America’s defined contribution system is unsustainable—urgently requiring an upgrade to effectively deliver on its intended goal, which is to help millions of Americans enjoy a timely and comfortable retirement.
The primary symptoms of unsustainability include:
- Rampant cash-out leakage;
- An explosion of small-balance accounts;
- A surge in the number of participants who’ve lost track of their retirement savings.
The good news is that our defined contribution system can be fixed.
The solution—auto portability— will deliver tremendous benefits but requires collective action on the part of policymakers, service providers and plan sponsors.
The concept of ‘sustainability’ is ubiquitous in our culture, and its principles have been broadly applied to large swaths of society, including our consumption patterns, housing, economic development, business models, agriculture, and energy production. Sustainability’s goal is to “meet the needs of the present without compromising the ability of the future generations to meet their own needs.”
When examining our defined contribution system, three symptoms point to fundamental unsustainability:
- Rampant Cash-out Leakage
Every year 14.8 million, or 22 percent, of all active defined contribution participants change jobs and will consider their options for retirement savings they’ve left behind. Six million, or over 40 percent of these job-changers, will choose to prematurely cash out $68 billion in savings.
Consider these figures: That’s six million people – every year – who will effectively drop out of our defined contribution system. In fact, the defined contribution system’s cash-out rate is 24 percent higher than America’s high school drop-out rate.
What gives rise to this level of cash-outs? Contrary to conventional wisdom, only slightly more than one-third of these “retirement drop-outs” need the funds for a true financial emergency. The rest are simply making poor decisions. Unfortunately for these bad decision makers, the defined contribution system perversely doubles-down on human nature by making the worst choice (cashing out) the easiest, while simultaneously making the best choice (consolidating retirement savings) the most difficult.
To add insult to injury, plan sponsors (and their consultants) will invest considerable time and money in financial wellness initiatives, improving plan choice and a myriad of other features, but very few will bother to measure cash-out leakage levels, set goals for it or attempt to actively manage the problem.
- The Explosion of Small-Balance Accounts
Combining Employee Benefit Research Institute statistics with the Department of Labor’s Form 5500 data, we estimate that there are 5.1 million inactive defined contribution accounts with a balance less than $5,000. For accounts with a balance less than $10,000, this figure rises to 6.8 million.
Over 80 percent of these accounts are held by participants who have already enrolled in another defined contribution plan with their current employer, so these participant accounts are effectively stranded, where they will pay excess fees, earn sub-optimal returns, or both.
Meanwhile, former employers are saddled with the cost, fiduciary risk and administrative burden of large numbers of small-balance accounts. Many plan sponsors will seek to minimize the small account burden by utilizing automatic rollovers or automatic cash-outs. This approach simply exacerbates the problem of cash-out leakage.
- A Surge in Missing Participants
The problem of missing participants in defined contribution plans is pervasive and has many causes, including:
- Frequent job-changing and the rise of the “gig” economy;
- Geographic mobility;
Additionally, defined contribution features such as auto-enrollment (particularly with low deferral rates) can play a role, resulting in “zombie” accounts that former employees never realized they had.
For participants, the ultimate risk of disappearing is not getting the benefits they’ve earned.
Plan fiduciaries, on the other hand, are the parties held responsible for locating missing participants and can’t afford to assume that recordkeepers will ensure accurate participant contact information. It’s up to the plan sponsor to find missing participants; however, they must cope with unclear guidance on when and how to locate them. If their plan is audited, they may also confront inconsistent enforcement actions.
How bad is the missing participant problem? Unfortunately, no one knows for certain as there are no credible statistics, studies or surveys that definitively address the scope of the problem. At present, the industry’s best guess is that approximately 6 percent of defined contribution participants are missing.
The Missing Link in Sustainability
Auto portability is 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.
There is a wealth of evidence demonstrating that auto portability would create a more robust and sustainable defined contribution system. The most compelling evidence was delivered in March 2017, when EBRI presented new research that $1.5 trillion of retirement savings would be retained through auto portability when applied to accounts with less than $5,000.
For participants, auto portability overcomes systemic friction and as such, directly addresses poor decision-making by turning the best choice (consolidation) into the easiest choice for participants. This means greatly-reduced levels of cash-outs and long-term preservation of retirement savings.
For plan sponsors, auto portability would result in fewer small balance accounts and sharply-reduced levels of missing participants. In addition, new participants would be more likely to roll-in balances from previous employers’ plans. Thus, average plan balances would rise, which generally translates to lower plan costs.
Finally, for service providers, including recordkeepers, fund managers, financial advisors and others, auto portability would result in increased retention of retirement assets, the foundation upon which their business models depend.
Moving Auto Portability Forward
To facilitate widespread adoption of auto portability, action is required.
For policymakers, the primary action item is the delivery of guidance by the Department of Labor (DOL) that would serve to mitigate any perception of fiduciary liability on the part of plan sponsors for the automatic roll-in of participants’ funds. We understand that this guidance is now a priority and should be forthcoming in 2018 in the form of a Prohibited Transaction Exemption (PTE), an advisory opinion or both.
Service providers should embrace auto portability due to the significant benefits it offers for their business models. Plan sponsors, too, need to understand and embrace auto portability for the benefits that it will deliver for their plans and for their plans’ participants. In the near-term, the best action that a plan sponsor can take is to let their recordkeeper know about their interest in, and support for, auto portability.
By acting collectively and adopting auto portability, America will finally have a defined contribution system that it deserves, one which has long-term sustainability and will generate the retirement outcomes originally envisioned.
Tom Hawkins is vice president of sales and marketing with Retirement Clearinghouse, and oversees all key operational aspects of this area, including RCH’s web presence, digital marketing and plan sponsor proposals. In other roles for RCH, Hawkins has performed product development, helped lead the company’s re-branding, evaluated & organized industry data and makes significant contributions to RCH thought leadership positions.