401(k)’s can partially solvetwo more public policy problems

Brookings InstitutionSeptember 18, 2015

John Beshears, Harvard Business SchoolJames Choi, Yale School of Management

David Laibson, Harvard University Faculty of Arts and SciencesBrigitte Madrian, Harvard Kennedy School

The power of 401(k) choice architecture• Workers overwhelmingly say that they want to save more retirement• Workers accept (reasonable) 401(k) default savings and even auto-

escalation.• If the default savings rate is set well (i.e., 6% of income + 3% match),

most workers will retire in comfort.• Can we use the 401(k) to address other social problems?

Two problems:

1. Firms stop hiring and begin firing workers during recessions because the firms face cash-flow problems.

2. Many households live paycheck to paycheck; when they need liquidity (e.g., to pay medical bills) they use high cost debt or deplete their retirement funds.

Problem 1: Firms stop hiring and begin firing workers during recessions because firms face cash-flow problems.

Pro-cyclical 401(k)• Pro-cyclical employer-funded 401(k) contributions.• For example: • 0% contribution during and immediately after recessions• 10% in all other years• (On average, employer contribution is 7% per year.)

• Recession years would be determined by a third party • (Firms could slowly join the new system: raising the employer’s contribution rate

1% per year until they reach the full 10% number.)

The economic case for pro-cyclical employer contributions: 10% during normal times and 0% during and immediately after recessions.

• Worker take home pay does not fall during recessions• But employer labor costs fall 10% during recessions• Firing pressure is alleviated• Hiring continues to be profitable• Weaker propagation of macroeconomic shocks (i.e., weaker multipliers)• take home pay doesn’t change• unemployment is reduced

This idea isn’t out of the blue.

• US payroll tax holidays during recessions.• US firms that temporarily cut 401(k) matches during recessions.• Profit sharing plans.• Singapore’s Central Provident Fund (pro-cyclical employer

contributions to a defined contribution plan)

Historical CPF Contribution RatesKoh (2014)

Problem 2: Households live paycheck-to-paycheck; when funds are needed, they use high interest debt or deplete retirement funds.

Rainy-day 401(k)• Set up parallel 401(k) accounts – a worker would use both:

1. Retirement account (partially illiquid; e.g., early withdrawal penalty)2. Rainy-day account (liquid; e.g., Roth or outside ERISA)

• For example: 1. 4% default contribution to retirement account2. 4% default contribution to rainy-day account, which transitions to

retirement account when balance reaches 3 months of income

The case for a rainy-day 401(k) with a default contribution rate of 4%• Reasonable 401(k) defaults tend to stick.• Employees report overwhelming support for auto-enrollment; here we are

extending the franchise to rainy-day 401(k) accounts.• Households are not likely to set up rainy day accounts on their own.• The rainy day 401(k) will reduce leakage from retirement savings (the

leakage rate is now 40%; Argento et al 2014).• The rainy day 401(k) will also reduce household borrowing: payday loans,

credit card borrowing, and even cash-out refinancing. • The rainy day 401(k) will reduce financial stress.• (Could encourage enrollment with active choice, rather than default.)

Summary: two problems and two separate 401(k) solutions

1. Firms with cash-flow problems, fire workers during recessions.Pro-cyclical employer contributions to the 401(k): Pro-cyclical 401(k)

2. Households live paycheck to paycheck.A parallel auto-saving account for financial emergencies: Rainy-day 401(k)

End

Appendix slides follow

Singapore

• The Central Provident Fund• Mandatory employer contribution 16%• Mandatory employee contribution 20%• Employer contribution is time-varying and pro-cyclical