Those of us who work on retirement policy sometimes overlook how retirement savings fit into a person’s larger financial picture—in particular, how those savings interact with debt.
Two questions highlight the connection between savings and debt: Does debt inhibit people from saving for retirement? And does saving for retirement lead to greater debt?
The answer to the first question appears to be that people are less likely to save for retirement when they have personal debt. A survey of small-business workers conducted by The Pew Charitable Trusts found that 75%of those who were not contributing to a plan at work said paying down their debt first would motivate them to save. Similarly, a study of tax data suggests that while self-employed people are more likely to save for retirement if they have a home mortgage, they’re less likely to do so if they’re saddled with high business-related debt.
These findings suggest several things. Debt that could lead to financial hardship, such as large unsecured loans or credit card balances, inhibits saving for retirement. Home mortgages, which can give people some financial security by allowing them to purchase an asset that can appreciate over time, may not be a brake on saving. And people generally know their financial situation—and understand whether saving for retirement fits their circumstances.
The second question—does saving for retirement increase debt?—is important because the answer helps shed light on whether participating in a retirement plan leads to real savings. Workers who contribute 5%of their wages to fund their retirement contribution are taking a pay cut. Do they compensate for this smaller paycheck by reducing spending—or, by contrast, do they run up their credit cards, take on payday loan debt, or spend down their liquid assets?
These questions are important because, increasingly, workers find themselves automatically enrolled into a retirement plan. When a worker is automatically enrolled in a plan, contributions are set at a default rate, such as 3% of his or her wages or salary, with the employee able to opt out of the plan or change the contribution level. According to an analysis by the mutual fund provider Vanguard of its large client database, for example, 46%of plans used automatic enrollment in 2017, up from 20% in 2008. And while auto-enrollment can be helpful for saving, it also carries the risk that some employees may not realize what they’re being enrolled in—and could slip into more debt than if they had simply opted out of the plan.
A recent study of civilian workers in the U.S. Army may offer some clues to the question of whether saving for retirement leads to debt. The research found that after four years, those who were auto-enrolled in a retirement plan did not significantly add to their unsecured debt, such as credit cards, but did increase their secured debt, such as automobile loans and first-time mortgages. The increase in auto debt was not significant enough to offset the retirement savings, but the addition of mortgages was—bringing up the question of whether taking out a mortgage negates the benefits of participating in a retirement plan. And if it does, is that a problem, considering that a home is still the largest asset owned by most American families?
The potential of debt offsetting savings among auto-enrolled employees is not just a concern for the employees themselves; it’s also a public policy issue, now that state and municipal legislators are starting to focus on the potential impact on state budgets—due to increased social safety net costs—of private sector workers’ lack of retirement savings. California, Connecticut, Illinois, Maryland, Oregon, and Seattle have begun requiring that private-sector workers who don’t have a plan at their workplace be automatically enrolled in a state-sponsored individual retirement account.
A recent Pew survey asked workers how they would react if they were auto-enrolled in a state-sponsored plan: Would they stay in the plan at the default contribution level; increase the contribution; decrease the contribution; or opt out of the plan? Or were they just not sure? To make certain that respondents clearly understood the choice, they were asked for their reactions more than once: After the survey asked for an initial reaction to a short description of a plan, it then described individual elements of the plan and then asked again what workers would do. Even after the details of the plan had been laid out, 64% said they would stay in the plan, 13% indicated they would opt out, and 24% said they weren’t sure.
When given sufficient information, people support saving for retirement through automatic enrollment. But as more people participate in retirement plans, workers, researchers, and policymakers should continue to monitor how retirement savings interact with personal debt.
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