Mental Accounting Fiscal Accounting or Pensions as Piggy

Mental Accounting, Fiscal Accounting, or Pensions as Piggy Banks? John A. Turner Pension Policy Center Bruce W. Klein Pension Policy Center September 2019

Mental Accounting • Mental accounting is a theory developed by Richard Thaler, the 2017 Nobel Prize Laureate in Economics. • With this theory, money is treated as nonfungible when it is placed in accounts for special purposes. • While it applies in other situations, the example we consider is money placed in individual account pensions. • Thaler argues that money in these pension accounts is treated as nonfungible because of mental accounting. 2

Fiscal Accounting • While accepting the possibility of some effect of mental accounting, we make two counter arguments. • First, we argue that fiscal accounting can explain people treating pension accounts as nonfungible because pension plans receive special tax treatment, including penalties or prohibitions for their use before retirement. Fiscal accounting varies across countries depending on the tax and pension laws in countries, which presumably vary depending on issues relating to political economy. 3

Pensions as Piggy Banks • The second counter argument to mental accounting is an empirical one. • In many countries, tax and pension rules prohibit workers from accessing their pension plans before retirement. Their pension accounts are “locked in” until retirement. • In the U. S. , however, the rules for pre-retirement access are much more lenient. Workers who have left the job providing an individual account pension can withdraw money from that pension at any time, paying a tax penalty if they do so before age 59 ½. Also, preretirement access is available through loans. • Thus, fiscal accounting in the US has important exceptions. 4

A Piggy Bank 5

Piggy Bank • A piggy bank is the image for an account that is used for short term savings. Children in the U. S. sometimes are given piggy banks where they can save their allowance for future purchases. • In the U. S. , it is not uncommon for workers to access their individual account pensions before retirement and use that money for varied nonretirement purposes. • Thus, there is empirical evidence that the effects of mental accounting and of fiscal accounting are not sufficiently strong to prevent many workers from accessing their pension accounts before retirement. • For some people, the mental accounting may be that they think of their pension like a piggy bank. 6

This Presentation • The remainder of this presentation will elaborate on these points. 7

Mental Accounting • Richard Thaler (1999) writes, “Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. … mental accounting involves the assignment of activities to specific accounts. Both the sources and uses of funds are labeled in real as well as in mental accounting systems. Expenditures are grouped into categories (housing, food, etc. ) and spending is sometimes constrained by implicit or explicit budgets. ” 8

Framing • Mental accounting involves a narrow framing where accounts that could be treated as equivalent are treated differently because they are established for different purposes. • Separate accounts are set up mentally, and possibly institutionally, for separate purposes. • For example, it might make sense in terms of budgeting and financial management for a person to have liquid savings in a savings account and long-term savings in stocks and bonds in a different account. 9

Commitment • For mental accounting to work, the pension participant must make a commitment to preserve the pension account until retirement rather than to use it for purchase of a home, or for other purposes. • However, it has long been recognized that many people have difficulty making and keeping such financial commitments. • That recognition is one of the reasons why Social Security participation is mandatory. • It also is a reason why there are fiscal incentives, both subsidies and penalties, for encouraging pension participation and discouraging using pension accounts for other purposes. 10

Fiscal Accounting • Our concept fiscal accounting as an alternative to mental accounting is not new. In fact, the concept relies on neoclassical economics because it relies on the incentives embedded in taxes and penalties. • According to the fiscal accounting perspective, people generally don’t naturally treat their retirement money as being in a separate nonfungible mental account. For that reason government policy has set up rules to make pension accounts relatively illiquid. 11

Limits to Mental and Fiscal Accounting • If mental accounting concerning pension accounts was a strong force, government rules prohibiting early withdrawals would be unnecessary. • However, fiscal accounting also has weaknesses, depending on government policy. In the U. S. , fiscal policy allows for a considerable amount of pre-retirement liquidity. 12

Pensions as Piggy Banks in Mental Accounting • Despite mental accounting and fiscal accounting, there is considerable pre-retirement liquidity in pensions in the U. S. • However, it may not be despite those issues but in part because of them. • For some people, their mental accounting is to treat pensions as piggy banks. • 13

Explanations for Pre-retirement Withdrawals • In the U. S. , pre-retirement withdrawals are permitted when a worker changes jobs. They are also permitted while continuing to work for the job providing the pension for hardship, broadly defined, disability, education and purchasing a job. • Argento, Bryant and Sabelhaus (2013) find that pre-retirement withdrawals from individual account pensions are equal to 30 to 45 percent of annual contributions, with the amount varying across years. 14

Job Change, Low-wage Households • Amromin and Smith (2003) find that workers who lose their jobs are more likely to take a pre-retirement pension withdrawal. • Ghilarducci, Radpour and Webb (2019) find that low-wage households are more likely to experience economic shocks, and also more likely to make pre-retirement withdrawals from their retirement accounts when they do. 15

Liquidity Constraint • Young people are likely to be liquidity constrained, but lack of liquidity affects people of all ages. • Beshears et al. (2018 a) find that U. S. households do almost all of their voluntary savings in illiquid assets (primarily homes and pensions). 16

Loans • Taking a loan from a 401(k) plan involves using pension assets for non -retirement purposes, and thus violates the non-fungibility perspective of mental accounting. • A 2012 study by the National Association of Realtors finds that 9 percent of recent home buyers used money from a 401(k) plan or pension plan to help make a down payment (Block 2013). A typical down payment on a home loan is 20 percent and the term is 30 years. • Another survey finds that 29 percent of Millennials used money from a 401(k) plan or IRA to make the down payment for a home purchase (Shell 2018). Millennials were born between the early 1980 s and the mid-1990 s and early 2000 s. 17

Loan Defaults • Deloitte (2018) projects that more than $2 trillion in potential future pension account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years. • Ten percent of plan loans default each year. Loan defaults are thus a major aspect of pre-retirement leakage from the pension system. 18

Autoenrollment • The problem of workers using their pensions as a piggy bank for purposes other than retirement savings seems to be particularly an issue for workers who passively are automatically enrolled in a pension, rather than proactively enrolling in a plan. • Beshears et al. (2018 b) find that 40 percent of the increase in savings due to autoenrollment is lost due to pre-retirement leakage. 19

Political Economy of Pre-retirement Liquidity • Changes in tax laws have made IRAs more liquid over time. • While not initially possible when IRAs were first established in 1974, the Taxpayer Relief Act of 1997 made it possible to withdraw money from an IRA for the purpose of buying one’s first house. • Roth IRAs also were initiated by the Taxpayer Relief Act of 1997. With Roth IRAs, the person can withdraw their own contributions at any time because they have already paid taxes on those contributions. 20

Other Countries • The issue of pre-retirement access to pension accounts is not just an issue in the United States. • In some other countries, pre-retirement liquidity is built into a voluntary pension system in the hopes that doing so would increase pension coverage. • To encourage increased pension coverage, in 2018 Spain made it possible to withdraw pension savings after 10 years (Garrido 2018). • A commentator on the 2019 pension reform in Poland writes, “Other features written into the PPK law include inheritability, and the ability to access funds before retirement in some circumstances, such as house purchases” (Krzyzak 2019). 21

UK • For example, in the United Kingdom, the Housing Secretary has argued that young people should be able to withdraw from their pension accounts in order to purchase their first home (Bartholomew 2019). 22

Conclusions • Defined contribution pension accounts, such as 401(k) plan accounts in the U. S. , are frequently cited in the pension literature as examples of mental accounting. This paper re-examines the empirical evidence. • While mental accounting for pension accounts would clearly be desirable behavior, and is thus an aspect of normative economics, its role in positive economics is less clear. 23

Conclusions 2 • To the extent that people treat pension accounts differently from other accounts, we argue that there are other possible explanations besides mental accounting. • In particular, we argue that the concept of fiscal accounting should be seen as an alternative to mental accounting in some situations, such as with pension accounts. • Fiscal accounting, which is the traditional view as to the differences between pension accounts and other accounts, recognizes that pension accounts are viewed separately from other accounts. • Government policy purposely sets up barriers to pre-retirement withdrawals from pension accounts through the use of tax penalties or outright prohibitions. 24

Conclusions 3 • Despite the effects of both mental accounting and fiscal accounting, in the United States, greater liquidity is provided for pension plans than in a number of other countries. • There is considerable evidence that mental and fiscal accounting are not overwhelming forces, and many people take pre-retirement withdrawals and loans from their pension accounts. • Thus, we argue for a rethinking of both concepts. First, some people’s mental accounting may be that they intend to use their pension account as a piggy bank. Second, in some countries, due presumably to issues relating to political economy, the tax and pension rules allow for pre-retirement withdrawals from pension plans. 25