The Relative Effects of Economic and Non-Economic Factors on Taxpayers’ Preferences Between Front-Loaded and Back-Loaded Retirement Savings Plans

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To understand the potential impact of tax incentives on individual retirement saving, we must understand how individuals make decisions about saving. We examine individual taxpayers’ choices between front-loaded (e.g., traditional) and back-loaded (e.g., Roth) defined contribution retirement savings plans, as well as their saving levels and investment style choices within a plan. To do so, we conduct a series of experiments that allow us to consider individual-specific expectations regarding the economic factors that normatively drive retirement saving decisions, as well as non-economic attitudes and preferences that may also impact these decisions. Overall, we find that participants generally prefer back-loaded retirement plans to front-loaded plans. We find mixed evidence regarding whether individuals appropriately weight expected tax rate changes in their plan choices, despite the fact that these tax rate changes are the primary factor driving the relative after-tax returns of front- and back-loaded plans. Conversely, we find evidence that plan attributes related to individuals’ non-economic attitudes and preferences consistently influence plan choice. Saving levels, while idiosyncratic and difficult to predict, are negatively associated with preference for back-loaded plans and may be influenced by tax-related contextual variables as well. Investment risk is also negatively associated with preferences for back-loaded plans.

The paper found that:

  • Taxpayers prefer back-loaded plans over front-loaded plans.
  • Individuals may not systematically rely on their beliefs regarding their relative tax rates when making plan choices. At least part of that failure is due to a lack of awareness and/or understanding.
  • Individual saving levels and investment selections, while largely idiosyncratic and difficult to predict, are negatively associated with a preference for back-loaded plans and may be influenced by tax-related contextual variables as well.

The policy implications of the findings are:

  • The fact that features of the tax law provide non-economic (dis)utility beyond their impact on expected returns (1) suggests that neither the potential effectiveness of alternative savings incentives nor taxpayers’ investment choices should be evaluated purely based on their financial efficacy; and (2) provides evidence of a systematic preference for a particular savings incentive not discernible from analytical or archival analysis.
  • Our results suggest that individuals, on average, do not respond “rationally” to the relative economic incentives associated with alternatively structured plans. Further, although errors can be reduced with tax-related guidance, our evidence illustrates that individuals systematically incorporate non-economic factors into their retirement plan choices, often leading to a preference for back-loaded plans even when such a choice is economically adverse.
  • While archival data show that retirement savers utilize front-loaded plans to a much greater extent than back-loaded Roth plans (70.6 percent vs. 23.1 percent of defined contribution retirement accounts) (Copeland 2015), the fact that we find a strong preference for back-loaded plans across several experiments and conditions suggests that the greater use of front-loaded plans is an artifact of artificial barriers to participation in back-loaded plans (e.g., income limitations, employer plan offerings, etc.).