Another Nobel Laureate in Economics Who Was Focused on 401(k) Plans - Part 2 of 3

In October, our blog focused on Richard Thaler, the 2017 Nobel prize winner in Economics and recounted how his insights into the world of behavioral economics impacted 401(k) plans and the retirement savings industry (https://www.psca.org/blog_jack_2017_10 ). But, did you know there were two other Nobel prize winners in Economics whose work has also focused on 401(k) plans and saving for retirement? First up, Franco Modigliani, the 1985 winner of the Alfred Nobel Memorial Prize in Economic Sciences for his pioneering analyses of saving, and specifically his life-cycle hypothesis of household saving.   

One of the cornerstones of the British economist John Maynard Keynes' general theory, presented in 1936, is the relationship between consumption and national income. According to Keynes, it is a "psychological law" that "households increase their consumption as their income increases, but not as much as their income increases."  So, according to Keynes, the proportion of national income allocated to savings increases during periods of economic growth. However, Keynes' theory of saving was not born out by empirical facts – in the United States, long term saving has not increased commensurate with economic growth. Modigliani and his student, Richard Brumberg, assumed that households strive to maximize their utility of future consumption. Modigliani and Brumberg’s model is a micro-economic study of savings behavior. Since consumption is distributed over a lifetime, they argued that workers naturally build up a stock of wealth while active that would be consumed during old age. Sounds like a 401(k) plan to me.  

A famous twist (famous only for benefit weenies like me) was that almost 25 years ago, Professor Modigliani patented a method for issuing 401(k) credit cards with the aim of increasing liquidity from 401(k) plans (https://www.google.com/patents/US5206803 ). He believed workers should be able to utilize retirement savings without triggering leakage – confirming the dual-purpose nature of 401(k) plans that  can be used to meet current consumption needs, and when loans are repaid, can rebuild the account for future needs. Monies would be available up to and throughout retirement.  

This author believes 21st Century liquidity provisions are essential if your goal is to encourage retirement preparation/savings by those working Americans who live paycheck to paycheck. (See our articles on  loans and liquidity https://www.psca.org/embracing-liquidity-in-your-savings-plan) and our prior blog https://www.psca.org/blog_jack_2017_15 )

Why access funds using a loan from your own 401(k) plan account?

• Allows you to save more on a tax preferred basis than you might otherwise be willing to earmark for retirement,
• Provides access to monies not available anywhere else (employer match, deferred federal and state income taxes),  
• Uses modest interest rates (this is a secured loan, after all), 
• The interest you pay is almost always credited to your own account,  
• The interest you pay may be tax-deductible (for home loans), and, that same interest payment may be tax free when you receive it at/after retirement (if secured with Roth assets), 
• Plan loans enable workers to avoid high cost debt transactions such as payday loans, cash advances on credit cards, pawn shops, etc., 
• A focus on accumulating assets in a flexible, almost unrestricted savings account, is an effective financial wellness solution for unexpected interruptions in income and/or unexpected expenses, and  
• Greater access may enable the plan sponsor to improve retirement preparation by minimizing leakage – by eliminating hardship withdrawals and post-separation payments prior to retirement.    

Many ordinary Americans value the access plan loans offer.  In a survey, most define financial wellness and security as having “enough money to pay the bills, a little left over for small extras or savings, and few worries about making ends meet” (http://www.pewtrusts.org/~/media/assets/2015/02/fsm-poll-results-issue-b...).  While only half of the those surveyed by Pew claim to be financially secure, more than half said that they break even or spend more than they make each month and that their income or expenses also fluctuate, making it difficult to plan and save.  A full third of surveyed workers reported having no savings.

So, consolidating/aggregating monies in your 401(k) plan coupled with savvy, 21st Century liquidity capability has been shown to increase participation, increase savings rates and reduce the likelihood of leakage - but only when people save.  

And, oftentimes, people save only when they know that they have tax-favored access prior to retirement. 

Thank you Professor Modigliani.