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Employee Benefit Research Institute
The Employee Benefit Research Institute (EBRI) is a Washington-based,
nonprofit, nonpartisan public policy research institution. EBRI's overall
goal is to promote the development of soundly conceived private and
public employee benefit plans.
Through research, policy forums, workshops and educational publi-cations, EBRI contributes to the expansion of knowledge in the field
and to the formulation of effective and responsible health, welfare
and retirement policies. This work is intended to complement the
research and education programs conducted by academia, the gov-
ernment and private institutions.
EBRI's educational and research materials aid the public, the media
and public and private sector decision makers in addressing employeebenefits issues before policy decisions are made. The Institute seeks
a broad base of support among interested individuals and organi-
zations as well as those sponsoring employee benefit plans or pro-
viding professional services in the employee benefits field.
Dn. SOPHIE M. KOnCZYK is an EBRI Research Associate specializing
in pension-related investment and tax policy issues. She holds grad-uate degrees in economics from Washington University in St. Louis,and an undergraduate degree from LeMoyne College, Syracuse, NewYork. Prior to joining EBRI, she was on the staff of the CongressionalBudget Office. Dr. Korczyk has published research on federal pensionpolicy, government policy toward business, and federal budget issues.
More information on the Employee Benefit Research Institute can be
obtained by writing: President, EBRI, 2121 K Street, NW, Suite 860,
Washington, DC 20037 (202) 659-0670.
BySophie M. Korczyk
AN EBRI-ERF POLICY STUDY
EBRIEMPLOYEE BENEFIT RESEARCH INSTITUTE
© 1984 Employee Benefit Research InstituteEducation and Research Fund
2121 K Street. NW, Suite 860
Washington, DC 20037(202) 659-0670
All rights reserved. No part of this publication may be used or reproduced in
any manner whatsoever without permission in writing from the Employee Ben-efit Research Institute except in the case of brief quotations embodied in news
articles, critical articles, or reviews. The ideas and opinions expressed in this
publication are those of the author and do not necessarily represent the views
of the Employee Benefit Research Institute, its trustees, members or associates.
Library of Congress Cataloging in Publication Data
Korczyk, Sophie M.
Retirement security and tax policy.
(An EBRI-ERF policy study)
Bibliography: p.
I. Old age pensions--Taxation--United States. 2. Old age pensions--Tax-ation-Law and legislation--United States. 3. Tax expenditures--UnitedStates. I. Title. II. Series.
HJ4653.P5K67 1984 343.7305'23 84-7975
ISBN 0-86643-037-7 (pbk.) 347.303523
Printed in the United States of America
Table of Contents
List of Tables .......................................................... ix
Executive Summary .................................................. xiii
Foreword ............................................................... xix
Introduction ........................................................... 1
Chapter IEmployee Benefits: Categories, Trends, and Tax Policy ......... 3
Classifying Employee Benefits .................................... 3Legally Required Employer Payments; VoluntaryEmployee Benefits; Employee Benefits in the NationalIncome and Product Accounts; Employee Benefits andTax Policy
Policy Issues Raised by the Growth of Voluntary EmployeeBenefits .............................................................. 10
Benefit Growth and Federal Revenues; The DifferentTreatment of Cash and Noncash Compensation; EquityEffects of the Tax Treatment of Pensions; EmployeeBenefits and Basic Income Tax Reform
Tax Policy and Retirement Policy: Conflict andCompatibility ....................................................... 13
Chapter IIStatutory Provisions for the Tax Treatment of Pensions ........ 15
Legislative History ................................................. 15Early History; Recent History
Employer Contributions ........................................... 18Defined-Benefit Plans; Defined-Contribution Plans;Employee Stock Ownership Plans; Participants in MoreThan One Plan; Top-Heavy Plans
Tax Principles Governing Employer Contributions ........... 22Qualified Plans; Nonqualified Plans
Taxation of Investment Earnings ................................ 25
V
Employee Taxation ................................................ 26Employee Contributions .......................................... 26
Mandatory Employee Contributions; Voluntary EmployeeContributions
Individual Retirement Accounts ................................. 29
Plans for the Self-Employed ...................................... 30
Tax Principles Governing Employee Retirement Saving ..... 31Plan Distributions .................................................. 33
Types of Distributions Identified Under the Tax LawNonqualified Plans ................................................. 36Conclusions ......................................................... 37
Chapter IIIThe Tax System and Other Factors Encouraging PensionGrowth ................................................................. 39
The Tax System .................................................... 39Marginal Tax Rates; Regulation of Specific Benefits
Income Growth ..................................................... 45
Employer Cost Considerations ................................... 46Economies of Scale; Labor Demand and Compensation
Packages; Benefits and Indirect Labor Costs; Employerand Employee Preferences
Conclusions ......................................................... 49
Chapter IVThe Measurement of Pension-Related Tax Benefits .............. 51
Pension-Related Tax Benefits Over the Participant'sLifetime ............................................................. 51
Current Dollars; Real Dollars; Tax Payments Adjusted forInterest
Who Benefits from Pension-Related Tax Policies? ............. 58
Tax Expenditures and Retirement Policy ....................... 59The Benefits of Pension-Related Tax Policies; Interactions
Among Tax-Code ProvisionsConclusions ......................................................... 63
Chapter VPensions, Savings, and Financial Markets ......................... 65
Who Are the Participants? ........................................ 65The Role of Employer Pensions in Household Savings andRetirement Planning ............................................... 67
Capital Investment; Retirement Security
vi
The Impact on Savings if Tax Policy Toward PensionsChanges .............................................................. 69
Assets Purchased for Capital Gains; Tax-Free MunicipalBonds; IRAs; Implications for Tax Policy
Pension Funds as Institutional Investors ........................ 72
Comparison with Other Institutional Investors;Concentration of Funds Within the Pension Sector; Effectof Institutional Trading on Asset Prices
Conclusions ......................................................... 76
Chapter VIPensions and Basic Tax Reform .................................... 77
Alternative Tax-Code Formulations .............................. 77
Consumption Tax; Comprehensive TaxEvaluating Tax Policy Options ................................... 81
Equity; Efficiency; Simplicity
Problems in Valuing Pension Accruals During theIndividual's Work Career ......................................... 82
Plan Features; Length of the Employee's Work Career;Employee Age
Recent Legislative Proposals ..................................... 85
Comprehensive Income Tax; Consumption Tax;Comparing Major Proposals
Conclusions ......................................................... 88
Chapter VII
Pension Tax Policy Issues ............................................ 91
Changes in Section 415 Limits ................................... 91
Limits Enacted in TEFRA; Limits Proposed in theBradley-Gephardt Bill; Short- and Long-Term Effects ofthe Proposed Changes; Other Effects
Distributions in Defined-Contribution Plans ................... 99Retirement Income Distributions; Pension-Plan
Distributions and Tax LiabilityConclusions ......................................................... 101
Chapter VIII
Retirement and Tax Policy: Changes and Implications ......... 103
vii
Appendix
Model, Data, and Procedures Used in Analysis ................... 105
References ............................................................. 119
Index ................................................................... 127
viii
List of Tables
Table Page
1.1 Employee Benefits in Medium-Size and Large Private-Sector Firms, 1982 ..................................... 4
1.2 Tax-Favored Employee Benefits in Medium-Size andLarge Private-Sector Firms, 1982 .................... 6
1.3 Employer Outlays for Employee Benefits in the Na-tional Income and Product Accounts for SelectedYears, 1950-1982 ....................................... 8
III.1 Marginal Tax Rates for Federal Personal Income Tax
tor Selected Years, 1960-1983 (Current Dollars) .. 41
III.2 Marginal Tax Rates for Federal Personal Income Tax
for Selected Years, 1960-1983 (1980 Dollars) ....... 42
III.3 Employer Contributions for Pensions and Group LifeInsurance as a Percent of Employee Compensationfor Selected Years, 1960-1982 ........................ 44
IV.1 Taxes Deferred on Pensions and Paid on Benefits bv
Workers Aged 25 to 34 (Current Dollars) ........... 54
IV.2 Taxes Deferred on Pensions and Paid on Benefits byWorkers Aged 25 to 34 (Real Dollars) ............... 55
IV.3 Taxes Deferred on Pensions and Paid on Benefits by
Workers Aged 25 to 34 (Discounted at Pension-FundRate) ..................................................... 56
IV.4 Taxes Deferred on Pensions and Paid on Benefits bvWorkers Aged 25 to 34 (Discounted at Federal BondRate) ..................................................... 57
ix
IV.5 Net Lifetime Pension-Related Tax Benefit Shares
Among Employees Aged 25 to 34 .................... 59
IV.6 Tax Expenditures Under Alternative AssumptionsAbout the Funding ot Employer-Sponsored PensionPlans ..................................................... 61
IV.7 Lifetime Pension-Related Tax Benefits and the Elderly
Exemption .............................................. 64
V.I Savings, Pension Coverage, and Income, 1983 ........ 66
V.2 Increases in the Assets of Individuals as a Percent of
Gross Saving, 1970-1982 .............................. 68
V.3 Pension-Plan Participation Relative to Pension Con-tributions and Earnings ............................... 73
V.4 Investment by Non-Bank Institutions .................. 74
VI.l Benefits and Lifetime Tax Liability tbr Employees with
15 Years of Pension Coverage ........................ 80
VI.2 Voluntary Benefits: 1982 Federal Tax Expendituresand Employer Cost ..................................... 88
VII.1 Percent of Vested Participants Affected bv TEFRA
Changes to Section 415 Limits ....................... 92
VII.2 Percent of Vested Participants Affected bv Bradlev-
Gephardt Changes to Section 415 Limits ........... 94
VII.3 Percent of Vested Participants Affected bv TEFRA andBradley-Gephardt Section 415 Limits ............... 95
VII.4 Wage Level and Pension Coverage by Industry ....... 98
VII.5 Employment Termination and Defined-ContributionPlans by Employee Age and Benefit Value ......... 99
VII.6 Defined-Contribution Plan Benefits Analyzed by PlanAssets Used for Retirement (1983 Dollars) .......... 100
X
VII.7 Dcfincd-Contribution Plan Benefits and Tax Liability(1983 Dollars) ........................................... 102
A.I Description of the Population Included in the Simu-lation Data Base ........................................ 107
A.2 Alternative II-B Economic Assumptions for SelectedYears, 1979-2000 ....................................... 109
A.3 Average Incomc in thc Highest Fivc of the Last TenWork Years Before Retirement ....................... 114
A.4 Sample Population Data ................................. 117
xi
Executive Summary
Employer contributions for employee benefits have increased steadilyas a share of compensation over the last thirty years. According toDepartment of Commerce estimates, cash outlays for employee ben-efits beyond wages and salaries have grown from 4.9 percent of totalcompensation in 1950 to 15.8 percent in 1982. Over a third of thisamount finances employer-sponsored pension plans. Pension contri-butions increased from 1.8 percent of employee compensation in 1950to 5.3 percent in 1982. Pension assets have grown from less than $20billion in 1950 to over $1 trillion today. Benefits paid have grownfrom $1 billion in 1950 to nearlv $90 billion todav.
The tax-favored treatment of qualified pensions predates even theestablishment of the Social Security system in 1935. Statutes enactedin 1921 and later, covering income from trusts and pension plans,were intentionally designed to encourage the expansion of pensioncoverage and increased saving levels, and to provide a private sourceof retirement security. The preferential tax treatment accorded morerecently developed retirement and capital accumulation vehicles such
as individual retirement accounts (IRAs); simplified employee pen-sion plans (SEPs); section 401(k) plans; and qualified voluntary em-ployee contributions (QVECs) indicates continued interest in increasingvoluntary individual retirement savings. The tax treatment accordedqualified plans provides incentive for both employer and employeeto establish and participate in such plans.
The continuing growth of pensions raises certain policy questionsabout the role of the tax code in their encouragement. Among thepolicy questions are:
(1) Should the tax code encourage pensions?
(2) Who benefits from pension tax policy?
(3) How much does pension tax policy cost in federal revenue?
(4) What role should pensions play in basic tax reform?
Benefits and the Tax Code
The federal tax system is the most important factor influencingbenefit growth. The tax code makes benefits cost-effective as com-
Xlll
pensation and encourages the broad coverage of employees. Histor-ically, the tax code has worked with inflation to encourage benefitgrowth as protection against the inflation-driven increases in realmarginal tax rates.
The tax code makes benefits cost-effective bv providing a tax de-duction for employers and preferential tax treatment for employees.As a result, a dollar in benefits may be worth more to the employeethan a dollar in cash wages.
The tax code encourages employers to extend their benefit coverageto lower- and middle-income employees. The preferential tax treat-ment accorded benefits is contingent upon compliance with the taxcode's nondiscrimination provisions governing coverage of the em-ployer's work force.
During the past twenty years, inflation has pushed most taxpayersinto higher marginal tax brackets, despite legislation lowering nom-inal tax rates for the different income levels. This "bracket creep,"the gradual increase in real marginal tax rates, has prompted the useof noncash benefits to stem the erosion of real income. Up to 30percent of the benefit growth over this twenty-year period may beattributed to attempts to alleviate inflation's impact on employeecompensation.
While the tax code is a major factor encouraging benefit growth,it is not the only factor. Employee compensation also depends onincome growth, employer cost considerations, and employer and em-ployee preferences.
Income Distribution and Pension Policy
Critics of the pension system allege that pension-related tax pro-visions are regressive, providing tax shelters for the wealthy and littleor no benefits for anyone else. The distributional effects of pension-related tax provisions, however, have not been adequately assessedin the past. Data presented in this report indicate that pensions areprimarily a middle-income benefit. An income profile of all pensionparticipants indicates that over three-quarters are lower- and middle-income employees. Younger employees currently earning between$20,000 and $50,000 will receive more than half of their age group'stotal pension-related tax benefits.
Previous studies of pension distribution have tended to ignore theeffect of pensions on the distribution of wealth and savings. Publicpolicy encourages pension growth to increase individual retirementsaving. Employer pensions affect saving and wealth in several ways:
xiv
(1) Increase Total Saving--Pensions add to total saving primarily becausethey are nondiscretionarv. A study of 1983 data revealed that _pensionswere the major source of savings for over half of the covered employees.
(2) Redistribute Saving Amollg Income Groups--Pensions are distributedmore broadly among income groups than other forms of savings. Non-pension saving is concentrated among relatively high-income individ-uals. If pension contributions were received as cash income, total savingwould not only decrease but the drop would be relatively greater amonglower- and middle-income employees.
(3) Redirect Savbl_--Pensions change the distribution of saving amonginvestment vehicles. Nonpension saving consists primarily of liquidsaving deposits and investments in owner-occupied homes or otherconsumer durables. Pension funds, in contrast, invest in securities thatfinance productive capacity' and employment. Pension funds have grownto be the single largest source of institutional investment funds.
Tax Expenditures and the Social Costs of Pensions
Pension-related tax expenditures are commonly used in public pol-icy debates as an indication of the social cost of fecteral pension policy.Tax-expenditurc measures used in the budgetary process are calcu-lated on a cash-flow or cross-sectional basis, with the amount of the
taxes deferrcd by current pension-plan participants offset against theamount of taxes paid bv current beneficiaries.
Problems of measurement and definition make cross-sectional es-
timates an unrealistic measure of the social cost of pension policy.These estimates overstate the amount of the true tax benefits accruingto current participants bv failing to distinguish between taxes de-ferred and taxes permanently lost to the Treasury. When tax benefitsare measured in a lifetime context, the revenues lost to the Treasurydecrease significantly. Tax expenditures measurcd on a cash-flowbasis total more than 80 percent of deferred taxes while the real(inflation-adjusted) value of tax expenditures measured in a lifetimecontext is about one-quarter the value of deferred taxes.
When tax de|crrals and payments are further adjusted to reflectthe interest foregone by the Treasury, the value of lifetime tax ex-penditures increases but remains less than half that of deferred taxes.Cross-sectional estimates, therefore, vastly overstate the true federal
revenue costs of pension policy. The increased saving and retirement
income resulting from the current preferential tax treatment of pen-sions are due mainly to federal revenue deferrals--not losses.
Tax-expenditure statistics are also misleading because thev implythat only advance-|unded plans impose social costs. Tax deferrals are
XV
measured only on contributions and earnings actually received byplans, which means that a pension plan must be advance-funded toresult in tax expenditures. The Employee Retirement Income Secu-rity Act of 1974 (ERISA) established minimum funding standards forprivate-employer defined-benefit plans, enhancing benefit security.In contrast, the Civil Service Retirement System (CSRS) and theMilitary Retirement System (MRS), the two major federal retirementplans, have little impact on tax expenditures because they are fundedprimarily on a pay-as-you-go basis. Underfunded or unfunded plans,however, can cost the taxpayer much more in the long run.
Even lifetime tax-expenditure measures ignore the likelihood thathigher-income taxpayers would invest in other tax-preferred assets(e.g., housing, state and local government bonds, assets purchasedfor capital gain) in the absence of employer-sponsored pensions. Thus,a change in the current treatment of pensions might not recover eventhe lower, long-term estimated federal revenue losses.
Pensions and Basic Tax Reform
Despite the weaknesses in the tax-expenditure concept, persistentfederal deficits have generated interest in policy initiatives aimed atcurbing pension-related tax benefits. These changes are generally partof basic tax reform proposals.
The consumption or cash-flow tax and the comprehensive incometax, two major theoretical alternatives to the current system of tax-ation, have received particular attention in recent debates concerningbasic tax reform. Basic tax reform could significantly affect employeebenefits. While consumption-tax proposals would retain the currentpreferential tax treatment of pension contributions, investment earn-ings, and benefits, some comprehensive-tax proposals would treatnoncash benefits like cash income in determining tax liability.
The tax code would become more complex if pension accruals weretaxed on a current basis, because there is no uniquely correct way tomeasure the current value of future benefits. Differences in pensionaccrual and vesting patterns mean that two employees with exactlythe same benefit rights at retirement can have very different benefit-accrual patterns during their work careers. Taxing pensions on acurrent basis would also penalize better-financed plans, encouragingplan sponsors to defer their financing obligations to the limit allowedunder ERISA.
As an alternative to restructuring the tax treatment of pensions, ithas been proposed that pension-related tax preferences be cut back
xvi
significantly bv lowering the limits on benefits and deductible con-tributions under section 415 of the Internal Revenue Code. This could
bring a different set of problems. Onlv those employees earning $125,000or more would be immediately affected bv the changed limits; butwage growth over time would bring more employees in all incomegroups to the benefit and contribution limits, if such limits were set
without regard for real and nominal wage growth. These effects could
differ considerably by industry, with high-wage and high-coverageindustries the most significantly affected. Should stringent limits beimposed on benefit contributions and earnings, moreover, they wouldprobably have an indirect impact on even those employees who neverapproach the statutory limits. Lowering benefit and contribution lev-els could increase the cost of plan sponsorship--as more benefits
would probably be provided through costlier nonqualified plans. Ifemployers should respond to these cost increases bv foregoing benefitincreases or enrichments, all plan participants could be affected.
Conclusions
The growth of employee benefits has brought numerous social ben-
efits. Over 70 percent of all full-time employees over age twenty-fivewith at least one year of service with their current employer arecovered by an employer-sponsored pension plan. Between two-thirds
and three-quarters of current employees can expect to receive em-ployer-sponsored pensions when they retire, while only about one-
third of current retirees receive pensions. Today's prime-age workerscan expect to receive a retirement income about twice as large (inreal terms) as that of a current retiree and will draw nearly half of
this amount from an employer pension. Also, employer pension plansadd to total saving and broaden the distribution of retirement savingsamong income groups.
The success of federal tax-code provisions in encouraging the growthof pension coverage and benefit levels has led to increased policyinterest in the federal revenue losses attributable to pensions. It mustbe remembered that tax-expenditure estimates are flawed for use as:(1) budget policy guides, since they fail to take into account the sec-
ondary effects of tax-code changes and the interaction and substi-
tutability of tax-code provisions; and (2) retirement policy guides,since they offset tax deferrals by current participants against themuch lower taxes paid by current retirees. Thus, tax expenditures
seriously overstate the amount of the federal subsidy of employerpension plans.
xvii
Tax-expenditure measures do not and cannot take into account thesocial goals promoted by pension policy. Major social goals of pension
policy include: increased and more widely distributed saving; higherretirement income; and increased benefit security. This report as-
sesses the available evidence and provides new information for pol-icymakers to use in evaluating pension policy. It evaluates the roleof the tax code in fostering pension growth and the impact of thepreferential tax treatment of pensions and other benefits on the dis-tribution of employee income, wealth, and tax liability. Only byweighing these benefits against the cost of the pension system, cansociety decide if it is a good buy.
xviii
Foreword
Economic security for retired Americans is a national goal that hasbeen supported by both the Republican and Democratic politicalparties and by both the public- and private-sectors for well over acentury.
In response to this national consensus, Congress established mili-tary pensions before the Civil War and employers established the firstpensions for municipal- and private-sector employees before 1900.
Congress legislatively recognized the need for tax incentives for pri-vate pension programs in the Revenue Act of 1921. The need for agovernment-sponsored base of retiree income was recognized withpassage of the Social Sccuritv Act in 1935.
Retirement Securilv and Ta_ Policy documents and analyzes the roleof federal tax laws in fostering the creation of over eight-hundred
thousand employer-sponsored pension plans and the resulting effectson the distribution of income, wealth, and tax liabilitv among indi-viduals. Over seventy-five million workers, retirees, and their depen-dents gain economic benefit from these pension programs.
Author Sophie Korczvk details the costs and social benefits of the
preferential tax treatment of pensions, presenting analysis assessingthe lifetime tax value of the tax deferral afforded pension contribu-tions and earnings. Korczvk's work indicates that Congress has achievedits objective of improving the economic security of the nation's re-tirees through the encouragement of pensions.
Korczvk's study presents data on pension entitlement and receiptshowing that the middle class is the major beneficiary of pensions.
Her work finds that pension saving is more broadly distributed amongincome groups than other forms of saving, and that the eliminationof pensions would harm low- and middle-income individuals the most.
The preferential tax treatment of pensions has played a major rolein tax reform proposals beIore the Congress in recent years. The factthat such treatment has caused over one trillion dollars in pensionreserves to be accumulated almost guarantees ongoing media andcongressional attention.
Retirement Security and Tax Policy should be a valuable resource
[or those interested in economic security in general, and those inter-
xix
ested in assessing the costs and benefits of the preferential tax treat-ment of pensions in particular.
Sophie Korczyk is a Research Associate at the Employee Benefit
Research Institute (EBRI). Maureen Machisak edited the manuscript.Mary Catherine Calvert typed the many drafts during the study de-
velopment. W. Hardee Mahoney exhibited persistence and creativityin undertaking the extensive data processing required for the study.Debra Parel Hostyk prepared the first draft of Chapter II. David Ken-nell and John Sheils of ICF, Inc., prepared the data base used inchapters IV and VII.
On behalf of EBRI, I wish to thank those who provided funding forthe study. Numerous persons also took the time to review the manu-
script and to make comments. Their input was especially helpful inassuring a balanced and objective treatment of this controversialsubject. Special thanks go to: Charlotte Armstrong, Esq.; Allen S.Arnold, F.S.A.; Paul S. Berger, Esq.; Edwin Boynton, F.S.A.; ManuelCastells, F.C.A.; Jack Doherty; William A. Dreher, F.S.A.; Joseph Ei-chenholz; Peter Elinsky, C.P.A.; Edward A. Foley; Jon S. Fossel, C.F.A.;Alan R. Glickstein; Daniel Halperin, Esq.; Richard Hubbard, Esq.; T.J. Hurley, Tax Consultant; Paul H. Jackson, F.S.A.; Daniel Klein, Esq.;Susan Koralik, M.B.A.; Thomas D. Levy, F.S.A., M.A.A.; Thomas Mal-loy, F.S.A., E.A.; Judith Mazo, Esq.; Michael Melton, Esq.; MaureenMullen; Larry Ozanne, Ph.D.; Frank Peabody III; Anthony J. Pellechio,Ph.D.; Mary S. Riebold, F.S.A.; Sylvester J. Schieber, Ph.D.; HarryG. Smith; A. Dale Stratton; James R. Swenson, F.S.A.; Robert Wal-
lace; Howard C. Weizmann, Esq.; Susan Young; Barry Zinns, Esq.;and Andrew E. Zuckerman, J.D.
Views expressed in this book are solely those of the author. Theyshould not be attributed to the officers, trustees, members, associates,contributors or subscribers of the Employee Benefit Research Insti-tute, its staff, or its Education and Research Fund.
DALLAS L. SALISBURY
President
September 1984
XX
Introduction
Employee benefits have become increasingly, important in em-ployee compensation over the last thirty years. Pension plans are nowthe largest component of employee benefits. Over forty-nine millionemployees are currently covered by' pension plans. 1
The growth of benefits has been encouraged bv favorable tax-code
provisions. High and persistent federal deficits are now causing pol-icymakers to reassess the whole range of incentives contained in thetax code, including those governing the tax treatment of benefits.Particular attention is being paid to the perceived federal revenuecosts of the tax incentives related to employee benefits.
This report presents new evidence and analyzes available infor-mation on the role of the tax code in fostering pension growth andon the effects of pensions and related tax preferences on the distri-bution of income, wealth, and tax liability among employees.
Chapter I provides background on the growth of benefits and re-lated tax-policy issues.
Chapter II describes the tax treatment of the different componentsof the pension system, including employer plans and individual ini-
tiatives. It describes the legal arguments and legislative history be-hind the current tax treatment of pension plans and explains thevariation of treatment among plans.
Chapter III discusses the role of the tax code and other factors inencouraging benefit growth.
Chapter IV presents alternative measures of pension-related taxexpenditures. Lifetime measures of pension-related tax benefits are
developed and compared with cross-sectional measures. The chapterconcludes that tax-expenditure measures currently used in the budgetprocess overstate tax benefits to pension participants.
Chapter V discusses the effect of both employer-sponsored plansand individual retirement initiatives on the level, composition, anddistribution of savings among income groups. Most analyses of thedistributional effects of pension-related tax policies focus on the ef-
_Preliminary EBRI tabulations of May 1983EBRI/HHS CurrentPopulation Survey Pen-sion Supplement.
fects of these provisions on tax liability and ignore the savings thatpensions generate.
Chapter VI examines the tax treatment of pension plans in thecontext of basic income tax reform.
Chapter VII examines the effects of selected current-law pensiontax policy options.
Chapter VIII summarizes the study's major conclusions.
I. Employee Benefits: Categories,Trends, and Tax Policy
This chapter lavs the basis for the assessments of current and al-
ternative policies contained in the following chapters. The first sec-tion discusses the types of employee benefits currently offered, detailstheir growth, and explains their tax status. The second section ex-
plains the policy issues raised bv the growth of employee benefits.The third section discusses points of conflict and compatibility be-tween tax policy and relirement policy.
Classifying Employee Benefits
The broadest definition of employee benefits is that part of com-pensation not received as cash. Using this definition, two categoriesof benefits may be distinguished. One category includes all benefits
that are required legally, such as Social Security, unemploymentcompensation, and other benefits financed by payroll taxes. The sec-ond includes those benefits provided as the result of a voluntaryagreement between the employees and their employer. These benefitsmay be further classified as fully taxable, tax exempt or tax deferred.
The U.S. Chamber of Commerce annually collects data on the typesof benefits offered by medium-size and large private employers. TheChamber's sample is small (about fifteen hundred firms) and notscientifically selected or weighted to be an accurate representationof national totals, but the data provide a useful picture of the benefitsoffered bv private employers and highlight the relatively small shareof total benefits receiving preferential tax treatment.
Legally Required Employer Payments--Legallx, required employerpayments constitute 7.6 percent of total private-sector compensationand over a quarter of all benefit outlays (table 1.1). Two-thirds of thecost are legally required employer payments for Social Security ben-efits, while the remaining one-third finances social-insurance pro-grams designed to protect employees against loss of income resultingfrom unemployment or on-the-job injury. These employer "contri-butions" for legally mandated benefits arc not included in the tax
3
TABLE 1.1
Employee Benefits in Medium-Size and Large Private-Sector Firms, 1982 a
Employer PaymentsTotal All
Compensation b BenefitsType of Benefit (Percent) (Percent)
Legally required employer payments 7.6 26.0
Social Security 5.3 18.1
Unemployment compensation 1.1 3.8Worker's compensation 1.1 3.8Other payments c 0.1 0.3
Discretionary taxable benefits 10.0 34.1
Time not worked d 7.3 24.9Rest periods 2.3 7.8Other taxable benefits e 0.4 1.4
Discretionary tax-favored benefits 11.7 39.9
Pension, thrift, profit-sharing,and disability plans 5.6 19.1
Group health and life insurance f 5.5 18.8Other tax-favored benefitsg 0.6 2.0
Total benefits 29.3 100.0
Source: EBRI calculations based on survey results presented in Chamber of Com-merce of the United States, Economic Policy Division, Survey Research Cen-ter, Employee Benefits 1982 (Washington, D.C.: Chamber of Commerce of theUnited States, 1983), table 4.
aThe Chamber's sample of firms is primarily those with more than one hundred em-ployees.
bCompensation is defined as total wages and salaries plus employer outlays for benefits.CIncludes railroad retirement tax, railroad unemployment and cash sickness insurance,state sickness benefits insurance, and other payments.
dIncludes vacation pay, sick leave, holiday pay, and pay for other types of leave._Includes certain bonuses, awards, and special payments.fIncludes dental insurance premiums.gIncludes tuition, employer-provided meals, employee discounts, and miscellaneousbenefits. Tax-favored benefits are overstated by the amount of severance pay receivedby employees but not distinguishable from other tax-favored benefits in the Chamberof Commerce data.
base, because they are actually taxes levied on the employer by var-ious levels of government. In some cases, beneficiaries are taxed onreceipt of benefits under these programs.
Voluntary Employee Benefits--Most (about three-quarters) of the
4
employer-provided benefits are voluntary, though they may be reg-ulated by state and federal laws (table 1.1). Employers may provide
these benefits either as the result of collective-bargaining contracts
or in response to the need to design a compensation package that will
attract, motivate and retain the type of labor force the employer
wants. Some of the voluntarily provided benefits are fully taxed,while others receive favorable treatment under the tax code.
Voluntam" Taxable Benefi'ts--Benefits fully included in the tax base consistprimarily of paid absences from work (vacation time, sick leave, lunch andrest periods) as well as payments for jury duty and personal leave. Bonusesand other special payments are also taxable. These taxable benefits costprivate employers 10.0 percent of compensation or 34.1 percent of totalpayments for benefits (table 1.1).
Voluntar), Tax-Favored Bene/its--Some employer-provided benefits receiveconcessions in the tax code. These benefits are not only tax-deductible tothe employer, but they provide preferential tax treatment to employeesthrough tax exemptions or deferrals. Tax-favored benefits make up 11.7percent of total compensation (table 1.1).
(1) Tax-Exempt Benefits--Tax-exempt benefits constitute 6.1 percent of com-pensation, comprising just over half the tax-favored benefits (table 1.2).Employer contributions toward tax-exempt benefits are not only tax-deductible compensation expenses for the employer, but are not taxableto the employee. The major benefits in this categow are employer-spon-sored group health and life insurance, which comes to 5.5 percent of totalcompensation and 18.8 percent of total employer benefit spending (table1.2). Miscellaneous tax-exempt benefits (e.g., employee discounts andcompany-furnished meals) account for 2.0 percent of benefit costs.
(2) Tax-Deferred Benefits--Tax-deferred benefit payments that are not tax-exempt include employer contributions for pension, profit-sharing, thrift,and short- and long-term disability' plans. These benefits make up 5.6percent of total compensation (table 1.2). Employer contributions to theseplans are not included in the adjusted gross income of the employee whenthev are made. When the employee begins to receive the benefits, thedoliar amount of the benefits is included in the employee's taxable in-come.
Employee Benefits in the National Income and Product Accounts--
The Chamber of Commerce data provide a useful overview of the
benefits available to a limited sample of private-sector employees.
To assess benefits in the entire labor force, it is necessary to turn to
statistics on employer spending for benefits compiled by the U.S.
Department of Commerce in the National Income and Product Ac-
5
TABLE 1.2
Tax-Favored Employee Benefits in Medium-Size andLarge Private-Sector Firms, 1982 a
Employer Contributions
Total Compensation All BenefitsType of Benefit (Percent) (Percent)
Tax-deferred benefits 5.6 19.1
Pension, thrift, and profit-sharing plans 5.2 17.7
Short-term and long-termdisability insurance 0.4 1.4
Tax-exempt benefits 6. I 20.8
Contributions to grouphealth and litc insurance h 5.5 18.8
Other tax-exempt benciits' 0.6 2.0
Total tax-favored benctits 11.7 39.9
Source: EBRlcalculationsbascdonsur_e}, results presented intheChamberofCom-merce el the United States, Empl_o'ee Belle/ils 1_)82(Washington, D.C.: Cham-ber el Commerce of the United States, 1983), table 4.
"The Chamber's sample ot litres is primarih' those with more than one hundred em-ployees.
hlncludes dental insurance, vision care, and prescription drug insurance premiums.Life insurance premiums paid by the employ, or are tax-exempt up to a policy valueo[ $50,000. Premiums linancing insurance uxer tiffs anlount are taxable income tothe employee. Lile insurance proceeds receixed as death benetits ma\ be taxable tothe beneticiarv under estate tax laws, but are not taxable under the personal incometax.
_Includes tuition, employer-provided meals, emphocc discounts, and miscellaneousbenctits. Tax-layered bcnetits arc ovcrstatcd bx tbe anloullt o[ severance pay' receivedby employees but not distinguishable hum other tax-tavored henelits in the Chamberof Commerce data.
counts (NIPA)J These statistics reveal actual employer outlays for
both legally mandated and voluntary benefits given public- and
private-sector employees. NIPA benefit totals do not itemize data on
taxable benefits, instead counting these benefits as part of taxableincome.
Since 1950, payments [or legally mandated benefits have more than
doubled as a share of employee compensation, rising from 2.4 percent
IU.S. Department of Commerce, Bureau o| Economic Analysis, The National l_wome andProduct Accounls o[the UHited States, 1929 to 1976: Statistical Tables (Washington, D.C.:U.S. Government Printing Office, 1981); and U.S. Department of Commerce, Bureau ofEconomic Analysis, Sun,ey o[Current Business, annual July issue (various years).
6
in 1950 to 6.6 percent in 1982 (table 1.3). Outlays of private- and
public-sector employers for voluntary benefits have nearly quadru-pled-rising from 2.5 percent of total compensation in 1950 to 9.2
percent in 1982. Health and life insurance contributions are the fast-
est-growing component of voluntary benefits. Employer outlays forgroup health and life insurance grew from 0.7 percent of compen-sation in 1950 to 3.9 percent in 1982.
Employee Benefi'ts and Tax Policy--Tax policy does not affect allbenefits identically. Over 60 percent of private-employer benefits ei-ther are legally required or are fully taxable (calculations based on
table 1.1). Less than 40 percent of employer-sponsored benefits aretax-favored, and half of the outlays for benefits falling into this cat-egory are tax-exempt. Legally mandated benefits are probably notaffected by tax policy, since the employer contributions that finance
these benefits are payroll taxes themselves. Employer payments fortime not worked arc probably also unaffected by tax policy, unlessemployers and employees are willing to substitute increases in va-cation time at a constant wage for increases in cash wages.
Benefits most influenced by tax policy considerations are those that
provide something employees might purchase anyway. Employercontributions for pensions and insurance fall into this category, asdo child care, company cars, and similar benefits. Employer contri-butions for these benefits are worth more to the employee than anequal amount in cash compensation, because cash is taxed while
employer-provided benefits are not, and an employee's expendituresfor these purposes may not be tax deductible. If the compensationpackage does not reflect the employee's preferences, however, he orshe mav prefer more wages to more benefits.
Tax policy is also not the only influence on the compensation pack-age. Employer contributions for pensions, for example, increase withincome independently of tax considerations, due in part to income-
based pension formulas (see chapter III). Another factor encouragingbenefit growth is the cost reduction available through group purchaseof insurance and pension benefits by the employer, allowing em-ployees to obtain a better benefit package for the price than theywould be able to negotiate on their own (see chapter III). 2 The labor
2Employees could derive the benefits of group purchase through associations not related
to employment. Many professional associations, for example, offer group-rate life in-surance to their members. Access to such arrangements, however, is unequally distrib-
uted across the population, making voluntary, associations an unreliable means of assuringthat most people have access to at least a minimum level of benefit coverage.
_ '-_.E_
E_
0
_ _ ._:-_-_ .
movement has also fostered benefit growth. Finally, the provision ofbenefits is influenced bv the employer's desire to attract and retain
a particular type of labor force. Thus, some employee benefits wouldexist regardless of tax policy. In the absence of a tax policy favorableto benefits, however, employees would probably save less for retire-ment and would have less protection against various financial haz-ards.
Policy Issues Raised by the Growth of Voluntary EmployeeBenefits
The growth of employee benefits has raised several issues in recentdebates over tax policy. These include:
(1) the effects of benefit growth on federal tax revenues;
(2) the incentives created bv the different tax treatment of wage and non-wage compensation;
(3) the effects of the current tax treatment on various income groups; and
(4) the role of employee benefits in basic tax reform.
Beneli't Growth and Federal Revenues--As required by the Congres-sional Budget Act of 1974, the administration's annual budget con-tains estimates of the amount of federal tax expenditures or revenuesforegone due to the preferential treatment of various sources or usesof income. The act defines tax expenditures as "revenue losses at-tributable to provisions of the federal laws which allow a specialexclusion, exemption, or deduction from gross income or which pro-vide a special credit, a preferential rate of tax or a deferral of lia-bility. ''3
The administration's fiscal year 1985 budget proposal containedtax-expenditure estimates for twenty-one tax-code provisions affect-ing employee benefits. The largest of these items is the deferral oftaxes on contributions and earnings in employer-sponsored retire-ment plans, totaling $56.3 billion in tax expenditures for 1985.
The tax-expenditure concept presents numerous definitional andmeasurement problems and is, therefore, controversial. (These prob-lems are discussed in chapter IV.) A major problem encountered in
_For a discussion of conceptual and measurement problems involved in defining taxexpenditures, see: Executive Office of the President, Office of Management and Budget,Special Analysis o[ the Budget o[ the United States: Fiscal Year 1985 (Washington, D.C.:U.S. Government Printing Office, 1984), Special Analysis G, pp. G-1 to G-17.
10
using pension-related tax-expenditure estimates is that they are cal-culated in a cross-sectional framework. That is, tax deferrals by cur-
rent employees are offset against taxes paid by current retirees. Current
employees, however, have higher incomes and higher pension cov-erage rates than current retirees. The proper framework in which to
measure an employee's tax benefits is one that takes that employee'staxes paid on retirement benefits into account. When current em-
ployees retire, the taxes they pay on benefits will reflect their tax
delerrals. As a result, tax benefits accruing to current participantswill be smaller than cross-sectional measures suggest.
Benefit growth has also figured in debates over Social Securitypolicy. The Social Security Administration's Office of the Actuary has
estimated that as much as one-third of the long-term financing deficitprojected for the program prior to the passage of the Social SecurityAmendments Act of 1983 was due to projected growth in voluntaryemployer-provided benefits and consequent erosion of the tax base)While employer pension benefits are included in the personal incometax base upon receipt, they are not included in the Social Security
tax base. In the past, pension contributions and earnings have escapectpayroll taxes entirely.
The National Commission on Social Security Reform debated waysto halt the erosion of the payroll tax base. One wav to do this would
be to increase payroll taxes as the benefit share of compensationgrows. This would fix the Social Security tax base at a specific pro-portion of total compensation, though the effective tax on cash wageswould be increasing as benefits grow. Another way would be to set
some level of noncash benefits--fixed, perhaps as a percentage oftotal compensation--to be excluded from the Social Security tax
base. Employer contributions exceeding this percentage wouid beincluded in the payroll tax base.
The Commission recommended that salary deferrals under certain
types of pension plans be included in the payroll tax base. The SocialSecurity Amendments Act of 1983 included in the payroll tax basesalary deferrals in plans authorized under Internal Revenue Codesection 401(k); section 403(b); and section 457.
The Di[/erenl Treatment o/Cash and Noncash Compensation--Criticsof current tax policy argue that changing the relative attractiveness
4U.S. Department of Health and Human Services, Social Security Administration,Office of the Actuary, Growth m Fringe Be_zel_ts, by John C. Wilke'n et al., ActuarialNote Number _ 13 (Washington, D.C.: Social Security Administration, 1982).
11
of wages and benefits through tax policy is inappropriate. 5 Yet fewtax provisions are completely neutral with respect to economic de-cisions. Many provisions in the tax code, including those governingthe treatment of pensions, evolved as incentives to promote socialgoals. Pension policy should be evaluated in terms of the costs andbenefits of these incentives to society. Growth in pension coverageincreases current saving levels and the income of future retirees. Thesebenefits should be considered along with revenue costs in assessingpension policy.
Equity Effects of the Tax Treatment ofPensions--The tax treatmentof pensions and other employee benefits has also been questioned onequity or distributional grounds. Employees with the same total com-pensation face different tax liabilities if they receive different pro-portions of their income as employer contributions for benefits.Moreover, pension coverage is not evenly distributed among incomegroups, and the progressive tax system makes the deferral of taxeson employer pension contributions more valuable to higher-bracketthan to lower-bracket taxpayers.
While high-income employees may realize large lifetime pension-related tax benefits, the pension system as a whole is a middle-incomebenefit. Nearly 80 percent of aggregate lifetime pension-related taxbenefits goes to lower- and middle-income employees, partly because
these employees comprise a substantially larger share of the laborforce than do high-income employees. 6
Employer pensions also result in a more progressive distributionof wealth. If pension contributions were received as cash wages, mostwould probably be spent. The proportion spent would be greater atthe lower income levels. Employer pensions are more broadly dis-tributed than individual retirement accounts (IRAs), which are some-
times proposed as a substitute for pensions, Social Security, or both.Thus, in the absence of employer pensions, individual decisions onsaving would lead to a more unequal wealth distribution.
Employee Benefits and Basic Income Tax Refbrm--The basic taxreform movement has spurred consideration of the tax treatment ofpensions and other employee benefits. Advocates of tax reform believe
SSee,for example, Alicia H. Munnell, The Economics of PrivatePensions (Washington,D.C.: The Brookings Institution, 1982),p. 43.
6EBRI Issue Brief"Pension-Related TaxBenefits," no. 25(Washington, D.C.,December1983). Alsosee chapter IV for a further analysis of this issue.
12
that the complexity of the Internal Revenue Code and the prolifera-tion of social goals promoted bv various tax-code provisions threatenthe social consensus that has allowed the income tax to be virtually
self-enforcing. Moreover, the high tax rates made necessary by tax-base erosion are widely believed to distort economic incentives.
Tax Policy and Retirement Policy: Conflict andCompatibility
The current tax treatment of pensions reflects longstanding federalpolicies allowing and encouraging the expansion of coverage in em-ployer plans. Public policy has long been committed to assuring re-tirement income security for the elderly; tax-code provisions explicitlyallowing tax-deferred pension accumulation predate even the esta[_-lishment of the Social Security program. In addition, since the Rev-
enue Act of 1942, federal policy has actively promoted the expansionof coverage under employer plans by making important tax conces-sions contingent on the plan's compliance with nondiscrimination
standards. Federal policy has also encouraged the expansion of re-tirement savings as one way of increasing national saving rates. Thiswas a major factor behind the enactment of provisions in the Eco-
nomic Recovery Tax Act of 1981 that expanded eligibility for IRAs
to all employees, whether or not covered bv any employer-'sponsoredpension plan and behind provisions in tlae 1978 Revenue Act thatauthorized section 401(k) plans (see chapter II).
These federal efforts to encourage employer sponsorship of privatepension plans have been successful. Over the last twenty years, theproportion of retiree households receiving private pensions and theshare of the eldcrlv's income accounted for by pensions has morethan doubled. 7 Over one-fifth of all aged household units receivedprivate pensions in 1980; after Social Security benefits and assetincome, private pension benefits and earned income constitute thetwo most important income sources for the elderly. The relative im-portance of employer pensions in the elderlv's income may be even
higher than these figures suggest since one-time plan distributionsare not counted as retirement income in some federal statistics.
Current projections of pension receipt indicate that real retirement
income will more than double over the next forty years. Three-quar-
7Melinda Upp, "Relative Importance of Various Income Sources for the Aged, 1980,"_ocial Security BulMin 46 (January 1983):9.
13
ters or more of current employees can expect to receive employerpensions, in contrast with one-third of current retirees. _
In trying to reduce federal deficits the Congress should not losesight of retirement policy goals. Pension tax policies that may appearto serve short-term budget policy goals may impair the achievement
of retirement policy goals.
_American Council of Li|e Insurance, "Future Retirement Benefits under EmployerRetirement Plans: Final Report," paper prepared by ICF, Incorporated (Washington,D.C.: ICF, Incorporated, 1984),p. 63.
14
II. Statutory Provisions for the TaxTreatment of Pensions
The Internal Revenue Code contains provisions making contribu-
tions to qualified pension plans attractive as a way to receive com-pensation and to save. These provisions depart significantly from thegeneral principles inherent in the tax law and reflect longstandingpolicy decisions aimed at broadening pension coverage and strength-ening the pension system. This chapter describes the legislative his-tory of the tax law as it relates to pensions and other retirementarrangements and the current tax treatment of qualified and non-qualified plans.
Legislative History
Generally, the Internal Revenue Code provides: (1) current tax de-ductions for employer contributions to qualified pension plans; (2)deferral of employee taxes on employer contributions and investmentincome; and, in some instances, (3) tax deductions for employee con-tributions to qualified retirement arrangements.
Early History--Pension plans providing employer tax deductions
and opportunity for the tax-deferred growth of investment earningshave long been permitted under the tax laws. Tax deductions forpayments to retirement trusts for current costs were allowed evenbefore specific legislation was enacted, provided the amounts rep-resented reasonable compensation? The Revenue Act of 1921 ex-empted the net interest income of stock-bonus and profit-sharingplans from current taxation. 2 (This exemption was extended to pen-sion trusts in 1926)) Also beginning in 1921, employees were not
_Elgin National Watch Co. v. Commissioner, 17 B.T.A. 339, 358-60 (1929); Hibbard,Spencer, Bartlen & Co. v. Commissioner, 5 B.T.A. 464,474 (1926). However, no de-duction was permitted tbr additions to pension funds or reserves held by the employeruntil such amounts were actuall_ paid to the employee. Also see Reg. 45, art. 108
(Revemte Act o] 1918); Reg. 65, art. 109 (Revenue Act o[ 1924); and Reg. 69, art. 109(Revenue Act of 1926).
2Revenue Act o1 1921, sec. 219(t3._Revenue Act of 1926, sec. 219(f).
15
taxed when contributions were made but only when benefits weredistributed from the pension trusts (to the extent that the benefitsexceeded the employee's own contributions). 4
Before 1928, the tax code did not permit an employer deductionfor the funding of pension liabilities for an employee's services per-formed before the effective date of the pension plan. Consequently,although many employers established balance-sheet reserves for thispurpose (reserves that were not put into a separate fund), credits tothese reserves were not tax deductible. Influenced by the number andsize of these reserves, Congress enacted legislation in 1928 permittingemployers to deduct a "reasonable" amount in excess of the amountnecessary to fund the current pension liabilities, s
Not long afterwards, lawmakers became concerned that the leg-islation governing pensions favored owners, officers, and selected em-ployees without benefiting lower-paid employees. Of specific concernwas the fact that a pension trust was not required to be irrevocable,meaning that a pension plan could be dissolved immediately after asizable tax-deductible contribution had been made. The Revenue Act
of 1938 addressed this concern by establishing the "nondiversion"
rule and making pension trusts irrevocable. A pension trust is taxexempt only if it is impossible, at any time prior to the satisfactionof all employee liabilities, for any part of the contributions or incometo be used for a purpose other than the exclusive benefit of employeesor their beneficiaries. 6
During World War II, pension plans became more widespread asfederally imposed wage freezes induced employers and employees tonegotiate compensation increases in the form of employer contri-
butions to pension plans. The growing number of pension plans drewattention to their potential misuse as a management tax-avoidancedevice. To alleviate this problem, the Revenue Act of 1942 established
nondiscriminatory employee eligibility rules for pension-plan cov-erage, contributions, and benefits. Under these rules, a pension plan'seligibility requirements, benefits, and contributions, may not dis-criminate in favor of officers, shareholders, or highly compensatedemployees. In addition, limitations were placed on the allowableamount of the employer's deductions 7 and rules were developed to
4Revenue Act of1921, sec. 219(f). Such a provision is currently codified in the InternalReve_lue Code, secs. 72 and 402.
SRevenue Act of 1928, sec. 23(q)._Revenue Act of 1938, sec. 16S(a).7Revenue Act o[ 1942, sec. 162(b).
16
integrate pension plans with the Social Security system, s These pro-visions of the Revenue Act of 1942 were incorporated in the InternalRevenue Code of 1954, and todav constitute the basic rules governingthe qualification of pension plans.
Recent History--There were only about four-hundred private pen-
sion plans in operation in 1925, and about one-third of the total
participants were employed bv four of the country's largest corpo-rations. 9 There were 24,879 pension plans by 1954 with assets of $23.7billion, _° and this increase aroused new concern over the potentialfor fiduciary abuse. The Welfare and Pension Plans Disclosure Act of
1958 (WPPDA) _ sought to limit fiduciary abuse bv establishing cer-tain disclosure requirements. The WPPDA was more concerned withfiduciary standards, however, than employee rights. A 1965 reportissued bv President Kennedy's Committee on Corporate Pension Funds 12expressed concern over the benefits denied due to unduly restrictivevesting and forfeiture provisions, and the [ailure of some plans toaccumulate and retain sufficient funds to meet their benefit obliga-tions. In response to this concern and to the proliferation of pensionplans (423,662 plans with net assets of $194.5 billion existed in 1974),the Employee Retirement Income Security Act of 1974 (ERISA) wasenac ted. _3
ERISA was intended to: establish equitable standards of plan ad-ministration; create minimum vesting standards; establish standardsof fiscal responsibility by requiring the amortization of unfundedliabilities; insure most vested but unfunded liabilities against pre-mature plan termination; promote "a renewed expansion of privateretirement plans"; and increase the number of participants receiving
SRevemte Act o/ 1942, sec. 162(b), amending section 165(a) of the Internal RevenueCode (1939).
9U.S. Congress, Senate, Committee on Labor and Public Welfare, Legislative History of
the Employee Retiremozt l_wome Securio' Act o/1974 (Pub.L. 93-406), April 1976.inBoard of Governors of the Federal Reserve System, Ba_zkmg a_ld Monetam' Statistics:
1941-1970 (Washington, D.C.: Board of Governors of the Federal Reserve System,1976), p. 853; and Internal Revenue Serxice periodic press releases compiled byEmployee Benefit Research institute (EBRI).
11United States Code, vol. 29, sec. 301 (1976)(repealed)._ePresident's Committee on Corporate Pension Funds and Other Private Retirement
and Welfare Programs, Public Policy a_uf Private Pe_zsio_z Programs: A Report to thePresideHt o_z Private Employee Retirement PlaTts (January" 1965).
13United States Code, vol. 26, sees. 401 et seq. (1976). Plan data from Board of Governors
of the Federal Reserve System, Arousal Statistical Digest, 1972-1976 (Washington,D.C.: Board of Governors of the Federal Reserve System, 1977), p. 345: and Internal
Revenue Service, periodic press teleases.
17
private retirement benefits. 14ERISA supplemented existing tax pro-visions bv imposing contribution and benefit limits, as well as com-
prehensive requirements for eligibility, vesting, employer deductions,and benefit accruals. The basic tax structure under ERISA was sub-stantiallv the same as that which had existed sincc the Revenue Actof 1921.
Employer Contributions
Employee compensation is usually tax-deductible bv the employeras a business expense, under section 162 of the Internal Revenue Code.
In the early tax laws relating to pension plans, employer contribu-tions to pension plans were generally deductible as employee com-pensation; however, under current law the deductibilitv of employercontributions to pension plans is governed bv another part of theInternal Revenue Code, section 404(a). This separate treatment ofpension contributions applies to "any method of contributions or
compensation having the effect of a stock-bonus, pension, profit-shar-ing, or annuity plan, or similar plan deferring the receipt of com-pensation. ''Is In general, a contribution to a pension trust that qualifiesfor special tax treatment is immediately deductible in computing theemployer's taxes, but only becomes taxable to the employee uponsubsequent distribution from the plan. In the interim, investmentearnings on the contributions are not subject to tax. Thus, qualifiedstatus offers distinct advantages to the plan's sponsor and partici-pants.
In contrast, contributions to nonqualified plans are deductible onlyin the vear in which the contribution is included in the gross incomeof the employee. _6In nonqualified plans, the employer's deduction is
available only if separate accounts are maintained for each employee.The deductibilitv of contributions to both the qualified and non-
qualified plans is subject to the" reasonableness limits imposed bysection 162 of the Internal Revenue Code. 17 In a qualified plan, the
14U.S.Congress, House, Employee Retireme_zll_tcome Security Act, H. Rept. 533, 93dCong., 1st sess., 1973.
_STreasm3,Regulations, sec. 1.404(b)-1._OhztenlalRevemw ('ode, sees. 83 and 404(a)(5). In genet'al, contributions to a non-
qualified plan are includable in the employee's incolnc only when they becomesubstantially vested (Treasury Regtdatio_zs,see. 1.404(a)-12).
_Thtter_mlRevemw Codesection 404(a) provides that employer contributions "shall notbe deductible under section 162 (relating to trade or business expenses) or section212 (relating to expenses t0r the production of income); but, if they satisfy the con-ditions ot either section, they shall be deductible under this section."
18
employer may deduct conlributions to the plan onh up to certaindollar limits set by statute. These limits may differ by: (l) plan type
(e.g., defined-bcnefit, dcfincd-contribution, stock-bonus, profit-shar-ing); (2) whether employees are covered by more than one plan; and(3) whcthcr the plan falls into a special plan category' called top-hcavv plans.
Defined-Bene/i'l P&ns--In a defined-benefit plan, the employer agreesto provide the employee with a specified benefit amount at retirementand must arrange to fund this benefit in accordance with the actuarialprinciples under which the plan is managed.
(1) Maximum Fundi_tg Limits--The Internal Revenue Code sets a maxi-mum limit oil the amount of contributions for which a tax deductionmay be claimed each year by the plan sponsor. In most cases, this limitis: the normal cost tot the year plus amortization over a ten-year periodof thc initial unfundcd actuarial liability and any increases due tochanges or actuarial losses. Technically, the "deduction limit" doesnot limit contributions, since amounts in excess of the limit could becontributed, carried forward, and deducted in a later year, subject tothe tax-deduction limits tot that year. In practice, however, employersgenerally contribute only that amount for which they will receive adeduction in the year of contribution.
In addition to general limitations, the tax-deductibilitv of contribu-tions is also limited on an individual-participant basis. Generally, aplan must provide that the annual benefit for an individual participantcannot exceed the lesser of $90,000 or 100 percent of the participant'saverage compcnsation t0t his or her three highest-earning years. Is Ifthe plan provides for benefits in excess of the limits, the plan loses itstax-qualified status. Any contribution to fund a benefit in excess of thelimits is not deductible. 19
(2) Minimum Fundin_ Limits--A defined-benefit plan is also subject tomi_zimum funding requirements. -'° In general, the minimum amountan employer must contribute to a defined-benefit plan each year is:the sum of the normal cost of thc plan for the ,,'ear and the amountnecessary to amortize past service costs; this amount is then decreasedby the amount necessary to amortize decreases in pension liabilitiesand experience gains. Failure to comply" with these funding require-ments leads to the imposition of an excise tax equal to 5 percent of thetunding deficiency, and failure to correct the deficiency may result in
I'Under the Tax Relorm Actot 1984, the dollar limit is fixed until 1988. At that time,the limit will be adjusted tkorthe cost-of-living index using the adjustment factorthen in torcc t0t Social Security benefits (lntenzal Revenue Code, sec. 415).
I'_InlernalRevenue Code, sec. 404i[).2°[}l[_dDlf.l[ Rex,em_eCode. sec. 41Z.
19
an additional tax equal to 100 percent of the deficiency. 21The minimumfunding requirements may be waived in certain situations where com-pliance would cause substantial business hardship. These minimumfunding standards also apply to defined-contribution plans that aremoney-purchase plans (where contributions are expressed as a per-centage of covered payroll), but not to other defined-contribution plans.
Defined-Contribtttion Plans--In a defined-contribution plan, theemployer makes specified contributions to the employee's accountand, on termination of employment, the employee is entitled to thevalue of the vested part of the account. A defined-contribution plan
thus requires the establishment of an individual account for eachparticipating employee, since it is funded through the accumulation(including income and capital appreciation) of the contributions madeon behalf of each employee.
There are four principal types of defined-contribution plans: (1)money-purchase pension plans; (2) target benefit plans (where con-tributions are scaled to achieve a specified retirement benefit); (3)
profit-sharing plans (where contributions depend on the company'sprofits); and (4) stock-bonus plans (where contributions are made inthe form of the employer's stock).
(1) Maximmn Ftmding Limits--In general, annual additions 22to defined-contribution plans may not exceed the lesser of 25 percent of an em-ployee's compensation or $30,000 per year. 2_ The Internal RevenueCode further limits the maximum deductible contribution to profit-sharing and stock-bonus plans to an amount equal to 15 percent of thecompensation of all participants. 24
(2) Minimmn Ftmding Limits--If less than 15 percent is contributed inany year, the balance of the deductible amount may be carried forwardfor deduction in a later year, but the later-year deduction may notexceed 25 percent of the participants' total compensation for the year.
Employee Stock Ownership Plans--Employee stock ownership plans(ESOPs) are also defined-contribution plans. The traditional ESOPis a defined-contribution plan that invests primarily in the employer'ssecurities. 2s With certain exceptions, contributions to the traditional
21Internal Rewnz_eCode, sec. 4971.22Theterm "annual addition" means the sum (tot any year) of (1) employer contri-
butions; (2) the amount of the employee's contribution in excess of 6 percent of hisor her annual contribution or one-half of the employee's annual contribution, which-ever is less; and (3) forfeitures. (lntemal Revem_eCode, sec. 415(c)(2).)
2_lnternalRevenl_eCode, sec. 415(c).24Inter_mlRe_,em_eCode, sec. 404(a)(3).2Shlter_mlRewnt_eCode, sees. 409(A)and 4975(e)(7).
20
ESOP are deductible by the employer subject to the limitations gen-erally applicable to defined-contribution plans. Certain types of ESOPsoffer the sponsor an additional tax credit rather than a tax deduction.The Tax Reduction Act stock ownership plan (TRASOP) permits theemployer to receive an additional l-percent investment tax credit bytransferring to the TRASOP employer's securities in an amount equalto 1 percent of the employer's qualified investment for the taxableyear. An additional 0.5-percent tax credit is permitted if employeescontribute matching funds to the plan. 26
At the end of 1982, the TRASOP tax credit was replaced by a payroll-based credit, called the payroll-based employee stock ownership plan(PAYSOP). In general, as provided in the Tax Reform Act of 1984, a
PAYSOP permits an investment tax credit equal to 0.5 percent of theaggregate compensation paid to all participants in the plan. Thiscredit terminates in 1987.
Participants in More Than One Plan--In addition to limiting con-tributions to separate plans, section 415 of the Internal Revenue Code
provides further contribution limitations when an employee partic-ipates in both a defined-benefit and a defined-contribution plan ofthe same employer. Section 404(j) of the Internal Revenue Code denies
any deduction for amounts contributed to fund or provide benefitsin excess of the limits.
The limits are expressed both as a percent of compensation and asdollar amounts. In general, combined contributions for participantscovered bv both types of plans may not exceed 125 percent of thespecific dollar limit placed on each plan. For example, if the em-ployee's defined-benefit plan provides a benefit equal to 80 percentof the dollar limit of that plan and the employee's contribution to amoney-purchase pension plan equals 45 percent of the dollar limiton that plan, the combined contributions for the individual employee-
participant are still in compliance with the law. Together they equal125 percent of the dollar limits applicable to each plan separately.
If a plan participant's benefits and contributions do not exceed
dollar limits then the contributions and benefits in both types of planscan equal up to 140 percent of the limits placed on the plans sepa-rately. As discussed earlier, those limits are: for defined-benefit plans,
26TheEconomic Recovery Tax Act of 1981(ERTA)eliminated tax credits for TRASOPsas of December 31, 1982.However, unused investment tax credits for TRASOP con-tributions may be carried forth until 1989. For background and policy discussionson ESOPs, see David A.Peckman, EmployeeStock Ownership Plans:A Decision Maker'sGuide (Washington, D.C.: EBRI, 1983).
21
100 percent of the average compensation for the employee-partici-pant's three highest-earning years; and, for defined-contribution plans,25 percent of the employee-participant's compensation. 27
An additional limit is placed on the employer's tax deduction whenone or more employees are covered by both a pension or annuity planand a profit-sharing or stock-bonus plan. If this is the case, the totaldeduction for contributions to all plans may not exceed either 25percent of compensation paid or accrued to all plan participantsduring the taxable year or, if greater, the contribution necessary tosatisfy minimum funding standards for that year. Excess amountscontributed may be deducted in succeeding taxable years subject to
the 25-percent limit in the year deducted. 2_
Top-Hem?, Plans--The Tax Equity and Fiscal Responsibility Act of1982 (TEFRA) established a new category of plans known as "top-
heavy" plans. A plan is top-heavy if 60 percent or more of the accountsor accrued benefits under the plan are attributable to kW employees:officers (revised in 1984 to exclude those earning less than 1.5 timesthe dollar limit on contributions in a defined-contribution plan); the
ten employees owning the largest shares of the employer; owners ofmore than a 5-percent interest in the employer; or owners of morethan a 1-percent interest in the employer while receiving compen-sation from the employer in excess of $150,000.
A top-heavy plan must satisfy certain requirements concerning thebenefits or plan contributions for non-key employees. The plan mustmeet one of two accelerated vesting schedules and certain minimum
benefit or plan-contribution requirements. In determining plan con-tributions or benefits, only the first $200,000 of an employee's com-
pensation will be taken into account.
Tax Principles Governing Employer Contributions
The deductibility of employer contributions is governed, in part,by the same tax principles that govern the deductibility of otherbusiness expenses. Employer contributions to employee benefit plansare required to be otherwise deductible as reasonable compensationfor services rendered. 29 In this respect, therefore, the tax laws gOV-
27TEFRA actually set the combined-plan limit at 1.0 times the two limits separately.Because the separate fractions are computed differently from prior law, however,the efl_ect is to generate the limits discussed in the text.
28Internal Revenue Code, sec. 404(a)(7).2_lnternal Reve_zue Code, sec. 404(a).
22
erning the deductibilitv of pension contributions are narrower inscope than those governing the deductibilitv of other forms of com-pensation, because of the specific limit placed on the allowable de-duction amount and "reasonable compensation" limits. 3° Also, the
rules governing the timing of any business expense deductions aregenerally broader in scope than those applicable to the timing ofdeductions for pension contributions. A business expense deductionmav be taken in the taxable year during which the expenses are paidor incurred. 3_ Employers using the accrual method of accounting tocompute their taxable income are allowed to take the deduction inthe taxable year during which all events determining compensationliability have occurred and the amount incurred can be determined
with reasonable accuracv (the "all events" test), 32 even though suchcompensation is not paid during the taxable year.
In contrast to the rules governing other business expense deduc-tions, section 404 of the Internal Revenue Code requires that pensioncontributions and other types of deferred compensation must actuallybe paid to be deductible. This, in effect, puts all employers on a cash-accounting basis for these purposes. 33This rule applies to both non-qualified plans (funded or unfunded) and qualified plans. In non-qualified plans, it is further required that amounts paid or contributed
bv the employer be included in the employee's income for tax pur-poses in order to be deductible by the employer. 34 This requirementis met in unfunded plans when payments are actually made to thebeneficiary, 35and in funded plans when the employee's rights in em-ployer contributions are not subject to a substantial risk of forfei-ture .30
Oualifi'ed Plans--The statutory treatment of the deductibilitv of
contributions to qualified plans is consistent with pre-statutory rulesgoverning deductions for payments to pension trusts. Prior to theRevenue Act of 1928, such deductions were permitted based on thetheory that the employer had made actual payments to viable trustsas part of compensation, which, if reasonable, were deductible as
_°lnternal Revemw Code, scc. 162(a)( 1).311ntenlal Rm'emw Code, sec. 162(a).
32Treasury Regulatio_zs, sec. 1.461- l(a)(2).33With the limited exception that a deduction is permitted for a taxable year contri-
bution made after the close of the taxable year but prior to the return filing date(including extensions), hztenzal Re_'enue Coil< sec. 404(a)(6).
341ntenzal Revemw Code, see. 404(a)(5).3STreasury Regulatio_2s, sees. 1.404(a)- 12(b)(2)._°lmerual Revenue Code, sees. 83(a) and 402(b).
23
ordinarv and necessary business expensesS The deduction was notin question, despite the fact that the amounts contributed could revert
to the employer in the case of liquidation or revocation of the trustor that the employer retained the right to alter the provisions of thetrust.
Statutory provisions enacted in the 1920s continued the tax-
deductible status of employer contributions to qualified pension trusts.Subsequent statutory provisions restricted the conditions under whichcontributed amounts could revert to the employer. When a qualifiedplan terminates, current tax rules provide that only the excess amountresulting from erroneous actuarial computations may be returned tothe employer. 3_
Nonqualifi'ed Plans--The statutory treatment of employer deduc-tions for deferred compensation under nonqualified plans differs sub-stantially from pre-statutory rules governing such deductions. Prior
to the Revenue Act of 1942, unfunded noncontingent liabilities in-curred to pay deferred compensation were tax-deductible by anaccrual-basis employer even though such amounts were paid andincludible in the employee's gross income in later years. 39 Paymentsto trustees under deferred-income plans were also deductible, as longas the amount could revert to the employer only in situations beyondthe employer's control. 4°
Under the Revenue Act of 1942, the employer was permitted a taxdeduction only: (1) on the payment of benefits (unfunded plans); or(2) if the employee's interest was nonforfeitable at the time the con-tribution was made (funded plans). 41 Although the Tax Reform Actof 1969 continued the rule governing unfunded plans, it substantiallyrevised the treatment of funded plans bv permitting the employer totake a deduction when the employee's interest became vested even
though the employee's interest had been forfeitable at the time thecontribution was made. 42 The Internal Revenue Service had previ-
_7ElginNational Watch Co. v. Commissioner, 17B.T.A. 339 (1929); Hibbard, Spencer,Bartlett & Co. v. Commissioner, 5 B.T.A.464 (1926).
3_TreasuryRegulations, sees. 1.401-2(b)(I)._Globe-Gazette Printing Co. v. Commissioner, 16 B.T.A. 161 (1929), acq. IX-I C.B 20
(1930).4°Surface Combustion Corp. v. Commissioner, 9 T.C.631,655 (1947); Oxford Institute
v. Commissioner, 33 B.TA. 1136(1936).41RevenueAct o[ 1942, sec. 23(pj(l)(D). Also see Treasury Regulations, secs. 1.404(a)-
12(b)(2)and (c).42InternalRevenue Code, sec. 404(a)(5); Treasu_, Regulations, sees. 1.404(a)-12(b)(1).
24
ouslv taken the position that the employer was never entitled to a
deduction for contributions in which an employee's interest was for-feitable when the contribution was made. 43
Current statutorv treatment of tax deductions for nonqualified plancontributions restricts their availability. Deductions are still avail-
able for employer liabilities calculated on an accrual basis if there is
no deferral of compensation? 4 Contributions to nonqualified plansare deductible only when paid and included in the employee's grossincome. Contributions to qualified plans are also deductible only
when paid; however, thev are deductible whether or not plan partic-ipants are vested or contributions are included in their gross income.
Taxation of Investment Earnings
Generally applicable tax principles suggest that either the em-ployer or the trust should be taxed on a qualified trust's investmentearnings. Under the tax laws generally applicable to ordinary trusts,the employer would be taxed on a plan's investment income, if it
retained either a reversionary interest in plan assets due to vestingcontingencies or substantial powers over the trust (such as the rightto appoint trustees or to substantiallv alter the provisions of the trust).If the employer does not retain a reversionary interest or sufficientpower over the plan, the trust would be taxed on trust income notdistributed to participants.
In a nonqualified trust, these general tax principles are followed.The employer is taxed on investment earnings until the amountsbecome vested in the employee. At that time, the trust becomes tax-
able on earnings until the amount is distributed to the employee.
Ever since the Revenue Act of 1921, the investment earnings of aqualified pension trust have not been subject to taxation until dis-
tributed. This rule applies even though under current statutory pro-visions an employer max, retain the right to appoint trustees, or toalter, amend or terminate a pension plan.
4_TreasutT Regulations, sees. 1.404(a)- 12(c).
44Lukens Steel Co. v. Commissioner, 442 F.2d 1131 (3d Cir. 1971) (supplemental un-employment benefit plan): Washington Post Co. v. United States, 405 F.2d 1279 (Courtof Claims 1969) (profit-incentive plan), nonacq. Revemte Rulings, 76-345, 1976-2 C.B.134.
25
Employee Taxation
As a general rule, an employee does not include compensation intaxable income until it is actually or constructively received. 4s Con-
structive receipt occurs when the employee-taxpayer is entitled toobtain payment without substantial limitation or restriction. 46 The
tax rules governing employee taxation on employer contributions tononqualified trusts are consistent with this general rule.
As discussed earlier, the employee is taxed upon receipt of benefitsunder unfunded plans. However, in funded nonqualified plans, theemployee must include as income the value of the accrued benefits
not subject to substantial risk of forfeiture, a7 There exists a "sub-stantial risk of forfeiture," if the employee's right to full enjoymentof the property is conditioned on his or her future performance ofsubstantial services or other substantial conditions related to the
purpose of the transfer of the property. 4s When such a risk does notexist, the employee's rights to the employer's contributions in a non-qualified plan are deemed vested and that amount is taxable.
With respect to employer contributions to qualified plans, however,the general rule is changed by statute. Since the Revenue Act of 1921,
employees have not been taxed on employer contributions to qualifiedplans until distribution. 49 This is true whether or not the employeeis vested under the plan. Of course, before being vested, the employeecannot be taxed on employer contributions since this interest is for-feitable; however, once vested, this interest is nonforfeitable and not
subject to sufficiently substantial conditions as to preclude taxationunder the general rule, even though the benefits may not be payableuntil a later date (e.g., retirement or attainment of a certain age).
Employee Contributions
Some plans provide for employee contributions to both increaseretirement savings and reduce the employer's plan costs. The Internal
4_The employee need not receive cash (or equivalent) compensation so long as thereceipt of property from the employer in respect of services rendered confers aneconomic benefit on the employee. The value ot an employer-purchased annuity wasincluded in the employee's gross income on receipt even though the annuity was nottransferable and could not be surrendered tor cash. See Brodie v. Commissioner, 1T.C. 275 (1942).
4"Treasury Regtdatio_ls, see. 1.451-2(a).47hltemal Revem_e Code, sees. 83(a) and 402(b).
4*Treast_rv Regtdatio_ts, sees. 1.402(b)-1 and 1.83-3(c).4_Prior to the Economic Recovery Tax Act of 1981, employees were taxed on amounts
distributed or" made available" from a qualified plan. Section 314(c) of ERTA deletedreference to "made available." Sec Internal Revemw Code, sec. 402(a)(1).
26
Revenue Code imposes limits on both the mandatory and the vol-untary amounts employees may contribute to qualifiect plans. Limits
on the mandatory contribution amount are aimed at eliminating therisk that the contribution requirements will result in prohibited pat-terns of discrimination. If employee contribution requirements areparticularly burdensome, they could indirectly exclude employeesfrom participation. The statutory Limits on voluntary contributions,
in turn, are aimed at preventing a qualified plan from offering ex-cessive benefits to highly compensated employees in the form of sav-ings accounts accruing tax-deferred interest.
Ma_Matom, Employee Co_tributioHs--Emplox, ee contributions are
considered mandatory if thev are required as a condition of employ-ment; a condition of plan participation; or a condition of receivingemployer contributions. As a general rule, mandatory contributions
cannot be so burdensome as to permit participation only bv highlypaid employees, thus discriminating against lower-paid empioyees, g°While most required contributions are not deductible, earnings ac-cumulated on these contributions are not taxed until distributed.
Mandatory employee contributions are found in relatively fewprivate-employer plans. In 1977, the most recent year for which fed-
eral disclosure data are publicly available, only 6.2 percent of defined-
benefit plans and 8.7 pcrcent of defined-contribution plans reportedanv employee contributions at all. s_ Also, there is evidence that the
relative importance of employec contributions in private-employerplans is declining. In a 1980 survey of three hundred and twenty-five
plans accounting for 8.2 million participants, Bankers Trust Companyfound that thc number of contributory plans fell from 33 percent to19 percent between 1975 and 1980:2 This trend could reverse in the
future, however, if section 401(k) plans continue to grow in popular-itv.
Unlike private-sector plans, public-sector plans are predominantlycontributorv. Over 85 percent of all state and local government em-ployees are covered bv plans requiring employee contributions. The
typical plan requires contributions of 5 percent to 8 percent of salary.
S°As a rule ot thumb, such contributions cannot exceed 6 percent ot total compensationannually without Internal Rexenue Service scrutiny, and even lo_er contributionlevels may be deemed discriminatory. (Treasu_ 3' Re_ulatio_s, sec. 1.40 l-3(d); RevenueRulings, 80-307, 1980-2 C.B. 136.)
_EBRI calculations based on IRS Form 5500 and Form 5500C disclosure data [or 1977.
S2Bankers Trust Company, Corporale Pe_lsiopz Pla_ Study: .4 Guide/or the 1980s (NewYork: Bankers Trust Company, 1980), p. 12.
27
Employee contributions account for approximately 27 percent of totalcontributions to these plans. 53
Federal civilian employees (about half of federal employment) con-tribute 7 percent of compensation annually to the Civil Service Re-tirement System. 54 The President's fiscal year 1985 budget proposedraising this contribution rate to 9 percent by 1986. Beginning in fiscalyear 1985, the federal government will make contributions for mili-tary retirement benefits on an accrual basis, but the plan will con-tinue to be noncontributory for military personnel.
Volunta_ Employee Contributions--Employees can provide for theirretirement either by contributing to certain employer plans or byestablishing individual retirement accounts (IRAs) or other plansavailable to the self-employed. Generally, voluntary employee con-
tributions to employer-sponsored plans are not tax-deductible. If spe-cifically permitted by the plan, however, deductible contributionscan be made under Internal Revenue Code section 219(e)(2). Certain
deferral arrangements can be elected by a plan participant underInternal Revenue Code section 401(k), while similar plans are author-ized under Internal Revenue Code section 403(b) for certain nonprofitinstitutions.
Section 219(e)(2): Qualified Volunta_ Employee Contributions--Under theEconomic Recovery Tax Act of 1981 (ERTA), employees can make tax-deductible contributions to qualified employer-sponsored pension, annu-ity, and bond-purchase plans. To be deductible, contributions made underthe plan must be voluntary and limited to either $2,000 or 100 percent ofthe employee's annual compensation, whichever is lower. Amounts con-tributed to such a plan reduce the amount that may be contributed (bythe employee) to an IRA. Voluntary employee contributions (and relatedearnings) are fully vested at all times, regardless of the plan's generallyapplicable vesting provisions.
Among the advantages qualified voluntary employee contributions (QVECs)offer both employer and employee is the convenience of combining em-ployee savings for retirement with pension reserves accumulated in anemployer-sponsored plan. Potential disadvantages include administrativecomplications resulting from the need to account for more than one type
53U.S.Department of Commerce, Bureau of the Census, Employee Retirement Systemsof State and Local Governments: 1982Census of Governments (Washington, D.C.: U.S.Government Printing Office, 1982), p. v.
54Federalemployees hired after January 1,1984, are covered under both Social Securityand the Civil Service Retirement System (CSRS). Until the CSRS is redesigned toreflect Social Security coverage, contributions made by these employees will bedetermined differently than those made by previous hires.
28
of plan income and differentiate between employer's and employee's con-tributions upon distribution.
Section 401(k): Salary Reduction Anangements--The Revenue Act of 1978authorized cash or deferred arrangements (CODAs) under Internal RevenueCode section 401(k). An employee may elect to have a portion of his or hercompensation (otherwise payable in cash) contributed to a qualified profit-sharing or stock-bonus plan. These contributions are not treated as dis-tributed or available (taxable) income to the employee, but as deductibleemployer contributions to the plan. _s CODAs have achieved considerablepopularity since 1981, when the Internal Revenue Service regulations clar-ifying their implementation were published, s°
Among the advantages CODAs oft%rover other arrangements are: amountscontributed to CODAs are not offset against IRA limits and contributionlimits exceed those allowed for either IRAs or QVECs. As long as the planmeets certain participation and nondiscrimination standards, contribu-tions are governed by the same rules as other defined-contribution plans.
Individual Retirement Accounts
The Internal Revenue Code also provides that individuals can ini-tiate their own tax-favored retirement savings plans. IRAs allow allindividuals, whether or not covered by an employer's plan, to accu-
mulate tax-deferred retirement reserves. Keogh plans (H.R. 10 plans)allow self-employed individuals and noncorporate employers to ac-cumulate reserves on a par with accumulations allowed in corporateemployer plans.
Since the passage of ERTA in 1981, all individuals--with or withoutan employer-sponsored plan--can deduct the amount contributed to
an IRA or spent to purchase an individual retirement annuity (IRAN)from adjusted gross income. The maximum deductible amount is the
lesser of $2,000 or 100 percent of total compensation per year forsingle workers. The contribution limit for single-earner couples isincreased to $2,250 if the employee also covers the unemployed spouse.This amount is offset by QVECs made to an employer-sponsored plan.The maximum deductible amount is $4,000 for a two-earner coupleand $1,125 for nonworking divorced persons.
An IRA is a separate, trusteed account in which the individual has
a nonforfeitable interest, and from which the individual must beginto receive distributions by seventy and one-half years of age. An IRANis a nontransferrable annuity or endowment contract issued bv an
551ntenmlRevenue Code, sec. 402(a)(8).5_Final regulations were not published as o[ July 1984.
29
insurance company, which must commence payments to the individ-ual bv seventy and one-half years of age. Like earnings on reservesin employer plans, IRA and IRAN earnings accumulate on a tax-
deferred basis. Distributions to an IRA-holder prior to age fifty-nineand one-half are subject to a 10-percent penalty tax. 57
Simplified employee pension plans (SEPs) are employer-sponsoredplans that have certain features in common with IRAs. In a SEP, the
employer contribution--limited to the lesser of 15 percent of com-pensation or $30,000 for plan years beginning after 1983--is chan-neled into an IRA or IRAN maintained for the individual employee.For tax purposes, employer contributions are treated as if they werepaid to the employee who then contributed that amount to an IRA,so the employee may deduct the amount deemed so contributed fromadjusted gross income. This deduction is in addition to, not in lieuof, the deductible amount used for an IRA or the purchase of an IRAN.
The SEP plan must permit employer contributions to be withdrawnat any time bv the employee, and continued employer contributionsmay not be conditioned upon any portion of employer contributionsremaining in the account, s8 Earnings accumulated on employer con-tributions are not taxed to the employee until distributed.
Plans for the Self-Employed
Self-employed individuals and noncorporate employers can nowestablish retirement plans on a basis similar to that available tocorporate employers, s_ Prior to the passage of TEFRA, Keogh planswere subject to more stringent limitations on contributions than werecorporate plans. In addition, Keogb plans benefiting an owner-employee (a sole proprietor or partner whose partnership interestexceeds 10 percent) were required under pre-TEFRA law to meet
special standards with respect to plan coverage, vesting, distributionsand other matters affecting the security of employee benefits. Re-flecting the belief that the level of available tax incentives encour-aging retirement savings should not depend on whether the employeris incorporated or not, TEFRA repealed the special rules for Keoghplans and generally eliminated the distinctions between qualified
_rlnten_alRevem_eCode, sec. 408(f)(1),sHntenlal Reven,w Code,sec. 408(k)(4).S_Technically, contributions to these Keogh or H.R. 10 plans are not employee con-
tributions, since the self-employed individual is treated as an employer as well asan employee. In addition, the sell-employed individual must make contributions tothe plan on behalf of employees.
30
plans of corporate and noncorporate employers. Some of the specialrules formerly applicable only' to Keogh plans and intended to prevent
abuse with respect to the provision of retirement benefits were re-
tained, however, and made generally applicable to all tax-qualifiedplans. In addition, other rules formerly applicable only to plans forthe self-employed were made applicable to all top-heavy plans.
Keogh plans are now on a par with corporate qualified plans withrespect to limitations on contributions and benefits. Further, all qual-ified plans are now subject to the former Keogh rules relating to thetiming of benefit distribution and the integration of defined-contri-bution plans with Social Securitv. Top-heavy plans are subject tospecial limitations concerning includible compensation, vesting, dis-tribution and minimum nonintegrated benefits or contributions, many
of which formerly applied only to Keogh plans that benefited owner-employees. These changes apply to plan years beginning after De-cember 31, 1983.
Tax Principles Governing Employee Retirement Saving
Under general tax principles, income is taxed when it comes into
an individual's substantial control and discretion. 6° For example, whenan individual assigns a third party his or her right to receive com-pensation for past services, the individual--not the third-party re-cipient-is taxed on the income assigned. Income earned on investedcapital, for example, is generally deemed taxable when the individual
retains substantial control or discretion over it. Under general taxrules, therefore, employee contributions to pension plans would bemade with after-tax dollars, so the employee would be taxed on in-come attributable to such contributions as it is earned. These rules
would apply regardless of whether the employee contributions werevoluntary or mandatory. In the former instance, the contribution is
solely at the discretion of the employee. In the latter, although man-datorv contributions are a condition for participation in the plan, itis within the employee's control to decide whether or not to partic-ipate in the plan under the conditions imposed. Similarly', whereparticipation in a plan is a condition of employment, the individualhas the option of not taking the .job.
6°In Deupree v. Commissioner, 1 T.C. 113 (1942), the president of a corporation washeld to have constructively received the amount paid for an annuity' policy for hisbenefit. The taxpayer had lull discretion to take a cash payment, but directed the
company to purchase the annuity instead.
31
Under special statutory rules, however, certain employee contri-butions may be made with before-tax dollars (deductible) and theirearnings are tax deferred. This is true of QVECs and contributionsto IRAs, despite the fact that the employee has actually received thecompensation being saved for retirement and is immediately vested.Similarly, employer contributions to SEP plans are tax deferred eventhough the employee has elected to participate in the plan and isimmediately vested in the amounts contributed. In a cash or deferredarrangement under section 401(k) of the Internal Revenue Code, theemployee exercises discretion and control by annually electing whetheror not to forego cash compensation in favor of deferred compensationthat vests immediately, but amounts deferred are not included in theemployee's gross income until actually received.
The reason these special statutory rules depart from traditional taxprinciples is provided in the legislative histoo, of ERTA, authorizingQVECs and universal IRAs. Congress noted that during periods of highinflation in the late 1970s, the level of individual saving had fallen toa low of 5 percent to 6 percent of annual income. 6_Congress believedthat individual retirement saving was necessary to enable retirees tomaintain pre-retirement standards of living, and that the level of savingat that time was inadequate for that purpose. It was believed that thepre-1981 rules providing tax-favored treatment for retirement savingwere too restrictive for periods of high inflation and did not sufficientlypromote individual saving by covered employees.
In order to spur higher levels of individual retirement saving, themaximum allowable IRA deduction under section 219(b) of the InternalRevenue Code was increased; IRA eligibility was extended to includeemployees who were eligible or already participating in employer plans;and QVECs were permitted under certain types of employer plans. 62 Inaddition to promoting individual retirement saving (a needed supple-ment to a greatly overburdened Social Security system) and supple-menting plans with deferred vesting schedules, tax-deductible employeecontributions remove the responsibility for retirement saving from thesole discretion of the employer and provide added insurance againstthe possibility of early plan termination or the employee's involuntaryseparation from service by layoff or firing.
In sum, IRAs, SEPs, QVECs, and CODAs do not exist within the
6_U,S. Congress, Joint Committee on Taxation, General Explanation of the EconomicRecovery Tax Act o]1981, Joint Committee Print (Washington, D.C.: U.S. GovernmentPrinting Office, 1981), pp, 199-200.
62h_ternal Revenue Code, sec. 219(e).
32
confines of accepted pension tax principles. They are, instead, Congress'response to the need for increased levels of private retirement saving.
Plan Distributions
Under the statutory scheme, special rules govern the treatment ofdistributions from qualified plans, in some instances automaticallyterminating the tax-deferred status of amounts distributed and inothers providing further favorable tax treatment after distributionsare completed.
Types o[ Distributions ldentified Under the Tax Law
(l) Periodic Diswibutio_zs fi'om Accm_mlated Reserves in the Form of-anAmmitv--As a general rule, distributions from a qualified trust, pre-viouslv funded with deductible employer contributions and enhancedwith tax-free earnings, are includible in full in the gross income of theemployee when received. Thus, benefits payable in the form of anannuity are only included in the employee's income as payments arereceived. _3If the employee contributes some of the amount necessaryfor the purchase of the annuity', the employee's previously taxed con-tributions may be recovered tax free. If the employee recovers thecontributions within the first three vears during which annuity pay-ments are made, the employee does not include as income any amountreceived until the amount of the employee's own contribution has beenrecovered. Otherwise, the contributions are recovered ratably over theterm of the annuitv.
Only the earnings on annuities funded with employee contributionsgenerally are subject to tax, because these contributions are usuallymade with after-tax dollars. Contributions bv (or on behalf of) theemployee to QVECs, IRAs, SEPs, and CODAs, l']owever, are made withpre-tax dollars; accordingly, retirement benefits attributable to suchcontributions are fully taxable upon receipt.
(2) Lump-Sum Distributions o1 Accumulated Pension Contributions andEanlings--A lump-sum distribution to a common-law employee (i.e.,someone who is not self-employed) is entitled to special tax treatmentif it is a distribution of an employee's total accrued benefit made withina single taxable year and made on the occasion of the employee's death,attainment of age fifty-nine and one-half, or separation from the em-ployer's service. Self-employed individuals may receive lump-sum dis-
_3If the plan provides the employee with the option of receiving the amount as eithera lump-sum distribution of benefits or an annuity in lieu of the lump sum, theemployee must exercise the option to receive annuity payments within sixty daysfrom the date when the lump sum first became payable or be treated as havingconstructively received the entire value (Inter, ml Revenue Code, sec. 72(h); also see
Revetlue Ruli_lgS,59-94, 1959-1C.B. 25).
33
tribution treatment only in the case of death, disability or the attainmentof age fifty-nine and one-half. A distribution of an annuity contractfrom a trust or an annuity plan may be treated as a lump-sum distri-bution.
Generally, amounts distributed as a lump sum from a qualified planare separated into pre-1974 amounts and post-1973 amounts. This com-putation is made by multiplying the amount distributed by a fraction:the numerator is the number of months of active participation in theplan before January 1, 1974, and the denominator is the total numberof months of active participation. 64The resulting sum is deemed thepre-1974 portion and, in the absence of the election described below,is taxed as a long-term capital gain. Such treatment may be favorableto the taxpayer since only 40 percent of such capital gain is subject totax. The balance of the lump-sum distribution is deemed the post-1973portion and is treated as ordinary income. 6s
An employee participating in the plan for five or more years prior todistribution may elect to use a special ten-year forward income av-eraging method to compute the amount of tax on the post-1973 amount 66
Under this special income averaging rule, a separate tax is computedat ordinary income rates on one-tenth of the post-1973 amount (less aminimum distribution allowance), and the resulting figure is multi-plied by ten. Because of our progressive income tax rates and the factthat this tax is computed separately from the taxpayer's other income,the ten-year forward income averaging rule can result in substantialtax savings.
A separate election may be made to treat all pre-1974 amounts asordinary income eligible for ten-year forward income averaging. Suchan election could be advantageous since, depending on the amount ofthe distribution, ten-year forward income averaging may produce alower tax on the pre-1974 amount than would capital gains treatment.The election is irrevocable and applies to all subsequent lump-sumdistributions received by the taxpayer.
Lump-sum distributions from CODA plans are eligible for lump-sumtreatment. QVEC and IRA distributions, however, are not. In addition,distributions of account balances to self-employed individuals fromKeogh plans received by reason of separation from service other thandeath or attainment of age fifty-nine and one-half are not eligible forlump-sum treatment.
A lump-sum distribution received in the form of employer securitiesor retirement bonds receives additional favorable tax treatment. In
_4In computing months of active participation before 1974, any part of a calendar yearin which there was participation is counted as twelve months. When calculatingmonths of participation after 1973, any part of a calendar month of participation istreated as one month.
65Internal Revenue Code, sees. 402(a)(1 )(A), (B) and 402(a)(2).661ntenzal Revenue Code, sec. 402(e).
34
general, the net unrealized appreciation attributable to an employer'ssecurities is not taxed on distribution, but is taxed onh when thesecurities arc sold? 7 Likewise, gross income does not include amountsdistributed in the form of retirement bonds until the bonds are re-deemed ps
(3) Estate a_ld &m,ivor Betzefits--Benefits not attributable to the employ-ee's own contributions are, within certain limits, excluded from thedecedent's estate. The value of annuity payments from a qualified trustis excluded from the decedent's gross estate in an amount not to exceed$100,000. Similarly, a lump-sum distribution from a qualified trust isexcluded from the gross estate in an amount not to exceed $100,000,only if the recipient of the distribution irrevocably opts not to electlump-sum treatment for income tax purposes. Of course, any amountsreceived during the lifetime of the decedent or attributable to amountsaccumulated under nonqualified plans are includible in the decedent'sestate. Similarly, a participant who has elected to provide a survivorbenefit based on accrued benefits under the plan is deemed to havemade a gift to the beneficiary to the extent that the survivor benefitis based on the employee's own contributions.
(4) Certain Participam Loa_s--Loans to participants from qualified trustsare a use of pension assets that has received a good deal of policyattention in recent years. Prior to the passage of TEFRA, loans to par-ticipants from plan assets were subject only to the rules governingother plan investments: the loan had to bear a reasonable rate of in-terest, be adequately secured, and provide a reasonable repaymentschedule. Participant loans were generally secured by that portion ofthe participant's interest in the plan that was nonforfeitable at thetime the loan was made. It was further required that plan loans bemade available to all participants on a nondiscriminatory basis.
Bv 1982, Congress had become concerned that widespread borrowingfrom plan reserves could reduce the role of plans as retirement savings.At the same time, legislative debates reflected the concern that pro-hibiting loans entirely could discourage voluntary participation amongemployees who might need access to such funds during financial emer-gencies._9
In response to these concerns, TEFRA added new provisions restrictingplan loans under lhternal Revenue Code section 72: loans are to be
treated as plan distributions unless they meet certain requirements.These restrictions, however, were offset kxith certain concessions. Theamount of new loans after August 13, 1982, plus the outstanding bal-ance of loans made prior to that date, cannot exceed the lesser of$50,000; or the greater of one-half of the prescnt value of the employee's
67hztenlal Reventw Code, sec. 402(e)(4)(J)._l_tter_lal Revemle Code, sec. 405(d)( 1).69U.S. Congress, Joint Committee on Taxation, Ge_teral Explanation7 o/ the Revenue
Provisio_ls o[ the T:c_ Equity a_td Fiscal Responsibility Act ol 1982, Joint CommitteePrint {Washington, D.C.: Government Printing Office, 1982), pp. 294-295.
35
nonforfeitable accrued benefit under the plan or $10,000. 7°Loans mustbe repayable within five years except for mortgage and rehabilitationloans for owner-occupied dwellings, which are exempt from the five-year repayment rule. Loans from IRAs are treated as distributionsunder all circumstances regardless of whether the requirements ap-plicable to qualified-plan loans are met. Similarly, the pledging of anIRA or IRAN as security for a loan will result in the amount beingtreated as if it were distributed. In the case of an IRA, the amountconsidered distributed is equal to that portion pledged; in the case ofan annuity contract, the amount is equal to the fair market value ofthe entire contract. 7_In addition, loans to owner-employees from Keoghplans continue to be prohibited transactions.
(5) Rollovers--ln general, lump-sum distributions attributable to em-ployer contributions from a qualified pension trust or an IRA may berolled over tax free into other qualified plans, if the transfer is madewithin sixtv days of the participant's receipt of the distribution fromthe first plan. (Employee contributions may not be so rolled over.)Thus, an employee who receives a lump-sum distribution upon sev-erance of service with one employer generally may, without havingthat sum counted as income, redeposit all or part of the distributedamount in the qualified plan of a new employer (if that plan so permits)or in an IRA. Tax-free rollovers may not be made by a self-employedindividual from a Keogh plan to a corporate or another Keogh plan,but may be made to an IRA. If an amount otherwise eligible for thespecial lump-sum tax treatment discussed above is rolled over into anIRA, the special tax treatment is not available upon subsequent dis-tribution from the IRA.
Nonqualified Plans
Plans providing contributions or benefits exceeding statutory limitsor not meeting other requirements for qualification may, neverthe-less, be used to provide retirement income. Contributions made tosuch plans are ordinarily tax deductible to the employer in the taxyear during which benefits attributable to the contribution becomevested in the employee. Employees covered by such nonqualified plansgenerally include the amount of these contributions in their grossincome for the year in which they become substantially vested inplan benefits. 72 Nonqualified plans are governed by trust law ratherthan pension-related tax provisions. Investment income is taxableeither to the employer or to the trust (if the trust income exceeds
7°For purposes of this limit, all of an employer's plans are treated as one.711mernalRevenue Code, secs. 408(e)(3)and (4).72InternalRevenue Code, secs. 83(a) and 402(b).
36
disbursements) 73depending on whether the employee is vested. Uponretirement, the employee is taxed on distributions from the trust, but
contributions that have been previously taxed to the employee willnot be taxed again.
Because benefits to which the employee has a nonforfeitable rightunder a nonqualified plan are taxed to the employee only when con-tributions arc actually made, nonqualified plans have historicallytended to be unfunded74 Nevertheless, most employers establishbalance-sheet reserves to cover nonqualified benefits. ERISA estab-lished regulatory (non-tax) funding standards for nonqualified plans,but exempted manv of thc more usual types of nonqualified plansfrom these standards. 7s
Accrued benefits under unfunded plans are financed either fromcurrent operating income or from previously established reserves uponthe employee's retirement, and the employer takes a tax deductionfor payment of benefits at that time. Employees pay taxes on retire-ment income at their post-retirement marginal tax rate, but run therisk of the employer's financial inability to pay benefits.
Conclusions
The deductibilitv of employer contributions to qualified pensiontrusts under current law is consistent with pre-statutory law govern-
ing such deductions. The statutory treatment of trust earnings andplan participants dates from 1921 and represents a departure fromgeneral tax principles inspired by the express policy goals of en-couraging coverage expansion, increasing saving levels, and provid-ing a private, rather than public, source of retirement security. Thetax-favored treatment of qualified pensions is thus not a recent de-
velopment, but rather was present in early statutory rules and priornonstatutorv law. While of more recent vintage, the favorable treat-ment accorded IRAs, SEPs, 401(k) plans, and QVECs is similarly in-tended to increase voluntary individual retirement savings. Although
73Forpurposes of this determination, all of an employer's plans are treated as one.7aFora general discussion of the recent growth of nonqualified plans, see Diane Hal
Gropper, "The Furor Over TEFRA," lnstitutio_ml hn,estor 17(February' 1983): 71-80.7SExemptedplans include unfunded deferred compensation plans for highly compen-
sated employees and excess benefit plans. See ERISAsecs. 301-306,particularly secs.301(a)(3)and (9).
37
an employer's payments to employees under nonqualified plans willeventually generate a tax deduction, the additional tax benefits ac-corded plans that meet the requirements of qualified status are in-centives to employers and employees alike to establish and participatein qualified plans.
38
III. The Tax System and Other FactorsEncouraging Pension Growth
Some of the major factors determining the proportion of total com-pensation paid in the form of voluntary benefits (particularly pen-sions) include the tax structure, income growth, employer costconsiderations, and employer and employee preferences.
The Tax System
The tax system has fostered the growth and development of certainvoluntary employer-provided benefits. Employer contributions forhealth and welfare benefits are excluded from the personal incometax base bv statute, while pension contributions are not taxed until
received as benefits. The Tax Reform Act of 1984 provides that otheremployer-provided benefits are also excluded from the tax base if
thev meet one or more statutory conditions governing the nature of
the benefit and the employer outlay it represents. Benefit growth isalso encouraged by the fact that, with the exception of certain salary
deferral plans, neither benefit contributions nor benefit payments areincluded in the Social Security payroll tax base.
The tax treatment of employee benefits has encouraged the creationof new plans and the expansion of plan coverage, as well as the de-velopment of highly specific benefit programs to fit various needs
(e.g., Internal Revenue Code section 401(k) deferred-compensationplans and section 125(d) flexible benefit plans). Such plans allowemployers to tailor their benefit packages to fit both their budget andtheir employee needs.
Two aspects of the personal income tax structure influence the levelof benefits and the benefit package: 1
(1) Marginal Tax Rates--Increases in marginal tax rates lower the relativevalue of cash wages and increase the value of each dollar spent onbenefits.
_This discussion pertains to federal income taxes without considering the effects oftaxes levied by state and local governments.
39
(2) Regulation ofSpecific Benefits--Provisions governing the treatment ofspecific benefits mav affect their role in the benefit package.
Marginal Tax Rates--Marginal tax rates may change for two rea-sons: (1) a change in the statutory tax rate schedule and/or (2) an
income change moving employees upward or downward along a fixedstatutory progressive tax-rate schedule. Both changes alter the pro-portion of real income paid in income taxes, influencing the desira-bility of employee benefits as compensation.
Changes in tax rates could make benefits either more or less at-
tractive as compensation. A drop in tax rates can make wages rela-tively "cheaper," thereby reducing the attractiveness of benefits. Anincrease in tax rates, in turn, can increase the attractiveness of ben-
efits. The effect of tax-rate changes on benefit growth depends, inpart, on the relative movement of statutory and real tax rates.
Statutory Tax Rates--Statutory tax rates determine tax liability at variouslevels of nominal income. Statutorv income tax rates have declined con-sistentlv over the last thirty years. Marginal tax rates for single taxpayerswith no dependents fell 9 percentage points for those with adjusted grossincomes of $5,000 in nominal dollars and 28 percentage points for tax-payers with incomes of $75,000 in nominal dollars (table III.1). Marriedtaxpayers' tax rates also dropped at most income levels, though thesedecreases were smaller. In part, these drops in tax rates reflect the occa-sional "indexing" enacted in various revenue acts by increasing personalexemptions and standard deductions as well as changing the tax schedule.
Real Tax Rates--Changes in statutory tax rates do not describe changes inreal tax burdens, if inflation is also occurring. Real and statutory tax-ratechanges coincide only if the purchasing power of each income bracketremains constant over time. Because price levels rose faster than statutorytax rates fell since 1960, real marginal tax rates increased for some incomegroups. Real tax rates facing single taxpayers dropped by a maximum of12 percentage points (table 111.2).This is less than half the 28-point dropin the nominal tax rate (table III.1). Tax rates for married taxpayers in-creased in most income groups. Thus, for many taxpayers the decliningpurchasing power of nominal income was further eroded by real tax-rateincreases. These unlegislated (or inflation-driven) real tax increases areoften called "bracket creep."
Bracket creep does not necessarily result in benefit growth. On the onehand, bracket creep could be expected to foster benefit growth, since re-ceiving more compensation in the form of benefits can help forestall theerosion of real income caused by inflation-driven tax increases. On theother hand, bracket creep could discourage benefit growth by reducingdisposable income and making employees less willing to trade increasesin cash wages for increases in benefits.
To resolve this issue, it is necessary to turn to evidence from economic
40
TABLE III.1
Marginal Tax Rates for Federal Personal Income Taxfor Selected Years, 1960-1983
(Current Dollars)
Net ChangeAdjusted Gross 1960 1970b 1983 1960-1983Income a (Percent) (Percent) (Percent) (Percent)
Single employee, no dependents$ 5,000 22.0 19.5 13.0 - 9.0$10,000 34.0 25.6 17.0 - 17.0$20,000 50.0 34.8 28.0 - 22.0$25,000 56.0 39.0 32.0 - 24.0$35,000 62.0 46.1 36.0 - 26.0$50,000 72.0 61 .S 45.0 - 27.0$75,000 78.0 65.6 50.0 - 28.0
Married couple, two dependents$ 5,000 20.0 15.0 c - 20.0$10,000 22.0 19.5 13.0 - 9.0$20,000 30.0 25.6 19.0 - 11.0$25,000 38.0 28.7 23.0 - 15.0$35,000 47.0 40.0 30.0 - 17.0$50,000 56.0 49.2 35.0 - 21.0$75,000 65.0 56.4 44.0 - 21.0
Source: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract ofthe United States, 1984 (Washington, D.C.: U.S. Department of Commerce,1983), p. 329. Net change calculated by EBRI.
_Adjusted gross income is gross income from all sources subject to tax reduced bylegally permitted subtractions. Data are not comparable for all years due to tax-codechanges.
bIncludes tax surcharge in effect that year._No tax liability.
studies that trace the response of compensation packages to tax-rate changesover time. These studies suggest that increases in real marginal tax ratesexert a strong positive effect on both the proportion of compensation paidout as benefits as a whole and on the proportion of compensation receivedas contributions to pensions and deferred compensation. A 10-percent in-crease in real marginal tax rates increases the proportion of compensationreceived as benefits by about 2 percent. 2
2Stephen A. Woodbury, "Substitution Between Wage and Nonwage Benefits," Amer-ican Economic Review 73 (March 1983): 116-182. Woodbury reports a tax price elas-ticity of demand for benefits of 0.17. James E. Long and Frank A. Scott, "The IncomeTax and Nonwage Compensation," Revimv o[Economics and Statistics 64 (May 1982):211-219. Long and Scott report a tax elasticity of demand of 0.23 for pensions and0.22 for benefits. Woodbury's estimates thus suggest that a 10-percent increase in themarginal tax rate will increase the share of compensation received as benefits by 1.7percent while Long and Scott's estimates suggest the increase will be about 2 percent.
41
TABLE 111.2
Marginal Tax Rates for Federal Personal Income Taxfor Selected Years, 1960-1983
(I 980 Dollars)
Net ChangeAdjusted Gross 1960 1970 b 1983 1960-1983Income a (Percent) (Percent) (Percent) (Percent)
Single employee, no dependents
$ 5,000 20.0 16.8 15.0 - 5.0$10,000 22.0 21.5 19.0 - 3.0$20,000 30.0 25.6 28.0 - 2.0$25,000 34.0 27.7 32.0 - 2.0$35,000 43.0 31.8 40.0 - 3.0$50,000 50.0 41.0 50.0 0.0$75,000 62.0 51.2 50.0 - 12.0
Married couple, two dependents
$ 5,000 c c 12.5 + 12.5$10,000 20.0 16.8 15.0 - 5.0$20,000 22.0 19.5 19.0 3.0$25,000 22.0 22.6 26.0 + 4.0$35,000 26.0 25.6 35.0 + 9.0$50,000 30.0 32.8 40.0 + 10.0$75,000 43.0 43.0 44.0 + 1.0
Source: U.S. Department ot Commerce, Bureau of tile Census, Statistical Abstract olthe U_tited States, 1984 (Washington, D.C.: U.S. Department of Commerce,1983), p. 329. Net change calculated by EBRI.
JAdjusted gross income equivalent to 1980 adiusted gross income calculated using thepersonal consumption expenditure deflator.
hlncludes tax surcharge in eftcot that year._No tax liability.
These estimates of response rates, also called elasticities, help to explainchanges over time in the share of compensation received in the form ofbenefits. Between 1960 and 1982, employer contributions for voluntarybenefits like pensions and health insurance grew from 4.2 percent to 9.2percent of total compensation expenditures, an increase of just over 100percent (see chapter I, table 1.3). Over this same period, the real marginaltax rate facing the median taxpayer rose from 10 percent to 18 percent,an increase of 80 percent) Based on these response rates, more than 20percent of the change in voluntary benefits as a proportion of compensationover the last twenty years can be attributed to increases in the real mar-
3EBRI calculations based on U.S. Department of Commerce, Bureau of the Census,Statistical Abstract of the United States 1982-83 (Washington, D.C.: U.S. Departmentof Commerce, 1982), tables 431,433 and 437. Average real marginal rates were derivedas a weighted average of real marginal rates at various income levels.
42
ginal tax rates. If real fax rates had not increased, benefit growth as ashare of compensation could have been up to 20 percent smaller.
Indexing tax brackets starting in 1985, as provided in the Economic Re-coverv Tax Act of 1981, would keep the real marginal tax rates applicableto a given real income level constant over time by adjusting tax bracketsin response to inflation. Tax liability would only increase as the employee'sreal income grew. In this way, the indexation of tax rates could lead toslower benefit growth in the future.
Regulation ofSpecific Benefits--While changing the marginal taxrates affects the attractiveness of benefits as a whole, changing thestatutes regulating benefits can inIluence the relative desirability of
different benefits. The effects of the latter changes are more difficultto evaluate than are the effects of tax-rate changes. Tax rates mavchange annually providing numerous observation points on which tobase statistical generalizations while major statutory and regulatorychanges are enacted much less frequently, making it more difficultto sort their impact from that of other market factors. For example,in the five years (1970 to 1974) prior to the implementation of theEmployee Retirement Income Security Act (ERISA), pension contri-butions grew bv 0.8 percent of compensation--from 3.4 percent to4.2 percent (table III.3). Seven vears after the implementation ofERISA, despite the restrictions it imposed, employer pension contri-butions had grown .just over one additional percentage point as ashare of compensation.
Would pension contributions have grown more as a share of com-pensation had ERISA not been passed?
The passage of ERISA caused the termination of some pension plansthat could not meet its new funding or plan management standards.Plans remaining in operation were funded at a more rapid rate tocomply with ERISA's provisions. In fact, funding rates rose steadily
during the early 1970s as employers began to anticipate the fundingstandards enacted in ERISA. The relative importance of plan ter-minations and increased funding in the remaining plans would in-
dicate whether the net effect of ERISA raised or lowered the proportionof employer compensation outlavs directed toward pension contri-butions.
It is also difficult to measure the effects of statutory restrictions on
the tax treatment of employer contributions for group life insurance.The Revenue Act of 1964 required that employees include in theiradjusted gross income the portion of the employer-paid life insurancepremium financing coverage in excess of $50,000. Nevertheless,
43
TABLE 111.3
Employer Contributions for Pensions and Group LifeInsurance as a Percent of Employee Compensation for
Selected Years, 1960-1982
Pension Group Life InsuranceContributions a Contributions"
Year (Percent) (Percent)
1960 2.6 0.41965 2,9 0.41970 3.4 0.51971 3.5 0.51972 3.7 0.51973 3.9 0.51974 4.2 0.41975 4.5 0.51976 4,8 0.41977 5.0 0.41978 5.3 0.41979 5.0 0.4
1980 5.3 0.41981 5.3 0.41982 5.3 0.4
Sources: EBRI calculations based on the U.S. Department of Commerce, Bureau ofEconomic Analysis, The National Dzc'ome a_zdProduct Accounts of the UnitedStates, 1929-1976: Statistical Tables (Washington, D.C.: U.S. GovernmentPrinting Office, 1981) and Sttrt,ev of Cttrre,tt Busble.ss, annual July issuesthrough 1983, tables 6.8 and 6.15.
alncludes contributions made in behalf of federal and state and local civilian govern-ment employees as well as prix'ate-sector employees.
employer-paid group life insurance has maintained a virtually un-changed relationship to total compensation since 1960 (table Ili.3).
Some recent statutory and regulatory changes have had more easilyobservable effects on the creation and popularity of various plantypes. Section 401(k) salary reduction plans, authorized by the Rev-enue Act of 1978, have been quite popular since the preliminary reg-ulations were issued in late 1981.4 Similarly, cafeteria or flexiblecompensation plans, authorized under section 125(d) of the tax code,have grown rapidly even though final regulations have not yet beenpublished.
4Federal Reserve Bank of Atlanta, "Retirement Plans: Deferred Compensation's Pop-ularity Soars," by 13.Frank King and Kathryn Hart, Eco_zornic Review (October 1983):34-43.
44
Even in the face of such obvious popularity, however, it is difficultto predict the effects of these two benefit innovations on the com-
position of aggregate employee compensation. For example, section401(k) plans might be substitutes for other plans that have been ormight be established; thev might be secondary plans; or they mightrepresent net new plan growth. Flexible compensation plans couldbecome vehicles for revising existing employee benefit plans or, al-ternatively, lead employers to adopt new and expanded benefits. Fur-ther research is needed to assess the impact of these innovations, s
Income Growth
While income growth affects tax burdens, it also exerts an inde-pendent effect on aggregate benefit levels and growth. It is importantto understand this effect for many policy purposes. For example, ifincome tax indexing goes into effect as scheduled and the current taxtreatment of employee benefits remains in place, income growth willbe a major factor determining whether the share of aggregate com-pensation accounted for by pension contributions will grow, declineor remain constant over time.
In theo W, income growth could either increase or decrease the shareof compensation accounted for bv pension contributions. Higher-earn-ing employees without pension coverage may want it because at thehigher income levels the amount of pre-retirement income replaced by
Social Securitv declines. Employees currently covered by pension plansmay request more generous retirement benefits at higher income levelsin order to maintain their pro-retirement standard of living or defer taxliability. Income also affects pension growth through the technical con-struction of pension-contribution formulas. Many pension plans baseemployer contributions on cash wages, thus ensuring that pension con-tributions grow roughly in proportion to the employee's income.
Another perspective on the role of income in benefit growth is thatgrowth in cash wages could reduce the share of pensions and otherbenefits in compensation. 6 Adherents believe that total compensationfor any given job is determined b'v relatively competitive or decen-
SResearch nov,' under way at EBRI assesses the growth of section 401(k) plans and
their impact on new plan growth, as _,el[ as coverage under other types of pensionplans. Emily S. Andrews, The ChaFzgi_zg Profile of Pe_zsions in America (Washington,D.C.: EBRI, forthcoming).
OThis view is advanced in Robert Smith and Ronald G. Ehrenberg, "Estimating Wage-
Fringe Trade-Offs: Some Data Problems," in The Measuremem o['Labor Cost, ed. Jack
E. Triplett (Chicago: University o[ Chicago Press, 1983), pp. 347-367.
45
tralized markets. In such markets, employers will not willingly paymore than the "going" total compensation rate for a particular job,and will find they cannot attract good employees if their total com-pensation package is less than the market-determined level. Accord-
ingly, at any given level of total compensation, employees can onlyget more benefits by surrendering cash wages and vice versa. Thisview of compensation is based on the theory of equalizing differencesin labor markets, which holds that--all things being equal--a desir-able job characteristic (more benefits) can be used to compensate foran undesirable characteristic (less cash). 7 This approach may be moreuseful, however, in explaining employer differences at any one pointin time than long-term changes.
Evidence from both time-series and cross-sectional analyses of fac-tors affecting benefit growth suggests that changes in real incomelead to at least equal percentage changes in demand for pensions anddeferred compensation. 8 In the absence of real marginal tax-rate in-creases, the proportion of total real compensation attributable toemployer contributions for pensions and deferred compensation canbe expected to remain constant or increase slightly. Between 1960 and1982, pension contributions increased from 2.5 percent of total com-pensation to 5.2 percent--or about 108 percent (table III.3). Over thisperiod, the average real income of nonagricultural employees grew by5 percent. 9 Thus, about 5 percent to 6 percent of the growth of pensionsas a share of compensation was due to income growth alone.
Employer Cost Considerations
While tax considerations affect the desirability of benefits to em-ployees, thev do not directly affect employer cost. Subject to tax-code
7Robert S. Smith, "Compensating Wage Differentials and Public Policy: A Review,"Industrial and Labor Relations Review 32 (April 1979): 339-352; and Charles Brown,"Equalizing Differences in the Labor Market," Quarter(v Journal of Economics 94(February 1980): 113-134.
8Multivariate atta&sis, a set of statistical techniques, allows researchers to measureseparately the effects of various economic factors even when those factors are related.It is possible, therefore, to measure the separate effects of income growth and tax-rate changes even though these two factors often change simuhaneously. Most studiesestimate the income elasticity of demand [or pension contributions at 1.0: see Longand Scott, "The Income Tax and Nonwage Compensation"; and Robert G. Rice, "Skill,Earnings, and the Growth of Wage Supplements," American Economic Review 56 (May1966): 583-593. For a considerably higher estimate, however, see Woodbury, "Sub-stitution Between Wage and Nonwage Benefits."
9EBRI calculations are based on the Executive Office of the President, Economic Reportof the President: Transmitted to the Congress Februarv 1984 (Washington, D.C.: U.S.Government Printing Office, 1984), table B-39, p. 265.
46
and other restrictions on plan design, contributions for employeebenefits constitute a tax-deductible business expense for employersin the same wav that wage payments do.
Providing employee benefits as part of the compensation packagecan, howcvcr, rcducc cmployer costs indirectly. The provision of em-
ployee benefits can reduce employer costs in the following ways:economies of scale resulting from group, rather than individual, pur-chase; the effects of benefits on labor demand and compensationpackages; and the effects of benefits on turnover and productivity, m
Economies o[Scale--A major factor encouraging employer provi-sion of benefits rather than employee purchase is the pricing structureof benefits. In health insurance, for example, administrative costs canbe a larger percentage of premiums in plans covering only a fewemployecs than in plans covering one thousand or more employees.Brokerage rates are higher for individual retirement account (IRA)
and Keogh plans than for large pension plans, nl Thus, even thoughwages and benefit contributions may be treated identically in the taxcode, the employer can use $1.00 that would otherwise have been
spent on wages to buy benefits that, if purchased by employees, wouldcost more than $1.00.
Labor Demand atld Compe_satiotl Packages--Due to tax and scaleconsiderations, employers providing benefits may be able to hire more
employees for the same outlay or the same number of employees ata lower outlay than those that do not. Consider, for example, em-ployees in thc 25-percent marginal tax bracket. Other things beingequal, these employees would be indifferent between receiving anadditional $1.33 in cash wages (equal to $1.00 after taxes) or a benefitcontribution of $1.00. If we assume that scale economies reduce ben-
efit costs by 5 percent, it will cost the employer $0.95 to providebenefits worth as much as $1.33 in wages. This $0.38 difference be-
n°Advance-tunded pension plans can also reduce an employer's costs by allowing the
tax-deferred accumulation of investment earnings. If a sponsor can achieve a higherafter-tax return by' expanding the firm's productive capacity', however, then advancefunding a retirement plan can actually increase its total cost of doing business.
nIFor a discussion of scale economies and tax advantages resulting from employerpurchase ot various benetits, see Timothy M. Smeeding, "The Size Distribution ofWage and Nonwage Compensation: Employer Costs vs. Employee Value," in TheMeasureme_tt o[LaborCost, ed. Jack E. Triplett (Chicago: University of Chicago Press,1983), pp. 249-250. Scale economies in muhi-employer plans are explored in OliviaS. Mitchell and Emily S. Andrews, "Scale Economies in Private Multi-EmployerPension Systems," bT_tustrial apld Labor Relations Review 34 (July 1981): 522-530.
47
tween employer cost and employee value constitutes an area of po-tential gain for both the employer and the employees. If the employeesreceive $0.95 in benefit contributions they are as well off as theywould be receiving $1.33 in wages and the employer reaps both taxand scale gains. Similarly, if the entire $1.33 is received in benefit
contributions, the employees get the tax and scale gains. At any levelof benefit contribution between $0.95 and $1.33, both the employerand the employees receive a share of the tax and scale advantages ofbenefits.
How employers and employees split the tax and scale advantagesof benefits depends on the relative market power of each. In a tightlabor market, for example, employees may be able to win these fi-nancial advantages away from the employer; in the opposite marketsituation the employer will gain more. Estimates of the value of thetax and scale advantages of employer provision of benefits suggestthat these factors increase the value of benefits for employees by 37percent over their cost to the employer, and add almost 8 percent tothe total value of wages and salaries. 12
Benefits and Indirect Labor Costs--Benefits may also reduce laborcosts indirectly. Vesting requirements and the firm's benefit packagedesigned for the specific labor force it wants to attract can reduceemployee turnover and training costs and increase productivity, thereby
improving the firm's competitive position. Some researchers also be-lieve that the fixed-cost nature of some benefits (i.e., health insurance)
encourages employers to offer current employees overtime pay orhire part-time employees rather than hiring new full-time employees,thus also reducing labor costs. 13
Employer and Employee Preferences--Evidence suggests that em-ployers and employees want some level of employee benefits even inthe absence of tax benefits. In response to the pension-plan contri-bution and benefit limits imposed under TEFRA, for example, manyfirms are establishing or expanding nonqualified plans for highly
compensated employees. 14Such plans are generally not advance-funded
12TimothyM. Smeeding, "The Size Distribution of Wage and Nonwage Compensation:Employer Costs versus Employee Value," p. 255.
_3Marvin H. Kosters and Eugene Steuerle, "The Eifect of Fringe Benefit Tax Policieson Labor and Consumer Markets," Natio*talTax Jour_lal3S (December 1982): 87-88.
h4DianeHal Gropper, "The Furor Over TEFRA," lnstitutio_lal Investor 17 (February1983):71-80. These plans arc generally financed on a pay-as-you-go basis, althoughthe employer takes a tax deduction for the cost of the benefits as paid.
48
and do not benefit from some of the tax advantages accorded qualifiedplans. Similarly, about 2 percent of employees with employer-basedhealth insurance coverage do not receive any employer contribution
for their own coverage, and about 18 percent receive no employer
contributions for dependents' coverage, is These employees must payfor their health coverage with after-tax dollars.
In each of these cases, employers are responding both to their owninterests and to employee preference in offering the benefit, not totax benefits. Nonqualified pension plans exist because employers wantto continue to provide benefit levels greater than those available
through qualified plans. Employer-based health insurance programswithout employer contributions continue to exist, because even when
the employer does not contribute the employees save by electinggroup insurance over individually purchased coverage.
Conclusions
The composition of aggregate employee compensation depends onmarginal tax rates and other tax-code provisions, income growth,
employer cost considerations, and employer and employee prefer-ences. The tax code appears to be the most important. Caution isneeded, however, in using historical evidence to predict the effects
of major tax-code changes. It is impossible to assess to what degreeemployee benefits would grow if the only factor governing their growthwere employer and employee preferences and the cost savings fromgroup purchases. In the absence of benefit demand generated by theirfavorable tax treatment, some of the benefit pricing structures thatencourage group purchase might never have been developed. Evi-dence from econometric studies can be used to predict the effects ofchanges in tax rates on benefit growth, given the current tax structure.
Such evidence is less useful in predicting the effects of major changesin the tax structure itself. Such changes would alter the underlyingeconomic relationships that govern compensation. It is likely thatbenefit levels and growth rates would respond much more dramat-
ically to fundamental changes in the tax code than they respond tochanges in tax rates.
ISDeborah J. Chollet, Employer-ProvidedHealth Benefits: Coverage,Provisions, and Pol-ic_,Issues (Washington, D.C.: EBRI, 1984), pp. 50 and 53.
49
IV. The Measurement of Pension-Related Tax Benefits
Growth in pension coverage, inflation-induced "bracket creep," andchanges in the Treasury's method of calculating tax expenditureshelped make pension-related tax benefits ($56.3 billion), the singlelargest tax-expenditure item in the Reagan Administration's fiscalyear 1985 budget. Critics of the pension system charge that the treat-ment of pensions is not only costly but regressive. _
Three issues should be examined in deciding whether the tax treat-ment of pensions is .justified:
(1) How should the revenue costs of pension tax policies be measured?
(2) Who benefits from pension tax policies?
(3) How should tax-expenditure statistics be used in the design of retire-ment income policies?
Pension-Related Tax Benefits Over the Participant's Lifetime
Tax expenditures arc often used to measure the social costs of stat-
utes governing the tax treatment of pensions. Since pension plansdefer taxes until employees retire and their tax rate is lower, this is
sometimes viewed as a government subsidy for pension-plan partic-ipants. Tax expenditures as measured in the budget process, however,do not give a realistic picture of the tax benefits received by pension-plan participants.
The federal budget takes only a cross-sectional measure of pension-related tax expenditures; taxes deferred on that year's pension con-tributions and investment earnings accruing to currently employedplan participants are offset against the taxes paid by current benefitrecipients. This procedure unsuccessfully attempts to compare twowidely disparate groups. Current employees are more likely to becovered bv pensions and have higher incomes, which will subjectthem to higher taxes in retirement than current retirees.
_AliciaH. Munnell summarizes arguments along this line in The Eco_lomics ol PrivatePensions (Washington, D.C.: The Brookings Institution, 1982),pp. 30-61.
51
Measuring the tax benefit received by pension-plan participantsrequires offsetting their tax deferral against the taxes they will haveto pay in retirement. Since this requires projecting the income levelsand pension coverage of current employees, the existing cross-sectional data bases cannot be used. These data limits can be over-
come, however, by using microsimulation analysis to generate em-ployee work and pension histories. (This requires the use of assumptionsabout future economic and demographic conditions as well as pro-
jections of pension coverage, accrual, and benefits.) The Pension Re-tirement Income Simulation Model (PRISM), developed by ICF, Inc.,
is a dynamic microsimulation model which simulates the distributionof retirement income for a representative sample of 7,665 employees
between the ages of twenty-five and sixty-four drawn from the U.S.Department of Commerce Bureau of the Census May 1979 CurrentPopulatio_ Survey. 2 These histories cover forty-four years (until theyear 2023), thereby including a substantial part of the work life andretirement of most sample members.
The length of the simulation period imposes limitations, becauseforty-four years is not long enough to include the entire work careerand retirement of all the employees in the PRISM data base. The
simulation period does not cover the entire pension careers of olderemployees, because nothing is known about their coverage and ac-crual patterns prior to the base year. These prior accruals are esti-mated to arrive at correct retirement benefits.
The work career of those employees between the ages of twenty-five and thirty-four in 1979 can be studied in its entirety. These em-
ployees are particularly interesting because their experience providesa forecast of tax benefits in a mature pension system, with a relativelystable number of active participants and beneficiaries. While one-
third of the youngest group survives beyond the simulation period,the PRISM model projects a date of death for each employee. Since
pension and Social Security benefits are known for all employeeswho retire during the simulation period, retirement income and re-sultant tax liability can be projected beyond the simulation period.
In some of the analyses below, the simulation period was extended
an additional eighteen years to cover the major part of younger work-ers' retirements. Employees who were twenty-five years old in the
base year (1979) and survived the full simulation would be eighty-seven years old at the end of the simulation period.
-'The model and assumptions used to generate this data base are described in theappendix.
52
In developing a lifetime measure of tax expenditures, it is necessaryto determine what proportion of any year's tax deferrals is repaid inretirement and what proportion represents revenues permanentlylost to the Treasury. Since taxes are deferred and paid over an ex-tended number of years, the estimate of revenues permanently, lostalso has to include an estimate of interest lost to the Treasury on the
deferred taxes. The ratio of taxes paid to taxes deferred (the repay-ment rate) is that share of the average tax dollar deferred during the
participant's active work career that is repaid in retirement.Tax deferrals are calculated as the difference between each partic-
ipant's annual tax liabilitv under current law and the liability thatwould result if the full value of the participant's annual pension con-
tributions and earnings were included in adjusted gross income. Thisis the method used to calculate tax deferrals in the federal budget.
Using this procedure, tax deferrals automatically accrue interest atthe pension fund's pre-tax rate of return. This procedure results inhigher imputed "taxes" than the participant would pay if pensionaccruals were treated like ordinarv savings, because each year's im-
puted taxes are "replaced" in the pension fund to continue earninginterest. Taxes paid under ordinary savings treatment would be less
than taxes computed using this procedure because interest would beaccruing each year on an after-tax total. Tax deferrals were added
over each individual's work career and averaged over all participantsin each income group.
Taxes paid by retirees on pension benefits were calculated as thedifference between the individual's taxes due under current law and
the taxes that would have been due if the retiree had no pensionbenefits. This procedure may slightly understate the pension-planparticipant's tax benefits, because it does not include the added ben-efit of being able to defer taxes on annuity yields during the retirementperiod. (This added gain is small and difficult to include in the currentdata base.) Tax payments were summed over each participant's re-tirement and averaged over all participants reporting pension ben-efits in retirement.
To illustrate the relative importance of inflation and foregone in-terest in determining repayment rates, these rates were computed incurrent dollars, in real dollars, and using different interest factors torepresent the Treasury's interest costs.
Curre_lt Dollars--When lifetime tax liabilities are computed with-out adjusting for inflation or the value of deferring taxes during re-
tirement, pension participants repay virtually all or, in some cases,
53
more than the total value of the taxes deferred during the simulationperiod. As a group, the younger participants (i.e., workers aged twenty-five to thirty-four years) repay 86 percent of deferred taxes duringthe simulation period (table IV. 1). Within the group, repayment ratesvary by nearly 40 percentage points, from a low of 64 percent amongthose employees earning more than $50,000 in the base year to 102percent among those earning between $15,000 and $20,000. 3
The lowest- and the highest-income groups repay the smallest shareof deferred taxes. Repayment rates in the lowest-income group arelow because these employees derive the greatest relative benefit fromboth the extra tax exemption accorded the elderly and the overallprogressivity of the income tax. Higher-income participants also de-rive greater tax benefits than the group as a whole because at higher
TABLE IV.I
Taxes Deferred on Pensions and Paid on Benefits byWorkers Aged 25 to 34
(Current Dollars)
Taxes Deferred Taxes Paid Taxes Repaid
Employees EmployeesAverage Affected Average Affected Average
Income a Amount (Percent) Amount (Percent) (Percent)
$ 5,000 or less $ 81,642 40.0 $ 49,522 47.8 72$ 5,001 to $10,000 116,362 49.7 99,289 56.8 98$10,001 to $15,000 59,865 52.6 52,100 56.3 93$15,001 to $20,000 133,444 63.4 112,555 65.3 102$20,001 to $30,000 171,499 69.7 148,581 68.3 85$30,001 to $50,000 282,508 68.3 282,857 65.6 95$50,001 or more 319,150 68.9 213,001 66.1 64
All income groups 158,218 56.5 129,662 59.2 86Source: EBRl calculations based on PRISM simulation results._'Total 1979 income in 1983 dollars.
XTax repayment rates would be higher if the PRISM model allowed for indexing pri-vate-sector pension benefits. While occasional benefit adjustments are common, suchincreases are difficult to model because they do not [ollow any systematic pattern.Taxes eventually paid in retirement would also be higher if these results included thetaxes paid on Social Security benefits by employees whose pension benefits raisedtheir incomes above the statutory $25,000 (single employee) and $32,000 (couple)limits. These taxes are properly attributed to Social Security benefits, even thoughthe presence or absence of pension benefits may determine whether the Social Securitybenefits are taxed.
54
TABLE IV.2
Taxes Deferred on Pensions and Paid on Benefits byWorkers Aged 25 to 34a
(Real Dollars)
Taxes Deferred Taxes Paid Taxes Repaid
Employees EmployeesAverage Affected Average Affected Average
Income b Amount (Percent) Amount (Percent) (Percent)
$ 5,000 or less $ 32,253 40.0 $18,506 47.8 69$ 5,001 to $10,000 47,296 49.4 36,515 56.8 89
$10,001 to $15,000 23,984 52.6 18,468 56.3 82$15,001 to $20,000 51,517 63.4 41,485 65.3 83$20,001 to $30,000 68,873 69.7 54,692 68.3 78$30,001 to $50,000 120,143 68.3 86,814 65.6 69$50,001 or more 140,027 69.0 71,436 66.1 49
All income groups 65,483 56.5 44,672 59.2 72
Source: EBRI calculations based on PRISM simulation results._Extended-period analysis._'Total 1979 income in 1983 dollars.
tax brackets even a small percentage drop in post-retirement income
will mean a large absolute drop in tax liability.
Real Dollars--Since cross-sectional estimates of tax benefits are (bydefinition) computed in the current year's dollars, lifetime tax defer-
rals and payments have to be adjusted for inflation to put them onthe same basis. 4
In the extended analysis, 72 percent of the real value of deferred
taxes was paid in retirement (table IV.2). s Since 9 percent of this
group survived beyond the extended period, it is likely that today's
younger employees will repay close to 75 percent of their deferred
4See table A.2 in the appendix for the inflation rates assumed during the simulationperiod.
SWhen recomputed as the reduction in lifetime tax liability resulting from pensionlaw, these results are comparable to results obtained in calculations for hypotheticalpension-plan participants by Richard A. Ippolito, "Public Policy Toward Private Pen-sions," Conternpora_ Policy Issues 3 (April 1983): 57. Ippolito estimated that the taxsavings inherent in pension policy reduce the emplovee's total lifetime tax liabilityby amounts ranging from 39 percent (lower-income levels) to 18 percent (higher-income levels). The reduction in lifetime tax liability implied by the results reportedabove is about half the size of those reported by Ippolito. This difference can beexplained, in part, by the fact that the results reported in this chapter were computedon a group basis rather than an individual-employee basis, and take into accounttaxes paid by survivors.
55
taxes in retirement. Repayment rates were lowest among those earn-ing $5,000 or less and those earning over $30,000 in 1979. 6
Tax Payments Adjusted for Interest--Since tax payments are de-ferred, the Treasury may need to borrow more to finance federalspending during the deferral period. (Alternatively, the federal sur-plus may be lower.) Taxes paid, therefore, have to be discounted forinterest to reflect the fact that they are paid over an extended periodof time. Adjusting real tax payments at the real rate of interest earnedby pension funds (2 percent) reduces the tax repayment rate by 12percentage points to 60 percent (table IV.3).
The return earned by pension funds should generally be higher thanthe cost of funds to the federal government. The federal cost of funds
TABLE IV.3
Taxes Deferred on Pensions and Paid onBenefits by Workers Aged 25 to 34
(Discounted at Pension-Fund Rate) a
Taxes Deferred Taxes Paid Taxes Repaid
Employees EmployeesAverage Affected Average Affected Average
Income b Amount (Percent) Amount (Percent) (Percent)
$ 5,000 or less $ 32,253 40.0 $13,848 46.0 49
$ 5,001 to $10,000 47,296 49.4 29,981 55.6 71
$10,001 to $15,000 23,984 52.6 15,027 55.0 66
$15,001 to $20,000 51,517 63.4 37,472 61.3 70
$20,001 to $30,000 68,873 69.7 46,254 66.7 64
$30,001 to $50,000 120,143 68.3 77,555 64.9 61
$50,001 or more 140,027 69.0 60,445 66.1 41
All income groups 65,483 56.5 38,395 57.4 60
Source: EBRlcalculations based on PRISM simulation results.
"'Discount rate used is 2 percent. Extended-period analysis._'Total 1979 income in 1983 dollars.
6Base-year income does not necessarily reflect an employee's lifetime income. This isparticularly true in the case of younger employees, whose income growth can meanthat base-year income figures understate lifetime expectations. As a result, analysisof tax liability patterns by base-year income may distort the relationship betweenliability and income. To test for this effect, tax liability patterns were also analyzedby late-career income and the average income [0r the five highest-earning years ofthe employee's last ten work years. As in the base-year income analysis, consistentincome-related patterns failed- to emerge. When classified by late-career income, re-tirees repaid from 55 percent to 73 percent of deferred taxes (unpublished EBRItabulations).
56
is the interest paid on long-term federal bonds less taxes paid on thisinterest by bondholders. Between 1974 and 1983, for example, theaverage compounded real long-term federal borrowing rate was 1.1percent, and the average annual real return in a large sample ofprivate pension funds was 2.2 percent for equity funds and 0.6 percentfor fixed-income funds. 7
If the federal cost of funds is lower than the rate of return earnedby pension funds, adjusting for interest at the pension fund rate ofreturn will make the federal revenue losses appear too large. Adjust-ing tax deferrals and payments at a real interest rate of 1 percentincreases the repayment rate and reduces the apparent tax benefitsto pension participants. Over the extended simulation period, pensionparticipants repay 64 percent of the taxes deferred during their workcareers (table IV.4). The interest advantage in pension law is thusworth 8 percent (the difference between 72 percent and 64 percent)of the total value of taxes deferred.
TABLE IV.4
Taxes Deferred on Pensions and Paid on
Benefits by Workers Aged 25 to 34(Discounted at Federal Bond Rate) a
Taxes Deferred Taxes Paid Taxes RepaidEmployees Employees
Average Affected Average Affected AverageIncome b Amount (Percent) Amount (Percent) (Percent)
$ 5,000 or less $ 32,253 40.0 $14,881 46.0 53$ 5,001 to $10,000 47,296 49.4 32,345 55.6 77$10,001 to $15,000 23,984 52.6 16,159 55.0 70$15,001 to $20,000 51,517 63.4 40,321 61.3 76$20,001 to $30,000 68,873 69.7 49,667 66.7 69
$30,001 to $50,000 120,143 68.3 82,007 64.9 65$50,001 or more 140,027 69.0 65,052 66.1 45
All income groups 65,483 56.2 41,068 57.4 64Source: EBRI calculations based on PRISM simulation results._'Discount rate used is 1 percent. Extended-period analxsis.bTotal 1979 income in 1983 dollars.
7EBRI's federal return calculations are based on the composite long-term federal bondrate adjusted for changes in the Consumer Price Index. For more information onprivate pension tend returns, see A.S. Hansen, Inc., 15th Ammal Investment Per_brm-ance Survey: 1983 i_zReview (Lake Bluff, Ill.: A.S. Hansen, Inc., 1984). The after-taxfederal cost of long-term funds was - 1.4 percent over the ten-year period (assumingan average marginal tax rate of 30 percent).
57
In real dollars, therefore, each dollar of current taxes deferred by
younger pension participants can be offset by $0.60 to $0.72 in taxpayments, depending on whether or not an interest adjustment isused and the interest factor used. In contrast, on a cross-sectional
basis tax payments by current retirees total roughly $0.17 for everydollar of taxes deferred by current workers. _ Pension-related tax ex-
penditures measured in a cross-sectional framework are, therefore,three to four times as high as lifetime tax expenditures.
Who Benefits from Pension-Related Tax Policies?
The distribution of lifetime tax benefits among pension participants
does not support the criticism that pension-related provisions benefit
primarily the well-off. Comparing tax benefits within groups showsthat both higher- and lower-income participants receive greater rel-ative tax benefits from the pension system than pension-plan partic-
ipants as a whole. Since more of the higher-income employees arecovered by pensions than those at the lower-income levels, the rel-ative benefit to higher-income groups is further increased.
The largest share of total pension-related tax benefits, however,accrues to middle-income employees. Among younger employees (i.e.,those between the ages of twenty-five and thirty-four in 1979), 61
percent earned $20,000 or less in 1979. These employees will pay 42percent of the total federal taxes paid by this age group, and willreceive 24 percent of the group's lifetime pension-related tax benefits.In contrast, 34 percent of the younger employees in 1979 earned be-tween $20,001 and $50,000 and these employees will pay 42 percent
of the group's lifetime federal taxes and receive 53 percent of thegroup's pension-related tax benefits. Employees earning over $50,000in 1979 also receive a larger share of total tax benefits than theirshare of the population, but this difference is not as large as thatobserved in the middle-income group. (These income figures are in1983 dollars. For more information, see table IV.5.) It can be con-
cluded, therefore, that pensions are primarily a middle-incomebenefit.
_ln 1982, the most recent ,,'ear for which actual data on contributions, earnings, andbenefits are available, taxes deferred on pension contributions and earnings totaled$54.4 billion, while tax payments on pension benefits totaled $9.1 billion (17 percentof deferred taxes). The EBRI estimate is based on information supplied by Treasurystaff.
58
TABLE IV.5
Net Lifetime Pension-Related Tax Benefit SharesAmong Employees Aged 25 to 34
Lifetime Tax Lifetime PensionPension Shares by Benefit Tax Shares
All Persons Participants Income Class b by Income ClassIncome a (Percent) (Percent) (Percent) (Percent)
$20,000 or less 61 53 42 24
$20,001 to $50,000 34 4l 42 53
$50,001 or morc 5 6 16 22Source: EBRI calculations based on PRISM simulation results._Tota[ 1979 income in 1983 dollars.I:q'he share of lifetime taxes paid bv those with base-year incomes below $50,000 isrelatively high, because income growth occurring during the simulation period pushesindividuals into higher tax brackets. On a cross-sectional basis, taxpayers with in-comes over $50,000 paid 35.4 percent of total income taxes in 1982. U.S. Departmentof the Treasury, Internal Revenue Service, Statistics o]l_zconze Bulletbz, Winter 1983-1984 (Washington, D.C.: Internal Revenue Service, 1984), p. 20.
Tax Expenditures and Retirement Policy
Tax-expenditure statistics may be useful as a rough measure of the
economic effects of various tax-code provisions or as an aid to fore-
casting federal revenue flows. As a guide to retirement policy, tax-
expenditure statistics suffer from two shortcomings: they do not con-
sider other goals of retirement policy and they do not account for the
interactions among tax-code provisions.
The Benefits of" Pension-Related Tax Policies--Three benefits that
arise from pension-related tax policy include:
(1) the higher lifetime incomes made possible by tax-deferred accumu-lation of pension reserves;
(2) the increase in benefit security that results from advance funding ofpension plans; and
(3) the effects of employer-sponsored pension plans on saving levels andpatterns.
hzcreased Retirement Income--Over the next forty years, real retirementincome will more than double. The average annual retirement income forthose reaching age sixty-five in the 1980s is projected to be $13,376 perhousehold (1983 dollars). It is expected to increase to $26,802 for thoseretiring between 2010 and 2019. 9 Average pension benefits other than So-
*Sylvester J. Schieber, Social Security: Perspectives on Preserving the System (Washing-ton, D.C.: EBRI, 1982), p. 100.
59
cial Security will increase from $5,315 lot those retiring in the 1980s to$12,417 lot those retiring between 2010 and 2019. The proportion of newretiree households receiving pension income will grow from 37 percent inthe 1980s to 71 percent bv 20197 o
Tax payments bv retirees will reflect this income growth. Pension bene-ficiaries retiring in the 1980s will pay an average of $15,808 in taxes (1983dollars) on their benefits over the course of their retirement? 1 Pensionbeneficiaries retiring between 2010 and 2019, in contrast, will pay anaverage of $44,672 in taxes (1983 dollars) on pension benefits during theirretirement (table IV.2).
Tax Expe_lditures a_ld Fu_ldi_,g Procedures--Since tax-expenditure statisticsare calculated using contributions and earnings actually received by em-ployer plans, these statistics arc very sensitive to changes in plan fundingprocedures. At anv level of benefits, the more rapid the tnnding rate, thelarger the associated revenue deferrals will be. Adequate funding levels,in turn, increase saving rates (additions to pension reserves constitute netsaving) and the security of promised benefits.
The impact of funding procedures on tax-expenditure estimates can beillustrated by assuming various funding rates for federal, state and localgovernment, and private-sector plans. Under current law, private-sectorplans must set aside funds to meet future benefit obligations as theseobligations accrue. In a defined-contribution plan, the employer remitsthe funds specified in the plan's benefit [brmula to the plan. In a defined-benefit plan, the employer sets aside--in a specified time period--a sumthat, together with accrued investment earnings, is projected to be suffi-cient to pay promised benefits when they come due. Most state and localgovernment plans, while not necessarily funded in compliance with theEmployee Retirement Income Security Act (ERISA), also set aside fundsto meet tuture benefit obligations as accrued? 2 Federal employee plans,however, are not actuarially funded. The military retirement system hasnot been advance funded at all though it will accumulate reserves startingin fiscal year 1985. The Civil Service Retirement System (CSRS) accu-mulates some reserves, but is not actuariallv funded.
If the CSRS were funded in accordance with the standards set out inERISA, it would have required contributions equal to 105 percent of pay-roll in 1982. _ Actual contributions, including payment of interest on un-
I°lbid., p. 90._ Unpublished EBRI tabulations of PRISM simulation results._-'Most large plans, encompassing the bulk of plan participants, use funding procedures
that result in asset accumulation patterns compatible with ERISA requirements. Formore information, see The Urban Institute, The Futl_re of State a_M Local Pensio_is:Final Report (Washington, D.C.: The Urban Institute, 1981), chap. 5.
13Based on an unpublished estimate of Edwin Boynton, F.S.A., of The Wyatt Company.If the system had always been funded on an ERISA basis, this total would be muchcloser to private-sector funding levels. Applying a less rigorous forty-year amorti-zation standard would have required 91.9 percent of payroll in 1982.
60
funded liabilities, were $26.4 billion or an estimated 38 percent of payroll. 14The actual contribution thus amounted to 36.2 percent of what the ERISArequirement would have been. If we assume that this same relationshipholds in 1985, funding the CSRS at the ERISA level would increase pension-related tax expenditures to $72.0 billion or 27.9 percent more than theTreasury's projection of $56.3 billion for that year (table IV.6).
Suppose, in turn, that private and state and local government plans werefunded at the rates used to fund the CSRS. If both private and state andlocal government plans were funded at 36.2 percent of funding levels pro-jected under current funding practices, pension-related tax expenditureswould be $12.0 billion in 1985. The sensitivity of tax-expenditure statisticsto alternative funding assumptions suggests that reducing funding levelswould reduce tax expenditures as well. Underfunded plans, however, re-duce the security of future retirement benefits.
Tax Expenditures and Saving--The tax treatment of pension plans alsocreates social benefits by influencing the level and the distribution of say-
TABLE IV.6
Tax Expenditures Under Alternative AssumptionsAbout the Funding of Employer-Sponsored Pension
Plans
Tax Expenditures aAssumption (Billions)
Current law b $56.3
CSRS funded to meet ERISA standard _ 72.0
Employer plans funded using CSRS standard d 12.0
Sources: EBRI calculations based on Executive Office of the President, Office ofManagement and Budget, The Budget of the United States Govermnent, FiscalYear 1985 (Washington, D.C.: U.S. Government Printing Office, 1984), p. v-100; and unpublished estimate of Edwin Boynton, F.S.A., of The WyattCompany.
aFiscal year 1985.bCurrently the CSRS receives contributions from the federal government equal to eachyear s normal cost and interest on accrued unfunded liabilities. Neither unfundedliabilities nor actuarial gains and losses are amortized.
_Estimate for 1985 calculated under the assumption that 1985 tax expenditures areunderstated bv 27.9 percent (see text).
dCalculation assumes that both private-sector and state and local government em-ployers make contributions equal to 36.2 percent of the contributions projected underexisting funding procedures.
_4EBRI calculations based on U.S. Department of Commerce, Bureau of the Census,Statistical Abstract of the United States 1982-83 (Washington, D.C.: U.S. Departmentof Commerce, 1982), table 450, p. 26. See also the Executive Office of the President,Office of Management and Budget, The Budget of the United States: Fiscal Year 1985,(Washinston , D.C.: U.S. Government Printing Office, 1984), p. v-100.
61
ings. Employer-sponsored plans add to total savings, influence the allo-cation of saving among investment vehicles, and change the distributionof total saving among income groups. Is Pension |und reserves are investedprimarily in securities that finance investments and the expansion of pro-ductive capacity'. The savings generated by pension funds are spread morewidely than discretionary forms of saving, thus leading to an equalizationof the distribution of wealth among households.
Interactio_zs Amo_zg Tax-Code Provisions--Just as tax expenditurescannot take account of the benefits of federal policy toward pensions,they also cannot take account of the interactions among various tax-code provisions. These interactions stern from the fact that more than
one tax-code provision is aimed at increasing saving or benefiting theelderly. Such interactions can lead to overestimates of the tax defer-
rals and losses due to pension-related tax provisions.Savings benefit from several tax-code provisions. Researchers have
estimated that a dollar of pension reserves adds between $0.30 to$0.80 to total savings. (See chapter V for further discussion.) Thismeans that in the absence of employer pensions, between 20 percentand 70 percent of pension contributions might continue to be heldas household savings, if employees received them as ordinary income.As a substitute for the tax advantage currently accruing to pensions,employees wishing to save for retirement might seek out other tax-favored assets. Assets benefiting from tax preferences include assets
held for capital gains, state and local government bonds, housing andreal estate investments, and individual retirement accounts. _6 Over
80 percent of pension reserves are held in investments eligible forpreferential tax treatment, including stocks, bonds, and real estateinvestments. In the absence of pension-related tax preferences, taxexpenditures attributable to these other tax-preferred forms of sav-ings would probably increase significantly. As a result, estimates ofthe tax losses due to the treatment of pensions would prove to be toohigh given the opportunity for taxpayers to substitute one tax benefitfor another.
The elderly also benefit from more than one tax-code provision.Tax benefits available only to those sixty-five or older also influencecalculations of pension-related tax deferrals and losses. The mostimportant of these provisions is the extra personal exemption avail-
LSSeechapter V for a further discussion of these points._6Fora discussion of these assets, their preferential tax treatment, and their suitability
as retirement income vehicles, see chapter V.
62
able to this group. _7Pension-related tax expenditures are calculatedon the assumption that all other tax-code provisions remain un-
changed. Estimates of taxes paid on pension benefits thus reflect the
"tax-shelter" effect of tax-code provisions that benefit the elderly;benefits may be taxed at a lower marginal tax rate due not to pension-related provisions, but to social decisions affecting the elderlv's taxburdens.
In the absence of the extra personal exemption available to those
sixty-five or older, lifetime tax payments of pension-plan participantswould rise. In the oldest sample group, 26 percent of pension-relatedtax benefits are accounted for bv the tax shelter effect of the elderly
exemption (table IV.7). This effect becomes less important in theyounger groups, however, because with growth in pension benefits
and the maturing of the pension system, the elderly exemption be-comes a smaller proportion of income. Thus, of the pension-related
tax benefits accruing to the two youngest sample groups, only 5 per-cent and 2 percent (respectively) are accounted for bv the elderly taxexemption.
The elderly exemption has relatively less impact on the tax liabilityof the higher-income groups in the sample. The exemption accounts
for 3 percent of the pension-related tax benefits received by employeeswith incomes over $30,000, compared with 3 percent to 13 percentat incomes below this level (table IV.7).
Conclusions
Pension-related tax benefits, or tax expenditures, are generallymeasured in a cross-sectional framework, with taxes deferred by cur-rent participants offset against taxes paid bv beneficiaries. This method
overstates true tax benefits accruing to current participants. Whentax benefits are measured in a lifetime context, the taxes repaid tothe Treasury are three to four times as large as cross-sectional meas-ures suggest. Cross-sectional estimates, therefore, vastly overstate thetrue federal subsidy in pension policy.
This analysis suggests that current tax policy toward pensions may
not be as costly as some critics of the pension svstem charge. Theincreased saving and retirement income that results from the current
WElderly employees also benefit from the exclusion of half of Social Security benefitsfrom the taxable income of some households and from the elderly tax credit. Benefits
_rom these provisions, however, go predominantly to lower- and middle-income em-ployees, thus not having a major impact on estimates of pension-related tax expen-ditutes.
63
TABLE IV.7
Lifetime Pension-Related Tax Benefits and the ElderlyExemption a
Benefits Tax BenefitsWithout for Pensions
Tax Benefits b Elderly Related to theCurrent Law Exemption c Elderly Exemption
Category (Percent) (Percent) (Percent)
Age group
25 to 34 years 45 44 235 to 44 years 39 37 5
45 to 54 years 18 16 ll55 to 64 years 19 14 26
Income
$ 5,000 or less 34 31 9$ 5,001 to $ l 0,000 37 36 3
$10,001 to $15,000 24 21 13$15,001 to $20,000 44 42 5
$20,001 to $30,000 38 36 5$30,001 to $50,000 35 34 3$50,001 or more 38 37 3
Source: EBRI calculations based on PRISM simulation results."Calculations based on tax deierrals and payments in 1983 dollars. Tax calculationsassume that the tax code is fully indexed for inflation.bDefined as: 1 taxes paid on benefits
taxes deferred on accruals and earnings
tax treatment of pensions comes largely at the expense of federalrevenue deferrals, not losses. The effects of pension-related tax pro-visions on retirement incomes, benefit security, and saving patternsare all effects that should be taken into account in measuring thecosts and benefits of pension policies. The demands of the budgetprocess have required instead that legislators focus their attentionon revenue loss estimates alone, and not on what society gets inreturn. The design of balanced retirement policies has to look beyondnarrowly defined short-term budget goals.
64
V. Pensions, Savings, and FinancialMarkets
A major reason for the government's promotion and support ofpension growth is the desire to increase retirement savings, partic-
ularly for lower- and middle-income employees. Although the impactof pensions on total savings has been explored extensively elsewhere,other effccts of pensions have received considerably less attention?Among the questions that should be considered are:
(I) Who are the pe_lsio_z-plml participmzts? The distribution of pension sav-ings in the population should be as important a public policy' consid-eration as the effect of pensions on total savings.
(2) How do pe_zsio_zsaffect the allocatio_l o/savi_zgs? Pension reserves areinvested differcnth, from other forms of household weahh.
(3) How do pe_zsio_zfimds al]ect /hmtzcial markets? Could the concentrationof pension assets in a few large funds affect the operation of financialmarkets?
Who Are the Participants?
One major criticism of pension-related tax provisions is that theyare regressive; that is, they arc more beneficial to those in highermarginal tax brackets than in lower marginal tax brackets. Suchjudgments of the distributional impact of pensions do not take into
account the effect of pensions on the distribution of wealth amongindividuals, but instead concentrate on the distribution of tax liability
across the population.
Employer-provided pensions are more widely distributed amonghouseholds than other forms of savings. Since tax policy encouragesthe growth of pension coverage, therefore, it results in a progressiveredistribution of wealth. This redistribution can be demonstrated by
comparing asset income and pension coverage data as reported inthe May 1983 Employee Benefit Research Institute (EBRI) and Health
tEconometric studies dealing with the effect of pensions on savings levels are reviewedin Sophie M. Korczyk, Retireme_zthzcome Opportmzities in all Agi_zgAmerica: Pe_zsio_zsa_zdthe Eco_mmy (Washington, D.C.: EBRI, 1982),pp. 72-79; 119-136.
65
and Human Services (HHS) Current Population Survey (CPS) PensionSupplement, the best available source of information on the jointdistribution of pension coverage and income from savings. Directinformation on savings would be preferable to the data on incomefrom savings, but it is not available on a current basis. 2
According to the CPS, more than 40 percent of the labor forcereported no savings income (table V.1). This group's average incomewas $9,651, just under half the average income of those reportingsome asset income. Some 55 million workers, including almost halfof the group reporting little or no savings income on the CPS, werecovered by employer pensions in 1983. Pensions thus constituted anet increase in savings for these workers.
Employer-provided pension coverage is also more widespread thanindividual retirement account (IRA) participation. Preliminary EBRIresults from the EBRI/HHS CPS Pension Supplement suggest that
middle- and higher-income individuals were the primary benefici-aries of the broadening of IRA eligibility. An estimated 31 percent of
households reporting incomes of $15,000 or higher hold IRA accounts,compared with 9 percent of households with incomes below $15,000.
TABLE V.1
Savings, Pension Coverage, and Income, 1983
Employees Employees Average AnnualSavings Covered b Not Covered IncomeStatus a (Millions) (Percent) (Millions) (Percent) (Dollars) (Percent)
No savings 18.2 19.0 20.6 21.5 $ 9,661 40.5Some savings _ 36.9 38.4 20.3 21.1 19,209 59.5
Total 55.1 57.4 40.9 42.6 15,338 100.0Source: EBRI calculations based on preliminary data from May 1983 EBRI/HHS
Current Population Survey Pension Supplement._Individuals are classified as having some savings or no savings based on whether ornot they reported any asset income in response to the survey questions. Asset incomeincludes interest, dividends, rents, and royalties.
hCoverage refers to public- and private-sector pension plans and includes holders ofIRA and Keogh accounts.
_Includes individuals reporting negative asset income (i.e., decreases in asset values).
2Among the problems with using CPS asset income data are: (l) most forms of assetincome tend to be under-reported; and (2) asset income totals taken from the CPS donot include the increases in homeowner equity for owner-occupied homes, therebyunderstating the true asset income of those individuals with the bulk of their savingsin this form. The Department of Health and Human Services is currently undertakinga survey that will generate household-level asset data to update data in DorothyProjector and Gertrude Weiss, Survey of Financial Characteristics of Consumers (Wash-ington, D.C.: Board of Governors of the Federal Reserve System, 1966).
66
By comparison, 43 percent of workers earning less than $15,000 arecovered bv employer pensions. Assessments of pension-related taxpolicies should consider the net increase and redistribution of wealththat results from expanded pension coverage.
The Role of Employer Pensions in Household Savings andRetirement Planning
One reason public policy encourages employer-sponsored pensionsis to increase total retirement savings. Employer pension contribu-tions, as well as some employee contributions, are essentially non-discretionary savings from the plan participant's point of view'.Empirical evidence suggests that $1.00 of employer pension contri-butions may add as much as $0.80 to total savings.3 An equal amountof cash wages would probably be used partly for saving and partlyfor spending.
Employer-sponsored pension plans also change the allocation oftotal savings among various assets. If public policy should becomeless favorable toward employee pensions, the resulting changes insaving patterns would probably affect not onlv asset holdings, butalso retirement income security.
Capital hzvest,ze_zt--Employer-sponsored pensions favor long-term
capital investment. Nearly half of 1982 gross individual saving--thatis, the amount saved before deducting increases in household debt--consisted of liquid assets in the form of currency, demand deposits,time deposits (33.0 percent), and net investment (15.9 percent), with
most of the latter consisting of increases in equity in owner-occupiedhomes (table V.2). Nearly one-quarter of total saving was in money-market fund shares, securities and other financial assets, while in-
surance and pension reserves composed another 27.7 percent. Thismeans that less than a third of nonpension household saving--mainlythe share held in money-market fund shares, securities, and otherfinancial assets--is invested in assets that finance productive capac-ity.
Unlike individual savings, net additions to pension reserves areinvested predominantly in stocks and bonds which enhance produc-tive capacity. In 1981, for example, less than 5 percent of net additionsto pension reserves consisted of liquid assets, while between 80 per-
3Sophie M. Korczyk, RetiremeJztl_zco,zeOpportm_ities iu a_zAgi_zgA_nerica:Pe_siousa_zdtl_eYcono,zy, p. 76.
67
68
cent and 90 percent (depending on the type of plan) was invested infinancial securities. 4
Retiremem Security--Employer pensions provide a risk-pooling fea-ture that helps to ensure a reliable source of income for retirees. Bvinvesting in a number of assets and amortizing individual pensionliabilities over lcngthy periods of time, employer pension funds gen-erate a steady stream of retirement income that is not dependent on
changes in the value of individual assets. 5
The Impact on Savings if Tax Policy Toward PensionsChanges
If tax policy were to discourage employer pensions, household sav-ings could be redirected to other tax-favored assets. Assets currentlyreceiving preferential tax treatment include those purchased for long-term capital appreciation and tax-free municipal bonds. It has alsobeen suggested that IRA limits could be increased in order to sub-stitute for employer pensions.
Assets Purchased for Capital Gains--Some assets (real property orfinancial securities) provide income primarily through their appre-ciation in value, even though periodic income in the form of rent,interest or dividends may also be received. Such assets carry benefits
and risks to the taxpayer. For example, capital gains are taxed at arate lower than the taxpayer's marginal tax rate. Since manv indi-viduals are in a lower marginal tax bracket after retirement thanbefore, this could mean that the effective tax rate on capital gainsnot realized until retirement would be negligible. Assets purchasedfor capital gains differ widely in risk, return, and other features. Asa result, they would also differ in suitability as retirement incomevehicles.
Real Estate--One asset often purchased for capital gains is real estate.Capital gains on the sale of owner-occupied housing are tax-exempt up to$125,000, if the seller is at least fifty-five years old and has lived in thehouse at least three years. (This exemption may only be taken once.) Owner-occupied housing can also offer retirees financial advantages even if they
4Detailed statistics on the investment of private- and public-sector pension-fund assetsmay be found in Sophie M. Korczyk, Retirement Income Opportunities in a_z AgingAmerica: Pe_zsions a_td the Eco_tomy, pp. 45-71.
SWhile many defined-contribution plans allow the participants some choice amonginvestment vehicles, this choice is usually limited to a preselected set of options.
69
do not choose to sell. Reverse annuity mortgages (RAMs) could offer re-tirement income in the torm of an annuity based on the owner's equity inthe property, while allowing the owner to remain in the home. °
Owner-occupied homes may be a good investment, since they are not onlythe owner's primary shelter but also appreciate in value. Between 197_3and 1980 alone, the tax advantages of homeownership combined withincreases in housing values were 58 to 108 percent as large as new homemortgage interest costs] Other real estate investments also offer importanttax benefits because housing investments can be depreciated for tax pur-poses even if their actual value is increasing.
It should be remembered that the 1970s may not accurately reflect futurehousing appreciation patterns, however. Lil<e anv market, the real estatemarket fluctuates and an investor holding only one asset faces the risk ofretiring during a market downturn.
Other Assets--Other assets that are bought for capital gains could presentditt'erent risks. Investments in collectibles (such as art or antiques) mightnot provide reliable retirement income streams because fluctuations inpopular taste can erode the item's market value. Small collectors can findtheir capital gains eroded by dealer and other transaction costs. Also, thoseowning antiques or paintings might view them as possessions and notinvestments, refusing to part with them even when the income is needed.
Investors may also purchase financial assets for long-term appreciation.Properly managed, financial assets can be a more reliable source of re-tirement income because they are more liquid than real assets. But suc-cessful investors may need to watch stock and bond markets carefully andtrade frequently to take advantage of price movements. Investment infinancial assets may impose information and transaction costs that are toohigh for many investors.
The tax advantage of assets bought in anticipation of capital gains can bemixed. If an asset appreciates at a rate higher than the rate of inflation,the tax treatment of capital gains may provide the investor with an ad-vantage over those investments with income taxed at ordinary rates. TheInternal Revenue Code, however, does not index capital gains for inflation.As a result, if an asset appreciates at the rate of inflation, the investor istaxed on this appreciation even though it does not represent real (inflation-adjusted) income.
Tax-Free Municipal Bonds--These bonds could also be attractive
for retiremenl planning. The income from these bonds is not subject
_For a discussion o1 the issues and problems involved in converting home equity intoretirement income, see EBRI Issue Briel"Reverse Annuity Mortgages: A Viable Sourceof Retirement Income?" no. 12 (Washington, D.C., September 1982).
7EBRI calculations based on Ann Dougherty and Robert Van Order, "Inflation, HousingCosts, and the Consumer Price Index," The American Economic Review 72 (March1982): 154-164.
70
to federal income tax and, in addition, any realized capital gain istaxed at a lower rate than ordinary income, s Many investors find
these bonds attractive because the interest they provide does not fullyreflect the fact that it is tax-exempt. Research studies suggest thatonly about half the federal revenue lost due to the preferential taxtreatment of these bonds is reflected in lower interest payments by
state and local governments. The remaindcr surfaces as higher netincome to bondholders. 9
While some investors could benefit from the use of municipal bondsas their retirement income vehicle, this would not be true of all inves-
tors. An increase in demand for state and local bonds (or any assets,
for that matter) would increase their market value, reducing theireffective yields. Faced with a robust market for their debt issues, stateand local governmcnts could offer lower rates of return on new issues
as well. Taxpayers would benefit fl'om this reduction in interest costs,at the expense of bondholders.
IRAs--The Economic Recovery Tax Act of 1981 extended IRA eli-
gibility, to all persons, regardless of whether or not they are covered
bv an employer-sponsored pension plan. With the broadening of el-igibility, some have argued that IRAs could play a more dominantrole in retirement income policy, substituting for Social Security oremployer pensions (or both). 1°
Used as a supplement to other retirement income arrangements,IRAs can perform a valuable function, particularly for persons withintermittent work histories or frequent job moves who choose to usethem. If they are intended to be used as the sole source of retirement
income, however, IRAs present certain problems. Like any defined-contribution retirement income arrangement, the IRA places the fullrisk of market swings and inflation on the holder. Experience with
IRAs suggests that most households do not invest in the higher-yield-
*While municipal bond interest is not itself taxable, under the Social Security Amend-
ments Act of 1983 this income is included in adjusted gross income for the purposeof determining whether Social Security benefits are to be taxed.
9Joseph A. Pechman, Federal YeLv Policlv, 4th ed. (Washington, D.C.: The BrookingsInstitution, 1983), p. 119.
WSee, for example, Peter J. Ferrara, Social Security Rejbn_z: The Famih' Pla_l (Wash-ington, D.C.: The Heritage Foundation, 1982); National Taxpayers Legal Fund, The
Social Security Crisis." ._la_Mate /or Re/o_pl (Washington, D.C.: National TaxpayersLegal Fund, 1982); and S. 541 introduced in the first session of the 98th Congress bvgenator Jesse Reims (R-NC).
71
ing vehicles available to them. I_ At the same contribution level, there-fore, an IRA might not provide the same level of retirement income
as an employer-sponsored pension plan. IRAs are fully portable, avail-able to all employees as well as their unemployed spouses, and areused by all age and income groups, so they effectively complementemployer pensions.
Implications [or Tax Policy--Since other tax-preferred investment
vehicles could, at least in part, substitute for tax-preferred employer-sponsored retirement income programs, employer-sponsored plans
probably do not cost the Treasury as much in net revenues as currenttax-expenditure estimates or alternative lifetime estimates suggest
(chapter IV).While all alternative investments would not offer a tax deduction
for the original invested principal, thev do offer a tax deferral or tax
exemption on the investment earnings. Over even a moderate-lengthpension career, accumulated earnings on pension contributions canaccount for a majority of accumulated pension reserves. For example,consider a retirement plan to which the employer has contributed$1,000 annually for thirty years, at 10-percent annual investmentearnings. After ten years of participation, investment earnings ac-count for 37 percent of accumulated reserves; after twenty years, thisgrows to 65 percent; and after thirty years, investment earnings com-prise 82 percent of accumulated reserves (table V.3). 12
Pension Funds as Institutional Investors
Employer-sponsored pension funds have become increasingly im-portant in securities markets. In 1981, the latest year for which surveydata are available, employer-sponsored pension plans invested 12.3percent of all funds supplied to credit markets. Private plans aloneheld 12.4 percent of all corporate equities and 24.3 percent of allcorporate debt in 1981.13
This growth in asset holdings has generated interest in the invest-
iLFor an analysis of IRA investment patterns and comparative yields, see EBR[ IssueBrief"Individual Savings for Retirement: A Closer Look," no. 16(Washington, D.C.,March 1982).For an analvsis of the EBRI-HHS CPS data on IRA participation, seeEBRI Issue Brief "Individual Retirement Accounts: Characteristics and Policy Im-plications," no. 32 (Washington, D.C., July 1984).
_2Salarygrowth would increase the relative importance of contributions, as would alower assumed investment return.
_3SophieM. Korczyk, Retirement Income Opportunities in an Aging America: Pensionsand the Economy, pp. 46 and 49.
72
TABLE V.3
Pension-Plan Participation Relative to PensionContributions and Earnings a
Years of TotalPlan Reserves Contributions EarningsParticipation (Dollars) (Dollars) (Percent) (Dollars) (Percent)
5 years 6,105 5,000 82 1,105 1810 years 15,937 10,000 63 5,937 3715 vears 31,772 15,000 47 16,772 5320 years 57,275 20,000 35 37,275 65
25 years 98,347 25,000 25 73,347 7530 vears 164,494 30,000 18 134,494 82Source: Calculated by the author."Calculations assume a contribution o[ $1,000 annually, 10-percent investment returns,and no salary growth.
merit patterns and behavior of pension funds. The trading patterns
of larger institutional investors 14 may influence not only the firms
whose securities are being traded, but also the price of the securitiesinvolved.
Comparison with Other lnstittttional Investors--One way to assess
the influence of pension funds on market behavior is to compare thesize of their holdings with those of other financial institutions. Pen-
sion funds are now the largest source of institutional investment funds.
In 1960, life insurance reserves accounted for 40 percent of the assets
held by non-bank and non-thrift institutional investors, while total
private and state and local government pension funds accounted for
29 percent of all assets held by institutions (table V.4). _s In 1982,
private and state and local government pension funds held 42 percent
of total assets, while life insurance reserves accounted for 18 percentof institutional assets.
The share of financial assets held bv institutional investors as a
whole has been more stable than that of pensions. Between 1960 and
14In this discussion, the term "institutional investor" is used to refer to the institutionfor whose benefit a particular stock or fund is invested. Various institutional man-agers may administer portfolios for institutional investors. For a discussion of therelationship between institutional managers and investors, see the U.S. Securitiesand Exchange Commission, lnstitvtional lm,estor Study Report of the Securities andExchange Commission: Summary Volume (Washington, D.C.: U.S. Government Print-ing Office, 197l), chaps. 4-6.
_SBanks and thrift institutions are excluded from this comparison because they tendnot to hold corporate securities.
73
TABLE V.4
Investment by Non-Bank Institutions
1960 1970 1980 1982Investor (Percent) (Percent) (Percent) (Percent)
Life insurance reserves _ 40 27 21 18
Private pension funds 21 22 28 29Insured 8 7 11 12Trusteed 13 16 17 17
Other insurance 10 1 I I2 l0
State and local governmentretirement funds 8 13 13 13
Finance companies 11 13 13 12Investment companies 7 9 4 5Money market funds 0 0 5 10Securities brokers and dealers 3 4 2 3Real estate investment trusts 0 2 1 b
Institutional assets as a
percent of all holdings 13 12 14 16
Total assets (billions) $249.9 $623.8 $1,490.3 $1,983.7
Sources: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract ofthe United States, 1984 (Washington, D.C.: U.S. Department of Commerce,1983), p. 505, Also see American Council of Life Insurance, Pension Facts:1983 Update (Washington, D.C.: American Council of Lite Insurance, 1983),pp. 6-7.
_Excludes those pension funds investing their assets with life insurance companies;those are tabulated under pension fund assets.
bLess than 0.5 percent.
1982, the share of outstanding financial assets held by all institutional
investors rose from 13 percent to 16 percent, a change of only 3percentage points (table V.4).
Concentration of Funds Within the Pension Sector--The impact ofpension funds on financial markets is also seen in the concentration
of assets within the pension sector. If control over pension-plan assetsis broadly dispersed, then the ability of pension funds to dominatemarket movements will be limited.
Evidence on the concentration of pension-plan assets among plans
is mixed. Both private- and public-sector pension-plan assets are highly
concentrated among a small number of plans. In 1977, the latest year
for which public-use data are available, twenty-three plans (0.1 per-
cent of all plans) held 20 percent of all the assets in those private
74
single-employer plans with one hundred or more participants. 16An-other way to measure the concentration of pension-plan assets is their
distribution among employers. Fourteen firms (0.1 percent of all spon-sors) accounted for 20 percent of the plan assets of all sponsors ofplans with one hundred or more participants in 1977. Public-sectorplan assets are also concentrated. In 1982, 99 percent of all state andlocal government plan assets were held by 34 percent of state andlocal plans. 17
The concentration of plan assets, however, does not necessarilyimply a concentration of buying power with respect to financial as-sets. Most plans--both public and private--employ more than onefiduciary to manage plan assets. The amount of assets committed to
each fiduciary as well as each fiduciarv's particular specialtv and
stvle will determine how pension-fund assets are allocated amongavailable securities. Moreover, both the Employee Retirement In-come Security Act (ERISA) requirements and standard investmentmanagement practices suggest that plan assets will be diversifiedamong various types of securities and various issuers, is This diver-
sification reduces the likelihood that pension plans will deploy theirbuying power in a focused wav.
Effect ofInstimtio_ml Tradi_Tg o_7Asset Prices--While the dispersionof pension-plan assets makes it unlikely that the market power oflarge employer plans will be used in unison, the trades executed bv
various institutional investors in the course of managing portfolioscould still have market impacts because of their large size. It is pos-sible that even if institutional investors do not intentionally pursuethe same market goals, their trading behavior can affect market prices.
Economic studies of the effect of institutional trading on stock priceshave concluded that institutional trading affects securities prices,although it is seldom the only or dominant influence. In a congres-sionally mandated study of institutional trading, the Securities and
Exchange Commission (SEC) concluded that institutional trading isas likely to create or strengthen price movements as it is to offset
_OEBRItabulations of 1RS Form 5500 pension-plan disclosure data. Plans with morethan a hundred participants account for close to 90 percent of all single-employerplan assets.
_TU.S.Department o[ Commerce, Bureau of the Census, Employee Retirement Systemsof State a_zdLocal GovetTmze_tts:1982Ce_lsusolSGoverTmze_zts(Washington, D.(_.:U.S.Government Printing Office, 1982),p. 12.
_*Anexception to this would be the various types of stuck-option and stock-bonusplans.
75
those caused by the trading patterns of other investors. 19 A decadelater, an SEC study suggested that even though the market impactof institutional investors is significant, it is neither systematic nordominant.2°
In conclusion, available evidence suggests that the concentration
of pension assets in a relatively small number of plans does not haveany clear effects on financial markets. These conclusions should beevaluated in light of the scarcity of plan-level data on holdings ofparticular issuers' securities. If it were possible to compare the planholdings of particular securities, these conclusions about the relativediffusion of pension-plan market power might be different. Analyzingthe holdings of investment managers, rather than those for whom theinvestments are managed, could also yield different conclusions aboutthe concentration of pension-plan assets. 2t
Conclusions
Employer pensions both increase and redistribute savings. Pension
plans add to saving because pension-plan participants would spendmore if they received all their compensation in cash. Much of thisincrease in saving benefits lower- and middle-income individuals,since they tend to save the least out of their current income. Thisleads to a more equal distribution of savings than would occur in theabsence of pensions. Pensions also affect the allocation of savingsamong alternative investment vehicles. Pension plans invest in se-curities that finance productive capacity. More than half of nonpen-sion saving, in contrast, is held in cash, savings deposits, and owner-occupied housing. These effects of pensions on savings and capitalformation should be considered in the assessment of the impact of
pension policy.
_U.S. Securities and Exchange Commission, Institutional lm,estor Study Report o[theSecurities and Exchange Commission: Summary Volume (Washington, D.C.: U.S. Gov-ernment Printing Office, 1971), chap. 10.
-'°U.S. Securities and Exchange Commission, Directorate of Economic and Policy Anal-vsis, The Effect ofNet htstitutio_ml Tradbtg Imbalances o_z Stock Prices: CapitalMarketWorking Paper Number 6, by William J. Atkinson, (Washington, D.C.: U.S. Securitiesand Exchange Commission, 1981), pp. 1-20. (Mimeo.)
.,IFor a discussion ot the concentration of holdings among plan managers, see DonaldE. Farrar and Lance Girton, "Institutional Investors and the Concentration of Fi-nancial Power: Berle and Means Revisited," The Journal o/Finatwe 36 (May 1981):369-381.
76
VI. Pensions and Basic Tax Reform
Reforming the personal income tax has attracted increased atten-
tion in recent vears. Alternative tax systems being considered in pub-
lic debates include the consumption tax, the comprehensive income
tax, the value-added tax, and the national sales tax. Those offeringalternate svstems assert that their proposal would make the tax sys-tem simpler, more equitable, and less intrusive in economic decision
making. Questions thai should be considered in pension tax policydebates include:
(1) How should the system treat pensions?
(2) How do alternative tax treatments compare with respect to criteriacommonh used in evaluating tax policy options?
(3) What mcasurcnlcnt problems are involved in implcmenting alternativetreatments?
(4) What are the implications of rccent legislative proposals before theCongress?
Alternative Tax-Code Formulations
Currently, tax policy debates center on two theoretical approaches
to taxation: (1) consumption or cash-flow tax and (2) comprehensive
tax. Each option would affect the computation of tax liability, the
index of equality used to assess individual tax liability, and the typesof transactions that are taxable. Taxes on consumption like the value-
added tax and the national sales tax do not have any clear implica-tions for the treatment of employee benefits, i
Depending on their formulation, both the consumption tax and thecomprehensive tax could resuh in a broader tax base and lower mar-
ginal tax ratcs than under current law. In this respect, both systemscould be considered "fiat-rate" taxes. Either tax system could also
be designed to produce the samc amount of revenue as the current
_For a detailed discussion of the cflccts ot alternatixe tax systems on the provision ofemplo>cc bcnctits, see: Dallas L. Salisbury, "Statement on Tax Reform, EmployeeBenefits, and Economic Security, submitted before the U.S. Senate Committee onFinance Hearings on Major Tax Retorm August 7 and 9, 1984" (T-33) (Washington,D.C.: EBRI, 1984).
77
tax system. This discussion, therefore, will focus on the impact ofincluding or excluding certain items from the tax base and not theimpact of the alternative system on tax rates or the amount of revenueproduced .2
Cotlsumptio_z Tax--Under the consumption tax, tax liability is basedon the amount of income spent, regardless of the nature of the pur-chase. Savings and investment income are not taxed until spent. Tax-able income would be computed bv first calculating total income andthen subtracting all savings. For this calculation, income would in-dude wages, employer contributions for nonpension benefits; totalproceeds from the sale of assets (e.g., houses, cars, financial securi-ties); and loans. Savings would include money in savings accounts;expenditures for income-producing assets; pension-fund assets; andamounts spent to repay loans.
The consumption tax has aroused interest because it is perceivedto encourage saving. In some respects, the consumption tax would
not be a drastic departure from the current income tax. Some savingsalready receive deferred tax treatment, while others are not taxed at
all. Individuals are usually taxed only upon the constructive receiptof income from individual retirement arrangements and most em-ployer-sponsored pension plans. Some other investment income (e.g.,interest on tax-free municipal bonds and income from certain housinginvestments) is excluded from the tax base entirely.
Comprehe_lsive Tax--Unlike the consumption tax, the comprehen-sive income tax includes as taxable income not only wages but alsonearly every type of increase in asset value not currently subject totax. These include ccrtain additions to pension funds, unrealized cap-ital gains, undistributed corporate profits and contributions to in-
-'This discussion ol the role ol pensions and deferred compensation in basic tax reform
relies in large part on a report prepared bv the Treasury at the end of the FordAdminist,ation: U.S. Department of the Treasur.v, Bluepri_zts /or Basic Tax Relbrm(Washington, D.C.: National Technical lntormation Service, 1977). This report andits conclusions provided the basis for William E. Simon, Re/brmi_l,g the hwome Tax
System (Washington, D.C.: American Enterprise institute, 1981 ). The Blueprints reportdetails man_ ot the transitional and implementation problems in basic tax reform.
Bluepri_zts concepts have tormed the basis tor many recent tax retorm discussions,including the testimony ot John B. Cbapoton, Assistant Secretary of the Treasury,belore the Senate Finance Comminee on September 28, 1982.
78
dividual retirement arrangements. This broad definition of incomeis often called the Haig-Simons definition. 3
Some formulations of the comprehensive income tax would sig-nificantly increase the lifetime tax burden for pension-plan partici-
pants. (The consumption tax would continue current-law treatmentfor retirement income programs.) One version of the comprehensiveincome tax proposal would tax employees on increases in the presentdiscounted value of future retirement benefits as such increases ac-
crue. 4 This would bc difficult to do in defined-benefit plans since theseplans do not accumulate contributions and earnings in separate ac-counts for individual participants. Separate accounts would need tobe set up. Pension-plan investment earnings could be included in theemployee's taxable income as they accrue, and then benefits couldbe taxed with no recognition of the taxes previously paid. Under analternative version of the comprehensive income tax, employer con-tributions to retirement income programs would be included in theemployee's taxable income as they are made. Employees would betaxed on receipt of the retirement benefits, while previously taxedcontributions would be amortized tax-free. _
The impact of these alternatives on the lifetime tax liability of
pension-plan participants can be compared using a simplified ex-ample of an employee receiving an annual pension contribution of$1,000 over fifteen years, with no salary growth, an annual investmentreturn of 10 percent, and a 33-percent marginal tax rate both beforeand after retirement (table VI.I). Under current law', this employeewould pay $10,485 in taxes on retirement benefits, assuming thesebenefits are taxed as ordinary income. If both investment earningsand pension benefits were taxed, the participant's lifetime tax lia-bility would rise to $15,319, or 46 percent more than under currentlaw. Of this total, $7,216 would represent taxes paid on investmentearnings during the individual's work career and $8,103 would bepaid on benefits received during retirement. Taxing employer con-tributions and investment earnings as they accrue would result inthe same lifetime tax liability as taxing investment earnings and
_See R,M. Haig, "The Concept of Income: Economic and Legal Aspects," in The Federalhwome Tax, ed. R.M. Haig (New York: CoLumbia University Press, 1921};and H.C.Simons, Perso_mlIncome Ta_vatiopz(Chicago: University of Chicago Press, 1938).
aSee Bluepri_tts,chap. 4.5Emil M. Sunlcy, Jr., "Employee Benefits and Transfer Payments," in Comlorehe_2sivel_zcomeTa_vatio_t,ed. Joseph A. Pechman (Washington. D.C.:The Brookings Institution,1977), p. 82.
79
TABLE VI.I
Benefits and Lifetime Tax Liability for Employees with15 Years of Pension Coverage a
Accumulated LifetimeTax Pension Taxable Tax onTreatment Benefits b Benefits Benefita
Current law $31,772 $31,772 $10,485
Employer contributions andbenefits taxed _ 31,772 11,237 d 14,193"
Investment earnings andbenefits taxed 31,772 24,556 15,319 t
Contributions and investment
earnings taxed butbenefits received
tax-free 31,772 g 15,319
Source: Calculated by the author._Calculations assume an annual pension contribution of $1,000 over fifteen years, withno salary growth, an annual investment return of 10 percent; and a 33-percent mar-ginal tax rate both before and after retirement. Benefits and taxes on benefits areassumed to be paid in one lump sum at retirement.
bAmounts reflect assumption that plan remains unchanged._Employee recovers previously taxed contributions in retirement tax free.dTotal benefits accumulated at retirement are $21,287. After deducting previouslytaxed benefits of $10,050 (15 × $670), taxable benefits are $11,237.
_Of this total, $8,658 represents taxes paid by the employee and $5,535 representsforegone interest on taxes paid during the work career.
tOf this total, $7,216 would represent taxes paid on investment earnings during theindividual's work career and $8,013 would be paid on benefits received during re-tirement.
gNot applicable.
benefits. Taxing employer contributions as made and then taxingbenefits upon retirement (after allowing for amortization of previ-ously taxed contributions) would cost the employee $14,193 (35 per-cent more than under current law). Of this total, $8,658 would representtaxes paid by the employee, while $5,535 would represent foregoneinterest on taxes paid during the employee's work career.
Advantages of a comprehensive income tax could include the eliminationof the tax-avoidance incentives and income-earning disincentives somebelieve to be embedded in the current tax structure's progressive rates,deductions, and exemptions. It has been argued that a comprehensive taxwould enhance horizontal equity, since tax liability would not depend onthe form in which the income is received or the assets held.
Disadvantages of a comprehensive income tax could include the formidablemeasurement problems involved in taxing unrealized income. In some
80
cases, a taxpayer's property rights may not be clear or the property maynot generate the cash needed to pay the tax liability.
Evaluating Tax Policy Options
Three criteria are commonly used to evaluate tax-code provisions:equity, efficiency, and ease of administration (simplicity).
Equity--A major problem with the current tax system is the pop-ular belief that the system is not fair. Many are convinced that dif-
ferences in tax liability result from the exploitation of tax-codeprovisions as much as from differences in actual ability to pay.
The tax code's fairness can be measured in terms of horizontal
equity and vertical equity. Horizontal equity is the principle thattaxpayers in the same economic circumstances (i.e., the same abilityto pay) should be subject to the same tax liability. Vertical equity isthe principle that taxpayers in different circumstances should be treateddifferently .6
To design a svstem that treats all taxpayers fairly, it is first nec-essary to select an index for comparing individual circumstances. For
tax purposes, comparison can be based on consumption, income, orwealth.
A consumption1 tax--(e.g., a sales tax) imposes tax liability on the basis ofthe use that is made of the income, or the living standard the individualchooses to support, rather than on total income. Taxes on wealth (e.g.,estate or property taxes) may be designed to tax individuals either on asset-related income or the actual value of the assets involved.
A_z i_zcome tax--imposes liability on the value of what the taxpayer pro-duces as represented bv income. Income is the predominant index usedbv the U.S. tax system, even though the income tax currently containsaspects of a consumption tax. Taxes based on consumption or wealth areintegrated with the income tax through income tax deductions for suchpayments.
Efficiencv--A tax svstem's efficiency is generally measured in termsof its impact on economic decisions. This means that the more a
taxpayer's behavior is altered (to avoid paying taxes), the less efficientthe tax system. At the same time, however, using the tax code to alter
°Arguments concerning the relationship between horizontal and vertical equity aresummarized in Richard A. Musgrave, The Theory o[Public FiHa_tce:A Study i_lPublicEco_lomv(New York: McGraw-Hill Book Company, Inc., 1959),p. 160.
81
individual behavior has been viewed as an important tool of social
and economic policy.Most tax-code provisions alter economic behavior. Taxing a par-
ticular transaction often discourages the activity. For instance, the
imposition of excise taxes on alcohol, tobacco or gasoline, makes thesecommodities more expensive and discourages some purchases. Con-
versely, if a particular activity is tax-favored, it is substantially en-couraged. The existing pension-related tax provisions encourageindividuals to provide for their future, increasing total saving andretirement incomes. In this way, tax provisions altering economicbehavior also encourage socially beneficial goals.
Simplici(v--A third criterion used to evaluate the existing tax sys-tem and proposed tax-code changes is simplicity. In general, tax-codeprovisions should be designed to be easily understood, while not con-flicting with equity or efficiency. A tax code that is easy to understandand administer not only reduces administrative costs but also in-
creases taxpayer compliance. This is particularly important in theU.S. tax system, which relies largely on voluntary compliance forcollecting taxes.
Problems in Valuing Pension Accruals During theIndividual's Work Career
If employees were required to include additions to pension reservesin adjusted gross income for tax purposes, procedures would have tobe established to measure pension accruals correctly and consistently
among individuals. Measuring pension accruals correctly for tax pur-poses would be difficult. The personal income tax determines theindividual's ability to pay on the basis of income. The value of anindividual's pension accrual, however, depends on many factors otherthan income (i.e., plan features, length and timing of pension-plan
participation, and the employee's age).
Plan Features--The type of plan, funding patterns, and vesting pro-visions, affect the pattern of pension accruals over an employee's workcareer.
Plan Type--There are two ways to measure the change in an individual'spension wealth accruing in a given year. One way is the employer's pension-plan contribution on the individual's behalf plus an appropriate proportionof the pension fund's investment earnings on prior years contributions.
82
The other way is to measure that year's change in the present discountedvalue of future retirement benefits.
(1) Deft'ned-Contribution Plans--In most defined-contribution plans, thesetwo values will always be equal by definition. The vested share ofcontributions plus accumulated investment earnings determine theindividual's pension wealth.
(2) Defined-Bene/'it Plans--In defined-benefit plans, it is not necessary thatthe present value of benefits credited and the funds accumulated topay these benefits be equal at any point in time. Benefits in these plansare credited on the basis of service and earnings, but various types ofdefined-benefit plans accrue benefits in different patterns. Actuarieschoose from a number of different formulas for valuing plan liabilitiesand determining the contributions necessary to fund them in a rea-sonable manner as mandated bv the 1974 Employee RetirementIncome Security Act (ERISA). The formula used in the pension plandetermines the contribution pattern.
Defined-benefit plan accruals and the contributions necessary to fundthem diverge most significantly when a plan is initiated or benefitimprovements are made. In both cases, the present discounted valueof the participant's future retirement income increases significantlywithin a one-year period. The plan contributions necessary to fundthese benefits, however, are made over an extended period.
Another complication encountered in valuing an employee's pensionwealth is that instead of allocating contributions or projected benefitsto individuals, the actuarial formulas used in defined-benefit plansmake contributions for an employee group based on aggregate forecastsof its demographic and economic experience. If all employees in adefined-benefit plan were credited with some "average" group contri-bution, younger employees would be credited with too large an amount,while older employees would be undercredited.
Further problems would occur when measuring and imputing pension-fund investment income to participants. Changes in interest rates canlead to capital gains or losses. Averaging out such changes in the in-dividual's pension wealth would impose an administrative burden onplan sponsors.
Thus, if pension accruals were included in the tax base, the difficulty ofattaching a unique value to pension accruals in all plans would com-plicate both individual tax computation and the design of an equitablesvstem.
Funding Patterns--Difficulties in evaluating employee pension rights arefurther complicated by variations in plan funding status over time andamong plans. Since defined-benefit plan sponsors have considerable lati-tude in timing their contributions, even financially stable plans will notbe fully funded at all times. On the one hand, a plan's funding status doesnot affect the participant's benefit rights, because benefits do not dependon funding status. Therefore, funding levels would seem to be irrelevant
83
to valuing an individual's interest. On the other hand, it is difficult to taxa transaction that has not taken place.
If contributions were only taxed when made, serious penalties would belevied on those very plans whose benefits are most secure (see chapterIV). The better funded a plan, the higher the tax bill would be for itsparticipants. Participants in private-sector plans and large state andlocal government public-sector plans would be penalized most heavily.Those in federal-employee plans, which are either pay-as-you-go or onlypartially funded, would be taxed lightly compared with the future ben-efits earned. Taxing individuals on benefit accruals would, therefore,require imputing pension wealth increases to participants in unfundedor underfunded plans.
Vesting Provisions--ERISA permits a number of different vesting schemesin qualified plans. Differences in vesting patterns complicate evaluatingan employee's rights prior to full vesting. For example, a participant ina plan with a ten-year graduated vesting schedule has different benefitrights and expectations over the first ten years of employment than anemployee on a ten-year cliff vesting schedule. After the first ten yearsof employment, their benefit expectations may be identical, if all otherterms of employment are identical. Including only vested contributionsor benefit accruals in the tax base would reduce these problems. Unlessall taxes on contributions made prior to full vesting were eliminated,however, some form of income averaging could still be required to avoidimposing prohibitively high tax liabilities in the year the employee be-comes fully vested.
Length of the Employee's Work Career--The length and timing ofan employee's pension-plan participation determine how much ofthe employee's retirement benefits are financed by contributionsor derived from investment earnings. For those employees withshorter periods of pension-plan participation (enrolling closer tothe age of retirement), contributions account for most of the valueof benefits at retirement. For those employees with a longer historyof plan participation, investment earriings play a more importantrole in determining the level of benefits (see table V.3 in chapterV). Including contributions or investment earnings (or both) in thetax base would impose different liabilities on individuals depend-ing on the length of their work career and the length of time re-maining until retirement.
Employee Age--An advantage of advance-funded pension plans isthat contributions accrue tax-deferred investment earnings. As aresult, lower employer contributions may be needed to fund a givenlevel of retirement benefits than if all benefits were funded on a
pay-as-you-go basis. Pension-plan contributions must be larger tofund a specific benefit for an older employee, because the invest-
84
ment earnings have a shorter period of time in which to accrue.For a younger employee, the contribution needed to fund a specificbenefit is smaller, so the benefit that can be supported by a givencontribution is larger.
For any given year, therefore, either contributions (in a defined-
benefit plan) or the increase in the present discounted value of futurebenefits (in a defined-contribution plan) will vary by employee age,
assuming equal salary levels. This lack of correspondence betweenincome and pension contributions or accruals would create horizon-tal equity problems in taxing pension contributions on a currentbasis. For example, consider two hypothetical employees, who eachearn $25,000 annually. Employee A has one year until retirement,and employee B has twenty years. If both employees are creditedwith a 1983 pension-plan contribution of 5 percent of pay, upon re-tirement employee A will have an additional $1,250 in pension re-serves and employee B will have $3,316.62 (assuming the 1983contribution is invested at a 5-percent rate of return).
Recent Legislative Proposals
About a dozen tax-reform proposals were introduced in the 97thCongress and more were introduced in the 98th Congress] Someproposals simply direct the Treasury to study the feasibility of taxreform, while others contain detailed amendments to the InternalRevenue Code.
Four recent legislative proposals implement both the comprehen-sive tax and the consumption tax. All combine tax-rate reductionwith tax-base expansion, and would affect most employee benefits.
Comprehensive Income Tax--Senator Bill Bradley (D-N J) and Rep-resentative Richard Gephardt (D-MO) have introduced a comprehen-sive income tax proposal (S.1421/H.R.3271). It would raise the sameamount of revenue as current law bv using only a three bracket tax-rate structure: 14 percent, 26 percent, and 30 percent. The reducedrate structure would be financed bv eliminating or cutting back ap-
proximately forty items receiving preferential tax treatment undercurrent law. Among those that would continue to receive preferential
:For summaries of bills introduced in the 97th Congress see U.S. Congress, Co_gres-sional Record (Washington, D.C.: U.S. Government Printing Office, 1983), p. S1511.See also Robert E. Hall and Alvin Rabushka, Lon' To_r,Simple r_r, Flat Tar (NewYork, McGraw-Hill Book Company, Inc., 1983).
85
tax treatment are deductions for home mortgage interest, charitabledeductions, state and local property and income taxes, and somemedical and business expenses. All employer-provided benefits, ex-cept for pension-plan contributions, would be included in the em-ployee's taxable income. The Internal Revenue Code section 415 limitson pension benefits and contributions would be made much morerestrictive. (See chapter VII for further discussion.)
Representative Jack Kemp (R-NY) and Senator Robert Kasten(R-WI) have introduced a similar proposal (H.R. 6165/S. 2948) alsoknown as the "Fair and Simple Tax." This proposal would have asimpler tax rate and deduction structure than Bradley-Gephardt andwould also offer added savings incentives.
Senator Mark Hatfield (R-OR) has also introduced a comprehensive
tax proposal (S.2158). Under this proposal, most deductions, credits,and exemptions would be repealed, so that many items currentlyexcluded from adjusted gross income would be included. The Hatfield
proposal would retain current-law treatment for employer-providedpensions, but all other employer contributions for benefits would beincluded in taxable income. There would be six tax brackets, ranging
from 6 percent to 20 percent. The existing structure of exemptionsand deductions would be replaced by five tax credits for the taxpayer,spouse, and dependents; and for portions of charitable contributions,home mortgage interest, taxes paid to other jurisdictions, and med-ical expenses.
Consumption Tax--Senator Dennis DeConcini (D-AZ) has intro-duced a consumption tax proposal (S.557). Under this proposal, allincome other than that used for investment would be taxed at a
marginal rate of 19 percent. This tax structure would be financed byeliminating nearly all preferential tax treatment available under cur-rent law. All income would be taxed once, as close to the source as
possible. Advocates of such a tax structure argue that it would elim-inate the existing problem of some income escaping taxation entirely,while other income is taxed more than once.
Contributions and benefits in retirement income programs wouldretain their current-law tax treatment. The employer's contributionfor health, welfare, and "fringe" benefits, however, would no longerbe deductible as a business expense for employers. Employees wouldnot be taxed on the value of employer contributions for nonpension
benefits, since the employer would already have paid tax on thesecontributions. Since cash compensation would continue to be a tax-
deductible business expense for the employer, the employer would
86
presumably have an incentive to offer more in cash compensationthan in benefit contributions. 8
Comparing Major Proposals--All three legislative proposals, thoughthey are based on different tax principles, would result in similartreatment for many benefits. Tax preferences for most nonpensionbenefits would bc eliminated and such benefits would be treated as
taxable income. Had such a provision been in effect in 1982, an es-timated $72.9 billion would have been added to that year's taxableincome. Federal tax revenues, as measured by the U.S. Treasury'scalculations of tax expenditures attributable to these benefits, couldhave been over $19 billion higher, assuming current-law tax rates(table VI.2). 9
The primary differences among the proposals relate to their treat-ment of retirement income programs, m The DeConcini and Hatfieldproposals would continuc the current-law treatment of pensions.Bradlcy-Gephardt would impose more restrictive benefit and contri-bution limits under section 415 of the Internal Revenue Code. Limits
on allowable benefits in defined-benefit plans would be reduced from$90,000 under current law to $60,000; contribution limits in defined-
contribution plans would be lowered from $30,000 to $20,000; andindexing of these limits would be eliminated. The immediate effectsof this change would be felt primarily by higher-paid employees. Thelong-term repercussions could be much broader. As many as 20 per-cent of the younger pension-plan participants could be directly af-fected, and many more could be affected indirectly by the adjustmentspension-plan sponsors could be forced to make (see chapter VII).
These proposals, therefore, would change the relative attractive-ness of cash and benefit compensation, as well as the relative attrac-tiveness of specific benefits. In general, tax policy under these proposalswould continue to provide some encouragement for benefits that con-stitute capital accumulation, but employer incentives for benefitsproviding current protection against various financial hazards wouldbe reduced.
SThis argument is advanced in Robert E. Hall and Alvin Rabushka, Low Tar, SimpleTax, Flat Tax, p. 90.
9Current-law tax expenditures overstate potential revenue gains resulting from theelimination of the preferential tax treatment of certain items, since the reform pro-posals would also result in lower marginal tax rates.
raThe DeConcini proposal would continue the current-law treatment of interest earnedon whole life insurance, while the Bradley-Gephardt bill would include it as taxableincome. Most employer-provided life insurance plans would not be affected, sincethey are term hfe insurance with no savings component.
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TABLE VI.2
Voluntary Benefits: 1982 Federal Tax Expenditures andEmployer Cost
Employer Federal TaxCost b Expenditure b
Voluntary Benefit a (Billions) (Billions)
Insurance
Health $65.7 $16.4Life 7,2 2.0
Accident and disability c 0.1
Other employer-provided benefits
Child care, tuition aid,
and legal services c 0.6
Total $72.9 $19.1
Sources: EBRI calculations based on employer cost data from table 6.15 in U.S.Department ot Commerce, Bureau of Economic Analysis, Sura,(v o/('tttTz'_ltBusiness 63 (July 1983): 74; and tax-expenditure data from the ExecutiveOffice of the President, Of/ice Management and Budget, The Budget o/theU,tited Slates: Fiscal Year 1982 (Washington, D.C.: U.S. Government PrintingOffice, 1981), Special Analysis G, table G-I, p. 229.
"Voluntary benefits arc those not mandated by law. Examples of mandatory benefitsare Social Security and unemployment compensation.
t'Totals cover both private- and public-sector employees."Not available.
Conclusions
Basic tax reform could affect retirement income plans in one of
three ways. Pensions could continue to receive current-law treatment
(DeConcini proposal or value-added and sales taxes). Alternatively,
pension accruals could be included in the tax base on a current basis,
like cash income (comprehensive tax). Finally, limits on pension con-tributions and benefits could be cut back sharply (the Bradley-
Gephardt proposal). More stringent limits on the tax-deductibility ofpension contributions could result in the inclusion of more pension
contributions in the tax base as wage growth brings more employees
to the statutory limits. The fundamental goals of tax reform--in-
creased equity, efficiency, and simplicity--would not necessarily be
served by including contributions for employer pensions in the tax
base. The tax system's equity would not necessarily be enhanced,
since measurement and valuation problems make interpersonal com-
parisons of pension wealth difficult.
Taxing retirement income programs on a current basis could also
88
interfere with efficient pension-related financing decisions. Taxingcontributions could penalize better-financed plans and encourage plansponsors to defer their financing obligations as long as possible. Tax-ing only vested contributions could likewise create perverse incen-tives for sponsors with liberal vesting schedules to lengthen theirschedules to the maximum level allowed under ERISA. Finally, schemesto tax accruals on a current basis would make the tax code more
complex and impose administrative burdens on sponsors.In summary, tax-reform proposals that would change the tax treat-
ment of employee benefits are usually also intended to simplify thetax code, reduce its influence on economic decisions, and make it
more equitable. The analysis in this chapter suggests that broadeningthe tax base to include pension contributions could mean some sac-rifices of efficiency and equity and the addition of considerable ad-ministrative and compliance costs. Both tax reform goals and incomesecurity goals might best be served by tax reform proposals that donot disrupt the existing structure of retirement plans.
89
VII. Pension Tax Policy Issues
Two pension-related concerns in current tax policy are:
(1) the impact of changes in Internal Revenue Code section 415 limits onplan contributions and benefits; and
(2) the taxation of defined-contribution plan distributions.
Changes in Section 415 Limits
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
imposed stricter limits on benefits and contributions in employer-sponsored plans (see chapter II). Later, the Bradley-Gephardt bill(submitted in 1983) proposed even lower dollar limits for defined-benefit plans ($60,000--down from the 590,000 limit set by TEFRA)and defined-contribution plans ($20,000--down from the 530,000 limitset by TEFRA). The Bradley-Gephardt bill also proposed that these
limits no longer be indexed for inflation. The following is a discussionof the impact of changes in Internal Revenue Code section 415 on
pension-plan participants in selected income and age groups. _
Limits Enacted in TEFRA--TEFRA limits immediately affect onlythose employees earning $125,000 or more a year, 2 although TEFRAlimits eventually will affect some employees in each age and incomegroup at some point in their work careers. If the limits are imposedwithout indexing, 4.1 percent and 6.6 percent of the workers in theoldest employee groups would reach the limit in at least one plan,while 13.1 percent and 7.8 percent of those in the two youngest groupswill have their benefits or contributions restricted at some point dur-ing their work careers (for details, see table VII. 1). Inflation and real
income growth are less likely to make the older employees' pensionplans exceed section 415 limits, because they were closer to the peakof their earning careers in 1979.
_The PRISM model uses plan descriptions predating the implementation of TEFRA.So the imposition of either the benefit or contribution limits will determine whichindividuals will be affected by TEFRA or other proposals.
2Michael J. Canan, Qualified l_etirement Plans (St. Paul, Minn.: West Publishing Com-pany, 1977).
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TABLE VII.I
Percent of Vested Participants Affected by TEFRAChanges to Section 415 Limits
Combined-PlanSingle-Plan Limits Limits _
Unindexed a Indexed bCategory (Percent) (Percent) (Percent)
Age group (1979)
25 to 34 years 13.1 9.5 0.635 to 44 years 7.8 6.6 0.045 to 54 years 4.1 3.3 0.055 to 64 years 6.6 4.1 0.0
Income (1979)
$ 5,000 or less 9.8 7.2 0.3$ 5,001 to $10,000 lO.1 7.3 0.0$10,001 to $15,000 7.3 6.3 0.0$15,001 to $20,000 8.7 6.5 0.0$20,001 to $30,000 9.1 6.6 0.3$30,001 to $50,000 9.0 6.6 0.4$50,001 or more 12.8 9.3 0.7
Total 9.4 7.1 0.6
Source: EBRI calculations based on PRISM simulation results._Unindexed throughout simulation period.hindexed according to the limits set by TEFRA.LUnindexed. The employees reported in this column would trot have exceeded theInternal Revenue Code section 415 limit on either plan, if the amount of each planwere calculated separately. They exceeded the amount, however, when their benefitswere combined. (The first and third columns of this table are cumulative.) As shown,the combined-plan limit did not signilicautly change the number of persons alreadyaffected bv the single-plan limits.
All base,year (1979) income groups would be affected by the TEFRA
limits during the simulation period if there were no indexation. Even
in the lowest income group (those earning $5,000 or less), 9.8 percent
of the employees would receive lower benefits or employer contri-
butions in their employer-sponsored pension plans.
Indexing the limits, scheduled in TEFRA to begin in 1986, would
reduce the number of pension-plan participants affected by the limits
to 9.5 percent of those in the youngest employee group and 6.6 percent
of those in the next-youngest group (table VII.l)) Indexing will pri-
3The method used here to index plan contribution and benefit limits is not exactly themethod specified under TEFRA, which provides that these limits are to be indexedby the factor intended for the future indexation of Social Security benefits.
92
marily affect younger employees since the impact of inflation on their
benefits would be far greater. It also will have the greatest impacton those employees who earned $50,000 or more (1983 dollars) in1979: the number of affected individuals falls from 12.8 percent to
9.3 percent when the limits are indexed. In the total sample, thenumber of pension-plan participants affected by the TEFRA limitsfalls by 2.3 percentage points when the limits are indexed.
The Tax Reform Act of 1984 extends the freeze on section 415 in-
flation adjustments for two additional years. This freeze brings anadditional one-tenth of 1 percent of plan participants in the data baseunder the indexed limits. The additional participants affected are inthe younger group and at higher income levels.
TEFRA also imposed stricter limits on employer pension-plan con-tributions and benefits for those participants covered by more thanone employer-sponsored pension plan of the same employer (see chap-ter II). Employees covered by more than one plan face more stringentlimits than they would in a single plan. Under the conditions usedin the simulation, only an additional 0.6 percent of participants areaffected by the combined-plan limits when no indexing is used (tableVII. 1). Employees whose benefits or contributions fail the combined-plan test usually do so on the basis of one plan's features and not thecombined-plan limits.
The combined-plan limits have relatively little effect on benefitsand contributions due, in part, to the assumptions governing thesimulation. The Pension and Retirement Income Simulation Model
(PRISM) does not assume any growth over time in secondary-plancoverage. Consequently, if secondary-plan coverage is growing, tab-ulations based on PRISM results will understate the impact of thecombined-plan limits. 4
Limits Proposed in the Bradlev-Gephardt Bill--The section 415 planlimits proposed in the Bradley-Gephardt bill would affect two-thirdsmore employees than the existing TEFRA limits do. Of the pension-plan participants in the sample, 7.7 percent were affected by TEFRA,
According to the Social Securitv Amendments of 1983, if the Old Age Survivors' andDisability' Insurance (OASDI) trust fund balance falls below designated levels, SocialSecurity benefits are to be indexed against the change in either the Consumer PriceIndex or the wage index, whichever is lower. For the purpose of this simulation, theCPI was used to index both the Social Security benefits and the TEFRA limits, sincethe PRISM model does not simulate trust fund balances.
4Secondary-plan growth is discussed in Emily S. Andrews, The Changing Profile of
Pe_Isionsin America (Washington, D.C.: EBRI] forthcoming).
93
TABLE VII.2
Percent of Vested Participants Affected by Bradley-Gephardt Changes to Section 415 Limits a
Single-Plan Combined-PlanLimits b Limits c
Category (Percent) (Percent)
Age group (1979)
25 to 34 years 7.7 1.135 to 44 years 4.4 0.145 to 54 years 0.4 0.055 to 64 years 0.8 0.0
Income (1979)
$ 5,000 or less 2.6 0.4$ 5,001 to $10,000 2.6 2.0$10,000 _o $15,000 1.5 0.8$15,001 to $20,000 2.8 0.5$20,001 to $30,000 4.8 0.9$30,001 to $50,000 7.0 0.6
$50,001 or more 9.66 0.0Total 4.8 1.0
Source: EBRlcalculations based on PRISM simulation results._'The percentages calculated assume that the TEFRA section 415 limits are in efl_tct.bUnindexed throughout the simulation period."Unindexed. The first and second columns ot this table are cumulative.
while an additional 5.8 percent would reach the Bradley-Gephardtlimits during their work careers (tables VII.1 and VII.2).
A particular age or salary group of plan participants could be moreaffected than pension-plan participants as a whole. In the youngestgroup (employees twenty-five to thirty-four years of age), 8.8 percentmore participants would be affected by the Bradley-Gephardt limitsthan the TEFRA limits (see table VII.2). The greatest difference inthe number of employees affected by the different limits occurredamong those with 1979 earnings of $30,000 or more (1983 dollars).TEFRA affected 6.6 percent of those employees earning between $30,000and $50,000 (1983 dollars), and 9.3 percent of those employees earningmore than $50,000. The proposed Bradley-Gephardt limits would af-fect an additional 7.0 percent and 9.6 percent, respectively (tablesVII.1 and VII.2).
As in the TEFRA analysis, the single-plan limits constitute the mostimportant restriction on pension-plan benefits and contributions. Giventhe single-plan limits imposed under the Bradley-Gephardt bill, an
94
additional 1 percent of the plan participants would have their con-tributions or benefits reduced by the combined-plan limits (tableVII.2).
The impact of the proposed section 415 limits on pension-plan par-ticipants can be best seen by examining the cumulative impact ofboth TEFRA and Bradley-Gephardt limits. If the Bradley-Gephardtbill were enacted, 12.9 percent of the employees vested in their pen-sion plans (about one out of every eight participants) would receivelower retirement benefits than under the pre-TEFRA provisions (tableVII.3). In the youngest group (age twenty-five to thirty-four), one outof every five participants (19.8 percent) would have their benefitsreduced.
It should be remembered that not all participants ultimately be-come vested. The simulation data base used contains only the ac-cruals and benefits of those participants with vested pension rights.No accruals or benefits were projected for unvested participants who
TABLE VII.3
Percent of Vested Participants Affected by TEFRA andBradley-Gephardt Section 415 Limits a
Bradley-TEFRA Gephardt TotalLimitsb Limitsc Affected
Category (Percent) (Percent) (Percent)
Age group (1979)
25 to 34 vears 9.5 10.3 19.835 to 44 years 6.6 4.5 11.145 to 54 vears 3.3 0.5 3.855 to 64 vears 4.1 0.9 5.0
Income (1979)
$ 5,000 or less 7.2 3.1 10.3$ 5,001 to $I0,000 7.3 4.6 11.9$10,001 to $15,000 6.3 2.3 8.6$15,001 to $20,000 6.5 3.3 9.9$20,001 to $30,000 6.6 5.7 12.3$30,001 to $50,000 6.6 7.6 14.2$50,001 or more 9.3 9.6 18.9
Total 7.1 5.8 12.9Source: EBRI calculations bascdon PRISM simulation results.
_Wested plan participants only.bSingle-plan limits only. When the single-plan limits wcre indexed, no additionalpersons were afflected bv the combined-plan limits.
Cgingle- and combined-plan limits.
95
are not projected to vest in a pension plan at some point. Unpublished
EBRI tabulations of the May 1983 Current Population Survey suggestthat between 30 and 40 percent of current pension-plan participantsare not vested. Adding the number of unvested participants to thosevested could mean that approximately one-third of the younger par-ticipants would be affected by changes to the Internal Revenue Codesection 415 limits set by TEFRA and the Bradley-Gephardt bill.
Short- and Long-Term Effects of the Proposed Changes--These resultssuggest that the long-term effects of changes in the section 415 limitswill be very different than the short-term effects. Inflation, real in-come growth, increased pension coverage, and job and work-hourchanges eventually will bring employees at all income levels underthe section 415 limits.
Inflation rate and real wage growth assumptions are particularlyimportant in projecting the impact of section 415 limits. These pro-jections assume a long-term inflation rate of 4 percent (see the ap-pendix). This inflation rate is consistent with the last two years'experience, but lower than that experienced in the last decade. Be-tween 1974 and 1983, for example, prices rose at a 7.3 percent com-
pounded average annual rate. A higher inflation rate would placemore pension-plan participants at the section 415 limits. Consideran employee earning $20,000 at age thirty-five. Over a thirty-yearwork career, this employee's salary would increase to $114,870 underthe assumptions of the PRISM model. If the employer provided adefined-benefit plan offering one-third of final pay, the employee wouldbe eligible for a retirement benefit of $37,907 (in current dollars) atage sixty-five. Neither the provisions of the Bradley-Gephardt bill northe TEFRA limits would reduce this benefit. Under an alternate in-
flation assumption of 6 percent, however, the employee's salary atretirement would be $201,253. Under the same retirement plan, the
projected retirement benefit would increase to $66,414 and thus wouldbe reduced if the Bradley-Gephardt bill were to pass.
The assumed growth rate of real wages also has an important effect
on these projections. This model assumes an annual 1.1 percent realwage growth rate until 1990, then 1.5 percent in 1991 and later years.This is optimistic compared with recent experience. Between 1973and 1983, real wages fell at an annual rate of 0.9 percent. The lowerthe growth rate of real wages, the fewer employees will reach thesection 415 limits.
Other Effects--A change in the section 415 limits will also indirectly
96
affect those employees not immediately subject to the limits, althoughthis could vary greatly among industries.
Indirect Effects--In response to TEFRA, employers are establishing non-qualified plans for high-paid employees to supplement the corporate pen-sion plan and help these individuals maintain their income levels inretirement. 5 The use of nonqualified plans has two implications for lower-and middle-income workers. First, because nonqualified plans are not gov-erned by the nondiscrimination provisions of the 1974 Employee Retire-ment Income Security Act, increased reliance on such plans reduces theretirement protection available to lower- and middle-income employees.Second, nonqualified plans can increase the costs of plan sponsorship, sincethese plans are generally unfunded and employers must meet the entirecost of the plan's benefits as they come due. This increases pension costs,unless the employer would be abie to invest the pension-plan contributionsat a higher after-tax return than the pension fund's yield. Employers facedwith such cost increases might forego enriching plan benefits for pension-plan participants to contain their pension costs.
Models like the one used in this study cannot capture these indirect effects,which are largely dependent on the individual employer's circumstances.The fact that such effects are difficult to measure, however, does not meanthat they should be ignored. Since pension planning involves a very longtime period, such effects could be hard to reverse.
lnter-lndust_, Effects--Major factors determining the impact of changesin the section 415 limits on various industries include: wage levels, pension-plan coverage rates, and the relative generosity of plans. The higher anindustry's average wage level and pension coverage rate and the moregenerous the typical pension plan, the more employees it will have ap-proaching the legislated limits.
One way to compare industry wage levels is to measure them against wagesin the economy as a whole (table VII.4). The highest wages are found inthe mining (173 percent of the national average); construction (160 per-cent); and the transportation, communications, and public utilities in-dustries (149 percent). The lowest wages are in the retail trade (62 percentof the national average); services (84 percent); and finance, insurance andreal estate sectors (90 percent).
The better paying sectors of the economy do not always have the highestpension coverage rates. The highest pension coverage rates are in wholesaletrade (135 percent of the national average); mining (120 percent); andmanufacturing (111 percent). If both wage levels and pension coveragerates are used jointly as an index to rank industries, then the mining;wholesale trade; and transportation, communication, and public utilitiessectors emerge as the industries most likely to be affected by changes inthe section 415 limits.
_Diane Hal Gropper, "The Furor Over TEFRA," lnstitutio_al Investor 17 (February1983): 71-80.
97
TABLE VII.4
Wage Level and Pension Coverage by IndustryPension
Wages _ Coverage Rates Combined Index b(Percent of (Percent of (Percent of
Industry National Average) National Average) National Average)
Manufacturing 125 111 118Mining (including oil) 173 120 147Construction 160 75 118Transportation,
Communication,and
Public utilities 149 108 129Wholesale trade 116 135 126
Retail trade 62 60 61Finance, Insurance,
and Real estate 90 97 94
Services 84 73 79
Sources: EBRI calculations based on U.S. Department ot Commerce, Bureau ot theCensus, Statistical Abstract o/the U_zitedStates, 1982-83 (Washington, D.C.:U.S. Department of Commerce, 1982), table 065; and Sylvester J. Schieberand Patricia M. George, Retiremeptt Income Opportmtities i_ta_2AgiHg Amer-ica: Coverage a_td Be_w/i't E_ttitlement (Washington, D.C.: EBRI, 1981 ), p. 38.Coverage rates for wholesale and retail trade sectors calculated using U.S.Social Security Administration, Of|ice of Research and Statistics, PensionCoverage and (/esti_tg Amo_tg Private Wage a_td Salary Workers, 1979: Prelim-inaty Estimates/iom the 1979 Sun,ey o/Pensio_t Plan Coverage (Working PaperNumber 16), by Gavle Thompsun Rogers (Washington, D.C.: U.S. SocialSecurity Administration, 1980).
_Gross weekly wages.bComputed by muhiplying the wage and coverage indices each bv 0.5 and summingthe results.
Pension-plan structure also will influence the impact of changes in thesection 415 limits. Consider the situation of pension participants in oneFortune 500 industrial corporation. This company offers its employees adefined-benefit plan which replaces about 45 percent of pre-retirement payand a defined-contribution plan which permits the employer to contributean amount equal to 5 percent of the employee's earnings and the employeeto make a pre-tax contribution equal to 15 percent of earnings. For em-ployees covered only bv the defined-benefit plan, permanently freezing theTEFRA limits wou(d reduce projected benefits for all employees earning$23,000 or more in 1983, given the plan's actuarial assumptions. For em-ployees covered by both the defined-benefit and the defined-contributionplans, imposing the TEFRA limits without indexing would reduce theprojected benefits of all employees earning $13,000 or more in 1983.
98
Distributions in Defined-Contribution Plans
Defined-contribution plans offer the participating employee a uniqueopportunity to build a fully portable retirement program. As the pen-sion-plan participant changes jobs, accumulated contributions andearnings can be rolled over--tax deferred--into an IRA or qualifiedemployer-sponsored plan, earning interest until retirement. Partici-pants electing a lump-sum distribution upon termination of serviceprior to retirement age may choose to treat such a distribution asordinary taxable income; some will be saved and some will be spent.The tax treatment of different benefit forms influences their relativeattractiveness and thus also affects the amount of retirement incomegenerated .6
Retirement Income Distributions--Of all employees in the simula-tion data base eligible for defined-contribution plan benefits, 52.6percent will terminate service in at least one covered job before reach-ing age fifty-five (table VII.5). Employees covered by defined-contri-bution plans would accumulate assets worth $350.1 billion (1983dollars) at termination of service. Of this total, $111.7 billion (nearlyone-third) will be accumulated in jobs that are terminated prior toage fifty-five.
TABLE VII.5
Employment Termination and Defined-ContributionPlans by Employee Age and Benefit Value
Employee Terminations Pension-Plan Assets
Pension-Plan in Year of EmploymentEmployees Participants a Termination
Age Group (Millions) (Percent) (Billions)
Younger than 55 6.7 52.6 $111.7
55 or older 7.9 61.7 238.4
Total b b $350.1
Source: EBRI calculations based on PRISM simulation results."Columns add to more than 100 percent, because an individual max terminate sex'era]covered jobs before retirement.
bNot applicable.
6Lump-sum distributions and their potential retirement income effects are discussedin Emily S. Andrews, The Changing Profile of Pensions in America (Washington, D.C.:EBRI, forthcoming).
99
If only the plan assets from jobs terminated at age fifty-five or olderare held to retirement, participants will enter retirement with assets
of $238.4 billion (table VII.5). If participants use these assets to pur-chase annuities, they will receive approximately $386.8 billion inannuity benefits during their lifetimes assuming a 6 percent (nominal)investment return on the annuity (table VII.6).
If all pension-plan assets are held to retirement, participants willenter retirement with $579.4 billion in assets, more than twice as
much as the amount of assets accumulated when only late-careerpension plans are used to provide retirement income. This amountrepresents not only contributions from early-career plans, but alsoaccrued investment earnings on contributions. Over the course ofthese participants' lifetimes, these assets could be expected to provide$940.1 billion in annuity income. Thus, while plan assets accumulatedin jobs terminated before age fifty-five would represent less than one-third of total assets credited to these participants' accounts at ter-mination of service, they could account for over half of potentialretirement incomes.
Pension-Plan Distributions and Tax Liability--The type and the tim-ing of the distribution elected affect the employee's tax consequences.Periodic pension-plan distributions (or annuities) are included in tax-
able income only as received and only to the extent that they are notbased on previously taxed employee contributions. If a retiree electsto receive a lump-sum distribution from a qualified plan, however,he or she may be eligible for special ten-year forward income aver-
TABLE VII.6
Defined-Contribution Plan Benefits Analyzed by PlanAssets Used for Retirement
(1983 Dollars)
AnnuityPlan Assets Used Cash Value a Benefits bfor Retirement (Billions) (Billions)
Plan assets from jobsterminated after age 55 $238.4 $386.8
Plan assets from all jobs $579.4 $940.1Source: EBRI calculations based on PRISM simulation results._Value of plan assets at retirement prior" to purchasing annuity. Total includes in-vestment earnings on contributions as well as contributions.
bCalculated assuming average retirement age ot sixtv-txvo, life expectancy at retire-ment of seventeen years, and interest at 6 percent. :Fotals include benefits paid outafter the end of the simulation period.
100
aging. 7 Using this procedure, the employee pays taxes as if the income
were: (1) received in ten equal installments; (2) the employee's onlytaxable income; and (3) received bv an unmarried employee with nodependents. The tax on the distribution is determined separately fromthe tax on the participant's other income, with the result that themarginal tax rate on the distribution may be lower than that appli-cable to the participant's other income sources. 8
The effect of alternative distribution options and tax treatmentson each participant's retirement income and tax liability would de-
pend on the individual's own financial circumstances and marginaltax rate and the size of the distribution. 9 In the simulation, however,ten-year forward income averaging will result in the lowest lifetimetax payments of the options available to the employee at retirement.If all pension-plan assets are held to retirement and all participantsthen choose ten-year forward income averaging, benefits would betaxed at an average rate of 5 percent (table VII.7). If the distributionsare then invested in nontaxable assets or used for current consump-tion, no further tax liability would be assessed. If the distributions
are used to purchase annuities, benefits would be taxed at an averagerate of 27 percent.
Conclusions
The section 415 limits on benefits and contributions in qualifiedplans can affect pension-plan participants at all income levels. Wagegrowth will bring increasing numbers of employees under the section
415 benefit and contribution limits, if the limits are set without regardfor real and nominal wage growth. Imposing stringent limits on ben-efit contributions and earnings may even affect those employees whonever approach the statutory limits. Lowering benefit and contri-
7After age fifty-nine and one-half, employees may use ten-vear income averaging onlyonce. This rule permits all employee distributions madeafter this age to be treatedas if thev were made during the same year. If the eligibility requirements are notmet, however, the taxpayer must report the amount of the distribution as ordinaryincome. Even when this is the case, five-year income averaging may be available.
aDepending on when the employee's creditable service occurred and the timing of thedistribution, a portion of the distribution may be eligible for treatment as a long-term capital gain. In fact, such treatment may actually, be more attractive to thepension-plan participant than ten-vear forward income averaging. Unfortunately, thecurrent data base does not provide sufficient information to allow the capital gainsportion of the distribution to be calculated.
_For a discussion of the relative importance of some of these factors, see Christopher
R. Hoyt, "Choosing Between Special Ten-Year Forward Averaging and Deferring TaxThrough a Rollover," Journal of Finance (February 1984): 90-96.
101
TABLE VII.7
Defined-Contribution Plan Benefits and Tax Liability(1983 Dollars) a
Total Taxes Paid Average TaxBenefits on Benefits Rate on Benefits b
Benefit Payment (Billions) (Billions) (Percent)
Lump sumOrdinary tax treatment $579.4 $127.5 22Ten-year forward income
averaging 579.4 28.8 5
Annuity benefits 940.1 254.2 27 _Source: EBRI calculations based on PRISM simulation results._'Calculations assume all plan assets are held until retirement regardless of the par-ticipant's age at job termination.
hThis tax rate retlects the higher real incomes and correspondingly higher tax liabilityof the late-career retirees included in the simulation.
"Average tax rate paid on entire benefits, including minimum distribution allowanceunder ten-year forward income averaging option.
bution levels will increase the costs of plan sponsorship as morebenefits have to be provided through nonqualified plans. Nonquali-fled plans do not offer benefits for lower- and middle-income em-ployees. Moreover, if employers respond to these cost increases byforegoing benefit increases or enrichment, all participants will beaffected.
The tax treatment of distributions in defined-contribution plans
influences the retirement income these plans deliver. The retirement
income generated by these plans is highest if participants roll overthe assets on termination of employment, then purchase annuities at
retirement. Annuity benefits do not receive the favorable treatment
available for lump-sum distributions, however, making lump-sumdistributions more attractive for many participants.
102
VIII. Retirement and Tax Policy:Changes and Implications
Persistent federal deficits have called attention to those Internal
Revenue Code provisions that appear to subsidize select groups of
taxpayers. The Treasury estimates that pension-related tax provisionscost the federal government over $50 billion each year in lost reve-nues. Such estimates are not a realistic reflection of the amount of
revenue lost due to such provisions, however. Treasury estimates
overstate these losses, because these estimates are calculated by off-setting current tax deferrals against the taxes paid by current retireeswho receive much lower retirement incomes than current workers
will when they retire. Measured this way, about $0.83 out of everytax-deferred dollar appears to be permanently lost to the Treasury.Because today's pension-plan participants will have higher retire-ment incomes than today's retirees, they will pay more taxes in re-tirement. Over their lifetimes, those employees now at the beginningof their pension careers will repay all but $0.25 to $0.40 of every tax-deferred dollar. As the pension system matures, pension-related taxexpenditures measured in a cross-sectional framework will be muchcloser to the lifetime estimates reported in this studv.
Even a more realistic lifetime measure of tax expenditures probablyoverstates the revenue costs of pension-related tax policy. Taxpayershave access to many other tax-favored investment vehicles that couldbe used for retirement saving in place of employer pensions. In theabsence of tax provisions favoring pensions, taxpayers would prob-ably make more use of these vehicles. This would increase the revenueloss attributable to these alternative investments. Pension-related tax
policy is not, therefore, as costly as available revenue-loss estimateswould suggest.
Those tax benefits that do accrue to pension-plan participants arenot limited to select income groups. In fact, the pension-plan partic-ipants receiving the major part of pension-related tax benefits aremiddle-income workers.
Tax benefits are not the onlv advantage received by pension-planparticipants. Whatever the revenue cost of the pension-related tax-
code provisions, sound retirement policy design requires that this
103
cost be measured against the social benefit of expanded pension cov-erage and higher benefit levels. Pensions enhance the income securityof both currently employed pension-plan participants and retirees.Pensions add to the savings of active workers by creating new savingsfor those who would otherwise save little or nothing out of their
current income. This results in a more progressive distribution ofwealth, since those with little savings tend to be at the lower end ofthe income scale.
Retirees not only receive larger retirement incomes as a result ofemployer pensions, but their benefits are more secure due to legallymandated advance funding. This security is all the more importantas debates over the fiscal stability of the Social Security system con-tinue. If public policy continues to encourage increased pension cov-
erage and benefit levels, the pension system could have a positiveimpact on the federal budget by reducing the pressure for ever-increasing Social Security benefits.
Federal tax policy has promoted and encouraged growth in pension
coverage and benefit levels. The demands of the federal budget pro-cess may require that some measure of tax expenditures be calcu-lated. Available measures are limited as guides to retirement income
policy, however. Retirement income policy requires a broad per-spective on the goals, accomplishments, and benefits of the pensionsystem.
104
AppendixModel, Data, and Procedures Used inAnalysis
This is a description of the model, data, and assumptions used togenerate the results presented in chapters IV and VII.
Microsimulation Analysis
The pension system is constantly changing. As more employees arecovered by pensions, the income, accrual, and projected benefit pat-terns of current pension-plan participants increasingly diverge fromthose of current retirees. Like other dynamic systems, the pensionsystem has certain data problems which must be considered whendesigning research studies. For example, cross-sectional data bases
do not correctly reflect the equilibrium characteristics of the pensionsystem because it changes over time. Cross-sectional data bases de-
signed to study the pension system operate on the built-in assumptionthat at their retirement current pension-plan participants will befinancially situated much like current retirees.
Dynamic systems like the pension system can best be analyzedusing microsimulation modeling techniques. A model is an abstrac-tion replicating the key features of an economic system (e.g., theemployee's pension career). If the model accurately reflects the op-
erating features of the system, then policy experiments performedwith the model will provide a reasonable approximation of the effectsof policy proposals on the economy. Models have been developed toreplicate the operation of national economies, industry sectors, andindividual households.
Microeconomic models--thosc using the household as the unit ofanalysis--face certain problems generating data that are not en-countered when modeling larger systems. Researchers working withmodels that track and predict the behavior of macroeconomic ag-gregates (e.g., employment and prices) have access to quarterly andmonthly data series collected by federal agencies. Such frequent re-measurement of individual household behavior is not possible, how-
ever, making it necessary for large-scale microeconomic models to
105
rely on simulation techniques to generate the key events in a house-
hold's life cycle, (e.g., marriage, divorce, childbirth, job-change, death).Using evidence from economic studies and statistical data series,researchers build assumptions about these events into their models.
Microsimulation techniques, however, have an advantage over otheranalytical approaches in that the researcher is not limited to ana-lyzing events that have already happened. Instead, these techniquesallow the researcher not only to extrapolate current trends into thefuture, but also to conduct "what if" experiments. This is particularlyuseful in studies of pension-plan coverage and benefits, because cur-rent employees' pension benefits depend on events that can be pre-dicted in the aggregate.
The PRISM Model
EBRI's analysis of retirement benefits and pension accrual patternsis conducted using the Pension and Retirement Income SimulationModel (PRISM) developed by ICF, Inc. PRISM is a dynamic micro-simulation model which simulates the distribution of retirement in-
come for a representative sample of the U.S. population. The modelhas three basic components:
(1) An Input Data Base--The input data base contains the survey andearnings histories of all employees in the sample.
(2) A Work-History Simulation--This component uses dynamic aging sim-ulation techniques to generate work, wage, and family data from thesample population. It assigns a set of plan characteristics to each surveyrespondent participating in an employer-sponsored pension plan. Themodel is then linked to the ICF Macroeconomic-Demographic Modelto produce long-term estimates consistent with the macroeconomicand demographic projections of the U.S. economy.
(3) A Retirement-Benefit Simulation--This calculates the total retirementbenefits earned by an individual employee. It includes data from eachplan in which the employee participates during his or her work career,including Social Security benefits and IRA benefits. Finally, the modelcalculates benefits for low-income individuals from the SupplementalSecurity Income program. Thus, the model generates a detailed history(work and personal) for each employee in the sample population (tableA.1).
An earlier version of PRISM was developed in 1980 for the Officeof Pension and Welfare Benefit Programs of the Department of Laborand for the President's Commission on Pension Policy. During 1981,ICF, Inc., substantially enhanced the model for the American Council
106
TABLE A.I
Description of the Population Included in theSimulation Data Base
Data on hzdividual Employee_Spouse:Age: 1979
Death
OASI acceptanceJob termination
Primary plan benefits acceptanceSupplementary plan benefits acceptance
Sex
Education
Number of children
Employment: Annual earnings (1983 dollars)Annual hours workedIndustvv
Number of prior .jobs (job number): first iob- 1, etc.
Income other than earnings:
IRA benefit (1983 dollars)Social Security benefit (1983 dollars)Survivor benefit
Taxable unearned income (1983 dollars)
Speci/ic PlaHs a_ut Accrual.s:
Benefit (i.e., early, normal, vested, survivor)
Plan type: Primary (defined-benefit, defined-contribution, etc.)Supplementary (profit-sharing, saving, thrift, etc.)
Defined-benefit: AccrualPresent-value method
(1983 dollars)Age eligible for retirementBenefit received (1983 dollars)
Percent of employees vested
Defined-contribution: Accrual
Benefit received (1983 dollars)
Percent of employees vested
Individual retirement account:
Amount contributed ( 1983 dollars)
107
of Life Insurance. In 1982, ICF further revised the model under con-tract to EBRI to better project the impact of changes in the SocialSecurity program.
The version of the model used in this book is unchanged from the1982 version. Although it incorporates some of the changes in theSocial Security program enacted in the 1983 amendments, includingpayroll tax increases and the inclusion of some benefits as taxableincome. The model does not account for the changes in the early and
normal retirement ages for those individuals born after December31, 1960. Instead, the present analysis adjusts Social Security benefitsto reflect the statutory adjustments that apply to benefits for thoseemployees retiring at the age predicted under the pre-1983 statutoryprovisions. This adjustment does not take into account the fact thatmany employee retirement decisions are likely to be affected by thestatutory changes. The adjustment does, however, result in a correctSocial Security benefit given the terms of the model.
Assumptions Used in the PRISM Model
To generate work histories and retirement income levels, the modelmust operate from certain assumptions:
Economic Assumptions--The model makes certain assumptions aboutmacroeconomic conditions to predict future income levels. The eco-nomic assumptions used in PRISM are consistent as far as possiblewith those used in Alternative II-B of the 1982 Social Security Trust-ees' report. These assumptions were used in the intermediate val-uation of the Social Security system. The Alternative II-B economicassumptions are the slightly more pessimistic of the two intermediatevaluations, predicting improvement in the economy over the shortterm with moderate inflation and real growth stabilizing at an annualrate of 3.0 percent starting in 1985 (table A.2). Total employment,real wage growth, and other variables are constrained to be consistentwith the ICF Macroeconomic-Demographic Model forecasts of eco-nomic aggregates.
Health and Family Characteristics--The model simulates health and
family characteristics of the sample population in order to capturethe effects of these events on labor force participation decisions. Fore-casts of marriage, divorce, fertility, disability, and death are con-trolled to be consistent with the Alternative II-B forecast used in the
1982 Social Security Trustees' report. The Social Security Adminis-
108
TABLE A.2
Alternative II-B Economic Assumptions for SelectedYears, 1979-2000
Real GNP CPI Average Annual Average AnnualGrowth Interest Interest a Unemployment
Year (Percent) (Percent) (Percent) (Percent)
1979 b 2.3 11.4 9.1 5.81980 b 0.4 13.5 11.0 7.11981 b 1.9 10.3 13.3 7.61982 b -- 1.8 6.9 13.0 9.71983 4.2 7.9 11.4 8.51984 3.3 7.4 9.3 8.01985 3.0 6.6 8.0 7.71986 3.0 5.8 7.1 7.41987 3.0 5.5 6.8 7.11988 3.0 5.3 6.6 6.81989 3.0 4.9 6.5 6.41990 3.0 4.5 6.4 6.11995 2.5 4.0 6.1 5.02000 c 2.6 4.0 6.1 5.0
Source: Board of Trustees of the Federal Old-Age and Survivors Insurance and Dis-ability Insurance Trust Funds, Tlle 1982 Report o/the Board ofTrustees of theFederal Old-Age and Stm'ivors h_sura_we Trust Ftlnd atM the Federal Disabilitylnsura_tce Trust From (Washington, D.C.: U.S. Government Printing Office,1982), p. 32.
"This interest rate is the average annual rate returned on reserves imested in specialsecurities issued by the Treasury exclusively to the Social Security trust funds.
_Historical data are used for these years._Projections apply to year 2000 and beyond.
tration (SSA), however, forecasts only aggregate demographic prob-abilities, and so the SSA methods had to be modified for use in
forecasting probabilities for individuals.
The Alternative II-B assumptions reflect projected changes in lon-
gevity and fertility. During the simulation, aggregate patterns of mar-riage, divorce, and remarriage are assumed to remain constant. Theprobability that an individual will become disabled is assumed to
remain a constant function of age and sex.
Labor Force Activity--To derive retirement income projections, the
model has to forecast major labor force decisions and events. Thesedecisions include the individual's choice of whether or not to work
or change jobs; number of hours worked; the wage earned; the in-
dustry of employment; and the election to accept a pension or Social
109
Security benefit in a given year. The probabilities of various outcomes
are based on analyses of employment data from the Current Popu-lation Survey (CPS). Because the CPS provides information on thesame individuals over a two-year period, changes in the labor forcecan be tracked.
While an individual's labor force participation changes over time,the underlying patterns that give rise to these labor-force projectionsor probabilities are expected to remain constant. Patterns of em-ployment by age, sex, industry, annual hours worked, and full- orpart-time employment status are assumed to remain constant. The
probability that an individual will change jobs is assumed to be aconstant function of age, full- or part-time employment status, and
job tenure. The relationship between real wage growth and age, sex,and job-change status is assumed also to remain constant over time.
Pension Participation and Coverage--The PRISM model reflects cer-tain assumptions concerning future pension-plan coverage patterns.While the extent of pension coverage in the base year (1979) can bedetermined directly from the survey sample in the model's data base,pension coverage during the simulation years can be acquired in oneof two ways: (1) an individual moves into a covered job; or (2) anemployer without a pension plan initiates one. Changes in the de-mographic composition of the labor force, a result of the maturation
of the "baby boom" generation, are a major source of pension cov-erage growth. In general, individuals are most likely to move intocovered jobs when their employment patterns satisfy the minimumEmployee Retirement Income Security Act (ERISA) standard for par-ticipation. ERISA does not permit an employer to exclude from itspension plan, an employee in the covered group who: (1) is at leasttwenty-five years of age; (2) works at least one-thousand hours an-nually; and (3) has at least one year of service in his or her presentjob. I Of those workers satisfying these criteria in 1979, 74 percentwere covered by a pension plan and 68 percent participated in theiremployer's plan. z In the total work force, 56 percent of the employeeswere covered by their employer's plan, while 46 percent participatedin the plan in 1979.
New plans are assumed to be started at rates consistent with the
1Employers are not required to cover workers who are within five years of normalretirement age when first employed.
2Sylvester J. Schieber and Patricia M. George, Retirement Income Opportunities in anAging America: Coverageand Bene[_t Entitlement (Washington, D.C.: EBRI, 1981),p. 27.
110
moderate growth assumptions used in two previous EBRI studies. 3
These assumptions lead to the following projected industry growth
patterns and annual coverage growth rates:
(1) Agriculture and other industries with relatively high pension coveragerates in 1979 (mining, federal government, and state and local gov-ernment) will not experience pension coverage growth for employeesin any age group.
(2) Industries with intermediate coverage levels will experience total cov-erage growth of about 10 percent over the next twenty years.
(3) Industries with low coverage levels will experience total coverage growthof about 15 percent over the next twenty years.
By specific industry the annual growth projections are as follows:
(1) 0.87 percent per year in the construction, trade, and service sectors;
(2) 0.57 percent in the finance sector;
(3) 0.44 percent in the transportation sector and among the self-employed;and
(4) 0.33 percent in the manufacturing sector.
For the purposes of the model, participation in thrift and savingsplans was assumed to vary with income and with the employer'smatching rate. The assumed participation rate ranged from 20 per-cent (workers with hourly wages of less than $4.00 in 1980 dollarsand less than a 50-percent employer match) to 90 percent (workers
earning $7.00 or more an hour and an employer match of 100 percentor more). 4
Pension Benefit Acceptance--The PRISM model allows workers to
retire at any time after age fifty as long as the eligibility rules forearlv or normal retirement in the employer-sponsored pension planare met. If eligible employees elect to receive Social Security benefitsin a given year, then they automatically accept a pension benefit aswell. Probabilities for benefit acceptance were estimated using theCPS data on benefit acceptance and worker vesting patterns. Benefitacceptance also includes a decision about whether or not to provide
joint-and-survivor benefits. Of those employees with less than a $3,000
3Employee Benefit Research Institute, Retirement Income Opportunities in an AgingAmerica: Income Levels and Adequacy (Washington, D.C.: EBRI, 1982) and SylvesterJ. Schieber, Social Security: Perspectives on Preserving the Svstern (Washington, D.C.:EBRI, 1982), p. 100.
_See Schieber, p. 83.
111
(1980 dollars) annual pension benefit, 70 percent of the married menand 75 percent of the married women are assumed not to elect to
take the post-retirement joint-and-survivor option in their pensionplan compared to those employees with $3,000 or more (1980 dollars)in annual pension benefits, of whom 30 percent of the married menand 50 percent of the married women are assumed not to take thisoption.
Estimating Retirement Benefit Accruals
To estimate the tax benefits to pension-plan participants, it wasnecessary to impute annual benefit accruals) While benefits do notaccumulate in individual accounts in defined-benefit plans, a sim-plified method was developed to approximate benefit accrual pat-terns.
Defined-Benefit Plans--For participants in defined-benefit plans,annual benefit accruals were estimated as the change in the presentvalue of vested benefits from one year to the next. To estimate thevalue of the benefit accruals under this present-value method: (1)PRISM is used to estimate the future annual benefit earned by theemployee at the end of each year in the simulation period; and (2)the present value of the benefits earned during the specified year inthe simulation period is then estimated using appropriate annuityfactors.
Tax deferrals calculated using the present-value method reflect eachyear's change in the value of expected benefits rather than the em-ployer contribution used to fund the benefits. The present-value methodoffers some conceptual advantages over estimating tax expenditureson the basis of employer contributions. If pension-plan accruals wereto be taxed on a current basis, it would be necessary to impute thevalue of the benefit accrual to the employee regardless of whetherthe benefit was fully funded as accrued. The present-value methodoffers a way to calculate annual increases in the value of the pensionbenefits no matter how the plan is funded.
Deft'ned-Contribution Plans--The value of the benefit accrued in adefined-contribution plan is the sum of the contributions and interest
_For a detailed explanation of these procedures, see ICF, Inc., "Design of the TaxExpenditure Data Base and the ICF Tax Calculation Model," paper prepared by DavidL. Kennell and John F. Sheils for EBRI, Washington, D.C., 9 June 1983. (Typewritten.)
112
earned on prior accumulations. Defined-contribution plan assets con-tinue to accumulate interest until withdrawn as retirement income,
even if the individual does not remain with the pension-plan sponsor(employer). However, if an employee is less than thirty years old ontermination of employment or the accrued benefit is less than $1,750(1980 dollars), the benefit is assumed to be spent.
Presentation of Simulation Results
Since the simulation model generates work histories for nearlyeight thousand people over forty-four years, the volume of data makes
it necessary to select some points of comparison among the employeesfor presenting the results. In addition, since tax deferrals and taxpayments occur over different periods, it is necessary to adjust thesevalues for the interest rate to reflect the economic value of the taxdeferral.
Tax Liability by Group--Since the model simulates an individual's
marriage and family history, pension recipients can be the partici-pants themselves or the participant's survivors. In order to include
taxes paid by pension-plan participants' survivors in each age group'srepayments, the tax benefits and tax payments were computed on agroup (rather than an individual) basis. Computing tax benefits andpayments for each individual and adding the results would have re-
suited in lower estimates of lifetime tax payments. Excluding taxpayments by survivors would have resulted in ignoring a large por-tion of the tax payments attributable to each age group's work andpension-coverage history.
The simulation results are presented classifying individuals by agein the base year (1979) and by various measures of income:
(1) Age in the Base Year--Some of the simulation results in this report arepresented according to the individual's age group in the simulation'sbase year. As the pension system changes, the experience of youngerand older groups yields valuable insight into the impact of these changeson individual employees.
(2) Income--Most of the simulation results are also presented by income,since the distributional effects of various policies are an importantelement of tax and retirement income policies. Grouping individualsby income presents a problem, however, since there are potentiallyforty-four different income groups (one for each simulation year) inwhich the individual can be classified. In the analysis, employees wereclassified both by base-year income and bv the average income in thehighest five of the last ten work years before the employee's retirement.
113
Classifying employees by base-year (1979) income provides a commonstarting point for all the employees in the data base. Also, since thesample on which the simulation is based is stratified by income, thebase-year income distribution is statistically representative of that year'slabor force.
Base-year income presents certain problems as a classification crite-rion, particularly for the very youngest and very oldest workers in thesimulation. For these employees, base-year income may differ consid-erably from lifetime income: younger employees have not yet reachedtheir peak earning years, while employees close to retirement may beworking fewer hours during the year, and thus earning less than duringtheir prime earning years. Accumulated lifetime pension-related taxbenefits will, therefore, look disproportionately high relative to incomein these two groups, if base-year income is used as the standard ofcomparison.
Alternatively, it is possible to classify employees by their average late-career income, the income in the five highest-earning years of the lastten years worked before retirement. This provides a measure of incomethat is close to peak lifetime earnings. Because this measure is basedon the employee's earnings in several years, it is less dependent onyear-to-year fluctuations.
These two income measures yield different income patterns. Among
persons in the two youngest groups (aged twenty-five to thirty-fouryears and thirty-five to forty-four years) base-year income is lower thanlate-career income in nearly all income groups. Only in one group--those thirty-five to forty-four years of age and earning $30,000 to $50,000in 1979--did late-career income fall within the range as base-yearincome (table A.3). In the two older groups, the late-career income
TABLE A.3
Average Income in the Highest Five of the Last TenWork Years Before Retirement
Age Group(Years)
Base-Year Income a 25 to 34 35 to 44 45 to 54 55 and older
$ 5,000 or less $18,016 $16,775 $16,797 $21,732$ 5,001 to $10,000 19,096 17,348 14,039 8,839$10,001 to $15,000 20,936 15,470 13,154 12,205
$ l 5,00 l to $20,000 27,954 22,791 18,574 16,451$20,001 to $30,000 40,133 30,741 26,444 23,577$30,001 to $50,000 59,462 46,562 39,871 34,829$50,001 or more 99,480 73,388 66,552 69,478Source: EBRI calculations based on PRISM simulation results._Total 1979 income in 1983 dollars.
114
pattern was much more consistent with base-year income. Only in the twolowest-income groups did late-career income differ from base-year income.
Comparing Dollars in Different Years--To compare tax deferrals and
tax payments occurring over different periods of time it is necessaryto convert them into the same year's dollars. This can be done in oneof two ways. The flows can simply be added. This fails, however, totake into account the fact that payments made or received at differentperiods of time are not strictly comparable as long as the market rateof interest is greater than zero. Accordingly, it is also useful to dis-
count (for future payments) or compound (for past payments) to re-flect accrued interest.
To adjust tax benefits and tax payments for the value of time, thesevalues in different years were converted into values at retirement.
This was carried out in two steps. First, taxes deferred on pensioncontributions and pension-plan asset income were computed for each
year of the employee's work career. Similarly, taxes repaid on pensionbenefits during retirement were computed. Second, the amount of
deferred taxes was treated as if the taxes had been paid into a pension
fund at the fund's rate of return and compounded until the employeeretired, while the taxes paid on benefits were discounted to the yearof retirementP The real rate of return used to discount tax paymentswas 2 percent. This rate was chosen for overall consistency with theeconomic assumptions used in Alternative II-B of the 1982 Social
Security Trustees' report. A comparison of the discounted paymentflows with the undiscounted flows indicates how much plan partic-ipants benefit both from the tax deferrals in pension tax law and fromthe lower tax brackets of retirees.
Estimating Taxes
Tax deferrals and tax payments were computed using a tax cal-culation model that estimates the amount of federal taxes owed under
the tax law prevailing in each year of the simulation period. For 1979through 1984, the model uses the existing Internal Revenue Service
bAll beneficiaries were assumed to elect a benefit option providing periodic paymentsover the course of"retirement. See chapter VII for a comparison of periodic anc] lump-sum distribution tax liabilities.
115
tax tables specified for those years. For the post-1984 period,the model automatically indexes the tax brackets to the rate ofinflation as specified by ERTA. The model will automatically cal-culate: (1) the working spouse deduction available beginning in1982, and (2) the portion of Social Security income that was taxablebeginning in 1984. 7
The tax model simulates individual's decisions to itemize de-ductions and the amount of deductions taken. The ICF tax model
uses random processes to select individuals to itemize based uponthe proportion of individuals who itemized in 1978 as reported inthe Internal Revenue Service Statistics of Income (SOI). a The in-
dividual's deductions are estimated as a percentage of income basedupon the ratio of average adjusted gross income to average deduc-tions in each of twelve adjusted gross income groups as reportedin the 1978 SOI. Because individuals who itemize tend to itemize
each year (e.g., homeowners), the model uses the same randomnumber for an individual in each simulation year. This is designedto remove random variation from the decision to itemize?
The model estimates the number of exemptions for an employee
based upon the number of children in the family and marital status.The model also includes the additional exemptions for employees
age sixty-five and older. Once exemptions and deductions are de-termined, the model determines the appropriate tax table (i.e., joint,single, or head of household) and estimates the employee's taxes, l°
The tax model estimates the amount of the employee's taxes for
the base year based upon a set of parameters passed to the modelby the user. Variables used include the following:
VMarried couples (both working) filing joint returns in 1982 were able to deduct 5percent of the lower-earning spouse's income--minus qualified individual retirementaccount contributions--up to $1,500. In 1983, this deduction increased to 10percentof the lower-earning spouse's income--minus qualified IRA contributions--up to$3,000.Beginning in 1984,a portion ofSocial Security income will be taxable, if the recipient'sadjusted gross income exceeds a designated base amount (e.g., $32,000 for a marriedcouple filing jointly and $25,000for a single individual). When the recipient's adjustedgross income exceeds these limits, the Social Security income is taxed equal to which-ever is less: (1) half the benefits received or (2) half the excess of adjusted gross incomeless half the Social Security benefit payment over the base amount.
_U.S. Department of the Treasury, Internal Revenue Service, Statistics oflncome Bul-letin (Washington, D.C.: U.S. Internal Revenue Service, 1978), table 1.4.
9For a discussion of this itemization simulation methodology, see: Employee BenefitResearch Institute, Retirement Income Opportunities in an Aging America: IncomeLevels and Adequacy (Washington, D.C.: EBRI, 1982),appendix B, p. 95._°Themodel automatically calculates the taxable amount of Social Security benefits
for fiscal year 1984 and later. (Before 1984, Social Security was not taxed.)
116
TABLE A.4
Sample Population Data
Simulation Year
lnfbrmation on Individual Employee."AgeNumber of children
EarningsOther taxable incomePension accrualPension incomeSocial Security benefits
In/ormation on Spouse (all values are zero ifno spouse):
AgeEarningsOther taxable incomePension accrualPension incomeSocial Security benefits
All of the required information is readily obtained from the historydata record described above.
117
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Index
Aas a business expense, 15, 18-
A.S. Hansen, Inc., 57 19, 23, 32, 36, 37, 39, 46, 47,
Alternative tax systems, proposed, 48, 78-80, 82-84, 86, 88, 89,77-89. (also see Taxes) 97, 115 (also see
comprehensive tax, 77-81, 85, Contribution)86, 88 --cost considerations, 46-49
consumption (cash-flow) tax, disability, 577, 78, 81, 85, 86-87 discretionary, 4, 5, 7
Fair and Simple Tax Act, 86 employer-employee preferred,national sales tax, 77, 88 48, 49value-added tax, 77, 88 employer-sponsored, 5, 7, 11,
American Council of Life 39, 43, 49, 86, 87
Insurance, 14, 106-108 estate and survivor, 35
American Enterprise Institute, 78 growth (factors affecting), 7,Amortization (of unfunded 10, 11, 39-43, 45, 46, 49
liabilities), 17, 19, 79-80 health insurance, 42, 43-44,
Andrews, Emily S., 45, 93, 99 47, 49, 73, 87Annuity, 18, 22, 28, 33, 35, 100, and impact on labor market,
102 48
Annual addition, 20 included in tax base, 5, 39Assets (also see Investments) life insurance, 5, 43-44, 73
income-earning, 65, 66, 78, 81 noncash, 3, 7, 11, 12, 26, 39,institutional, 73-75 40, 45-47
liquid, 62, 67, 69, 72-76, 78 pricing (economies of scale),
pension-plan, 17, 35 47purchased for capital gain, 69, required bv law, 3, 4
71 sick leave (voluntary, taxablesecurities, 34, 35, 62, 67, 69, benefit), 5
73, 75, 76, 78 social-insurance programtax treatment, 62, 72, 78, I01 (legally required employer
payment), 3B tax treatment, 3-6, 7, 10, 15-
38, 60, 63
Balance-sheet reserves, 16, 37 unemployment compensationBankers Trust Company 1980 (legally required benefit), 3
survey, 27 Bonds, 78Basic tax reform, 12-13, 77, 85-87, federal, 57
88 retirement, 35
Benefits (also see Flexible tax-free municipal, 69-71, 78compensation; Pension; Social tax treatment, 62, 71
Security) Boynton, Edwin, 60
127
Bracket creep, 40 tax systems)Bradley-Gephardt proposal, 70, Constructive receipt, 26, 78
85-88, 91, 93-96 Contribution (also see Personal
Brodie v. Commissioner (see Court income tax; Profit-sharingcases) plans; Self-employed
The Brookings Institution, 12, 51, individuals)71 after-tax dollars, 31, 33, 49
The Budget of the United States, 10, before-tax dollars, 32, 79, 98
61 business expense, 18, 32, 36,Bureau of the Census (see U.S. 39, 47, 48, 97
Government) "deduction limit," 19
Business expense (employers') for employee compensation,cost considerations, 46-49 16, 18, 26, 29, 31-33, 39, 41,employee compensation, 18- 43, 62, 78, 86
19, 32, 36, 39, 47, 48, 86 levels, 27, 42, 43, 60, 72, 85tax treatment of limits, 16, 19-22, 70, 91, 93-98
contributions, 15, 23, 37, 47, mandatory, 27-2878-80, 82-84, 86, 88, 89, 97, tax treatment, 3, 5, 7, 10-12,ll5 15, 16, 18, 19, 22-33, 36, 37,
39, 53, 60, 78-80, 82-84, 86,C 88, 89, 115
voluntary, 28-29Cafeteria plans (see Flexible Corporate debt, 78
compensation) Corporate pension coverage (byCanan, Michael J., 91 industry), 97Capital gain, 20, 34, 67, 69-7 I. Cost of employee compensation
(also see Assets) (see Benefits)Cash-accounting basis, 23 Court cases
Cash or deferred arrangement Brodie v. Commissioner, 26
(CODA) (see Salary reduction Deupree v. Commissioner, 31arrangement) Elgin National Watch Co. v.
Chamber of Commerce, U.S., 3, 5 Commissioner, 15, 24
Chollet, Deborah J., 49 Globe-Gazette PrintingCivil Service Retirement System Company v. Commissioner,
(CSRS), 28, 60 24
Cliff vesting schedule (see Vesting) Hibbard, Spencer, Bartlett, &CODA (see Cash or deferred Co. v. Commissioner, 15, 24
arrangement) Lukens Steel Co. v.Committee on Corporate Pension Commissioner, 25
Funds, 17 Oxford Institute v.
Compensation (see Benefits; Commissioner, 24
Income) Surface Combustion Corp. v.Compliance, 13, 20, 21,60, 82 Commissioner, 24Comprehensive income tax (see Washington Post Co. v. U.S.,
Alternative tax systems) 25Consumption tax (see Alternative Coverage (see Pension)
128
CPS (see Current Population 43, 116Survey) Ehrenberg, Ronald G., 45
Cross-sectional analysis, 11, 46, Elasticity, 4151, 52, 55, 58, 63 Elderly tax credit, 63
CSRS (see Civil Service Elgin National Watch Co. v.Retirement System) Commissioner (see Court cases)
Current Population Survey (CPS), Employee Retirement Income52, 66 Security Act of 1974 (ERISA),
13, 17, 18, 28, 37, 43, 60, 6l, 67,D 71, 75, 83, 84, 89, 97, 104, 110
Employee stock ownership plansDeConcini, Senator Dennis, 86-88 (ESOP), 20-21Deferred compensation (see Equalizing differences in labor
Pension plan types) markets (theory of), 46Defined-benefit pension plans, 19- Equity
21, 27, 60, 79, 83, 85, 87, 91, 96, homeowner's, 66, 7098, 112 horizontal, 80, 81, 85
Defined-contribution pension and taxation, 12, 81, 88, 89plans, 5, 15, 18-22, 27, 29, 31, vertical, 8160, 71, 83, 87, 91, 98, 99, 102, ERISA (see Employee Retirement112, 113 Income Security Act of 1974)
Deupree v. Commissioner (see ERTA (see Economic Recove_Court cases) Tax Act of 1981)
Distribution (also see ESOP (see Employee stockIndividual retirement account; ownership plans)Lump-sum distribution; Pensionplan; Qualified pension plan;Savings) F
defined-contribution plans,99-101, 102 Fair and Simple Tax Act (see
lump-sum, 33-36 Alternative tax systems,retirement (pension) savings, proposed)
12, 18, 26, 29, 33-37, 52, 65- Farrar, Donald E., 7667, 75, 76, 99, 101, 104, 106 Ferrara, Peter J., 71
rollovers, 36 Flexible compensation, 39, 44, 45self-employed, 30, 31 Fundingtax liability, 100-101 advance funding, 48, 60, 104
Dougherty, Ann, 70 --employer deductions for, 16better-funded plans, 84
E defined-benefit plans, 19, 81defined-contribution plans, 20
EBRI/HHS Current Population level set by ERISA, 43Survey Pension Supplement, 65, pattern, 82, 8366, 96 of pension liabilities, 16
Economic Recovery Tax Act of procedures, 59-611981 (ERTA), 21, 26, 28, 29, 32, unfunded plans, 17, 24, 26, 37
129
G wages, 7, 10, 11, 12, 16, 39, 40,45-48, 67, 68, 78, 96, 97,
George, Patricia M., 110 101, 106, 108-110, 111Gephardt, Representative Richard Income tax (see Personal income
(see Bradley-Gephardt proposal) tax; Taxes)Girton, Lance, 76 Indexation, 43, 45, 92-93
Globe-Gazette Printing Co. v. Individual retirement accountCommissioner (see Court cases) (IRA), 29-30, 32, 66, 7 l, 72
distribution, 34, 36
H voluntary contributions, 28,33
Haig, R.M., 79 Individual retirement annuity
Haig-Simons definition, 79 (IRAN), 29-30, 36. (also see Self-Hatfield, Senator Mark O., 86, 87 employed individuals, plans for)Health and Human Services, Inflation (also see "Bracket creep"
Department of (see U.S. Indexation)Government) and income erosion, 40
Health insurance, 42, 43-44, 47, Interest
49, 73, 87 bond, 71Hearings on Major Tax Reform nonforfeitable, 24, 26, 29, 35-
(Senate, Aug. 1984), 77 37Helms, Senator Jesse, 71 rate (for pension fund), 56
Hibbard, Spencer, Bartlett & Co. Internal Revenue Code, 5, 10-13,v. Commissioner (see Court 15-21, 23, 27-29, 32, 35, 39, 44,cases) 46, 47, 49, 59, 62, 63, 70, 77, 81,
Household savings (role of 82, 85-87, 89, 9l, 96, 103. (alsopensions in), 62, 65, 67-69 see "Tax code")
Housing (see Real estate) Internal Revenue Code (cited)H.R. 10 plans (see Keogh plans) sec. 72, 16
sec. 72(h), 33
I sec. 83, 18sec. 83(a), 23, 26, 36
ICF, Inc., 52, 106 sec. 162, 18Income (also see Assets; Benefits; sec. 162(a), 23
Distribution, Social Security) sec. 162(a)(l), 23
adjusted gross, 5, 29, 30, 43, sec. 165(a), 17, 2353, 71, 82, 86, 116 sec. 219(e), 32
averaging, 34, 84, 101 sec. 401(k), 11,28-29, 32before-tax dollars sec. 402, 16
(employees'), 32 sec. 402(a)(1), 26erosion of (inflation), 40 sec. 402(a)(1)(A) and (B), 34
post-retirement, 55 sec. 402(a)(2), 34PRISM analysis, 105-117 sec. 402(a)(8), 29real income paid as taxes, 40 sec. 402(b), 23, 26, 36ten-year forward averaging, sec. 402(e), 34
34, 101 sec. 402(e)(4)(J), 35
130
sec. 404(a), 18, 22 Keogh plans, 29-31, 34. (also seesec. 404(a)(3), 20 Self-employed individuals, planssec. 404(a)(5), 18, 23, 24 for)sec. 404(a)(6), 23 Korczyk, Sophie M., 65, 67, 69, 72sec. 404(a)(7), 22 Kosters, Marvin H., 48
sec. 404(j), 19sec. 405(d)(1), 35sec. 408(e)(3) and (4), 36 L
sec. 408(f)(1), 30 Labor costs (indirect), 48sec. 408(k)(4), 30 Labor market (impact onsec. 409(A), 20 benefits), 48
sec. 412, 19 Legislation (also see specific acts)sec. 415, 19, 21, 86, 87, 91,93, Economic Recovery Tax Act of
95-98, 101 1981, 21, 26, 28, 29, 32, 43,--and pension plan limits 116
(proposed changes), 93-98Employee Retirement Income
sec. 415(c), 20 Security Act of 1974, 13, 17,sec. 415(c)(2), 20 18, 28, 37, 43, 60, 61, 67, 71,sec. 4971, 20 75, 83, 84, 89, 97, 104, 110sec. 4975(e)(7), 20
Revenue Acts (see specific yearInternal Revenue Service, 115-116
under Revenue Act)
Investments (also see Assets; Tax Equity and FiscalBonds; Capital gain; Individual
Responsibility Act of 1982,retirement account; IRAN; 22, 30, 35, 48, 91-98
Keogh plans; PAYSOP; Pension; Treasury Regulations (seeRate of return; Real estate) specific section under
collectibles, 70 Treasury Regulations)"institutional investors," 73 Welfare and Pension Plansinstitutional trading, 72-76 Disclosure Act of 1958, 17pension fund, 62, 69, 73, 75,
Loans (see Pension)76
tax treatment, 72, 78, 79 Long, James E., 41,46Lukens Steel Co. v. Commissioner
IRA (see Individual retirement(see Court cases)
account) Lump-sum distribution of pensionbenefits, 33-36. (also see
J Distribution)
Joint Committee on Taxation, 32M
KMilitary Retirement System
Kasten, Senator Robert, 86 (MRS), 60
Kemp, Representative Jack, 86 Mortgage (see Real estate; ReverseKennedy, President John F. (see annuity mortgages)
Committee on Corporate MRS (see Military Retirement
Pension Funds) System)
131
Multivariate analysis (definition), --nondiscrimination rules, 16,46 97
Munnell, Alicia H., 12, 51 --rates, 11, 12, 52, 66, 97, 104,Musgrave, Richard A., 81 110, 111
distribution from, 33, 101N formula, 83
fund, 56National Commission on Social history, 15-17
Security Reform, 11 holdings (diversification of),Nondiscrimination rules (see 75
Pension) as "institutional investor," 72-Nondiversion rule (see Revenue 74
Act of 1938) --impact on financialNonqualified pension plans (see markets, 74-76
Pension plan types) interest rate (for pensionfund), 56, 57, 115
O investment, 25, 62, 69, 73, 75,76
Office of Management and Budget loans from plan, 35-36(see U.S. Government) participation, 21, 22, 65, 67
Oxford Institute v. Commissioner plan holdings (diversification(see Court cases) of), 75
plans, 48, 72, 74-76, 91
p portability, 35and redistribution of wealth,
Payroll tax base, 11, 39 12, 65, 67Payroll-based employee stock repayment of loans from plan,
ownership plans (PAYSOP), 21 35-36Pechman, Joseph A., 71 risk-pooling feature, 69Peckman, David A., 21 and tax expenditures, 51-53,Pension (also see Benefits; 58
Contribution; Coverage; taxation, 16, 18, 25Distribution; Household termination trust, 16, 18, 25savings; Keogh plans; Pension wealth, 82, 83, 84, 88plan types; Pension tax policy; Pension plan types, 3-10. (also seeStock-bonus plans) Defined-benefit pension plans;
accrual, 82, 106, 112 Defined-contribution pensionassets, 17, 35, 62, 65, 72, 74- plans; Employee stock
76, 100, 101 ownership plans; Pension;benefits and the personal Qualified pension plans; SEPs;
income tax, 11 Stock-bonus plans; Taxcoverage Reduction Act employee stock--expansion, 12, 13, 15, 37, ownership plans)
39, 45, 51, 52, 65, 93, 96, and accrual of pension104, 110, 111 benefits, 82-87
--industry, 97 advance-funded, 48, 60, 82, 84
132
capital accumulation, 20, 21, and pensions, 20, 22, 2967, 69-71 types of benefits, 5
deferred compensation, 23, 24, Progressivity of the tax system (see32, 39, 41, 46 Taxes)
--salary reduction plans, 44employer-provided plans, 29- Q
31, 36
nonqualified pension plans, Qualified pension plan, 15, 18, 23-24-25, 36-37 24
--and section 415 limits, 33 annuity payments, 35
profit-sharing, 20, 22, 29 contribution limits, 101public-sector, 27, 74-75, 84 distributions, 33-34, 100qualified, 15, 18, 19, 23-24 loans from, 35-36section 401(k), 13, 27, 37, 29, requirements, 19
44, 45 rollovers, 36Pension Retirement Income tax treatment, 23, 26
Simulation Model (PRISM), 54, vesting, 8491, 92, 105-117 Qualified voluntary employee
Pension tax policy contribution (QVEC), 28-29.
nonqualified plans, 36-37 (also see Self-employedand redistribution of wealth, individuals, plans for)
67, 104and retirement policy, 13-14 Rand statutes, 15-38, 39, 40, 44
viewed as a federal subsidy, RAMs (see Reverse annuity5 l, 63 mortgages)
Personal income tax, 39-40, 82 Rate of return, 53, 56, 57, 115deduction, 15, 30, 32, 40, 85- annuity benefits, 33, 36, 51
86, 116 pension fund's, 97, 115
and employer benefit Real estate, 36, 62, 67, 69-70, 76,contributions, 39 86
reform, 77 Retirement
tax exemptions, 86 benefits, 11, 26, 33-37, 43, 51-President's Commission on 59, 91-102, 106, 108, 109,
Pension Policy, 106 11 l, 112PRISM (see Pension Retirement income, 45
Income Simulation Model) planning, 67-69
Productive capacity, 67, 76 policy, 13, 14, 51,59-63,103,
Profit-sharing plans 104cash or deferred arrangement, saving, 10, 31-33
29 Revenue Act of
defined-contribution plans, 5. 1918, 1515, 18-20, 22, 29 1921, 15. 16, 18.25, 26
employer contributions, 18, --impact on stock-bonus20, 22 plans, 15
history, 5, 15 1924, 15
133
1926, 15 plans), 29-31, 34
1928, 16, 23 qualified voluntary employee1938, 16 contribution, 28-29
1942, 13, 16, 17, 24 Senate Hearings on Major Tax1964, 43 Reform (Aug. 1984), 77
1978, 13, 29, 44 SEP (see Simplified employeeRevenue Rulings, 25, 27, 33 pension plans)Reverse annuity mortgages Simon, William E., 78
(RAMs), 70 Simons, H.C., 79
Simplified employee pensionplans (SEP), 30, 32, 33, 37
S Smeeding, Timothy M., 47, 48Smith, Robert S., 45, 46
Salary deferral (see Salary Social-insurance program (seereduction arrangement) Benefits)
Salary reduction arrangement, I l, Social Security, 3, 1 l, 13, 17, 31,28, 29, 32-34, 39, 44 32, 39, 45, 54, 63, 71, 92, 104,
Sales tax (see Alternative tax 11 l, 116
systems) income, 3, I l, 13, 17, 31, 32,Salisbury, Dallas L., 77 39, 45, 54, 63, 71, 92, 104,Savings (also see Assets; 11 l, 116
Household savings) --integration with pension, 31distribution, 62, 65, 67, 76 Social Security Administrationlevels, 12, 62 (see U.S. Government)
nondiscretionary, 67 Social Security Amendments Actpatterns, 64, 66 of 1983, ll, 71,93, 108
retirement, 13, 26-30, 32-37, Steuerle, Eugene, 4865, 69-71 Stock-bonus plans, 5, 15, 18-20,
taxation of, 62, 78 22, 29
Schieber, Sylvester J., 59, 98, 110, Sunley, Emil M., 79111 Surface Combustion Corp. v.
Scott, Frank A., 41, 46 Commissioner (see Court cases)Section 401(k) plans, 13, 27, 37,
39, 44, 45Section 415 (see Internal Revenue
Code) TSelf-employed individuals (plans
for), 30, 31 "Tax code" (see Internal Revenueindividual retirement account, Code)
29-30, 32, 66, 71-72 Tax base--distributions from, 34, 36 erosion, I l, 13
--voluntary contributions to, items included in, 78, 83-8528, 33 and taxes, 7
individual retirement annuity, Tax Equity and Fiscal29-30, 36 Responsibility Act of 1982
Keogh plans (i.e., H.R. l0 (TEFRA), 22, 30, 35, 48, 91-98
134
top-heavy plans, 22 credit, 21Tax exemption (also see Personal deduction
income tax) --employer, 15, 16, 18, 19, 21-and benefits, 5, 7 24, 37, 38, 85-86
capital gains, owner-occupied --personal, 15, 30, 32, 40, 85-housing, 69 86, 116
Congressional Budget Act of deferred, 53-571974, 10 income, 29, 31
elderly, 54, 62, 63 liability
Hatfield proposal, 86 --and comprehensive incomeand indexation, 40 tax, 55, 79-81
investment earnings, 72 --and pension planRevenue Act of 1921, 15 distributions, 100-101
Tax expenditures, 10, 51-64, 72, limits, 22, 70, 93-98
87, 103, 104, 112 progressivity of the taxTax rate system, 12, 34, 40, 54, 65,
marginal, 37, 39, 40-43, 49, 63, 80, 10477, 79, 101 repayment of tax deferral in
nominal, 40 retirement, 53-57progressive, 34 shelter, 63
real, 40, 43 Social Security income, 54,statutory, 40 63, 92, 116
Tax Reduction Act employee stock treatment, 4, 35, 60, 63
ownership plans (TRASOP), 21 treatment of capital gains, 34Tax reform (see Alternative tax TEFRA (see Tax Equity and Fiscal
systems; Basic tax reform) Responsibility Act of 1982)Tax Reform Act of 1969, 24 Top-heavy plans, 19, 22, 31Tax Reform Act of 1984, 21, 39, 93 TRASOP (see Tax Reduction Act
Tax shelter (tax-code provisions employee stock ownershipas), 63 plans)
Taxes (also see Alternative tax Treasury, Department of (see U.S.systems; Annual addition; Basic Government)
tax reform; Funding; Internal Treasury RegulationsRevenue Code; Pension tax sec. 1.83.3(c), 26policy; Personal income tax; sec. 1.401-2(b)(1), 24Progressivity; Tax exemption; sec. 1.401-3(d), 27Tax expenditures; Tax reform) sec. 1.402(b)-1, 26
accrual method of accounting, sec. 1.404(a)- 12(b)(1), 2423-25 sec. 1.404(a)- 12(b)(2), 23
adjusted gross income, 5, 29, sec. 1.404(a)-12(b)(2) and (c),30, 43, 53, 71, 82, 86, 116 24
capital gains, treatment of, 34, sec. 1.404(a)-12, 18
101 sec. 1.404(a)-12(c), 25comprehensive, 78-81, 85-86, sec. 1.404(b)-1, 18
88 sec. 1.451-2(a), 26
consumption, 78-81, 86-87 sec. 1.461-1(a)(2), 23
135
U Van Order, Robert, 70
Unemployment compensation (as Vesting (see Pension)legally required benefit), 3 cliff vesting schedule, 84
Upp, Melinda, 13 nonforfeitable interest, 24, 26,U.S. Code, vol. 26, secs. 401 et 29, 35-37
seq., 17 of pension plan participants,U.S. Code, vol. 29, sec. 301, 17 17, 18, 22, 25, 28, 82, 84
U.S. Congress, 14, 16, 32, 33, 35, and qualified voluntary85 employee contributions, 28
U.S. Government ten-year cliff, 84Bureau of the Census, 5, 28, Voluntary benefits (see Benefits)
52, 61, 75, 98
Health and Human Services,Department of (see EBRI/ W
HHS Current Population Wages (see Income)Survey Pension Supplement) Washington Post Co. v. U.S. (see
Office of Management and Court cases)
Budget, 10, 61, 88 Wealth (see Pension)Social Security Weiss, Gertrude, 66
Administration, I l, 98 Welfare and Pension PlansTreasury, Department of, 5 l, Disclosure Act of 1958, 17
53, 56, 61, 63, 72, 78, 79, 85, Woodbury, Stephen A., 41, 4687, 103, 116 WPPDA (see Welfare and Pension
V Plans Disclosure Act of 1958)
Value-added tax, 77, 88 The Wyatt Company, 60
136
Selected EBRI Publications
Employer-Provided Health Benefits: Coverage, Provisions and PolicyIssues, 1984 (ISBN 0-86643-033-4)
Why Tax Employee Benefits?, 1984 (ISBN 0-86643-036-9)
Fundamentals of Employee Benefit Programs, 1983 (ISBN 0-86643-035-0)Employee Stock Ownership Plans: A Decision Maker's Guide, 1983 (ISBN
0-86643-031-8)
Employment Termination Benefits in the U.S. Economy, 1983 (ISBN 0-86643-030-X)
Pension Integration: Concepts, Issues and Proposals, 1983 (ISBN 0-86643-032-6)
Social Security: Perspectives on Preserving the System, 1982, paperback(ISBN 0-86643-028-8), hardbound (ISBN 0-86643-029-6)
Economic Survival in Retirement: Which Pension Is for You?, 1982 (ISBN0-86643-027-X)
America in Transition: Implications for Employee Benefits, 1982 (ISBN 0-86643-026-1)
Retirement Income Opportunities in an Aging AmericaVolume/--Coverage and Benefit Entitlement, 1981 (ISBN 0-86643-013-X)Volume//--Income Levels and Adequacy, 1982 (ISBN 0-86643-014-8)Volume Ill--Pensions and the Economy, 1982 (ISBN 0-86643-015-6)
Retirement Income and the Economy: Policy Directions for the 80s, 1981,paperback (iSBN 0-86643-023-7), hardbound (ISBN 0-86643-025-3)
Retirement Income and the Economy: Increasing Income for the Aged, 1981(ISBN 0-86643-024-5)
A Bibliography of Research: Retirement Income & Capital AccumulationPrograms, 1981 (ISBN 0-86643-022-9)
A Bibliography of Research: Health Care Programs, 1981 (ISBN 0-86643-021-0)
Should Pension Assets Be Managed for Social/Political Purposes?, 1980(ISBN 0-86643-001-6)
Arranging the Pieces: The Retirement Income Puzzle, 1980 (ISBN 0-86643-009-1)
Pension Plan Termination Insurance: Does the Foreign Experience HaveRelevance for the United States?, 1979 (ISBN 0-86643-000-8)
