Considerations for State-Sponsored Retirement Plans

Introduction

Several federal proposals that enhance Americans’ retirement savings drew substantial interest this year. The U.S. House of Representatives passed the Securing a Strong Retirement Act of 2022 (also known as the SECURE Act 2.0) in March.[1] Two bipartisan bills, the Retirement Improvement and Savings Enhancement to Supplement Healthy Investments for the Nest Egg Act (RISE and SHINE Act)[2] and the Enhancing American Retirement Now Act (EARN Act),[3] were introduced in the U.S. Senate a few months later. Many observers expect a reconciliation between these bills and that a final agreement will be reached. There are already many overlapping provisions in the current versions; one encourages small businesses without retirement saving plans to start one, primarily through higher tax credits.

At the state level, similar efforts to expand coverage take a different approach. In particular, an increasing number of states have begun to consider state-administered individual retirement account (IRA) programs. As of mid-2022, 12 states have either passed laws or implemented plans to offer these programs. This issue brief reviews such developments as well as different views about their merits.

The Policy Focus of Workplace Retirement Plans

The role of Social Security in supporting workers’ retirement income has gradually shifted over the past few decades, with individuals assuming more responsibility for safeguarding their retirement savings.[4] This structural change means workplace saving plans have become more critical. Several studies found that people who have access to retirement savings through work are more likely to save; most of these plans use payroll deductions to make saving easier for workers.

However, estimates show that roughly a quarter to one-third of private sector workers do not have access to workplace retirement plans. [5] A recent Federal Reserve study indicates that even with a strong labor market and low unemployment rate in 2021, 25% of U.S. workers still had no retirement savings. Among those with savings, 40% felt they were behind on retirement preparedness.[6] As such, how to close this stubborn retirement savings gap has become an important policy focus. So far, the federal government and some state governments have taken different approaches to the problem.

The federal government strongly encourages businesses to provide retirement saving plans. However, no federal mandate requires workplace retirement saving plans. Lawmakers in some states believe that federal efforts, such as tax credits and multiple employer plans, which allow two or more unrelated employers for federal income tax purposes to offer retirement savings plans jointly, have not significantly increased participation.[7] Clearly, a more direct mechanism that connects people to retirement savings through work is necessary, and the government believes that state-sponsored IRA plans are the solution.

State-Sponsored IRA Programs: How They Work

Although state-sponsored IRA plans have been getting attention recently, the idea was first introduced over 15 years ago.[8] The current state-level interest in them coincides with the tight labor market, where employers must provide better benefits to attract workers. In addition, the pandemic presented a convincing case for workers to save for a rainy day and protect themselves against a catastrophic financial fallout.

Many smaller employers cite costs and administrative burdens as primary reasons for not offering retirement plans. As such, supporters of state plans believe the plans are especially beneficial for small business employees. Part-time workers and those in the sharing economy also stand to benefit if states decide to include them in their retirement programs.[9]

Generally, employers deduct funds from employee paychecks (usually a percentage of pay pre-selected by workers or the state default rate) and deposit them into workers’ individual retirement accounts. These are usually Roth-IRA type of accounts, which means that workers pay income taxes on the amount contributed. Therefore, account owners can withdraw their contributions without penalty even before they reach retirement age. Supporters believe this feature will not discourage retirement saving. If workers have a financial emergency, they can access the funds immediately. In addition, these programs must follow the Roth IRA’s income and contribution limits: for single filers, the eligible income limit is $144,000 in 2022 and the contribution is limited to $6,000.

A major difference between state plans and typical workplace saving plans is that states, rather than employers, are the retirement plan sponsors. However, states do not manage the underlying assets themselves. Generally, a state-level retirement plan board oversees the program and is responsible for identifying the private asset management companies that will invest the funds. Because employers are removed from the plan sponsor role, they do not have a fiduciary duty to the retirement plans—which usually requires plan sponsors to act in the best interest of the plan participants. In addition, employers do not match a worker’s financial contribution to these plans. Employers simply act as conduits that channel funds from workers to state-sponsored plans, and their role is limited to encouraging employee saving.[10]

Beyond the overarching design of state-sponsored plans, each state may have slightly different rules, including eligibility requirements, default contribution rates, and state tax treatments. For instance, participation is mandatory in most states for businesses that do not provide their own retirement plans. Eligible employees are usually enrolled automatically unless they opt out. This is why these programs are often referred to as “auto-IRAs.” However, certain employers may be exempt because they are under a certain size or are a new business, but rules vary across states. Employees who do not specify a payroll deduction percentage will default to the state plan’s contribution rate, which usually ranges from 3% to 5% of payroll. Some states also have auto-escalation rules that increase contributions over time.

Interactions with the Employee Retirement Income Security Act (ERISA)

It does not take long for nascent state-sponsored IRAs to be challenged in court. An organization in California has filed a lawsuit against the state’s auto-IRA mandate, CalSavers Retirement Savings Program (CalSavers), asserting that workplace retirement plans fall within a federally preempted field; as such, state governments do not have authority to regulate these plans, they argue. Specifically, the plaintiff believes California’s attempts to sponsor auto-IRA plans violate the federal Employee Retirement Income Security Act (ERISA), a law Congress passed in 1974 to protect participants in private-sector pension plans.

In May 2021, the U.S. Court of Appeals for the Ninth Circuit upheld the CalSavers program. The court ruled that because California state government did not force employers to create their own programs, CalSavers can coexist with workplace retirement programs regulated by ERISA. The plaintiff appealed, but the U.S. Supreme Court in February 2022 declined to hear the case, which essentially allowed the CalSavers program to proceed.[11]

Despite the outcome of this case, many observers are nevertheless concerned about state-sponsored plans from an asset protection perspective. For instance, ERISA sets minimum standards for participation, outlines reporting requirements, and requires retirement plans to establish an appeals process.[12] It also holds employers and investment professionals to a fiduciary standard of care. State-administrated plans may lack adequate measures to protect plan assets and participants. However, supporters of state plans do not think these issues outweigh the benefits; they also believe state laws and regulations can fill the void and alleviate these concerns.

Another concern is that employers operating across multiple states could be required to participate in several state-sponsored programs, which could be administratively challenging.[13] If state plans become more prevalent in the future and remote work continues to be common, employers may spend more resources to monitor employee eligibility for different state programs. Some argue a key benefit of ERISA-regulated plans is the consistent federal standard across states. Therefore, they recommend either letting state programs follow ERISA standards, or have the federal government set a similar standard to resolve the inconsistent eligibility issue.[14]

Pros and Cons

Supporters of state-sponsored IRAs see great benefits in bringing new savers into the retirement saving system. They argue that retirement savings not only provide emergency financial safeguards, but also reduce savers’ reliance on social services in retirement. If a significant number of workers are unable to support themselves in retirement, there will be significant pressure on the public safety net and current workers will ultimately bear the costs.

Some are concerned that state-sponsored plans will replace existing employer plans. Specifically, because states are picking up costs of establishing and administrating retirement plans, employers may have incentives to cancel their own plans and ask employees to save through state programs. This could be a double whammy when it comes to retirement savings. First, many employer-sponsored plans are 401(k) type plans, which usually involve employer matching. Ending these plans will save employers the cost of matching contributions but discourage employee saving. In addition, 401(k) plans usually have a higher annual contribution limit than Roth IRA plans. In 2022, the contribution limit is $20,500 for 401(k) plans; the combined employee and employer contribution limit is $61,000.

The short history of state plans generates limited data. However, preliminary analysis does not find in general that employers substitute their plans for state plans. A survey-based study shows that there is little evidence that state initiatives crowd out employer plans.[15] On the contrary, some employers would rather start their own plans instead of using state-mandated plans.

Another major question is whether state-sponsored IRA programs provide workers with meaningful retirement savings, considering the high administration costs for managing numerous small accounts and for monitoring frequent withdrawals. So far, the three largest state-sponsored IRA programs with the longest operational history demonstrate similar patterns in terms of account balance and withdrawal frequency.

Oregon’s state-sponsored IRA plan, OregonSaves, was launched in 2017. As of August 31, 2022, the program managed 114,484 accounts and $157 million of assets.[16] The average contribution amount was roughly $177 per month and the average account balance was $1,369. About 25% of eligible participants opted out of the program. Among the 114,484 funded accounts, 30,073 (25%) were associated with at least one withdrawal. During August 2022, $7.4 million was deposited into the accounts and $3.5 million was withdrawn. 

These results are similar to the program’s 2020 statistics. In September 2020, the plan managed $70 million of assets in 74,333 accounts, out of which 17,724 (24%) were associated with at least one withdrawal.[17] The average contribution was roughly $136 per month and the average account balance was $931. About 34% of the eligible participants opted out of the program. Also in September 2020, $4 million was contributed to the program and $0.9 million was withdrawn. 

Illinois’ state-sponsored IRA began in 2018. As of September 30, 2022, Illinois’ Secure Choice reported $84 million of assets in 109,346 accounts. [18] The average contribution was roughly $144 per month and the average account balance was $768. About 32% of the eligible participants decided not to participate. Among the 109,346 funded accounts, 26,094 (24%) were associated with at least one withdrawal. In September 2022, participants contributed $3.8 million and withdrew close to $1 million.

California started its state retirement program in 2019. As of September 30, 2022, CalSaves had $272 million of assets in 360,237 accounts.[19] On average, these accounts had a $756 balance and a monthly contribution of $166. The opt-out rate for the program was roughly 37%. The data also showed 67,323 accounts experienced full withdrawals, meaning that workers completely emptied their accounts. Another 11,591 accounts experienced partial withdrawals.

Because of the frequent withdrawals and relatively small balances, administration costs are usually high compared with rates published by asset management companies with larger account balances. There are also separate fees charged by the state.

For instance, there are three types of fees charged by Illinois’ Secure Choice program: The state fee, the program administration fee, and the underlying investment fund fee.[20] The state fee funds board oversight and administration of the program. The program administration fee compensates a third-party program administrator, who is responsible for day-to-day program operations and recordkeeping associated with the accounts. Finally, the underlying investment fund fee is a payment for investment advisory services performed by financial service firms. For the most recent plan year, the state fee was 0.05% of net assets, the program administration fee was 0.61%, and the investment fund fees was 0.09%. The total fee for the state-sponsored IRA was therefore 0.75%.

Oregon conducted a feasibility study prior to launching the program.[21] The 2016 study indicates the two major program costs are the start-up cost and the ongoing cost. The former is a one-time cost to create the program and onboard employers. The study estimates the fixed cost of developing the infrastructure is $1 million and the variable cost of engaging employers is $10 million, for a total of $11 million. After the program is established, the annual ongoing cost includes administrative expenses ($1.3 million), recordkeeping fees ($30 per account annually), and investment management fees (0.15% of assets). The report uses a 1.2% annual fee on asset balances as its baseline assumption, and specifies the fees can be gradually reduced to as low as 0.3% to 0.5% once the start-up cost is recovered. Most recently, the program had an asset-based fee of approximately 0.25% and an account fee of $18 per year.[22] Based on the August 2022 average account balance of $1,369, the account fee is about 1.3% for an average account holder. As such, the total fee is approximately 1.55%.[23]

For CalSaves, the total fee is in the range of 0.825% to 0.95%. This includes a state fee of 0.05%, a program administration fee of 0.75%, and an investment funds fee that ranges from 0.025% to 0.15%.[24] State rules require that expenses do not to exceed 1% of program funds.

Conclusion

Americans are increasingly responsible for their own retirement income security, and many rely on workplace plans to achieve this goal. Although the federal government and certain state governments are taking slightly different approaches to retirement savings, it is promising that policymakers are prioritizing this issue.

Despite growing interest in them, state-led IRA programs are still somewhat new. Supporters and opponents can identify reasons that support their positions based on preliminary outcomes. Supporters assert that these initiatives engage non-savers that existing programs have not been able to attract. They claim that once saving is straightforward and habitual, workers will continue to deposit funds into these accounts. Although the accounts have frequent withdrawals and function like tax-favored emergency savings accounts, workers at least are coming into the system; if they have more funds, they will save more. An extra benefit is that by requiring employers to participate in state-sponsored IRAs, they may instead start their own plans. 

On the other hand, opponents question the complexity of the rules and the absence of consistent investor protections across states. The small account balances and frequent fund withdrawals and deposits make them question the programs’ ability to safeguard workers’ retirement income security. Currently, among other options, workers can take the initiative and open their own IRA accounts or the government can encourage employers to provide retirement programs. Having states administer a new retirement program is an expensive nudge. States need to create new rules and regulations, and they often have to hire third parties and charge administrative expenses to manage the accounts.

Overall, the debate will be settled as new state programs are implemented and more data becomes available. The success of the programs will largely depend on whether they can reach a certain scale, and more importantly, whether workers remain savers in the long run.

References