Due to the power of compound interest, seemingly small amounts that leak from tax-advantaged retirement accounts when people change jobs can cause major erosion to their nest eggs down the line, a study explains. The research seeks to examine what people do with their 401(k) balances when they leave an employer and looks at the demographics of people who roll in balances to their new employer.
Citing previous research, the study by Alight Solutions notes that four out of every 10 people cashed out their balances after termination within a 10-year period. Not surprising, Alight says, the group most likely to cash out were those with the smallest balances, such that 80% of people who had an account of less than $1,000 cashed out, while 62% of those with balances between $1,000 and $5,000 cashed out.
The study suggests that both age and income have an impact on roll-in behavior. Workers in their 20s are least likely to roll in money from a previous account to a new account, followed closely by those who are in their 60s. Workers in their 30s are the most likely to roll in balances. People with higher compensation were also much more likely to roll in balances. New hires making at least $80,000 were more than eight times more likely to roll in balances than new hires making less than $40,000.
There is a severe leakage problem when workers move to a new employer, particularly with small accounts, meaning they must completely start over when it comes to saving for retirement, says Spencer Williams, Retirement Clearinghouse founder, president and CEO. Using technology to save both time and resources, he notes that automatic portability seeks to help limit leakage by automatically moving retirement accounts from the old employer to the new employer.
For its version of auto-portability to work, the Retirement Clearinghouse follows guidance released by the Department of Labor that specifies the conditions that must exist for the company to be allowed to transfer a worker’s account, Williams says. Both employers must be signed up for the service, the worker must be notified no less than twice that a transfer will happen, and the worker must have the option to opt out at any time.
To illustrate the impact cash-outs can have on the future retirement accounts of those who chose not to roll their assets over to a new account, Alight made projections using a new-to-the-workforce employee.
For purposes of these projections, the firm assumed that a 22-year-old starts saving in a retirement plan at 3% and escalates that amount 1% each year, up to 6%. The plan matches 50 cents-per-dollar on the employee’s contributions. Interest was assumed to be 5% per year. The individual’s initial compensation was $25,000 and grew by 2% each year. Retirement was assumed to be at age 67.
If there is no leakage, the employee’s projected balance at age 67 could be almost $500,000, in this particular example. The study found that taking one early cash-out can having damaging consequences, while taking three small post-termination cash-outs during one’s working years can lead to a nearly 20% reduction in the projected age-67 balance, depending on when the cash-outs take place.
In the example, one cash-out at age 24 of $3,000 leads to a $23,000 (5%) loss in the projected age-67 balance, which equates to roughly half a year of additional working wages. An additional cash-out at age 26 of $4,500 leads to a $56,000 (12%) overall loss in the projected age balance, or roughly one year of additional working wages. A third cash-out at age 28 of $5,000 leads to a $91,000 (19%) overall loss—roughly 1.5 years of additional working wages.
Alight warns that this striking example may, in fact, paint an overly optimistic picture of the situation. First, the projections assume a modest, net-of-fees return of 5% per year. Alight’s 2020 Universe Benchmarks shows that, for the decade of the 2010s, the median return earned by participants was almost twice that. Higher returns would make the impact of the early cash-outs even more profound. Assuming a worker earned 7% each year, Alight found that the impact of the three cash-outs would be almost $200,000, or a 25% reduction in projected retirement income.
Additionally, the amounts shown for the cash-outs do not reflect the impact of any taxes or withholdings. Withdrawals of 401(k) balances are usually treated as income and can incur substantial federal and state taxes, Alight says. In most cases, people who take money out pre-retirement are also charged a 10% penalty tax.
“So, if anything, the amounts shown for the cash-outs in the projection can be viewed as an overstatement of the money the person would receive,” Alight’s analysis explains.
Leakage is most prominently seen among Black, Hispanic, women and other minority workers, says Renée Wilder Guerin, Retirement Clearinghouse public policy executive vice president. Research shows there is an “enormous benefit” to keeping peoples’ money in the tax-advantaged retirement planning system, and auto-portability helps to keep the playing field level and improve the wealth gap by ensuring there is no cash-out leakage when someone is moving to a new employer.
“In today’s world of growing interest in diversity, equity and inclusion, auto-portability is a solution that is measurable—you can measure the impact of someone keeping their retirement account going,” Wilder Guerin says.
She notes that, through Retirement Clearinghouse’s efforts to address the inequities and economic challenges many minority workers face, auto-portability has secured endorsements from two civil rights organizations—the National Urban League and the NAACP.
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