Federal tax policy, employer matching, and 401(k) saving: evidence from HRS W-2 records.(effect of tax policy on saving behavior)

INTRODUCTION

The ability of the federal government to stimulate retirement saving through tax policy is a central economic policy issue and often a point of contentious debate in the literature. Since 1981, when the Internal Revenue Service issued clarifying regulations, 401(k)-type pension arrangements have grown remarkably and become the primary vehicle for retirement saving in the United States. As is well known, 401(k)s subsidize saving through income-tax deferral on wages and salary dedicated to retirement saving and through investment accrual at the pre-tax interest rate. When compared with their closest substitute, Individual Retirement Accounts (IRAs), contributions to which, for many households, have limited or no tax deductibility, 401(k)s by far have the greatest tax advantages, especially for workers eligible for employer matching contributions.

Despite the important role that 401(k)s play in policy debates about the adequacy of retirement saving and the voluminous literature on their effect on household saving, there has been virtually no analysis of the effect of tax policy on 401(k) saving behavior. This is striking, given that, traditionally, the presumed mechanism by which 401(k)s raise saving is through the substitution effect from the preferred tax treatment. In addition, the focus of previous studies has been on the effect of employer matching on 401(k) saving. But there is little consensus as to what this effect is. In fact, some studies have suggested that conditional on being eligible for a match, an increase in the match rate lowers 401(k) contributions, which, if correct, suggests that the income effect dominates the substitution effect from the higher rate of return matching provides.

This paper uses a unique dataset on households in the Health and Retirement Study (HRS) to examine the responsiveness of 401(k) saving to tax policy, employer matching, and lifecycle factors. Specifically, the analysis is based on panel data from W-2 earnings records for jobs held in 1984-1991 by HRS individuals. Because elective deferrals to 401(k)-type pension plans appear as the difference between federal and FICA wages on the W-2, we are able to construct a panel dataset on 401(k) contributions from these records. We then match these data to self-reported income, demographic, and pension information from wave 1 (1992) of the HRS, as well as Social Security covered-earnings histories back to 1951 from the Social Security Administration (SSA), and information taken from employer-provided summary plan descriptions for all eligible pensions from employers.

Unlike the small number of previous studies, these combined data sources allow us to model 401(k) saving longitudinally as a function of taxes, lifetime earnings and characteristics of the 401(k) and other pension plans for which the household is eligible. Importantly, we can exploit the panel data to account directly for unobserved heterogeneity in saving behavior. Based on the maximum likelihood random effects estimates of the determinants of 401(k) contributions, there are two primary findings. First, the limit on the tax deductibility of IRA contributions enacted in the Tax Reform Act of 1986 (TRA86) is associated with an increase in 401(k) saving of 6 percent. So, tax policy matters. Second, employer matching is associated with a substantial increase in 401(k) saving, but this result is not robust once job and firm characteristics are taken into account.

The analysis yielded some other interesting findings. Alternative pension coverage (by plans other than a 401(k)) greatly reduces 401(k) saving. This suggests a significant pension-saving offset, in the range found by Gale (1998), among others. In addition, the estimates imply a small Social Security offset to 401(k) saving. Finally, although it is difficult to ascribe causality, the ability of the participant to direct the investment of the voluntary balance in the 401(k) is associated with a substantial increase in 401(k). This is consistent with the prior work of Papke (2002).

The paper is organized as follows. The second section reviews the existing literature. The third section describes the construction of the dataset. The fourth section lays out the econometric framework, the construction of the key variables, and discusses the estimation results. There is a brief conclusion.

EXISTING LITERATURE

Previous studies can be categorized in part by the source of data used. The main sources have been the May, 1988 and April, 1993 pension supplements to the Current Population Survey (CPS). (1) These supplements inquired whether the individual was offered a 401(k)-type pension plan, currently participated, the amount of the contribution, and whether the employer provided matching contributions. In addition, the CPS obtained detailed in formation on income and demographic characteristics, such as marital status, race, age, and number of children, as well as employer characteristics, such as industry, union status, and the number of employees at the firm.

These studies have defined an individual as having "participated" in a 401(k) if the individual contributed during the survey year. Given this definition, participation typically has been modeled as a function of the employer match rate, income, education, tenure, occupation, industry, demographic characteristics, and a dummy for whether the 401(k) is the main pension plan. For example, Andrews (1992) used the May, 1988, CPS. She found that the probability of participating in a 401(k) rose with household income, age, tenure, the existence of an employer match, and if the 401(k) was the sole pension plan. In addition, she found that participants' contributions rose with household income and age, but fell with the existence of an employer match.

Even and Macpherson (1996) used the May, 1988, and April, 1993, CPS surveys and found that the probability of participating rose with household income, education, tenure, the existence of an employer match, and if the 401(k) was the sole pension plan. They also found that participation was higher for whites than nonwhites, other things equal. Employee Benefit Research Institute (1994) also used these surveys, found comparable results, and, similar to Andrews (1992), found that the contribution rate was lower if there was an employer match.

Bassett, Fleming, and Rodrigues (1998) used the April, 1993, CPS and found that participation rose with household income, age, tenure, home ownership, the existence of an employer match, and if the 401(k) was the sole pension plan. They also found that participation was lower for married than non-married individuals, other things equal. In addition, education had a hump-shaped effect on participation: other things equal, those with a high school diploma had a greater likelihood of participating than those with no diploma or those with a college degree.

General Accounting Office (1997) used the 1992 Survey of Consumer Finances to examine the determinants of the 401(k) contribution rate out of earnings. The contribution rate was modeled as a linear function of gender, marital status, race, whether there was other pension coverage, the log of the employer match rate, and whether the plan had premature withdrawal provisions, and a non-linear function of age, education, income, and wealth. The primary finding was that the contribution rate was higher for whites, if covered by another plan, and if able to withdraw the funds. Contributions also rose with income, non--pension, non--Social Security wealth, and the employer match rate. In addition, the contribution rate was hump--shaped in age, with the peak for individuals who were 45 to 54.

Munnell, Sunden, and Taylor (2001) studied the determinants of 401(k) participation and contribution behavior using the 1998 Survey of Consumer Finances (SCF). Their probit estimates indicated that the likelihood of contributing rose with job tenure, planning horizon, income, private net worth, and defined benefit pension wealth, and was hump--shaped in age. In addition, they estimated by ordinary least squares models of the determinants of contributions on the subsample of contributors. They found contributions as a percent of income were 8 percentage points higher for individuals who self-reported being in plans with an employer match, but conditional on having a match, larger match rates lowered contributions.

Papke (2002) used two datasets, the National Longitudinal Survey of Mature Women (NLS--MW) and the HRS, and examined the effect of the ability of participants to direct the investment of their 401(k) account balances on participation. She estimated that those with investment choice were 36 percent more likely to make an annual contribution, made a larger contribution (conditional on contributing), and invested more heavily in equities than those without choice. This resulted in those with choice having larger 401(k) account balances.

While only Joulfaian and Richardson (2001) have used income tax data to study 401(k) participation, a few studies have used administrative data from one or more companies to examine 401(k) participation within a firm. Clark and Schieber (1998) used administrative data on individual employees for 1994 at 19 firms. (2) They modeled the individual's probability of participation as a linear function of the number of employees at the firm, dummy variables for various match rates, dummy variables for the quality of communications about the 401(k) plan to employees, and as a quartic function of age and earnings. Some specifications also controlled for the replacement rate on other pensions offered. They found that participation rose with the match rate. In addition, participation rose with increased communication about the 401(k) plan. Participation also rose with earnings and age, although it declined slightly for workers very close to normal retirement age.

Kusko, Poterba, and Wilcox (1998) used panel data on employees of a single firm and examined the effect of changes in the employer match rate on employee participation and contributions. They found a great deal of persistence in 401(k) contribution behavior. For example, an individual who contributed in one year had a greater than 90 percent probability of having contributed in the subsequent year. In addition, they found little sensitivity of contributions to changes in the employer match rate.

Finally, in a fascinating set of studies, Madrian and Shea (2001) and Choi, Laibson, Madrian, and Metrick (2001a,b) have examined the effect of automatic enrollment and other plan features on 401(k) participation. They used detailed administrative data on 401(k) behavior for a set of firms. They found that automatic enrollment (with the ability to opt out) substantially raises 401(k) participation. However, many participants tend to use the default contribution rates and investment vehicles as focal points, so that in some cases, 401(k) saving can be lower for some individuals than if the plan allowed voluntary enrollment. More broadly, these studies use "behaviorial" theories to explain 401(k) saving phenomena not easily accounted for by traditional saving frameworks.

There are a number of limitations of these previous studies. First, and surprisingly, none have examined the responsiveness of 401(k) saving to taxes. Because tax savings rise with marginal tax rates, and income and marginal tax rates are highly positively correlated, most of the previous estimates of the effect of income on participation are likely upward biased by the omission of taxes from the participation model. Furthermore, even if taxes had been included, many of these studies used only cross-sectional data, with which it is extremely difficult to convincingly disentangle the income from the tax price effects. Joulfaian and Richardson (2001) is an exception in this regard.

Second, most previous studies of 401(k)'s have omitted measures of Social Security and non-401(k) pension coverage because the datasets analyzed lacked sufficient detail on pension characteristics and covered-earnings histories needed to accurately measure these variables. This omission is problematic, for the decision to save for retirement through a 401(k) should be related to a large extent to the amount of wealth already accumulated for retirement in other forms.

Third, there may be significant measurement error on pension plan characteristics from the self-reported data asked in surveys such as the CPS and SCF. Studies that compared self-reported pension characterstics versus those from the employer's Summary Plan Description (SPD), such as Gustman and Steinmeier (1989,1999), Engelhardt (2001), Mitchell (1988), and Starr-McCluer and Sunden (1999), have found substantial evidence of measurement error in self-reported pension data. This has important implications for the simple measurement of 401(k) eligibility. (3)

In addition, because many of the survey questionnaires do not ask pension questions in great detail, individuals quite unintentionally may misreport voluntary contributions to a 401(k). For example, the SCF asks the amount the individual contributed (per time period or as a percent of pay) to a pension plan. (4) However, the SCF does not ask whether these contributions were mandatory, in the sense they were required by the plan as a condition of eligibility, or whether they were truly voluntary. So, analyses based on the self-reported data overstate voluntary participation and contributions. As shown below later, mandatory employee pre-tax contributions to pensions are not infrequent and can be nontrivial in magnitude, so that this is a legitimate concern. Likewise, employer match rates are often constructed from questions about whether the employer contributes to the plan. While these employer contributions could be truly employer matches, they also could be employer contributions for another part of the plan if the pre-tax voluntary component was amended to an existing profit sharing or money-purchase plan. Without detailed questions about matching of voluntary contributions, it is extremely difficult to correctly measure the effect of employer matching on voluntary 401(k) saving.

DATA DESCRIPTION AND SAMPLE CONSTRUCTION

This study addresses a number of the shortcomings in the previous literature by examining the effect of federal tax policy employer matching, Social Security and non-401 (k) pensions on 401(k) saving behavior using a rich dataset constructed from the Health and Retirement Study (HRS). This dataset is designed to circumvent many of the worst measurement issues that have plagued previous studies.

Specifically, the household-level data used in the empirical analysis below were drawn from wave 1 of the HRS. The HRS surveyed individuals born between 1931-41 and their spouses (regardless of birth year). In addition to information on demographics, income, wealth, health, and housing, it has detailed data on pensions and job histories. These data come from two sources. First, individuals working at the time of the interview (1992) were asked detailed questions about their current job, including industry, occupation, starting pay, current pay, union coverage, self-employment, and pension coverage? Specifically, the pension sequence started with a question about whether the individual was covered by a pension or tax-deferred saving plan through the job or union. Those that answered affirmatively were then led through a sequence of questions about as many as three plans. For those individuals not working at the time of the interview, a similar sequence of job and pension questions was asked about the last job. (6) In addition, for all individuals, regardless of whether working at the time of the interview, questions about pension coverage were asked for as many as three past jobs that lasted five years or more. (7) Second, and importantly, for all jobs for which the individual indicated pension coverage, the HRS contacted those firms to obtain summary…