Accounting and Personal Saving
By Annamaria Lusardi, Jonathan Skinner, and Steven Venti
According to the U.S. Department of Commerce, the personal saving rate in the United States has declined dramatically, from 10.6% of disposable personal income in 1984 to a low of 2.3% in 2001, before climbing to 3.9% in 2002. Debate rages over the reasons for this decline, as calculated by the National Income and Product Accounts (NIPA), as well as its usefulness as an indicator of saving. Many observers question the influence of stock market wealth on conventionally measured personal saving rates, and note three major ways in which the stock market and saving may be linked.
First, NIPA saving measures fail to account for capital gains. Therefore, when households spend newly gained housing or stock market wealth, their NIPA consumption increases but their income does not. Because saving is the difference between income and consumption, saving automatically declines as consumption rises. Recent studies have attempted to quantify the behavioral link between household consumption changes and stock market gains, with estimates ranging from two cents per dollar of wealth to 10 cents or more.
The second link involves capital gains taxation. When individuals sell appreciated stock, they must pay capital gains taxes. The realized gains do not affect NIPA income, but the taxes paid reduce disposable income. Even under the extreme assumption that individuals do not increase their consumption when they realize capital gains, NIPA saving would still decline because the increased taxes reduce disposable income. In the April 2002 Survey of Current Business, Maria Perozek and Marshall Reinsdorf wrote that capital gains taxes, as a fraction of disposable income, are estimated to have doubled between 1988 and 2000, rising from 0.8% to 1.7% in 2000.
The third link involves the treatment of pension plans in the NIPA. Dramatic swings in asset markets have perverse effects on the personal saving rate. Indeed, according to the official NIPA accounting rules, the entire retirement saving sector contributed nothing to measured personal saving between 1996 and 2000.
This analysis covers the years 1988 to 2000, during which time the stock market was booming and personal saving rates dropped. While these conditions reversed with the onset of the bear market in 2000, understanding the experience of the 1990s offers key insights into what is happening today.
Trends in Pension Contributions
The principal sources of private retirement saving in the United States are defined contribution and defined benefit pension plans sponsored by employers, and personal saving arrangements such as IRAs. Assets in pension plans and IRAs have grown considerably over the past two decades. Between 1975 and 2000, the ratio of retirement assets to disposable income increased more than fourfold. Although assets in both defined contribution and defined benefit plans have grown enormously, annual contributions to each plan type have taken different paths.
Over the past two decades, contributions to defined contribution plans have risen dramatically, with most of the growth in 401(k) plans, which expanded rapidly after 1982. These plans have grown because employees appreciate their greater flexibility and portability; also, employers usually find 401(k)s less costly to administer than defined benefit plans, and they can shift the investment risk to employees. Similar to defined contribution plans, IRAs also grew quickly following a legislative change in 1981, but were curtailed significantly by the Tax Reform Act of 1986.
Contributions to defined benefit plans, on the other hand, have leveled off since the mid-1980s. Contributions have been flat because the share of workers covered by these plans has dropped and because federal policies have effectively linked defined benefit contributions to asset market performance. In 1974, the Employee Retirement Income Security Act (ERISA) set minimum and maximum funding requirements for defined benefit pensions. When stock and bond prices increase, many firms respond by cutting back on pension contributions. In 1987, the Omnibus Budget Reconciliation Act redefined full funding and limited pension assets to no more than 150% of the legal liability (the balance firms must hold to pay future benefits). Funds up against this ceiling could no longer make tax-deductible contributions to their pension plans. In addition, increases in “reversion taxes” (i.e., taxes on any assets that remain after a plan is terminated) further discouraged contributions.
Overall, the size of the retirement saving sector doubled between 1994 and 2000, largely because of massive increases in stock prices inside these accounts. By 2000, private and public pension plans held $9.1 trillion of assets, while IRAs held another $2.6 trillion.
Pensions and NIPA Saving
A booming asset market means that, by NIPA conventions, resources flowing into the retirement sector will lag resources flowing out of the sector. To see this, it is important to understand exactly how pension funding and distributions are treated in the NIPA personal saving measure.
First, employer-sponsored pension funds are classified as the property of the individual employees. Therefore, both employee and employer contributions to defined contribution and defined benefit plans are counted as personal income during the employees’ worklives when the contributions are made. Interest and dividend earnings on these contributions are also included in employees’ NIPA income in the year in which they occur.
Second, when employees retire and begin receiving distributions from a defined benefit or defined contribution plan or an IRA, the distributions do not show up as personal income, because they were already counted as income during the employees’ worklives (again, with the exception of capital gains, which are never counted as NIPA income). Of course, the consumption that the pension-related distributions allow does show up as NIPA consumption. This treatment makes sense from the perspective of an individual: Over the first part of the life cycle a worker diverts some income to saving, and in later years receives and consumes retiree benefits.
But funny things happen when this NIPA convention is applied to the group of postwar workers who were most likely to hold defined benefit pension plans. In a fully funded system, the rate of growth of contributions will be less than the rate of growth of benefits because a large share of benefits will be paid out of the fund’s capital gains. This fact alone will drag down the NIPA saving rate. If asset prices are booming, pension plans can pay benefits entirely from sales of appreciated assets and remain fully funded. This situation is exacerbated by the host of legal and regulatory restrictions that further depress contributions.
Moreover, the benefits paid by the pension sector raise consumption without increasing income, and also trigger a tax liability that lowers NIPA income because at least a portion of pension benefits is included in an individual’s taxable income. Note that the tax liability and the associated income are separated in time, because the original pension contribution counted as NIPA income but was not subject to tax at the time it was made. This is consistent with the tax treatment of traditional IRAs. Roth IRAs are different, however; they are taxed when the contributions are made, not when distributions occur.
How serious a drag on NIPA saving might the treatment of pension plans be? Assume that all benefits paid are consumed. Then in each year the contribution of the pension sector to NIPA saving is as follows:
Saving = Contributions + Interest and Dividend Earnings – Benefits paid
Since the mid-1980s, benefit payments from defined benefit plans have exceeded contributions. In 1998, the most recent year for which data are available, employers contributed about $35 billion to defined benefit plans, but disbursed about $111 billion of benefits. Moreover, interest and dividend earnings in 1998 amounted to only $26 billion. More generally, defined benefit plans (and, to a lesser extent, IRAs) had distributions well in excess of income components throughout the 1990s. Despite this outflow, the value of defined benefit plan assets rose rapidly during this period due to the booming stock market. Among defined contribution plans, many of which are recently established 401(k) programs, contributions have always outpaced distributions. Thus, unlike defined benefit plans, defined contribution plans have contributed positively to NIPA saving.
To see how these trends affect the measured saving rate, Exhibit 1 shows the net contribution to NIPA saving for defined benefit plans, defined contribution plans, and IRAs during 1988–2000. This net contribution is simply the difference between NIPA income components (contributions plus investment earnings) and NIPA consumption (equal to benefits, assuming they are fully consumed). Defined benefit plans reduced NIPA saving in all years since 1988, and the amounts were increasingly large through 2000. For example, NIPA saving was lower by $60.7 billion in 2000 due to defined benefit plans. In contrast, the impact of defined contribution plans on NIPA saving was large and positive in all years. In 2000, they generated positive savings of $58.4 billion. The net contribution of IRAs has been negative since 1994. By 2000, outflows from IRAs exceeded inflows by $35.7 billion.
Exhibit 2 shows what the NIPA saving rate would have been without transactions involving defined benefit plans, defined contribution plans, and IRAs. Of the 5% drop in the NIPA saving rate between 1988 and 2000 (from 7.8% to 2.8%), fully 2.1%—nearly half of the drop—is explained by the accounting of pension plan inflows and outflows. Put another way, between about 1996—when the two lines in Exhibit 2 cross—and 2000, retirement saving accounts contributed nothing to NIPA saving.
Trend or Methodology?
Stock market wealth has had a direct effect on consumption. But stock market wealth is not the only thing that has dragged saving rates down to low levels. The treatment of pension plan contributions and benefits has also played a large role, accounting for over 40% of the total decline in the personal saving rate from 1988 through the turn of the century. The current economic downturn and stock market implosion, however, suggest that a reversal of the pattern of the 1990s may now occur, meaning that personal saving will begin rising. While it’s too early to be certain, the evidence is consistent: Personal saving rebounded somewhat last year, to 3.9% of disposable income (up from 2.8% in 2000).
Changes in personal saving rates may tell us less about the thriftiness of American families and more about the rules of national income accounts.
This article was originally published by the Center for Retirement Research at Boston College in April 2003 as part of its “Just the Facts on Retirement Issues” series. Reprinted with permission.
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