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One of the most important and controversial aspects of the pension system is its effect on private saving, wealth accumulation, and retirement preparedness . Although traditional pensions and other tax-deferred vehicles, like 401(k) plans and individual retirement accounts (IRAs), clearly make up a sizable share of households’ wealth in the pre-retirement years and during retirement , it is less clear how much of that wealth represents incremental balances that would not have existed in some other form in the absence of pensions. The saving incentive programs mentioned above raise private saving to the extent that households finance their own contributions with reductions in consumption or increases in labor supply; that is, to the extent that households choose to reduce their current living standards. To the extent that households finance their own contributions by shifting into the account existing assets or current-period savings that would have been set aside even in the absence of the incentive, or by increasing their debt, saving incentives do not raise private saving . Likewise, there is no increase in private saving to the extent that households respond to employer-provided pensions or contributions with reductions in their other saving or increases in their borrowing. 103 The Effect of Pensions and 401(k) Plans on Household Saving and Wealth william g. gale 5 I thank Eric Engen, Peter Orszag, John Karl Scholz, Timothy Taylor, and Mark Warshawsky for helpful comments, and the National Institute on Aging for research support. 05-3117-5 chap5.qxd 11/16/05 2:59 PM Page 103 Although a number of prominent economic theories have implications for the effects, if any, of pensions and tax-deferred saving on wealth accumulation, and how these analyses should be modeled, ultimately the question is empirical in nature. Moreover, it has taken on added importance in recent years, for at least two reasons. First, with individuals living longer and retirement ages not rising very fast, many or most people now face the prospect of a lengthy retirement period, for which they will need to find sources of income. But with projected financial shortfalls in Social Security and Medicare suggesting the possibility of significant benefit cuts, the financial status of the elderly in the future will depend heavily on private saving for retirement. Second, federal subsidies for new pensions cost almost $100 billion per year, or almost 1 percent of GDP. Subsidies of this magnitude deserve careful scrutiny. This paper addresses two key questions about the effects of pensions on saving . First, to what extent do traditional pensions and defined contribution plans raise aggregate wealth? The earliest research on both traditional defined benefit pensions and defined contribution or 401(k) plans appeared to demonstrate very strong effects on private wealth and saving. These efforts, however, were marred by a series of econometric and statistical problems. More recent research using improved econometric and statistical methods has found significantly smaller effects of tax-preferred saving vehicles on private saving and wealth, and in some cases no net effects at all. The second question is the target-effectiveness of pensions. That is, to what extent do the net tax benefits of pensions accrue to those who need to save more for retirement (or would need to save more in the absence of pensions), and to what extent are the increases in wealth caused by pensions accruing to those households? These issues receive far less attention than the overall impact of pensions on aggregate saving, but arguably are at least as important. Increasing the level of saving in the economy can have positive long-term growth effects, but for retirement income policy, who receives the benefits of pensions and whose saving actually rises is a central concern. If it were known, for example, that pensions and 401(k)s raised the wealth of the Forbes 400 (the richest members of society) but not anyone else, it would be hard to claim that broad retirement policy goals were being met. Although the example just given is extreme, it is nonetheless the case that pension benefits are skewed toward more affluent households. Evidence shows that these households would be more likely to be saving adequately for retirement even without pensions, and that they disproportionately use pensions as a tax shelter—that is, to divert other savings—rather than to raise their overall level of saving. In sharp contrast, pension benefits are meager among lower- and middle-income households. More often, these households are not saving adequately for retirement; when they do...

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