Low-income Americans without sufficient savings have faced an increasingly bleak outlook for financing life after retirement. The programs they bank on — Social Security, Medicare, and Long-term Medical Care — face severe funding shortfalls that could mean cutbacks in benefits. A new illustrative plan designed by the Penn Wharton Budget Model (PWBM) in response to policymaker questions may well be their silver bullet to have a decent-sized nest egg without actually having to save more than what they already do. Employers are also not burdened with higher administrative costs or contributions. The plan does not increase the federal deficit.

PWBM has analyzed an illustrative policy where individuals could potentially have retirement savings of more than $200,000 each in automatic retirement savings accounts. The plan is for the federal government to create those personal individual investment accounts for qualifying individuals, based on existing Earned Income Tax Credit criteria. Under different scenarios, the plan could cover between 56 million and 58 million low-income Americans by 2030.

Participants in the plan could bequeath those savings to their near and dear ones or other selected beneficiaries, although they cannot make early withdrawals before retirement at age 65. More often than not, low-income people have “very little to bequeath to the next generation,” other than a house, Kent Smetters, faculty director at PWBM said on the Wharton Business Daily radio show that airs on SiriusXM. (Listen to the podcast.) Smetters, who is also Wharton professor of business economics and public policy, guided PWBM senior policy analyst Brendan Novak in conducting the analysis, and helped write the policy brief.

A Fully Funded Retirement Savings Plan

PWBM has found an innovative solution to the biggest pain point of how to save enough. In its design, the retirement pool will grow with the federal government making annual contributions to the individual retirement savings accounts; households or employers are not required to make any contributions. In exchange, those individuals would give up the tax breaks they receive for investing in 401(k) retirement accounts.

“The idea was to take that money that we otherwise would have spent, and gear it toward low-income households.”— Kent Smetters

The resulting boost in federal tax collections will fully finance the annual contributions to the automatic retirement savings accounts. PWBM explained how that math unfolds: In its projections under the existing dispensation, the federal government will spend about $1.25 trillion over the next decade to subsidize retirement savings in 401(k) and similar retirement plans. The government’s tab for contributions to the automatic retirement savings policy could come close: PWBM projected that the government’s revenue losses over 10 years would range between $1.1 trillion and $1.4 trillion across three different plan scenarios.

How Retirement Savings Accounts Grow

The PWBM analysis projected savings under its plan for three types of savers by age 65: In the first setting, a person aged 24 in 2025 with the lowest average annual income ($12,700) could have an account balance of $125,000. In the second scenario, a person aged 26 in 2025 with earned income of $27,900 could have an account balance of between $150,000 and $200,000. The third type — a saver aged 24 in 2025 who has the highest average annual earnings of $59,300 could have a retirement account balance of between $100,000 and $125,000. These account balances are for an individual; a married couple with two earners could see larger balances.

In its plan, the government would make contributions of 10% of earned income that reach a maximum of $2,000, $2,250, and $2,500 under those three scenarios, respectively; contributions are phased out at a rate of 30% starting at $50,000 of earned income. The annual federal contributions are proportional to the individual’s earned income, subject to cap and phase-out based on their adjusted gross income.

Eligibility for the plan will be based on the criteria used by existing Earned Income Tax Credit program: Individuals must be between ages 25 and 64, and they must have investment income below $10,000 (based on 2020 dollars, indexed to inflation over time). For administrative efficiency, PWBM envisages it working through the EITC tax administration. The new accounts would be automatically set up if a household already qualifies for the Earned Income Tax Credit.

Shifting Benefits to Low-income Households

The PWBM plan is aimed to be equitable. Currently, retirement savings under 401(k) and similar plans mostly benefit higher-income households. The automatic retirement savings accounts will shift more of those benefits to lower-income households with little impact on retirement savings by higher-income households, it noted. “The idea was to take that money that we otherwise would have spent, and gear it toward low-income households,” said Smetters.

“You need a mechanism that basically says this is not your money until it is.”— Kent Smetters

The automatic retirement savings accounts will also help participants alleviate some of the pressure on the federal government and the programs of Social Security, Medicare, and Medicaid. “Those are now being used as primary retirement vehicles, even though they weren’t set up that way originally,” Smetters noted.

The Need for a New Retirement Savings Plan

Smetters explained that the hapless state of retirement savings for low-income Americans prompted PWBM to design its retirement savings plan, in addition to the depleting finances of Social Security, Medicare, and long-term care provided by Medicaid. “If all those three programs had enough money to pay for their benefits, then a lot of low-income people are probably secure because they don’t need to save a lot more than that for retirement,” he said. “The problem is those programs themselves are severely underfunded.”

Over the years, legislative efforts to boost retirement savings have brought little respite for low-income households. For instance, the 2006 Pension Protection Act aimed to help people save more for retirement and increased protections from unscrupulous practices. But that legislation “hasn’t worked at producing more assets for low-income households,” Smetters noted.

Those concerns have reverberated through Congress, especially because current plans favor higher-income households. At the same time, as a nonpartisan research think tank, PWBM does not advocate for policy changes. “We’re not proposing anything, saying Congress should do this,” Smetters said. “We’re just simply showing how it could be done.”

The key to making the automatic retirement savings plans successful is disallowing early withdrawals, although it may be an unpopular feature. “Congress has to resist the urge for early withdrawal before retirement, because that will unwind almost everything here,” Smetters said. Even with the Pension Protection Act, where employers can default employees into a qualified saving plan, “the evidence is overwhelming that they will tap into those assets well before retirement, often when they’re changing employers,” he pointed out. “You need a mechanism that basically says this is not your money until it is. And that is when you hit retirement or you pass away, in which case, even before retirement, this money can go to your heirs.”