and Reynolds

Written Testimony of Patricia Chadwick, chief investment strategist, Chancellor Capital Management

Written Testimony of John R. Serhant, chairman of the investment committee for State Street Global Advisers

Charts prepared by Thomas Healey, Goldman Sachs, and an ERISA Advisory Council member

October 10, 1996:

New Haven Register Article entitled "Tax reform could affect workers' benefit plans" by Paul F. Jackson, Register Business Editor and provided by Working Group Vice Chair Carl S. Feen.

As background for the Working Group, a bound volume from the Employee Benefit Research Institute--Education and Research Fund (EBRI-ERF) Policy Forum on April 30, 1996, on Comprehensive Tax Reform: Implications for Economic Security and Employee Benefits was provided. Included were:

  1. About EBRI-ERF Policy Forums

  2. Agenda

  3. About the Presenters and Discussants

  4. Michael Graetz, Yale Law School

    Daniel Halperin, Georgetown University Law Center

    "Comprehensive Tax Reform and Fringe Benefits: The Case of Employer- Provided Pensions and Health Insurance."

  5. James Poterba, MIT, Department of Economics

    "The Impact of Fundamental Tax Reform on Employer-Provided Health Insurance."

  6. David Cutler, Harvard University, Department of Economics

    "Comprehensive Tax Reform and Employer-Provided Health Insurance."

  7. Stephen Woodbury, W.E. Upjohn Institute for Employment Research

    "Employee Benefits and Tax Reform"

  8. William Gale, The Brookings Institution (co-author, Eric Engen, Board of Governors of the Federal Reserve System)*

    "Comprehensive Tax Reform and the Private Pension System."

  9. Giles Archibald, William M. Mercer Co.

    "The International Perspective"

  10. Richard Sawaya, Atlantic Richfield Company

    "Taxes, Pensions & Benefits: A Possible Employer View."

  11. Jonathan Forman, University of Oklahoma, College of Law*

    "The Impact of Shifting to a Personal Consumption Tax on Pension Plans and Their Beneficiaries."

  12. Randolf Hardock, Davis and Harman

    "The Reality of Tax Reform."

  13. EBRI Background Materials

    * Persons also appearing before the Working Group and listed previously.

VII. Members of the Work Group

Richard McGahey,
Neece, Cator, McGahey and Associates

Carl S. Feen,
Vice Chair
CIGNA Financial Advisors

Judith Mares,
Chair of the Advisory Council
Mares Financial Consulting, Inc.

Kenneth S. Cohen
Massachusetts Mutual Life Insurance Company

Glenn W. Carlson
Arthur Andersen LLP

Thomas J. Healey
Goldman, Sachs and Company

David G. Hirschland
International Union, United Automobile, Aerospace and Agricultural Implement Workers of America, United Auto Workers

Vivian Lee Hobbs
Arnold and Porter

Marilee P. Lau
KPMG Peat Marwick LLP

Edward B. Montgomery
University of Maryland

Zenaida Samaniego
Equitable Life Assurance Society of the United States

James O. Wood
Louisiana State Employees' Retirement System (LASERS)

If you have questions, please call the Council's Executive Secretary at 202-219-8753.