State IRA Plans Are Deeply Flawed

States' Rights The good news: Where the federal government has failed, state governments have stepped into the breach. For many years now, roughly one half of U.S. workers have lacked access to a 401(k) plan, because their employers (usually smaller companies) have opted against offering one. Several states, growing tired of waiting for Washington to address the problem, have come up with their own solutions.

These new programs are called "State IRAs." Their name reflects their heritage; they are an adapted version of the familiar individual IRA plan, launched in the 1980s during the Reagan administration. State IRAs take existing IRA structures--tax benefits, contribution limits, and so forth--and adapt them to become workplace savings vehicles.

Specifically, State IRAs' laws mandate that companies without 401(k) plans enroll their employees into an IRA account. So far, the states all plan on using the Roth IRA structure, offering no tax benefit during the year of contribution, but distributing its proceeds tax-free during retirement. As with 401(k) automatic-enrollment programs, the worker will be placed into the plan no matter what but may opt out at any time after the initial contribution.

Several states have passed laws creating State IRAs, including California, Illinois, Oregon, and Massachusetts. (Ironically, although the legislation mostly affects workers at smaller companies, the largest of the states have expressed the most interest.) Many more have established commissions to study the matter.

A Strange Brew The bad news: These plans are an intrinsically silly idea.

There's no sense in addressing a national issue with state-by-state solutions. Tennessee's workers need what New York's workers need, which is what Wyoming's workers need. Creating 50 different systems, each with its own regulations and oversight, to accomplish the same task isn't the successful exercise of "states' rights." It's a display of national stupidity.

State IRAs also carry unavoidable design defects. As Morningstar's Director of Policy Research Aron Szapiro says, State IRAs are a "bolt-on addition to the existing tax code," rather than new legislation that was carefully constructed to solve a specific set of problems. Square peg, round hole. With enough pounding, the peg eventually is driven into the hole, but imperfectly.

(For a much more thorough discussion of the workings, merits, and demerits of State IRAs than this column will give, see Aron's December 2016 paper, "Background on Recent State Efforts to Cover Private-Sector Workers.")

State IRAs are inferior to 401(k)s. Their contribution limits are lower; there is no company match; and deferring the tax benefit is usually a disadvantage (because most investors' tax rates are lower in retirement than when they are working). On the other hand, the alternative approach is … nothing. There have been no counterproposals. If State IRAs do not take off, the 50% of U.S. private-sector workers who lack access to defined-contribution plans will continue to lack access.

The Opposition Opponents have jumped on these points. Says U.S. Rep. Francis Rooney, R-Florida: "Employers will face a confusing patchwork of rules, and many small businesses may forego offering retirement plans altogether. Congress must act to protect workers and small businesses from these misguided regulations."

As this column has already noted, Mr. Rooney is certainly right about the patchwork of rules. There's no question that State IRAs introduce more fragmentation into what already is a scattered, complex U.S. retirement system. The legal code becomes longer; portability becomes more difficult; and nonsensical things can occur, such as somebody who earns too much to qualify for a Roth IRA being automatically enrolled via the state plan into a Roth IRA.

Perhaps Mr. Rooney is also correct with his concern that some companies that now offer 401(k) plans will drop those plans to join the less-robust state systems. Doing so would indeed lower the companies' costs and legal liabilities. On the other hand, those firms have already volunteered to shoulder such burdens. They may continue to do so, for the reason of attracting and retaining top-quality employees.

The other two major complaints against State IRAs are business-related, not investor-related.

One is that State IRAs will compete against private plans. This is to a degree correct. Although State IRAs will only be available at companies that do not have a private plan, in the sense of having a 401(k) program, it is true that the states may end up running the money (early days yet, so the details are still emerging). So the states might well compete against private money managers. This should concern money managers, but not, I think, investors who are preparing for retirement.

The second objection is weaker yet, which is that owners of State IRAs are not protected by ERISA regulations, instead being governed by the less-onerous rules that that apply to IRAs. Strangely, the people who make that argument never had a problem with IRA regulations before. What's more, most of them oppose the new fiduciary rule launched by the Department of Labor (DOL), which expands ERISA-like protections. Like ERISA here, dislike it there … the position smacks of expediency.

Standing in the Way The opposition will be partially getting its way. Under two "resolutions of disapproval" that have been introduced into both chambers of Congress, the DOL's 2016 go-ahead to State IRAs, which came in the form of a ruling that created a legal "safe harbor," will be reversed. The first of those bills, covering cities and counties, has already passed. The second, HJ 66, is also expected to pass, perhaps as quickly as this week. HJ 66 will not abolish State IRAs, but it will discourage their growth by creating uncertainty about their legal obligations.

These resolutions of disapproval do not strike me as a step forward. I remain unenthusiastic about State IRAs. Writing 50 rulebooks to do one book's work makes little sense. Also, the U.S. retirement system needs less fragmentation and more portability, not the reverse. But ignoring the problem simply won't do.

Washington has done nothing to help the tens of millions of Americans who can't invest in a defined-contribution program. It did nothing in the 1990s, nothing last decade, and has done nothing this decade. Thus, Washington is in no position to criticize other parties' efforts. It should stand aside and let the states do their thing, imperfect as that thing may be.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.