Every year retirement plan participants find themselves withdrawing funds from their retirement accounts to pay for unexpected short-term expenses and emergencies.
Every dollar leaked from a retirement account today loses interest that would have accrued over a lifetime. But still, according to PLANSPONSOR’s 2017 Defined Contribution (DC) Survey, on average 13% of DC plan participants have outstanding loans and 31% of plan sponsors surveyed allow participants to take out not just one, but two loans at a time.
To further understand the breadth of this issue, Stephen Utkus, principal and director at the Vanguard Center for Retirement Research and the Pension Research Council, says nearly 40% of Americans with 401(k) accounts have borrowed from their accounts over the last five years, while defaults on these loans create an estimated $6 billion in annual “leakage” from the retirement savings system.
If retirement plan participants had a source of emergency savings, they may not dip into their retirement accounts.
Establishing short-term savings
Within the context of overall financial wellness, Michael Knowling, head of client relations and business development for Prudential Retirement in Hartford, Connecticut, says, “We are exploring a number of components to help employees and sponsors, including sidecar accounts. These accounts, also known as emergency savings funds or rainy-day fund accounts, are designed to allow participants to meet short-term financial needs that retirement plans are not designed to address.”
“Side car” is used most often in the UK where employees make voluntary contributions via payroll deductions to emergency funds sitting alongside their retirement accounts—hence the term sidecar.
Designed either within the retirement plan, as a sidecar next to the retirement plan or completely separate from a retirement plan, the employer establishes an after-tax contribution source, in which the employee contributes up to a certain threshold, such as $1,000 to $1,500, through payroll deductions. Once the employee’s account reaches the specific threshold, in that source, future contributions shift to the participant’s formal retirement plan.
Before DC plans became the main retirement vehicle for employers, Thrift Savings Plans were offered to complement defined benefits plans. These plans were savings accounts that employees contributed to after-tax, which made withdrawals tax-free, and employers attached them to long-term savings plans. What differentiates sidecar accounts from thrift savings accounts is how they’re funded. When employers sponsor sidecar accounts, money is automatically deducted from payroll, like a participant’s retirement account contribution.
David Mitchell, associate director, policy and market solutions of the Financial Security Program of the Aspen Institute, a non-profit think tank, explains, “To ensure a constant savings buffer, the short-term account is automatically replenished as necessary. The hope is that by formalizing the dual role the retirement system currently plays, savers would be in a better position to distinguish between what is available now and what is locked away for retirement. This would allow them to meet both short- and long-term financial goals more easily.”
“With the change in the tax laws, some employers have cash that is available to them, that can be used on a discretionary basis to fund sidecar accounts or employers can do it as a matching component,” Knowling says. “Plan sponsors have some flexibility. If you have matching funds, you may incent people who are not even in the plan to join the plans. And the discretionary piece allows plan sponsors, for instance, to make a one-time discretionary contribution. If the fund is part of the plan it’s important for the plan sponsor to have a full discussion with their recordkeeper from a non-discrimination perspective. An analysis up front on the impact of the non-discrimination testing perspective may guide the employer to decide whether they should or should not make employer contributions to the account.”
Mitchell expounds on another regulatory challenge. “There are legal barriers to automatically enrolling workers into these accounts depending on how they are designed. Automatic enrollment makes such a difference when it comes to getting to scale. The industry knows how to implement auto enrollment into retirement accounts and the legal barriers have been relaxed in that area so there is a good argument for situating sidecar accounts within the retirement plan, so as to benefit from those advantages.”
Auto enrolling short-term savings
The Strengthening Financial Security Through Short-Term Savings Act, S.3218, was introduced by a bipartisan group of Senators—Cory Booker (D-New Jersey), Tom Cotton (R-Alaska), Heidi Heitkamp (D-North Dakota), and Todd Young (R-Indiana) to allow employers to offer short-term savings accounts with automatic contribution arrangements for financial emergencies, with the intent of reducing early withdrawals from retirement accounts and facilitating short-term savings by allowing employers to auto enroll their workers in emergency savings accounts in addition to retirement accounts. S.3218 is one of four retirement-related bills introduced by these Senators.
“The fact that this bill has such ideologically diverse bipartisan cosponsors—as part of the broader retirement security package of bills—shows the consensus behind the idea, which stems from the extensive research and analysis of this issue by folks at the Aspen Institute, Pew Charitable Trusts, AARP, the Bipartisan Policy Center, Harvard University, Prosperity Now and many others, says Shai Akabas, director of economic policy and the Bipartisan Policy Center.
He continues, “Short-term saving (sidecar) accounts through the employer could be a critical part of the answer, allowing workers to accumulate a meaningful emergency reserve and protect retirement savings for their intended purpose. This legislation would open the doors for employers to experiment with a solution that could bring meaningful improvement to the financial situation of millions of Americans.”
The Aspen Institute Financial Security Program’s Executive Director Ida Rademacher said the following in response to the introduction of the bill, “I commend Senators Heitkamp, Cotton, Booker, and Young for turning this promising idea into smart, carefully crafted legislation. By giving the green light for employers to automatically enroll their workers into short-term savings accounts, this bill has the potential to spur much-needed innovation, experimentation, and uptake—similar to what happened to employer-sponsored retirement accounts after the Pension Protection Act passed over a decade ago. Today’s working families need new tools to meet the unprecedented short- and long-term financial challenges they face. Sidecar rainy day savings may well do both—by building up an emergency fund while simultaneously reducing the need for premature withdrawals from retirement accounts.”
How sidecar accounts can help
Beth A. Pattillo, director of retirement programs for Leidos, in Reston, Virginia is contemplating such funds for their diverse, yet highly educated employee population. Pattillo believes that providing employees not only with education about being financially fit, but also the tools to assist in achieving their goals is imperative to successful behavior. “Employees should have access to a simple, easy-to-use process that would allow them to save for a rainy-day with systematic payroll contributions to a savings account specifically for emergencies. This would hopefully produce added benefits: getting into the habit of saving, building wealth and security, and reducing leakage from retirement plans through loans or hardship withdrawals. I believe that as regulations evolve and guidance is provided, employers will be very interested in exploring sidecar opportunities,” she says.
Mitchell addresses how having liquid savings can impact employees and employers. “I think this has a major promise in making workers a little less stressed out about their day-to-day financial obligations which right now can be all consuming and a drag on productivity.”
In addition, he says there are practical considerations for plan sponsors and recordkeepers. The administrative process of issuing a loan or hardship withdrawal from a DC plan is complex and time consuming for both employers and participants. “If participants instead had an emergency savings pocket they could access, no questions asked, it would make plan administration much easier,” Mitchell says.
“It’s hard to get anything through Congress these days, but there is momentum building for a bipartisan retirement package to make it through, and I think [S.3218] has a good chance of being included when that happens,” Akabas concludes.