The cap on tax-deferred retirement savings proposed in President Barack Obama’s 2014 budget, which limits accumulated savings in a retirement plan (including defined benefit accruals) to between $2.3 million and $3.4 million, will affect very few people immediately, but will have a bigger impact on plan balances over time, according to an issue brief published recently by the Employee Benefit Research Institute in August.
The proposed cap would affect tax-advantaged plans like IRAs, 401(k), 403(b) and 457(b) plans, and defined benefit plans. It would prohibit participants who reach the cap from making tax-deferred contributions until the balance falls below that level again, but earnings from market gains would be unaffected.
Obama’s budget ties the cap to the maximum annuity amount a participant can receive from a tax-qualified defined benefit plan, currently $205,000 per year, according to EBRI. The brief noted that those annual benefits, if they begin at age 62, would translate to a maximum permitted accumulation of approximately $3.4 million at today’s interest rates. If enacted, the cap would take affect for tax years 2014 and beyond.
However, that $3.4 million cap was determined by assuming the discount rate, which is the rate actuaries use to estimate how much future cash flows will be worth in today’s dollars, remains at 4%. EBRI noted that if the discount rate goes up, the present value of those benefits, and thus the level at which savings would be capped, could be reduced dramatically. If the discount rate increases to 6%, the cap would fall from $3.4 million to $2.7 million. At 8%, the cap would fall to $2.3 million.
EBRI said such a scenario isn’t out of the question. According to the brief, a reversion to historical norms “might be expected once the Federal Reserve eases its current monetary policies designed to keep interest rates low.”
EBRI ran several simulations to determine how the cap would affect different plans. The simulations assumed equity returns of 5.9% and bond returns of 3.3%. ERBI also assumed that even if participants were ineligible to make a contribution in a certain year because they reached the cap, they would continue to make contributions at the same rate in any year they were able to.
In the first simulation, EBRI assumed 401(k) participants with no defined benefit accruals. At a 4% discount rate, between 10% and 20% of participants would suffer reduced balances as a result of the cap; 10% would lose 1.7% of their balance and 5% would suffer a drop of at least 5.5%.
Between 20% and 30% of participants would be affected by the cap with a discount rate of 8%. Of those, 10% would lose at least 6.6% of their balance and 5% would lose more than 10%. However, a full 1% of participants would lose more than a quarter of their balance.
When EBRI added a 2% defined benefit accrual to the scenario at a discount rate of 8%, between 30% and 40% of participants were affected. Ten percent of participants lost more than 30% and 1% lost almost 58%. At a 1% accrual, losses were less pronounced: 10% experienced a drop of nearly 12% and 1% lost almost 46%.
In another scenario, EBRI considered the impact on small 401(k) plans and found that almost two-thirds of plans with between 51 and 100 participants would have at least one participant affected by the cap. In very small plans, those with between one and 10 participants, 18% would have at least one participant affected. With an 8% discount rate, those figures jumped to 29% of plans with one to 10 participants and 75% of plans with 51 to 100 participants.
EBRI noted that in at least some cases, employers with fewer than 100 participants may justify the cost of employer contributions with the benefit of tax-advantaged savings in their own plan. “While it is not possible in the database analyzed to identify which (if any) of the 401(k) participants in a plan is the owner of the firm, a proxy that is likely highly correlated with that status is the 401(k) participant who would reach the retirement savings account cap in the shortest number of years (if any).”
EBRI found that a “significant percentage” of small plans never have a participant reach the proposed cap. Furthermore, even in simulations that do eventually terminate, not all participants would be affected; for example, anyone who would retire prior to the cap being reached.
Check out 401 (k)s More Confusing Than Health Insurance: Charles Schwab on ThinkAdvisor.