State-Created Retirement Plans: New Proposals Aim to Close Small-Business Gaps

By James O'Brien.

More than a dozen states are exploring ways to offer new retirement options to private-sector employees. A number of the proposals under consideration are close to being implemented, and that could mean new and helpful retirement tools for workers, especially among small businesses.

More than 70 million baby boomers are preparing to retire, and the percentage of private-sector employees who can count on a defined benefit plan has dropped to just 13% compared to about 33% in 1985. Meanwhile, the average working household has virtually no retirement savings -- the median across all age groups is just $3,000.

It's clear that state legislators are taking these problems seriously, given the 17 new initiatives aimed to tackle them. The new state-administered retirement proposals differ in some details, but each revolves for the most part around simple, low-cost retirement instruments that could enable median- to lower-income workers at businesses that don't offer retirement plans to achieve better returns than they could get through a traditional IRA.

These workers would direct pre-tax money from their paychecks into a retirement account, the idea being that they'd enjoy higher interest rates than they could get from investing individually thanks to the pooled nature of the investments.

Let's take a closer look at how the frontrunners among these plans would work -- the ones that are close to becoming real.

Three key players
California, Connecticut, and Massachusetts have each reached a stage where legislation has been passed, significant resources assigned, and/or task forces formed.

Here are the details on each -- keep in mind that these plans are still being developed.

• California: Signed into law at the end of 2012, the California Secure Choice Retirement Savings Trust Act has prompted the creation of an investment board that is mapping out markets and feasibility for the new plan. The specifics that the board is considering call for businesses with five or more employees that do not offer a retirement plan to enroll their workers in a state-created system, one that would be managed by California's Public Employees' Retirement System. At a contribution rate of approximately 3%, the plan would keep employers liability-free and underwrite the investments via private insurers.
• Connecticut: In May, the state pledged $400,000 to the creation of its own Retirement Security Board. Connecticut expects to put an implementable plan before legislators by April 2016. As in California, leaders are calling for an automatic IRA administrated by an appointed board. The conditions for businesses are the same: Companies with five-plus employees and no offered retirement plans would have to enroll. The plan is expected to come with a guaranteed rate of return (how much, exactly, is still pending), backed by insurance, and low fees are promised. Retirees would be able to take a lifetime annuity or a lump-sum payout.
• Massachusetts: Perhaps furthest ahead is the Bay State, where a plan has already been passed into law and is now before the Internal Revenue Service pending final authorization. Aimed particularly at nonprofits with 20 or fewer employees, the Massachusetts program opens the door to a defined-contribution arrangement in which either employers or employees would contribute. A number of investment options would be available, and the state is creating a special committee to further develop the component details.

The other states with bills in various stages of development are Arizona, Colorado, Illinois, Indiana, Maine, Maryland, Minnesota, Nebraska, Ohio, Oregon, Vermont, Washington, West Virginia, and Wisconsin.

The size and shape of each proposal is largely similar. Generally, smaller shops would be required to allow employees to enroll in a state plan -- with an individual opt-out option -- that provides retirement savings where none were otherwise offered.

These plans would come as an alternative to the Obama administration's myRA workplace savings mechanism, which similarly offers a payroll deduction option for employees. The myRA, however, is not a mandated instrument like the states plans are destined to be, and myRA's infrastructure is largely based on that of IRAs and 401(k)s, whereas the state plans stand to take a higher-risk (and higher-return) approach to the portfolio created with participants' pooled assets.

Details and debates
Of course, the proof that these plans will be advantageous to retirement investors will lie largely in what kind of returns they generate and at what scale of participation they'll become viable.

"The question that I and other retirement researchers have is whether the state efforts will be sufficient to provide adequate retirement income, whether they will produce more the illusion than the reality of retirement security," says professor James Russell of Eastern Connecticut State University.

If the returns are higher than what individuals could achieve with, say, an IRA, then many states' existing public-sector pension infrastructure could help administrate the plans; states are typically efficient at managing the public-sector pensions with which they already deal.

But there are still doubts. Not everyone thinks their local government should be involved in closing the retirement savings gap. Some suggest it's tantamount to laying groundwork for government takeover of private-sector matters. On the other hand, government has shown that it can provide helpful financial instruments to families. Proponents of state-administered private-sector retirement savings point to 529 plans as one example.

Diane Oakley, executive director of the National Institute on Retirement Security, is one of those proponents, and she's on Maryland's state-appointed task force for developing a plan there. Oakley is optimistic about the potential of these state-administered plans. With enough contributors, in a state such as California, she suggests, initial returns could start in the neighborhood of 2%.

A key question, then, is whether a 2% annual return is sufficient. It's almost certainly not as good as a company-sponsored plan, but it could nevertheless outperform an IRA or solo 401(k) for an individual investor who contributes modestly -- and that's the participant these plans seem designed for. So will these state-administered plans attract retirement investors, or will their returns fall short of what workers demand?

"Even for those individuals in the low end of the spectrum, that would be a significant plus over what many could get today in the marketplace," says Oakley. "That's a dramatic improvement, because compound interest can work a little bit better then. And you might be able to further diversify the portfolio and get an even better return over time."

The bottom line
If nothing else, these proposed plans are an innovative and interesting development in retirement planning. They could serve as models for other state-administered benefits -- and as we've seen with new federal programs, states can serve as laboratories for testing new ways to relieve major financial burdens such as health care and college savings. And once a working model is in place, it can spread, state by state.

For the three states that are closest to rolling out their plans, the coming 24 months will be critical. Between now and 2016, much of what they have developed looks likely to become available to the public. And as they finish their initial iterations, the successes or failures of these new retirement instruments will likely set the tone for other states -- those farther behind with their own potential plans and those that haven't announced interest in one.

The tests are ongoing, and the results could be groundbreaking.