Obama's retirement cap might sound good but it has an annuity problem

When interest rates rise, the $3.4 million ceiling proposed could drop, trapping more people in a tax net

Feb 2, 2015 @ 2:21 pm

By Bloomberg News

The White House released its 2016 budget Monday, and among other initiatives aimed at raising tax revenue from the richest of the rich, the Obama administration is proposing a cap on how much money a person can have in all of her retirement accounts combined. It suggests a ceiling of more than $3 million per person.

The vast majority of Americans will only ever dream of such a well-padded retirement. Even most of the rich wouldn't hit Mr. Obama's cap. In 2011, only one out of every 1,000 Americans had more than $3 million in their retirement accounts, according to the Employee Benefit Research Institute. But it's not clear how that number will change in the future.

(More: Which Roth conversions are now penalty-free?)

The administration says it wants to "prevent additional tax-preferred saving by individuals who have already accumulated tax-preferred retirement savings sufficient to finance an annual income of over $200,000 per year in retirement — more than $3 million per person."

In other words, it reverse-engineered the cap, figuring out how much it would cost to buy an annuity that generates more than $200,000 in annual income. That's great — today.

Annuity prices vary with interest rates because insurance companies buy bonds to finance payouts. When bond yields are low, as they are now, annuities are more expensive. Right now a 10-year Treasury bond yield is just 2%. If it jumps to 5% (the rate in 2006), that $205,000 annual annuity would only cost $2.2 million.

Now it's not clear whether the cap will actually vary with interest rates. If it did, and rates did jump to 5%, the proportion of retirees affected would grow from 1 in 1,000 to 30 in 1,000, EBRI estimates. In that scenario, those people would suddenly have to pay taxes on their retirement accounts. If rates went down again, they could contribute more and avoid taxes. That makes retirement planning and the tax code even more complicated than it already is, and opens the door to more loopholes and tax dodges.

(More: 'Longevity' in annuities could be the big 2015 focus)

Keeping the cap at $3.4 million, or indexed to inflation, may seem more reasonable. But then the cap is arbitrary and hardly has any impact. There's already a limit on how much people can contribute to these accounts each year ($53,000 for a 401(k), including employer match; $5,500 for an IRA if you are not self-employed and under 50). These limits make it nearly impossible to have tens of millions of dollars in retirement accounts anyway.

The cap will initially impact only a rarefied population. But that population will grow as more people reach retirement with career-old 401(k) plans (defined-contribution pension plans did not really catch on until the mid-1990s) and rates rise. There are better ways to reform the tax code and collect revenue from the wealthy. A cap based on current, historically low interest rates merely adds more complication and little benefit.

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