Sent: 03-11-2009 09:03:02
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Is Retirement Saving In The US Really Any Different? (part 2)
Last time I outlined the problem with retirement savings in the US and mentioned the changes that have been implemented with the enactment of the 2006 Pension Protection Act. I also suggested that not only do I think my knowledge and expertise will translate I also intimated that Australian Financial Planners may have experience that US Planners will need. In this edition I outline why:
Similarities with Australia
The Australian and US approaches to retirement saving have much in common, both now and in the past. Until the late 1980's Australia had a voluntary system that relied upon employees making personal contributions to a retirement savings fund. Employers could supplement this with additional contributions. As a result the system became an incentive by which employers could attract and retain selected employees and was backed up by a means tested government aged pension for those with little or no retirement savings or other assets. However, the approach had many gaps, especially among the ranks of the low paid and part time workers.
That is very much where the US systems was prior to the introduction of the PPA reforms.
In 1983 legislation took effect to change the tax status of retirement savings and in 1986 compulsory saving was introduced with employers granting a pay increase based on improved productivity in the form of a retirement savings contribution of 3%. Over a number of years this contribution rate was raised to its current level of 9%. Coverage of the workforce increased dramatically from just over 40% of the workforce in 1987 to approximately 90% by 2001.
Following the enactment of the PPA, the US 401(k) DC system is not dissimilar to the DC system currently operating in Australia as cab be illustrated:
In the US if the individual does nothing, they are automatically enrolled in a retirement savings plan. In Australia, every person is automatically enrolled in a retirement savings plan.
Automatic Salary Deductions
In the US, a fund member's contributions can be automatically deducted from their pre tax income. In Australia, a member's contributions are automatically deducted from their pre tax income.
In the US if the individual does nothing, their contributions can be placed in a default fund, most likely a diversified fund. In Australia, if the individual does nothing, their contributions are placed in a default fund, usually a diversified fund
Asset Mixes Reflecting a Person's Age
The PPA has enabled the development of target date funds that change the asset allocation of a person's retirement savings as they approach their target retirement date. Whilst this approach is new to the US it is not new in Australia. Back in the late 80s I designed a series of funds and a system that automatically moved a person along a risk/reward spectrum depending upon the age of that individual and/or time to retirement. The use of different types of diversified funds to achieve this goal is now common.
Automatic Increases in Contribution Rates
Under the PPA it is possible to automatically increase the contribution rate over a period of timed from the default 3% up to a maximum of 10% of pre-tax earnings. These increases can occur without any conscious decision being made by the fund member. The Australian system started at 3% and over a period of time was raised to its current level of 9% of pre-tax earnings.
In the US, upon leaving an employer, the individual has the option to roll over their retirement savings into: an IRA, the retirement savings fund of their new employer, or to take the money as cash (after paying tax). In Australia, upon leaving an employer the individual has the ability to roll over their retirement savings into an IRA or into a fund with the new employer. The option to take the money as cash (after paying tax) was rescinded several years ago.
In the US it is up to individuals to decide what to do with their money once they retire, with many choosing lump sums and relatively few choosing an income stream. In Australia, individuals have to decide what to do with their money once they retire and many still choose a lump sum rather than one of the income stream products available.
Voluntary Changes to Contribution Rates
It the US it is possible for the individual to voluntary raise their pre-tax contribution rate. In Australia it is possible for a person to voluntarily raise their pre-tax contribution rate.
After Tax Contributions
In the US a person can contribute to their retirement savings using after tax contributions. In Australia it is possible to contribute to retirement savings using after tax contributions.
Consequently, as a result of the changes brought about by the PPA, the two systems are not radically different. The question is, will the reforms work? To answer that it would be helpful to examine the Australian experience, which I will do next time.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.