Statement of the
Investment Company Institute

On Savings and Investment Provisions in the
Administration's Fiscal Year 1998 Budget Proposal

April 2, 1997

Summary Points

Our recommendation: make the IRA available as broadly as possible; keep it simple; make it permanent.

Statement of the
Investment Company Institute

On Savings and Investment Provisions in the
Administration's Fiscal Year 1998 Budget Proposal

Submitted to the
Committee on Ways and Means
U.S. House of Representatives

April 2, 1997

A. Introduction
The Investment Company Institute ("Institute"),¹ the national association of the American investment company industry, appreciates this opportunity to present its views on the Administration's proposal to expand IRAs. We commend the Committee for holding hearings on a topic so vital to our economy and the retirement security of millions of Americans.

The U.S. mutual fund industry serves the needs of American households saving for their retirement and other long-term financial goals. By permitting millions of individuals to pool their savings in a diversified fund that is professionally managed, mutual funds provide an important financial management role for middle-income families. An estimated 37 million households, representing 37 percent of all U.S. households, owned mutual funds in 1996.² Mutual funds serve as the investment medium for retirement programs, including IRAs and employer defined contribution plans (the largest type being 401(k) plans). As of December 31, 1995, mutual funds held over $1 trillion in retirement plan assets, about 19 percent of the retirement market's total assets of $5.21 trillion. The remaining 81 percent is managed by such institutions as corporations, pension firms, insurance companies, banks and brokerage firms Of the retirement plan assets held by mutual funds, about half are IRA investments.³

The Institute has a long history of supporting legislative efforts to enhance individual retirement saving. For instance, we supported the establishment of the universal deductible IRA, as well as legislation creating the SEP, SARSEP and SIMPLE IRAs. We strongly opposed the 1986 Tax Act's restrictions on IRA eligibility. Moreover, we continue to support efforts, such as the Administration's 1998 Budget proposal involving IRAs and legislation introduced by Congressmen Thomas and Neal, H.R. 446, that would substantially expand IRA eligibility and simplify the tax rules associated with IRAs. Such legislation is both necessary and appropriate, because-

First, Americans are not preparing adequately for retirement and need more opportunities to do so;

Second, simple, universally-available IRAs will work to increase retirement saving; and

Third, such IRAs will generate new additional saving that would not be made absent such legislation.

B. America Is Not Preparing Adequately for Retirement
Stanford University Professor Douglas Bernheim found that members of the Baby Boom generation are saving at only about one-third the rate they need to maintain their pre-retirement living standards in retirement.⁴ Along that same vein, an Institute study of the "baby boom" generation similarly found that more than 6 out of every 10 "boomers" state that they are not saving for retirement even though more than half expressed concern about the inability to meet their financial needs after retirement.⁵

USA Today, on March 26, 1997, reported that 78% of retirees wish they had financially planned better for retirement; 42% of retirees wished they have saved more in retirement plans, while 37% wished they had opened IRAs or contributed to employer salary reduction plans.

C. A Simple, Universal IRA Effectively Increases Personal Retirement Saving
Our long time national experience with the IRA teaches that saving incentives work best if the rules are simple and consistent. In order for the IRA to be useful to Americans, it must be universally accessible, easy for the average American to understand, and easy to administer.

When Congress introduced universal deductions for IRAs in 1982, Americans took advantage of the opportunity. IRA contributions rose from less than $4 billion in 1980 to approximately $38 billion in both 1985 and 1986. At the IRA's peak in 1986, about 29% of all families with a head of household under age 65 had IRA accounts. Contrary to what IRA critics said at the time, these IRA contributions were not mainly "wealthy" families using IRAs as "tax shelters." In 1986, 75% of all IRA contributions were from families with annual incomes less than $50,000.⁶ Moreover, the median income of those making IRA contributions (expressed in 1984 dollars) dropped by 24 percent, i.e., from over $41,000 in 1982 to below $29,000 in 1986.⁷ The program was, indeed, effective and was being used by middle-class Americans and encouraging them to save for retirement.

When Congress restricted the deductibility of IRA contributions in the Tax Reform Act of 1986, the level of IRA contributions fell sharply and has never recovered. In 1986, IRA contributions totaled $38 billion; they were $15 billion in 1987, but only $8.4 billion by 1995.⁸ While it is true that as a result of the 1986 restrictions, many families are no longer able to deduct their IRA contributions, they still may take advantage of the tax deferral for earnings on non-deductible IRA contributions. This incentive, however, has proved extremely complicated and insufficient to induce continued participation in the IRA program. The 1986 changes introduced a level of complexity in an otherwise simple program that proved overwhelmingly oppressive to its success as a savings incentive program. Even among families not affected by the 1986 Act and who retained eligibility for fully deductible IRA contributions, IRA participation declined on average by 40% between 1986 and 1987, despite the fact that the change in law did not affect them.⁹

The lessons of the past are clear.

First, deductibility matters to people. Although non-deductible IRAs are available to all working Americans, without the deductibility feature, there are insufficient incentives to save. A front-end tax incentive gives households an immediate incentive to save. It is our view that this immediate incentive is a powerful alternative to the usual preference for current consumption of income.¹⁰

Second, confusing rules undermine even the powerful incentive of deductibility. When the tax rules are not simple, individuals are confused as to their eligibility. The post-1986 IRA with multiple limits, set offs, exceptions, exclusions and other technicalities cannot be understood by most Americans. American Century Investments recently surveyed 534 "savers" with respect to the rules governing IRAs. The survey found that "changes in eligibility, contribution levels and tax deductibility have left a majority of retirement investors confused."¹¹ It is no wonder: today, IRS Publication 590, which deals solely with taxpayer use of IRAs, contains 70 (seventy) pages of explanations, examples, and worksheets on the subject. Simply put, individuals stop investing and financial institutions cease marketing activity when the product cannot be readily understood and easily explained.¹²

Experience clearly demonstrates that Americans respond enthusiastically to appropriately designed tax incentives aimed at increasing retirement savings. For example, last year Congress enacted legislation creating the SIMPLE, a simplified retirement plan for small businesses that (because of the administrative burden) could not offer a pension program for their workers. The Institute's members report immediate, strong employer interest in the SIMPLE. One member in particular reports that it has sold over 1,000 SIMPLE-IRA plans to small employers since the program's inception on January 1, 1997. The reasons for such a high response rate are clear. First, the SIMPLE offers significant tax incentives. Second, the program's rules are indeed "simple," easy to understand and easy to communicate. Prior to 1986, the universal IRA had similar success and for precisely these same reasons.

D. IRAs Create New Retirement Saving
A great deal of research has been done on the effectiveness of IRAs as incentives for increased personal saving. Many studies have focused on whether the IRA tax incentive produces new saving or merely reshuffles existing saving from taxable to tax-favored accounts. Put differently, the issue is whether IRAs serve merely as a windfall to higher income taxpayers.

In study after study of this issue, economists have concluded that a substantial portion of IRA contributions in fact constitute new saving that otherwise would not have occurred. For example, extensive analyses of IRA contributors during the 1982-86 period were performed by Professors Steven Venti of Dartmouth and David Wise of Harvard. They estimate that 66% of the increase in IRA contributions come from current consumption, 31% from the tax subsidy and only 3% from reshuffled assets (emphasis added).¹³ Similar conclusions-that a substantial majority of IRA contributions represent new savings-has been reached in separate papers by Professor Hubbard of Columbia, Professor Skinner of the University of Virginia and Professor Thaler of University of Chicago.¹⁴ The IRA has resulted in additional saving in both tax-favored IRA accounts and non-tax-favored accounts. This is the kind of long-term saving that is essential to capital formation and economic growth.

E. Conclusion
Today's targeted individual retirement vehicles help millions of Americans secure their future retirement through long-term investment. By simplifying the IRA eligibility rules, making deductible IRAs available to as many Americans as possible and expanding IRA options, Congress can empower millions more Americans to save for their own long-term financial security.

Our recommendation: Make the IRA available as broadly as possible; keep it simple; make it permanent.

¹ The Institute's membership includes 6,266 open-end investment companies ("mutual funds") with assets of about $3.627 trillion, approximately 95% of total industry assets, and over 59 million individual shareholders.

² See Brian Reid, "Mutual Fund Developments in 1996," Perspective, Vol. 3, No. 1 (Investment Company Institute March 1997).

³ 1996 Mutual Fund Fact Book, Investment Company Institute.

⁴ Bernheim, B. Douglas, "The Merrill Lunch Baby Boom Retirement Index" (July 14, 1994).

⁵ "The Baby Boom Generation, A Financial Portrait," Investment Company Institute (Spring 1991).

⁶ Venti, Steven F., "Promoting Savings for Retirement Security," Testimony prepared for the Senate Finance Subcommittee on Deficits, Debt Management and Long-Term Growth (December 7, 1994).

⁷ Hubbard, R. Glenn and Skinner, Jonathan, "The Effectiveness of Savings Incentives: A Review of the Evidence" (January 19, 1995).

⁸ Internal Revenue Service, Statistics of Income.

⁹ Venti, supra at note 7.

¹⁰ Hubbard and Skinner, supra at note 8.

¹¹ American Century Investments asked survey participants, who were self-described "savers," ten general questions regarding IRAs. One-half of them did not understand the current income limitation rules or the interplay of other retirement vehicles with IRA eligibility. "American Century Discovers IRA Confusion," Investor Business Daily (March 17, 1997). Similarly, even expansive changes in IRA eligibility rules, when approached in piecemeal fashion, require a threshold public education effort and often generate confusion. See, e.g., Crenshaw, Albert B., "A Taxing Set of New Rules Covers IRA Contributions," The Washington Post (March 16, 1997) (describing 1996 legislation enabling non-working spouses to contribute $2,000 to an IRA beginning in tax year 1997).

¹² For this reason, the Institute opposes the addition of any offset of IRA contributions against those of a 401(k) plan. Such a rule would add unnecessary complication to the IRA, confuse the public, place additional burdens on 401(k) plan sponsors, and create disincentives to save.

¹³ Venti, Steven F. and Wise, David A. "The Evidence on IRAs," 38 Tax Notes 411 (January 1988).

¹⁴ Skinner, Jonathan, "Individual Retirement Accounts: A Review of the Evidence," 54 Tax Notes 201 (January 1992); Hubbard, R. Glenn and Skinner, Jonathan, "The Effectiveness of Savings Incentives: A Review of the Evidence" (January 19, 1995); and Thaler, Richard H., "Self-Control, Psychology, and Savings Policy, " Testimony before the Senate Finance Subcommittee on Deficits, Debt Management, and Long-Term Growth (December 7, 1994).