How the Obama Administration’s New Rule to Create State-Based Retirement Savings Could Hurt Savers and Cost Taxpayers

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How the Obama Administration’s New Rule to Create State-Based Retirement Savings Could Hurt Savers and Cost Taxpayers

November 17, 2016 14 min read Download Report
Rachel Greszler
Senior Research Fellow, Roe Institute
Rachel researches and analyzes taxes, Social Security, disability insurance, and pensions to promote economic growth.

Private-sector workers, beware: Your personal retirement savings could become subject to your state government’s control. A new rule from the Department of Labor (DOL) may have created the equivalent of Obamacare for retirement savings—that is, if you like your current 401(k), you may not be able to keep it.[1] Moreover, the rule would allow state governments to trap individuals’ savings in accounts that individuals cannot access or control.

Traditionally, employers who offer retirement plans are subject to various rules and requirements as specified in the Employee Retirement Income Security Act of 1974 (ERISA) and the tax code. ERISA was enacted, in large part, as a response to massive losses of promised pension benefits for thousands of workers when the Studebaker Auto Corporation closed its doors in 1963. ERISA establishes minimum standards and requirements for private employers’ retirement and welfare plans, with the goal of ensuring that workers’ pensions are funded with actual assets and not just empty promises.

The Obama Administration’s new rule would specifically exclude state-based retirement plans from ERISA’s rules and regulations, essentially opening workers up to the very same circumstances that allowed Studebaker to promise far more to its workers than it could afford to pay them. Moreover, the rule allows an ERISA exemption only if the state mandates that most employers who do not offer a plan participate in the state-based plan. This would give government-run plans a significant advantage over private employer plans and could ultimately shift most employees into such plans.

State-facilitated retirement savings plans could be a helpful means of increasing retirement savings, but they become highly problematic—even detrimental—when those plans:

  1. Hold a competitive advantage—through their exemption from federal regulations—over private-sector plans;
  2. Mandate that employers offer a retirement plan;
  3. Prohibit employers from contributing to employees’ accounts;
  4. Strip savers of federal protections that exist to safeguard their retirement security;
  5. Eliminate workers’ rights to access or control their money; and
  6. Consist of the very same types of state-run defined benefit plans that have short-changed workers and taxpayers by promising far more in benefits than they can afford to pay.

State-Based Plans Will Undercut Private Employment Plans: If You Like Your 401(k), You May Not Be Able to Keep It

Under new state-based retirement plans, many employees who like their employment-based 401(k) may not be able to keep it.[2] That is because private-sector retirement plans will be hard-pressed to compete with government-run plans that do not have to follow either ERISA or, presumably, many of the Internal Revenue Service’s (IRS) rules for qualified plans, and that can pass all costs and risks on to taxpayers.[3] This considerable disadvantage could substantially reduce private-sector employment plans among new businesses and will almost certainly cause a significant portion of employers that offer retirement plans to forgo them in lieu of the cheaper and no-risk state-based plan.

New employers typically have to wait a while until they are well-enough established to set up a retirement savings plan. They need both sufficient funds and the resources necessary to comply with federal regulations such as ERISA and the tax code. Most state-based plans require employers with as few as five employees to offer a plan, but employers often have five employees long before they are well-enough established to set up a plan of their own.[4] Even if employers have the means to establish their own plan, they will likely choose the lower-cost state-subsidized option (which is subsidized through regulatory favoritism that absolves them of any liability and by state payment of administrative and investment adviser costs).

Unlike Obamacare, which uses a “tax” to try to prevent employers from dumping their employees into the government-run exchanges, this new rule would directly encourage employers to dump their employees into state-run retirement savings plans, shifting costs and risks from employers to employees and taxpayers.

The favorable treatment of state-based retirement plans could cause a large proportion of retirement savings in private company securities to come under government control, resulting in the politicization of investment decisions and effective government control of the private sector.

Rule Requires Employer Mandate for State-Based Plans

In order to qualify for an exemption from ERISA’s rules and regulations, state-based retirement plans must include a mandate on employers to offer a retirement plan.[5] If they do not have their own private plan or do not want to start their own, they must participate in the state-based plan. The employer-mandate requirement prohibits some of the most beneficial state-based retirement plans from taking effect. Indiana, for example, has proposed the creation of a state-based Hoosier Employee Retirement Option (HERO). The HERO plan would set up portable Roth IRAs on a completely optional basis—any employees or employers could participate, but they would not be required to do so.[6] Under the DOL’s final rule, however, Indiana cannot follow through with its proposal unless it replaces the voluntary nature of its program with an employer mandate.

Employer mandates are costly. They force employers to do something they may not otherwise do on their own, costing them both time and money. Even if states choose to pay for some or all of their plan’s administrative costs with taxpayer dollars, employers will face significant compliance costs. For example, the mandate will require that employers either pay for a payroll deduction service (which half of small businesses currently do not do) or administer the deductions using their own employee resources.[7] These costs could cause employers to reduce compensation or employment.

Furthermore, while automatic enrollment has been shown to increase savings, the choice to automatically enroll an employee into a retirement savings plan should be left to employers who choose to offer a plan. Automatically enrolling an employee into a company’s plan—often including a company match—is entirely different than allowing state governments to require companies to automatically enroll employees into a plan from which the employer is legally detached. This could create significant costs and liabilities for employers as auto-enrollment will likely lead to disputes—even lawsuits—by some employees who argue that they were automatically enrolled without sufficient information or opportunity to decline enrollment.

Employer Prohibition on Contributions Would Limit Savings

Employer contributions make up a significant portion of workers’ retirement savings. According to data on private-sector compensation costs from the Bureau of Labor Statistics, employers contribute an average of $2,642 to workers’ retirement accounts annually.[8] Yet, the DOL’s rule would prohibit employers from contributing to state-based plans.[9] This prohibition is necessary to ensure the plans a “safe harbor” exemption from ERISA because employer involvement in the plan would trigger ERISA coverage, but without employer contributions, many workers would end up with significantly lower retirement savings.

Employers who shift employees into state-based plans and therefore have to end their existing contributions to employees’ retirement plans are likely to shift those lost contributions towards other forms of compensation such as cash wages. However, many employees will not increase their own savings enough to make up for their lost employer contributions. Moreover, because employer contributions are not included in the annual $18,000 limit on tax-free savings, employees who are shifted into state-based plans will face a lower overall limit on tax-free retirement savings. The combination of employers shifting from tax-free to taxable compensation and the lower cap on tax-free retirement savings could result in higher income taxes for affected workers.[10]

State-Based Plans Lack Important Participant Protections

ERISA was established for a reason: to protect workers’ retirement savings. According to the DOL, ERISA exists to ensure plans are “established and maintained in a fair and financially sound manner” and that “employers have an obligation to provide promised benefits.”[11] Moreover, it applies fiduciary responsibilities on plan administrators, requiring them to manage retirement plans for the exclusive benefit of plan participants, to refrain from transactions that involve a conflict of interest, to properly fund benefits, and to disclose certain information.[12] In an article advocating its push for state-based retirement plans, the Obama Administration emphasized the need to “ensure that workers can trust the investment advice they are receiving, that they won’t have their retirement security undermined by harmful conflicts of interest.”[13]

Yet, since the Obama Administration noted that ERISA proved to be a “roadblock” to state-based retirement programs, it decided to grant states a blanket “safe harbor” exemption from ERISA in order to reduce their risk.[14] If federal protections like ERISA and the fiduciary rule are so important, why does the Obama Administration want to shift a significant portion of Americans’ retirement savings into plans that lack all these protections? After all, it is difficult to imagine that politicians subject to four-year election cycles will be better stewards of workers’ savings than investment advisers, especially if they are exempt from the federal rules and regulations that apply to those advisers.

If states adopt defined contribution, or 401(k)-style plans, administrators will face pressure to engage in conflicted transactions, such as politically motivated investments or using state-based retirement funds to purchase pension bonds, effectively using private workers’ retirement savings to bail out state governments’ massively underfunded pension systems. With upwards of $5 trillion in unfunded state and local pension debt, states will face significant pressure to “invest” state-based retirement funds in their unfunded pensions, but this will only exacerbate the problem by providing additional time for pension systems’ unfunded liabilities to grow even larger.[15] Moreover, it could subject private retirement savings to risky pension investments without individuals’ consent.

A recent article in The Wall Street Journal highlighted the fact that the European Union has already taken measures—lowering capital requirement standards—to try to incentivize investments in public infrastructure.[16] The U.S. Department of the Treasury released a report last year encouraging state insurance regulators to consider similar measures “to increase incentives for infrastructure investments by insurers.”[17] Similarly, state-based plans would likely receive pressure to invest in socially desirable investments with lower returns.

The even riskier scenario is if states adopt defined benefit pension plans similar to their existing public-sector defined benefit pension plans. (See the discussion below of the problem with state-based defined benefit plans.) In addition to being able to make poor or conflicted investment decisions without legal consequence (unless states adopt their own prohibitions), state-based defined benefit pensions would allow state politicians to promise private workers (voters) far more in benefits than warranted by their contributions (which will result in potentially massive unfunded liabilities to be borne by taxpayers), and to use contributions to subsidize other government spending, all without savers’ consent.

Another component of ERISA was the creation of the Pension Benefit Guaranty Corporation (PBGC), which guarantees that if a private pension plan goes bankrupt, beneficiaries at least receive an insured level of benefits. Virtually all private-sector defined benefit pension plans are required to purchase PBGC insurance, but not state-based or local-based government pensions. If a state-based defined benefit plan goes belly up, either taxpayers would have to foot the bill of providing promised benefits, or beneficiaries could be left with little to nothing in promised benefits.

If workers in private retirement plans need ERISA’s protections, why do workers in state-based retirement plans not need those protections? After all, states’ track records in managing retirement savings plans—leading to trillions of dollars in unfunded promises—do not bode well for their ability to securely manage private workers’ retirement savings. If anything, past performance warrants stricter rules for government-based retirement plans as opposed to a carte blanche exemption from them.

Even the DOL acknowledged that “some workers might lose ERISA-protected benefits that could have been more generous and more secure than state-based (IRA) benefits if states do not adopt consumer protections similar to those Congress provided under ERISA.”[18] Nevertheless, the department declined requests to require states to adopt certain consumer protections, and instead stated that it “encourages the states to adopt consumer protections…as necessary or appropriate.” If states are best equipped to design and adopt retirement savings protections, however, why not repeal ERISA entirely and allow states to adopt their own retirement savings safeguards and regulations? Of course, the interstate nature of capital markets makes a state-based regulatory regime unreasonable.

Participants Unable to Access or Control Their Money

The original rule specifically prohibited state-based plans from imposing restrictions on individuals that would limit their control of or access to their retirement savings. As stated by the DOL, this was to “make sure that employees would have meaningful control over the assets in their IRAs.” Under the revised rule, however, the DOL reversed course and specifically allowed states to create plans that would lock employees in without any access to or control over their contributions.

The change is allegedly intended to prevent “leakage,” but the mere fact that the rule and its proponents refer to employees taking their own money out of their accounts as “leakage” reveals the true intent of some state-based plans. This change is necessary for states to create defined benefit pension systems, which are based on the paternalistic notion that the government or employers will do a better job managing workers’ retirement savings than those workers could do themselves.

As revised, the rule allows state-based plans to prohibit employees from accessing their money when they want and from controlling their investments. This means employees could be barred from rolling over funds from one account to another when they change jobs, from choosing their investment portfolio, from deciding how much money they want to take out each year in retirement, and from passing on their savings to a family member or other heir when they die. Since the original guidance on state-based plans prohibited plans from restricting workers’ access to and control of their funds, there are not yet any state-based defined benefit plans that serve as examples to the types of restrictions states will put on workers’ savings, but such restrictions are now possible.

Moreover, state-based defined benefit plans would lack portability across state lines. If state-based defined benefit plans work as the states’ public defined benefit plans do, workers who take new jobs in other states would not be able to take their retirement account with them. Depending on the vesting rules and benefit formulas that states establish, employees could potentially lose some or even all of their contributions.

Defined benefit pension plans are well and good for workers who, knowing the potential ramifications of limited access to their funds and the potential insolvency of their promised pensions, desire a promised benefit over a personally owned and managed account. The problem with state-based defined benefit plans is that a significant portion of workers could be driven into them—through auto enrollment and a lack of other viable options—by government action as opposed to personal preference.

New Rule Could Massively Expand Underfunded State and Local Pension Plan Structure to Private Workers

The ultimate goal of the Obama Administration seems to be the creation of state-based defined benefit plans, whereby workers contribute a fixed portion of their pay and are promised a fixed, lifetime benefit, proportional to their salary and years of service. Savers and taxpayers need look no further than existing state and local pension funds, however, to understand the danger of such plans.

State and local pension plans report about $1.4 trillion in unfunded pension liabilities based on their own, unreasonable estimates.[19] Under more appropriate assumptions, similar to those required of private, single-employer pension plans, state and local pensions’ unfunded liabilities are closer to $5 trillion.[20] A 2016 report from the American Legislative Exchange Council tagged state and local pensions’ unfunded liabilities at $5.6 trillion, or nearly $17,500 for every man, woman, and child in the U.S. Individual states’ unfunded liabilities per capita ranged from $7,246 in Tennessee to $42,950 in Alaska.[21] Granting states control over a whole new pool of private-sector defined benefit pensions could drive these unfunded liabilities even higher.

The reason state and local pension plans have been able to accumulate such massive unfunded liabilities is that they are not subject to ERISA, or really any requirements for that matter. As Andrew Biggs noted, “[A]lmost no other pension plans in the world are allowed to use the kind of accounting that U.S. state and local plans can.”[22] While states typically have actuarially required contribution (ARC) levels that they are supposed to make each year, state and local governments often reduce or skip these contributions altogether. Instead of considering pensions as an obligatory part of employees’ compensation (as employers who offer 401(k) plans do), state and local governments often treat their pension contributions as optional or discretionary spending, making full contributions only when and if all other budget priorities are met.

As a result of regular underfunding, many state and local plans owe far more than they can afford to pay. The Public School Teachers’ Pension and Retirement Fund of Chicago, for example, has $9 billion[23] in unfunded liabilities. (This plan is only one of Illinois’s 667 public pension plans which total $332 billion in unfunded liabilities.[24]) New Jersey has racked up $200 billion in unfunded pension liabilities and California has the largest unfunded pension liability, having promised $754 billion more than it has set aside to pay.[25] These unfunded pensions represent massive taxpayer liabilities, as state and local taxes will presumably rise to cover these unfunded promises.

So why would the federal government pave the way for states to set up a similar system for private savers? While states would not be pressured by a union to promise more than they can afford to pay, policymakers will always have an incentive to promise higher state-based pension payouts to win over voters. Excessive benefit promises and inaccuracy in assumptions on asset returns and life expectancies could create massive unfunded liabilities in state-based retirement plans that would either be passed on to taxpayers or result in benefits for state-based plan retirees substantially lower than promised.

In effect, this rule would allow states to create their own, more limited Social Security systems. Just as Social Security has been a source of revenue for federal government spending, state-based private pension plans could be used to shore-up dwindling public-sector pension systems. State-run (or at least state-selected) management and no federal conflict of interest prohibitions will create strong pressure to invest private pension assets in public pension bonds (or other politically motivated investments such as transit, alternative energy, or “economic development” projects that have political support but lack the economic potential necessary to obtain private financing). In other words, state-based private pensions could provide a revenue stream to kick the can down the road and delay action to address states’ unfunded public pension liabilities. This delay would allow unfunded liabilities to escalate and leave taxpayers on the hook for even larger unfunded liabilities in the future.


Increased retirement savings is a worthy goal, but the Obama Administration’s version of state-based retirement plans is not the solution. Workers without access to a retirement savings plan at work should not be pushed into plans that lack important protections established to help prevent workers from losing their retirement savings. While states could establish their own set of protections, nothing requires them to do so and their records in mismanaging their own defined benefit public pension systems to the tune of trillions of dollars in underfunded promises is evidence that states should not be entrusted with private workers’ retirement savings.

Based on the design of the rule, the Obama Administration’s real vision is not simply to increase enrollment in retirement savings plans, but rather to increase enrollment in government-controlled plans. By exempting state-based plans from the rules and regulations that apply to private retirement plans, many private plans will be driven out of business. Employees could lose their existing plans, as well as their employers’ contributions, and be placed in less secure retirement accounts. Moreover, workers could be automatically enrolled in incredibly risky defined benefit pension plans that would not only prohibit workers from accessing or controlling their money, but could result in over-promised and underfunded benefits. As is the case with current underfunded state pension plans, shortfalls will require either benefit cuts or force taxpayers to pick up the tab for other workers’ retirement benefits.

The Obama Administration’s rule seeks to increase retirement savings by pushing workers into what will almost certainly be less secure retirement plans, and which could put taxpayers at risk of covering the costs of mismanaged state plans. Rather than giving state governments a competitive advantage in managing workers’ retirement savings—an area in which both the federal and state governments have demonstrated complete incompetence—the federal government should encourage greater private savings by streamlining and removing restrictions on the types and amounts of tax-preferred saving and by making it easier for businesses to pool together to offer 401(k) plans.

—Rachel Greszler is Senior Policy Analyst in Economics and Entitlements in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.

[1] U.S. Department of Labor, Employee Benefits Security Administration, “Savings Arrangements Established by States for Non-Governmental Employees,” August 2016, (accessed September 29, 2016).

[2] U.S. House of Representatives, Committee on Ways and Means, “Executive Overreach: Replacing 401(k)s and IRAs with “Obamacare’ for Retirement,” October 6, 2016, (accessed October 13, 2016).

[3] The IRS rules that apply to qualified plans include the participation, top-heavy, and non-discrimination rules.

[4] Pension Rights Center, “State-based Retirement Plans for the Private Sector,” May 2016, (accessed September 30, 2016).

[5] U.S. Department of Labor, Employee Benefits Security Administration, “Savings Arrangements Established by States for Non-Governmental Employees,” pp. 8–10.

[6] Pension Rights Center, “State-based Retirement Plans for the Private Sector.”

[7] U.S. Department of Labor, “Savings Arrangements Established by States for Non-Governmental Employees,” Final Rule, 29 CFR Part 2510, p. 38, (accessed October 13, 2016).

[8] The average retirement contribution is based on a private-sector worker with average wages of $46,842 in the second quarter of 2016. U.S. Department of Labor, Bureau of Labor Statistics, “Employer Costs for Employee Compensation,” Table 5, (accessed October 31, 2016).

[9] U.S. Department of Labor, Employee Benefits Security Administration, “Savings Arrangements Established by States for Non-Governmental Employees,” p. 41.

[10] Employer-provided matches to retirement savings do not count towards the $18,000 personal limit, but there is a combined limit on employee and employer contributions of $53,000 in 2016. Internal Revenue Service, “Retirement Topics—401(k) and Profit-Sharing Plan Contribution Limits,” July 28, 2016, (accessed September 27, 2016).

[11] U.S. Department of Labor, “Employment Law Guide: Employee Retirement Income Security Act (ERISA) (29 U.S. Code §1001 et seq., 29 Code of Federal Regulations § 2509 et seq.),” (accessed September 29, 2016).

[12] Ibid.

[13] Tom Perez, “Clearing a Path for State-based Retirement Plans” U.S. Department of Labor blog, July 13, 2015, (accessed September 29, 2016).

[14] News release, “U.S. Department of Labor Announces Final Rule on State Payroll Deduction IRA Accounts,” U.S. Department of Labor, August 25, 2016, (accessed September 29, 2016).

[15] Andrew Biggs, “Are State And Local Government Pensions Underfunded By $5 Trillion?” Forbes, July 1, 2016, (accessed September 29, 2016).

[16] Phil Gramm, “The Subprime Superhighway: The U.S. and Europe Are Lowering Capital Standards for ‘Investments’ in Public Infrastructure—Ignoring the Lessons from 2007-08,” The Wall Street Journal, October 2, 2016, (accessed October 5, 2016).

[17] U.S. Department of the Treasury, “Annual Report on the Insurance Industry,” September 2015, (accessed October 5, 2016).

[18] U.S. Department of Labor, Employee Benefits Security Administration, “Savings Arrangements Established by States for Non-Governmental Employees.”

[19] Alicia H. Munnell and Jean-Pierre Aubry, “The Funding of State and Local Pensions: 2015–2020,” Center for State and Local Government Excellence, (accessed September 29, 2016).

[20] State Budget Solutions, “State Budget Solutions 2014 Unfunded Pension Liabilities Report,” (accessed September 29, 2016), and Biggs, “Are State and Local Government Pensions Underfunded By $5 Trillion?”

[21] Bob Williams, Jonathan Williams, Ted Lafferty, and Sarah Curry, “Unaccountable and Unaffordable 2016: Unfunded Public Pension Liabilities Near $5.6 Trillion,” American Legislative Exchange Council, October 13, 2016, (accessed October 13, 2016).

[22] Biggs, “Are State and Local Government Pensions Underfunded By $5 Trillion?”

[23] Ted Dabrowski and John Klingner, “11 Things You Need to Know about Chicago Teacher Pensions,” Illinois Policy, March 2016, (accessed September 30, 2016).

[24] Ted Dabrowski and John Klingner, “Pensions 101: Understanding Illinois’ Massive, Government-Worker Pension Crisis,” Illinois Policy, (accessed September 30, 2016).

[25] State Budget Solutions, “State Budget Solutions 2014 Unfunded Pension Liabilities Report.”


Rachel Greszler
Rachel Greszler

Senior Research Fellow, Roe Institute