YOU HAVE FOUND OUR OLD WEB SITE. BE SURE TO CHECK OUT OUR NEW AND IMPROVED SITE!     LSAs, RSAs, ERSAs and the 403(b) Marketplace by Chuck Yanikoski, President, Still River Retirement Planning Software, Inc.     Although the Bush Administration proposal to revamp the structure of tax-advantaged retirement savings in this country is already running into political trouble, it is worth examining because (a) it could still pass, in some form, and (b) it could come back next year, or the year after that.   Retirement Planning and Tax Policy The proposal is to eliminate most existing forms of tax-advantaged retirement plans, and replace them with three new ones. Two of the new ones would essentially be Roth IRAs for individuals: the LSA (Lifetime Savings Account) with no withdrawal penalties at any time, and the RSA (Retirement Savings Account) with a substantial penalty for withdrawal prior to age 58. Contributions of up to $7,500 per person per year would be permitted into each plan. The third new plan would be the ERSA (Employer Retirement Savings Account), which could be modeled on the 401(k) plan with the same contribution limits as 401(k)s, but with considerably eased non-discrimination rules, and with the option of making contributions on a pre-tax or post-tax (i.e., Roth) basis.   These ideas have strong appeal in certain ways: they greatly simplify existing rules, and they expand the ability of individuals to save money without paying taxes which, at least in theory, should encourage retirement savings. But at the same time, they have some significantly negative (or at least very doubtful) implications both for the country as a whole and for 403(b) plan participants specifically.   To begin with the broader concerns, the proposal is running into heavy criticism, both outside of Congress and within (including the Republican side of the aisle). Part of the Congressional opposition appears to be simple pique that this plan was developed without the input even of the Republican leadership, and that the generalities of the plan have been announced but not the details. But there are substantive concerns as well. Among the more significant criticisms to date:     This plan offers benefits to everyone, but only the upper classes can take advantage. The vast majority of individuals (one report says 96%) even today contribute less than the maximum permitted. Raising the limits, therefore, actually only helps the other 4%, who are generally the most highly paid employees. That's nice for them, but in the long run, it means that everyone else will have to pay more, via other kinds of taxes.   Small employers will be discouraged from offering plans to employees. Although the stated intention is to encourage such plans by providing greater simplicity, most outside commentators so far seem to agree that the effect will be profoundly negative. Business owners will be able to set up LSAs and RSAs for themselves, their spouses, and their children and grandchildren, and will therefore not need to offer plans through their businesses. Furthermore, under the eased non-discrimination rules, those employers who do offer ERSAs will be able to set up plans that tilt benefits more toward highly compensated employees. Again, the rank and file will suffer, but the upper echelon will do just fine.   Eliminating tax deductibility of contributions will drive down savings rates. It is almost certain that the savings rate will go down, since people will not be able to afford to save as much post-tax (into LSAs and RSAs) as they can pre-tax (into IRAs). This may be acceptable, assuming the long-term tax benefits are the same, which in principle is true. More serious, therefore, is the psychological effect. People like to make pre-tax contributions because they feel that they are getting a two-fer: a boost to their savings plus a reduction in their taxes. Without that second motivation, we have to expect that a lot of people will just not be sufficiently inclined to give up the joy of immediate consumption.   Our children and grandchildren will pay the bill. Under the proposal, all individual accounts will now be Roth-type accounts, and ERSA accounts will now have a Roth-type option (which will be very attractive to the largest contributors, because if you can shelter $14,000 after-tax, that is the equivalent of $20,000 pre-tax, if you are in a 30% tax bracket). This is a short-term boon to Uncle Sam, because all those IRA deductions and a big chunk of current salary deferrals will go away, and tax revenues will increase. But taxes will never again be paid on these accounts, and the bill comes due in later decades. Or, if that bill is just too big, some future Congress may decide that LSA/RSA/ERSA withdrawals have to be taxable after all, and today's smart savers will end up looking like suckers, having had to pay taxes at both ends.   The move to a tax on "consumption" is really a tax on wages. In the last few business days, the financial press has observed that the Bush Administration seems to be moving toward a federal tax structure that penalizes consumption rather than income. That might be the long-term goal, but the effect of the current proposals (including the proposed income tax exemption for stock dividends) is to focus taxation not on consumption, but on wages and salaries. If the Bush budget were to pass intact, both small savers and big investors would have the means to invest as much as they could afford, with almost all of it tax-free. But at the same time, wages and salaries not only continue to be taxed, they continue to be double- or even triple-taxed (income taxes plus Social Security taxes when the money is earned, sales taxes, in most states, when it is spent). Is this really where we want to go?     Potential Damage to Current 403(b) Participants Certain effects in the 403(b) market can be identified from the proposal as it currently stands. Others are uncertain, because inadequate detail has been provided. Still others are uncertain because they are speculative. But individuals currently benefiting from 403(b) plans should be seeing a flashing "caution" sign, at the very least:     Contributions limits will decrease for many employees. The ability to contribute $12,000 to both a 403(b) and a 457 will disappear under the Bush proposal. The $3,000 catchup for 403(b)s goes away. The 3-years-before-retirement catchup for 457 plans goes away. The ability of part-time or partial-year employees to contribute to a 403(b) based on the last full year of service, rather than on just the current calendar year compensation, goes away. The ability of employers to contribute to 403(b) plans for up to five years after retirement goes away The increased limits for individual accounts make up for a lot of this (and more than make up for it, for some people), but those accounts allow only after-tax contributions, which are not as appealing to a lot of people.   Participants may have a "choice" of only one provider. One of the special benefits of 403(b) plans is that most participants can choose among several (typically half a dozen, but sometimes dozens or even hundreds) of product providers. This is because the participant actually owns the account. Under current law, furthermore, if you don't like any of the sanctioned providers, you can transfer your existing funds to any vendor who will accept them, without generating a taxable event. In 401(k) plans, however, the employee does not own the account, and because there is a significant amount of paperwork in setting up a trustee to own the funds and manage the accounts, only a single provider is used. At the employer's choice, that provider may be a servicing firm that offers investment options from several competing fund families, or it may just be a single product vendor offering only proprietary investment options. The upshot is that, if ERSAs follow the 401(k) model, participants will have far fewer choices about where their funds can be invested, and will have no opportunity to transfer funds outside until they terminate employment (in most cases). It is true that many 403(b) plan participants today have a range of choices, all of them inferior; but this problem will get worse, not better, if the employer is forced to choose only a single vendor.   Participation rates and contribution levels could take a hit. In some instances, existing 403(b) plans have so many competing choices that employees can get confused and discouraged, so the proposed simplicity of the ERSA plan may provide some relief, and may encourage some additional participation. But if all ERSAs are truly modeled on 401(k) plans, we can foresee some of what will happen in this market. Over the long run, ERSAs even in school districts will be managed by a single provider who will offer on-line administration: you enroll on-line, you change your contribution amounts and fund allocations on-line, and you have on-line tools for retirement planning, asset allocation, Social Security benefit estimates, and generic investment advice. Your vendor will rarely provide an on-site representative, but there will be a toll-free phone number, and if you are lucky, your employer will be able to answer some questions, and may even offer a live educational session from time to time. All of this is good, but most of it is passive. Unless you go out seeking advice, you will get little or none. Rarely will there be anyone present to persuade you to participate in the plan, or to increase your existing contribution level. In the existing 401(k) market, this problem is less severe because, in order to meet non-discrimination tests, executives who want to contribute at high levels need to encourage rank-and-file participation. Therefore they often provide more extensive education, and, much more importantly, employer matches to employee contributions. For public school (and church-related) employers, non-discrimination rules do not apply, and therefore there is no extra motivation for employers to offer costly educational services or even more costly employer matching. ERSAs that replace 403(b)s, therefore, will rarely get the kind of participation rates that today's best 401(k) plans achieve. On the contrary, if, over time, the 403(b) product representatives who now haunt the schools looking for opportunities to meet one-on-one with employees disappear, there will be far fewer incentives for eligible employees to participate or to maximize their contributions. They will, for the most part, be on their own. And since giving up current income is always painful, most of us need a little (or more than a little) pushing in this direction to do what is right. When the current providers of that push eventually disappear, and most people have to log on somewhere to get advice, savings levels seem likely to drop considerably. If you compare 401(k) participation rates to 403(b) participation rates, the 403(b) rates look low. But 401(k) participation in plans that do not offer employer matches is much lower than in those that do. Furthermore, many employees in 401(k) plans have no employer-sponsored pension at all other than their 401(k), whereas most public school (and college/university) employees have relatively generous pension plans outside of the 403(b). Under these circumstances, 403(b) participation rates in the 50% neighborhood are actually quite remarkably high, and probably far better than would be found in a truly comparable 401(k) plan. We won't know for sure, though, unless the Bush plan passes.   School districts may decide not to offer ERSAs at all.The beginnings of most 403(b) plans are lost in the mists of time, but back in those days, setting one up was a no-brainer. There was essentially no IRS oversight back then, the employer did not have any fiduciary responsibility, and the product vendor(s) took care of all the administration other than the salary deferral on the payroll. A 403(b) plan was a virtually free benefit that school districts could offer to the unions in lieu of something else that would actually cost the district money. But since then, 403(b) plans have become compliance nightmares in many districts, and the source of acrimony in others. All districts now have potential liabilities that they never consciously signed up for. Wouldn't it be tempting to just get rid of it all, if they could just get by with it? Under the Bush proposal, they not only can, but they have to. By law, 403(b) plan contributions will disappear. But ERSAs do not automatically replace them: each employer will have make the effort of setting up its own new plan. But why should they? It's just another headache and expense for them (and a bigger one than the 403(b) plan was, in most cases). Furthermore, with LSAs and RSAs available to all employees individually, the employer can argue pretty convincingly that an ERSA is just not needed. Some unions, especially in larger districts, will probably bargain for ERSAs to be established, but that will cost them points that they might have used instead for higher salaries or for other benefits. Where ERSAs are not established, the financial education and encouragement for employees to save goes down pretty much to zero. Furthermore, the remaining options are for post-tax savings only, which, as discussed above, are less appealing to most people. So the total impact on saving for retirement could be very negative.     What is most likely to happen, if this proposal passes, is that the individual sales reps will be driven out of the cafeterias and teachers' lounges and into their homes. The pressure will be on employees (whether public, for-profit, or not-for-profit) to buy individual annuities and mutual funds for LSAs and RSAs. Perhaps in some ways this may be better, but overall it will probably be less effective. In the end, savings seem likely to decrease, and people's retirement years will therefore be more difficult. And oh yes, tax rates will almost certainly have to increase to cover for a future federal budget deficit that will make any past deficits look like chump change. We are probably lucky, therefore, that Congress appears to be resisting this proposal.   Home | Disclaimer | © 2003 bWise Guys, LLC. All rights reserved.				More Information More ERSA Information Treasury Department Press Release Got an ERSA/RSA/LSA question? Got an ERSA/RSA/LSA answer? Join Discussion