Potential New Retirement Legislation on the Horizon

Last month, the US House passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in a rare bipartisan 417 – 3 vote. The bill offers Americans more incentives to save and invest through tax-advantaged retirement accounts like 401(k)s and IRAs. With similar bills receiving broad Senate support—the Retirement Enhancement Savings Act (RESA) and the Retirement Security and Savings Act (RSSA)—many expect some version to become law before too long, changing America’s retirement system significantly. Predictably, there are good and some not-so-good provisions, in our view. Here we provide a rundown, focusing on the SECURE Act since it is furthest along in the legislative process but noting where the RESA and RSSA potentially differ.

The Good

Perhaps the biggest benefit from a retiree’s perspective: provisions raising the required minimum distribution (RMD) age to 72 from 70 ½ and allowing traditional IRA contributions after age 70 ½. This would help folks living and working longer by enabling more tax-deferred growth in their traditional IRAs (funded with pre-tax income), which could mean greater assets later in life, when medical care costs loom large. Note: The RESA doesn’t change the current RMD age, but the RSSA would up it to 75.

The SECURE Act would also increase the number of folks who might benefit from employer sponsored retirement accounts. Part-time workers—those working fewer than 1,000 hours a year for one employer—aren’t currently eligible for their employers’ 401(k) or similar savings plans. The bill would allow part-time employees who have worked at least 500 hours a year for 3 years to sign up. The RSSA is more generous, lowering the threshold to two years, but the RESA omits this. To encourage more small businesses to offer retirement plans, the bill would make it easier for them to band together by sharing administrative and fiduciary costs through multi-employer plan administrators—a “pooled plan provider.”

The Nice

As a further sweetener, the SECURE Act provides a $500 tax credit for 3 years to small businesses automatically enrolling employees in new 401(k) and SIMPLE IRA plans. Also, the cap on the amount employers can defer from employees’ pay when automatically enrolling them for 401(k)s would be 15% instead of 10%, helping employees save more. We are admittedly a little squeamish about legislative paternalism here. But some studies show participation rates rising to over 90% with automatic enrollment versus around 40% without. Plus, it is simply an “opt out” system rather than “opt in,” preserving freedom of choice, particularly for those living paycheck to paycheck. Ideally, most eligible workers would opt in, but failing greater financial education and outreach, auto-enrollment is a helpful stopgap for many.

The bill includes other bells and whistles, like penalty-free withdrawals from retirement plans up to $5,000 for birth or adoption expenses within the first year. Another provision allows tax-free withdrawals up to $10,000 from 529 education-savings plans to pay for student loans. Neither is included in the RESA, but the RSSA would allow employer matching contributions to employees’ retirement accounts in the amount of their student loan payments.

The Not So Great

To help offset the SECURE Act’s expanded tax deferral, those inheriting a retirement account would have to withdraw and pay taxes on all funds within 10 years (excepting spouses, minor children and other beneficiaries who are less than 10 years younger than the account owner). Current law allows more spread-out withdrawals, reducing taxes by limiting exposure to higher tax brackets (e.g., smaller distributions over a longer timeframe). The RESA would make it five years, but beneficiaries’ balances below $400,000 would be exempt. It isn’t clear what revenue offsets the RSSA contains—if any—but it would allow non-spousal beneficiaries to roll over inherited IRAs into 401(k)s.

The Ugly

Niceties aside, one could make a case the SECURE Act’s benefits are really just sheep’s clothing for a rabid wolf: provisions encouraging annuities’ use in 401(k)s, making them much more like 403(b)s’ tax-sheltered annuities (TSAs), which employees of public schools and other non-profits may be familiar with. Under the new bill, folks would likely find more annuity options within their 401(k) plans and greater temptation to annuitize—turn a lump sum into an income stream—at retirement or after.

The SECURE Act promotes this in three ways. First, it gives employers a “safe harbor” when picking insurance companies offering annuity products for their 401(k) plans. If something goes wrong—the annuities don’t deliver as advertised or the provider goes belly-up—the employer wouldn’t be liable. Not having safe harbor has kept annuity use out of most 401(k) plans; this bill and the others aim to change that. Second, portability: Annuities in one plan can transfer to another or an IRA without penalty. So if an employee changes jobs or retires, it would be easy to move their annuity with them. Third, it requires benefit statements to disclose hypothetical monthly payments their retirement account could support if converted to an annuity—free advertising for so-called “lifetime income” products. Thanks to the safe harbor, plan administrators would have no accountability if those projections prove too optimistic. In our view, to call this provision dangerous is an understatement, potentially misleading investors about annuities’ true value, costs and risks.

We see a host of problems with expanding annuities to 401(k)s. Some call the annuity provision a sop to insurance companies at vulnerable investors’ expense—we sympathize. Annuities are notoriously opaque and complicated, particularly deferred annuities. Will those who see an attractive line item on a statement understand the restrictions, penalties and fees, which may reduce total lifetime returns? Besides, it isn’t as though a plan participant couldn’t retire, roll over their 401(k) to an IRA and buy an annuity right now if they so chose. But most don’t, in our view, because annuities layer on extra complexity and costs without any greater benefit than well-diversified stock and bond portfolios. For those who do take out annuities, the vast majority never annuitize, balking at irrevocably handing their life savings over to an insurer to be pooled with others’ in exchange for contractual payments of uncertain length.

Further, any annuities in a tax-deferred retirement account would be redundant. Financial regulators like the SEC and FINRA have issued notices for years that there are no added tax benefits for buying annuities in qualified retirement plans.

Keep an eye on this. Educate kids and grandkids about potential changes, and talk to a financial adviser if you have any questions.