Economists typically support such plans because of their effects on savings. The plans also make the tax system fairer, granting all taxpayers access to the tax advantages enjoyed by employer pension plans.
But the truly brilliant part of retirement savings plans is their contribution to the fiscal challenges posed by population aging. In Canada, when a taxpayer turns 71, RRSPs must be converted to registered retirement income funds or RRIFs. Starting at age 72, the taxpayer must make annual, taxable, withdrawals. Similar rules apply to IRAs and 401(k)s. The baby boomers will be withdrawing funds from their 401(k)s and RRSPs -- and paying a good chunk of taxes on those withdrawals -- precisely when the revenue is needed to pay for their health care and other needs.
Brilliant economics. But lousy psychology. It ignores the basic insight of prospect theory: loss aversion.
Prospect theory says that reference points matter. I've had a small amount of money tucked away in one RRSP ever since I was 26. A few days ago I received my annual statement. The plan is now worth $12,811. That's now my reference point. Yes, a 25% or 40% increase in the value of the fund would make me happy. But the idea of losing 25% or 40% of my little nest egg to taxes makes me really unhappy.
People are strongly averse to losses. Applied to the problem of retirement savings plans:
The tax deduction associated with 401(k) or RRSP contributions creates a utility gain. But prospect theory predicts the tax paid on withdrawals from 401(k)s or RRSPs will create a much larger utility loss. I've spent years dreaming about the holiday I'll take using the funds in that little RRSP. The very idea of taxes shatters my dreams.
I have been unable to find much research on the psychology of taxation. However a recent working paper by James Poterba, Steven Venti and David Wise reports findings that are consistent with the loss aversion hypothesis. Generally speaking, people don't withdraw funds from their personal retirement accounts (PRAs) until they have to:
On average, households age 60 to 69 with PRA accounts withdraw only about two percent of their account balances each year, considerably less than the rate of return on account balances during our sample period. Even at older ages—after the required minimum distribution age--the percentage of balances withdrawn remains at about five percent.
The authors attribute this to saving for a rainy day, noting that a similar effect has been found for home equity. Moreover, not all PRA withdrawals trigger tax liabilities (Roth IRA withdrawals don't, but these have been unimportant until recently). Yet given that there are distinct advantages to spending down assets in the US context - people with low assets and income are eligible to have long term care needs covered by Medicaid - it would nice to have more explanations for people's reluctance to withdraw personal retirement account funds.
One explanation can be found in newspaper headlines: RRIF Rebels Take On RRSP's Dark Side. Baby Boomers' RRSP Tax Bill Looms Large. The Great RRSP/RRIF Tax Grab. The common thread running through these articles is that people do not like paying taxes on their RRSP withdrawals.
Canadians currently have about $2 trillion in various types of retirement savings: Canada/Quebec Pension Plan assets, employer pension plans, RRSPs and RRIFs. For governments, that's billions of dollars of potential tax revenue. For older Canadians, that's billions that they would rather not pay in taxes.
I predict that over the next decade there will be a major battle over the tax treatment of retirement savings plans. In particular, we will see:
- Canadians lobbying to wait longer to convert their RRSPs to RRIFs, and to make smaller RRIF withdrawals.
This prediction is a sure bet, as it's happening already.
As people become aware that RRSPs have a dark side, we will see:
- Calls for RRSP investments to be eligible for dividend tax credits and partial inclusion of capital gains.
Actually that might not be a bad idea anyways, as dividend tax credits integrate the corporate and personal tax systems.
Now that people are starting to think their RRSP "was our poorest investment but Ottawa's best one", people will be looking for alternatives to RRSPs, and places to invest their RRIF withdrawals. This means that we will see:
- Calls for an increase in the amount that taxpayers can contribute to a Tax Free Savings Account
(For US readers, a TFSA is similar to a Roth-style IRA.)
And predictably, there will be calls for lower rates and greater exemptions.
Will governments be able to resist? Retirees are a potent political force: they vote, they are organized.
Somehow the bills have to be paid.