New Study Examines Tradeoffs of Retirement Savings Plan Strategies

November 26, 2012

The United States spends more than $100 billion per year on tax subsidies for retirement savings accounts such as 401(k)s and IRAs. Yet policymakers wrestle with the question of whether or not these subsidies encourage families to save more, or simply induce them to shift money they would have saved anyway into tax-advantaged retirement accounts with no net increase in savings?

While many studies have investigated this question, the answers remain uncertain because of inadequate data in the U.S. A new research report co-authored by Harvard Kennedy School Assistant Professor John Friedman utilizes data from Denmark for fresh evidence on savings behavior as affected by tax breaks and nudges. The graphs below provide a visual representation of the findings.

When individuals in the top income tax bracket received a larger tax subsidy for retirement savings, they started saving more in retirement accounts...

... but the same individuals reduced the amount they were saving outside retirement accounts by almost exactly the same amount, leaving total savings essentially unchanged. The researchers estimate each that $1 of government expenditure on the subsidy raised total savings by 1 cent.

If subsidies have little impact on retirement saving, are other policies more effective? The authors find that "nudges" such as automatic contributions by employers have much larger effects on savings. When individuals switch to firms with higher automatic employer pension contributions, their savings rates increase significantly. Most individuals are passive savers who do not pay attention to employer pension contributions and thus do not offset such contributions by saving less in other accounts.

The study is co-authored by Raj Chetty, Harvard University; John N. Friedman, Harvard Kennedy School; Soren Leth-Petersen, University of Copenhagen; Torben Heien Nielsen, The Danish National Centre for Social Research; and Tore Olsen, University of Copenhagen.

Photograph of Assistant Professor John Friedman

John Friedman, assistant professor of public policy
Photo Credit: Michael O'Bryon

These findings call into question whether tax subsidies are the most effective policy to increase retirement savings. Automatic enrollment or default policies that nudge individuals to save more could have larger impacts at lower fiscal cost.

 


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