On February 3, 2017 the U.S. Chamber of Commerce released “Securing America’s Retirement,” their legislative road-map aimed at strengthening the retirement system.
These proposals detail policy solutions that Congress can act upon to achieve better retirement security for workers in the small business sector. Improving retirement security for the small business sector is sorely-needed, as only 14 percent of companies with less than 100 employees–representing 34 percent of private sector payrolls—offer their employees access to a retirement plan.
In general, the majority of the Chamber’s agenda should be well-received, and appears to be well-vetted.
However, one policy proposal, increasing the mandatory cash-out limit to $10,000, could have significant, unintended and adverse consequences for retirement security if implemented without additional safeguards.
Good for small business, bad for the mobile workforce
IRC Section 401(a)(31)(B) allows plan sponsors to force-out separated participants’ accounts with 401k balances under $5,000 into safe harbor IRAs, otherwise known as an automatic rollover. The essence of the Chamber’s recommendation is to increase the separated participants’ balances subject to force-out from $5,000 to $10,000.
It’s obvious why this position should appeal to employers. An increasingly mobile workforce, combined with the growing popularity of auto enrollment, has resulted in an explosion of small accounts, which carry additional costs, administrative burdens and fiduciary risk.
The Employee Benefit Research Institute (EBRI) estimates that 38 percent, or 5.2 million of the 13.6 million participants changing jobs each year have retirement account balances less than $5,000. Under the Chamber’s recommendations, the new $10,000 automatic rollover threshold would apply to 48 percent, or 6.6 million job-changing participants.
Given the choice of “holding the bag” of cost and risk associated with burgeoning small-balance, separated participants, the Plan Sponsor Council of America finds that over 59 percent of plans will force-out these participants by adopting an automatic rollover provision.
While good for employers, automatic rollovers haven’t been good for the retirement security of the participant. The problem is bad participant outcomes, principally coming in the form of cash-out leakage.
Small account cash-out leakage
There is now an overwhelming amount of data that definitively illustrates the epidemic of cash-out leakage for 401k small accounts.
- For accounts less than $5,000, studies published by Aon Hewitt, Fidelity and Vanguard show cash-out rates of almost 60 percent, during the first year following a job change.
- Retirement Clearinghouse demonstrated that the actual leakage for these accounts may be as high as 89 percent after 7 years, when you factor in the “slow leakage” that occurs in the years following an automatic rollover.
When balances between $5,000 and $10,000 are included, year 1 cash-out leakage still averages over 50 percent. In fact, research by Northern Trust indicates that “crossing the $10,000 threshold…reduces participants’ impulse to cash out, and may lead to substantially better retirement outcomes.”
Simply increasing the mandatory distribution limit will only push more participants and assets into the 401k cash-out drain, just as they could be ready to become long-term retirement savers.
Doing the right thing is hard for participants
The fundamental driver of cash-out leakage is the friction in our defined contribution system, making the cash-out the easiest choice for the participant. In most instances, the best choice is to move their balance forward to the next employer’s 401k (a roll-in) to consolidate balances in a single, incubating retirement account.
Unfortunately, executing a roll-in is the most difficult choice for participants:
- A 2015 study of mobile workforce behaviors by Boston Research Technologies (BRT) found that 62 percent of participants who had completed a roll-in did so with outside help, and took, on average, a month to complete.
- Not surprisingly, the same study found that 93 percent of participants considered a service to facilitate roll-ins a “good” or “excellent” benefit, if offered by their employer.
Bottom line: the friction associated with portability in today’s retirement system will continue to produce poor outcomes for participants unless changes are made.
A win-win solution: auto portability
In the defined contribution industry, the past is often prologue:
- Developments in behavioral finance have had a significant impact on retirement plan structure and participant education.
- When participant inertia resulted in poor investment decisions, the industry countered with target date funds and managed accounts.
- To counter stagnant plan participation, auto enrollment was launched. Both innovations received a very large boost from the Pension Protection Act passed in 2006.
Today, poor outcomes resulting from small 401k account cash-out leakage demand that the industry develop another default solution to plug the leak, before taking any measures that would exacerbate the problem.
The answer is auto portability, the routine, standardized and automated movement of an inactive participant’s retirement account from a former employer’s retirement plan to their active account in a new employer’s plan.
Automatic rollovers are a valuable tool for plan sponsors to manage retirement plan cost and risk, but without auto portability, they do harm to participant outcomes.
However, with auto portability in place, increasing the automatic rollover limit, as advocated by the U.S. Chamber of Commerce, would create a “win-win” for both plan sponsors and their participants, achieving the Chamber’s goals for small business, while increasing retirement security for millions of Americans.