United States
Compiled by Allianz Global Investors
Pension System Design
The United States is the largest pension market globally. Tax-favoured private pensions have a long history tracing back to the beginning of the 20th century making the US pension market one the most mature in the world. In 2007 retirement assets amounted to USD 17.4 trillion.
Americans use a variety of tax-advantaged investment vehicles with the bulk of assets, approximately 65%, allocated to employer-sponsored retirement plans. Another quarter of overall retirement assets is invested in Individual Retirement Accounts (IRAs) in which assets were partly originated in employer-sponsored plans and subsequently transferred to an IRA.
Defined contribution plans and Individual Retirement Accounts have experienced rapid growth compared to traditional defined benefit and annuity contracts. Their share of all retirement assets amounted to 52% in 2007. The importance of private defined benefit plans, as measured by total retirement assets, is decreasing, despite the fact that total DB assets slightly increased over the past years.
Traditionally, US pension funds have a high exposure to equities with approximately two-thirds of assets allocated to that asset class. Being strongly dependent on the market volatility, defined benefit plans have shown serious underfunding. As at 2005, underfunded DB plans reported a total underfunding of USD 450 billion due to inadequate funding rules. According to the Pension Protection Act 2006 new regulations for defined benefit plans are being phased in since the beginning of 2008. These measure pension liability closer to the market and introduce shorter amortisation periods for making up pension shortfalls.
Public Pensions
The American state pension system (official name: OASDI – Old-Age, Survivors, and Disability Insurance program) operates on a pay-as-you-go basis and is financed through social security taxes paid by employers and employees (accounting for 84%), tax revenues paid by upper-income social security beneficiaries (2%) and interest earned on accumulated trust funds reserves (14%). The social security tax is shared equally between employer and employee, and amounts to 12.4% of earnings with a contribution assessment limit of USD 102,000 in 2008. Contributions are tax-exempt, although the benefits are taxed if the total income in retirement exceeds a specified amount. The earliest time where one could receive retirement benefits is at the age of 62; however, the statutory retirement age depends on the retiree’s year of birth and lies between 65 and 67.
The gross replacement ratio of first pillar benefits is close to 38.5%, which reveals that the state pension system in the United States is not particularly generous. Beside social security the three main sources of income for the elderly are employer pensions, income from saved assets and earnings.
In the 1980s the American government recognised the extent of the future financial burden on social security that would result from the retiring baby boomer generation. In 1983 the social security tax was increased and surpluses have been accumulating in the Social Security Trust Fund since then to meet future expenditures. In 2004 the surplus amounted to USD 2.2 trillion. It is expected that in 2018 surpluses from revenues will not exceed expenditures anymore. The Social Security Trust Fund is expected to be exhausted in 2042, resulting from a sharp decrease of the worker-beneficiary ratio when the baby boomer cohorts retire.
Occupational Pensions
The Employee Retirement Income Security Act of 1974 (ERISA) is the federal law that sets minimum standards for most voluntarily established pension plans in the private industry to provide supplementary old-age protection. ERISA provides rules on:
- Reporting and disclosure
- Participation and vesting
- Funding
- Fiduciary responsibility
- Administration and enforcement
The most significant changes concerning pension plans since 1974 were made as part of the Pension Protection Act 2006 (PPA). The key regulations mainly relate to changes in the funding of defined benefit pension plans and have a significant impact on the design and operation of defined contribution plans.
In private industry 60% of the workforce has access to retirement plans. Defined contribution schemes dominate the occupational pension landscape and cover 43% of the workforce. By contrast, only 20% of the private sector workforce participates in a defined benefit schemes. Altogether, 51% of the total workforce is integrated into any kind of pension plan; the entire sum is less than the individual items because some employees participate in both types of plans.
According to section 414(i) of the Internal Revue Code, a defined contribution plan is an employer-sponsored plan providing an individual account for each employee. The most widespread type of defined contribution plan is the 401(k) plan. According to the latest data from the US Department of Labour, 401(k) plan assets amounted to USD 1.6 trillion accounting for 81% of total defined contribution assets in 2002.
401(k) plans enable employees and employers to make tax-deferred contributions from their salaries to the plan up to the lesser of USD 44,000 or 100% of compensation. The employee-only amount is USD 15,500 for 2008, with a USD 5,000 catch up for people aged 50 and older. Tax-deferred employee contributions vest immediately, whereas voluntary employer contributions are often linked to a specified period of service before they finally vest, but this depends on the design of the specific pension plan.
Most 401(k) plans provide retiring employees with multiple distribution options for receiving plan account balances. Lump-sum payments, instalment payments for a fixed number of months and annuities are available distribution methods. Finally, it is also possible to defer any payment until a certain age.
New PPA regulations facilitate and encourage the automatic enrolment of employees into existing employer-defined contribution plans if the employees fails to make any decision. New regulations effective as of January 1, 2008, now define mechanisms that a Qualified Default Investment Alternative (QDIA) must apply. The products asset mix must take certain characteristics, such as age and retirement age of an individual or a group, into account. Life-cycle funds, balanced funds and professionally managed accounts are examples that match these requirements. Employees that do not make any investment decision are consequently enrolled into this default option.
In addition to the popular 401(k) plan, the following scheme types could be set up to provide occupational pension coverage:
- 403(b) plans: employer-sponsored retirement plans, which enable employees of Universities, public schools, and non-profit organisations to make tax-deferred contributions form their salaries to the plan.
- 457 plans: employer-sponsored retirement plans, which enable employees of State and local governments to make tax-deferred contributions form their salaries to the plan.
- Thrift Savings Plans: employer-sponsored retirement plans that enable employees of: The Federal Government to make tax-deferred contributions form their salaries to the plan.
- Employer-sponsored IRAs
Employer-sponsored IRAs play a minor role in providing pension provision. Total assets under management amounted to USD 207 billion in 2005, according to estimates from the Investment Company Institute.
- A SIMPLE IRA plan is an IRA-based plan that gives small employers (those with less than 100 employees) a simplified method to contribute toward their employees' pension. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or non-elective contributions. All contributions are made directly to an Individual Retirement Account or Individual Retirement Annuity (IRA) set up for each employee.
- SEP IRAs: Simplified Employee Pension plans do not have the same start-up and operation costs as conventional work-based retirement plans and are designed mainly for small businesses. These plans are based on an Individual Retirement Account to which the employer contributes on a discretionary basis. The funding vehicle for Simplified Employee Pensions is a traditional IRA and is therefore regulated by the traditional IRA rules regarding distribution, investment, contribution and deduction. Trustees of SEP-IRAs are generally banks, insurance companies, mutual funds and other approved financial institutions.
As mentioned above, 20% of the private sector workforce participates in employer-based defined benefit schemes. The statutory definition of the defined benefit plan encompasses all non-DC pension plans, that is, those that do not have individual accounts (this captures hybrid pension plans such as Cash Balance and Pension Equity Plans (PEP)).
According to the Pension Protection Act, new regulations for defined benefit plans concerning funding and accounting requirements are currently being phased in.
Figures from the Investment Company Institute show retirement assets in the United States reached USD 14.5 trillion in 2005. Of this amount, approximately two-thirds are held in employer-sponsored retirement plans. In addition to these figures, the share held in Individual Retirement Accounts and the growth of these assets is due to significant rollovers from employer-sponsored defined contribution plans into IRAs. Upon termination of employment or when changing employers, employees are entitled to transfer their accumulated pension assets into Individual Retirement Accounts. To avoid penalties, the transfer must take place within 60 days; otherwise, an early-distribution tax of 10% applies in addition to the taxation of the entire amount, which accrued from pre-tax contributions.
Tax treatment of contributions and benefits
Contributions to qualified pension plans can be made on a pre-tax basis subject to certain limits. For the year 2008 the total deferral amount including employer and employee contributions must not exceed the lesser of USD 46,000 or 100% of compensation. The employee-only amount is restricted to USD 15,500 with a catch-up contribution of USD 5,000 for people aged 50 years and older. Dividends and capital gains remaining in the accounts accrue tax-deferred. Only when the money is withdrawn it is fully taxed as income.
From 2006 onwards, employees are allowed to transfer part or all of their contributions to a 401(k) plan as designated Roth contributions. The amount treated as Roth contributions is paid on an after-tax basis and, as a result, does not qualify for tax relief as the payments are included in gross income. Contrary to traditional 401(k) plans, investment returns and benefits remain tax-free. Another characteristic of traditional 401(k) plans that does not apply to Roth 401(k) plans is the forced withdrawal at a certain age. The retiree is completely free to choose the point of time when to withdraw the accumulated assets and particularly if, in fact, it will be withdrawn.
Outlook
Over the past years retirement savings have experienced steady growth with defined contribution plans and IRAs experiencing the most rapid growth. Among mutual fund investments, life-cycle and life-style funds have increasingly become popular with USD 255 billion1 assets under management held in retirement accounts. New regulations on default investment options are likely to boost further growth in these funds. What’s more, new rules encouraging employers to auto-enrol employees into their pension plan could stimulate further growth of occupational pensions, resulting in a higher coverage of private sector employees with supplementary pensions.
It is important to note that the Unites States is one of the very few countries in the industrialised world not faced with a decreasing population. Birth rates are slightly below the number needed to keep the population constant, but immigration will keep the population growing over the next decades, although at a decreasing rate.