Addressing defined contribution (DC) retirement plan leakage is a task the retirement industry has been working on for years.
Plans may allow for participants to take “hardship withdrawals,” but there are strict requirements dictating when a participant is eligible to do that. According to the Internal Revenue Service (IRS), a retirement plan may allow participants to receive hardship distributions due to an immediate and heavy financial need and limited to how much is necessary to satisfy that need.
The amounts an individual withdraws from a retirement plan before reaching age 59½ are called early distributions. Individuals must pay taxes on those funds plus an additional 10% early withdrawal tax unless an exception applies. Educating participants about these taxes may help discourage early withdrawals.
Loans are another withdrawal option for participants, assuming their plan allows for them. Plan sponsors can limit the number of loans participants may take or limit what accounts they may borrow from, to help reduce leakage. Nothing in the law says that participants must pay loans in full upon termination of employment; however, recordkeepers may take issue with letting such loans remain open. Educating participants about the hit to their total retirement savings from taking a hardship withdrawal, early distribution or loan also may help encourage them to keep the funds in their account.
But hardship withdrawals, early withdrawals and participant loans are not DC plans’ biggest leakage problem. “Without a doubt, cash-outs are the biggest portion of retirement plan leakage,” says Employee Benefit Research Institute (EBRI) Research Director Jack VanDerhei, based in Washington, D.C. An analysis he conducted for EBRI in 2014 found approximately two-thirds of the leakage impact is associated with the cash-outs that sometimes occur at job change.
A demonstration provided by Retirement Clearinghouse, in Charlotte, North Carolina, shows that, in just over 30 years, total cash-outs could reach $282 billion while rollovers to other qualified plans would be only $14.7 billion, among 8.4 million participants. The firm’s analysis excluded appreciation, so these amounts could be substantially larger.
Under the Employee Retirement Income Security Act (ERISA), defined contribution plan sponsors may automatically force out participant account balances of less than $5,000. For amounts between $1,000 and $5,000, the money must be placed in a safe harbor individual retirement account (IRA).
Retirement Clearinghouse President and CEO Spencer Williams says his firm has an automatic portability solution that would use the demographic data from that rollover, send it to recordkeepers to see if there is a match in their system and, if one is found, automatically roll over the employee’s IRA to his new employer plan.
Retirement Clearinghouse’s demonstration shows that, when applying auto-portability over that same 30-plus-year period, cash-outs decline to $144.3 billion, and rollovers increase to $133.5 billion, among 77.5 million participants.
VanDerhei says, until there is legislation to address cash-outs, automatic roll-ins are the best means by which to use employees’ inertia for their own good. “If we can link those relatively small amounts from the past employer to the future employer, we’ve seen over and over that the size of the account balance increases,” he says.
“And, if we can get employees’ balances up to a sweet spot for a particular age, they will see their balances as significant enough to not take out of the plan.”
Williams says that sweet spot starts at $10,000 and goes up to $20,000. “The probability of cashing out drops from 90% to 30% when a participant’s account goes over $20,000,” Williams says. He notes that auto-portability can help participant accounts grow to $20,000 much sooner, as well as make rollovers easier for participants.
Vanguard research supports the idea that there is a certain amount above which participants are less likely to cash out their balances.
The company examined the plan distribution behavior, through year-end 2015, of 365,700 participants ages 60 and older who left employment in calendar years 2005 through 2014. Looking at the group retired at least five years, Vanguard found that seven in 10 participants ages 60 and up who had terminated from a defined contribution plan had preserved their savings in a tax-deferred account for five calendar years.
The three in 10 retirement-age participants who cashed out from their employer plan over five years typically held smaller balances. The average amount cashed out is approximately $20,000, whereas participants preserving assets had average balances ranging from $160,000 to $290,000, depending on the termination year cohort.
One important question is how plan rules on partial distributions might affect participants’ willingness to stay within an employer plan. Eighty-seven percent of Vanguard defined contribution plans in 2014 required terminated participants to take a distribution of their entire account balance even if an ad hoc partial distribution was desired. Only 13% of plans allow terminated participants to take ad hoc partial distributions.
The analysis suggests that participant behavior is affected by plan rules on partial distributions. For the 2010 termination year cohort, Vanguard analyzed participants in plans allowing partial distributions and, separately, those in plans that did not. About 30% more participants and 50% more assets remain in the employer plan when ad hoc partial distributions are allowed. In the 2010 cohort, five years after termination, 22% of participants and 26% of assets remain in plans allowing partial distributions compared with only 17% of participants and 18% of assets for plans that do not allow partial distributions.
“One way sponsors might encourage greater use of in-plan distributions is by eliminating rules that preclude partial ad hoc distributions from accounts,” says Jean Young, senior research analyst at the Vanguard Center for Retirement Research, in Valley Forge, Pennsylvania, and lead author of the study report.
Regulations and Education
VanDerhei says he has no knowledge of anyone trying to address the overall cash-out problem legislatively. The IRS, however, has made attempts to improve the plan-to-plan rollover process, by: introducing an easy way for a receiving plan to confirm the sending plan’s tax-qualified status; issuing new guidance for allocating pre-tax and after-tax amounts among distributions that are made to multiple destinations from a qualified plan; and introducing a new self-certification procedure designed to help recipients of retirement plan distributions who inadvertently miss the 60-day time limit for properly rolling these amounts into another retirement plan.
VanDerhei says employees do get frustrated with the difficulties of rolling over their assets to a new plan; so making that easier is key to success.
However, he also says, with plan sponsors’ new interest in financial wellness, information directed at DC plan participants who are at the point of terminating employment could have an impact. “If they realize what cashing out will cost them in the long run and how it will affect their total retirement savings, that could modify the behavior of some participants,” VanDerhei says.
“In any case, automatic provisions trump anything plan sponsors can do with education,” he concludes. “It will still allow employees access to their cash if they need it, but the default will be best for them in the long run.”