Everyone hates “leakage.” The term itself has no known positive connotations, and if you are experiencing it, you always want to stop it—be it from a water pipe, a diaper or a 401k plan.
New research sheds a little bit of light on the latter, as the latest brief from the Employee Benefits Research Institute (EBRI) shows—among other things—how auto-portability in 401k plans could positively impact the retirement security for millions of job-changing Americans by preventing 401k plan leakage before it can occur.
The brief, EBRI Issue Brief No. 473, titled, “How Much Would It Take? Achieving Retirement Income Equivalency Between Final-Average-Pay Defined Benefit Plan Accruals and Automatic Enrollment 401(k) Plans in the Private Sector,”compares the outcomes of participants in 401k plans with auto-enrollment against defined benefit (DB) plans.
EBRI Research Director Jack VanDerhei, Ph.D., computes for several simulated employee contingencies (such as job turnover) what level of final-average DB accrual would provide an equal amount of retirement income at age 65 as would be produced if the projected sum of automatic enrollment 401(k) and IRA rollover balances were annuitized.
In so doing, VanDerhei provides a comparison in median outcomes for a variety of assumptions, both market returns and annuity purchase prices, and is intended to provide a reference point for policy makers evaluating plan designs in view of both current and future workforce trends.
“We have recently analyzed the impact of the Automatic Retirement Plan Act of 2017 (ARPA) proposal on retirement deficits and the impact of adopting auto portability, as well as interaction of auto portability with ARPA,” the Feb. 9 brief states. “With auto portability, a participant’s account from a former employer’s retirement plan would be automatically combined with their active account in a new employer’s plan. This would help keep the DC assets in the retirement system and—in theory—reduce leakage from cashouts upon employment termination. This is important because studies have found that cashouts are the most significant form of leakage from DC plans, especially among workers with low plan balances.”
The concept of auto-portability is a darling of major retirement industry associations, and it’s not hard to see why. EBRI’s Retirement Security Projection Model (RSPM) previously predicted that auto-portability alone, when applied to balances less than $5,000, could reduce the nation’s $4.1 trillion Retirement Savings Shortfall (RSS) by $1.5 trillion.
It is estimated that more than 5 million 401k plan participants with balances less than $5,000 change jobs each year, and that group currently experiences an alarming cashout rate of 55 percent during their first year after changing jobs.
In 2015, the Center for Retirement Research at Boston College found 401k plan leakage causes a 25 percent reduction in aggregate retirement wealth.
DB vs. DC break-even rates
The latest analysis found that for men, defined benefit “break-even” rates —or the percentage accrual rate required for a DB plan to generate the same retirement income that is projected to come from 401k plan participation for a given worker—are rarely less than 1.5 percent of final pay. In only 2 of the 16 combinations of wage quartiles and years of plan eligibility for men are defined benefit “break-even” rates less than 1.5 percent of final pay per years of service. In the case of women, only 5 of the 16 combinations have “break-even” rates under 1.5 percent.
When these findings are subjected to the scrutiny of various “stress tests” both by reducing the rate of return assumptions by 200 basis points and utilizing current annuity purchase prices, results show that in many cases the AE 401k plans lose their comparative advantage to the stylized, final-average DB plans, especially for lower-paid employees as demonstrated by the lower “break-even” accrual rates.
Adding auto-portability revives advantage
But when the comparisons incorporated auto-portability, AE 401k plans delivered much better results compared to DB plans, which would then have to provide far better accrual rates to achieve equivalence against the baseline.
The impact of auto portability would be greatest among the lowest income quartile given their lower account balances and the negative correlation between account balances and cashout activity. For example, for those in the lowest income quartile, the median DB accrual that males with 21‒30 years of plan eligibility would need in order to have the same retirement income that they are projected to have with a 401k plan is 2.3 percent of final compensation.
The results are even more dramatic for men in the lowest income quartile with only 11-20 years of plan eligibility. In this case, the 3.1 percent median DB accrual rate needed for equivalency is 82 percent greater than the baseline accrual rate of 1.7 percent.
Assuming the auto portability scenario for 401k plans, the results for those with only 1–10 years of eligibility are at least 6.2 percent for all income quartiles for men and at least 5.9 percent for women. This reflects the larger propensity for those who end up in this category to have shorter tenure positions and hence lower account balances at job change.
- MORE FROM EBRI: How Will Young Millennials Fare With Defined Contribution vs. Defined Benefit Plans?
Veteran financial services industry journalist Brian Anderson joined 401(k) Specialist as Managing Editor in January 2019. He has led editorial content for a variety of well-known properties including Insurance Forums, Life Insurance Selling, National Underwriter Life & Health, and Senior Market Advisor. He has always maintained a focus on providing readers with timely, useful information intended to help them build their business.
