ERISA-Extra Summer 2018

Retirement Plan Leakage

Ideally, employees who participate in your retirement plan will preserve the money in their plan accounts for retirement. Realistically, employees may struggle with competing financial demands and not always put their future financial security first. As a result, they may seize opportunities to tap their retirement savings early—resulting in "leakage" that erodes the assets they’ll have available to fund their retirement years. Here's a look at how leakage happens and steps plan sponsors might consider taking to curb it.

Cash outs

Upon separation from service, participants typically have several options for their plan savings. They may roll the money into an Individual Retirement Account (IRA) or their new employer's retirement plan—or leave it in their existing plan. But some may choose to cash out their accounts. Additionally, participants who have less than $5,000 in their account when they separate from service may be automatically cashed out by the employer.

A recent survey of 5,000 plan participants by the Defined Contribution Institutional Investment Association found that one-third of millennials and Gen-Xers and almost one-quarter of baby boomers had cashed out their retirement savings at least once when changing jobs. Many reported using the funds for non-emergency spending, such as weddings and cars. Cash-outs are one of the main sources of leakage from the retirement system.1

Withdrawals

In-service withdrawals are another significant source of leakage.2 For example, many 401(k) plans permit participants to request hardship distributions of elective deferrals for immediate and heavy financial needs, such as postsecondary education expenses and buying a primary residence.3 Hardship distributions are taxable and may be subject to the IRC Section 72(t) 10% additional tax on early distributions unless an exception applies.

While an argument can be made that employees may be more willing to save for retirement when they know they can access their plan savings if they really need to, the fact remains that funds withdrawn on account of financial hardship generally cannot be repaid to the plan or rolled over into an IRA or other qualified plan.4 Indeed, leakage from hardship distributions could increase in 2019 and beyond as retirement plans implement provisions of the Bipartisan Budget Act of 2018 (P.L. 115 – 123) that permit hardship distributions not only from elective deferrals but also from accumulated plan earnings, qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs).5

Plans may give participants additional opportunities to make in-service withdrawals—penalty free—after they reach age 59½. Although data suggest that a majority of funds withdrawn by older employees is rolled over into IRAs, approximately 30% of post-59½ withdrawals may represent leakages.6

Loans

Like hardship withdrawal provisions, plan loan options tend to encourage participation and higher contribution rates. And most retirement plan loans are repaid. However, should a loan not be repaid on time, there’s a potential for leakage. For example, a plan may give participants only a short window to repay their loans upon termination of employment. Where repayment does not occur, the loan is cancelled and the participant’s account balance is offset by the unpaid amount. A loan offset amount is treated as a distribution from the plan and is rollover-eligible. However, completing the rollover requires the participant to timely contribute the funds to an eligible plan or IRA. The Tax Cuts and Jobs Act of 2017 has extended the rollover period for plan loan offset amounts from 60 days to the participant’s tax return due date (including extensions) for the year of the distribution.7 In addition to triggering income taxes and a potential 10% penalty, failure to complete the rollover would diminish the participant’s retirement savings.

Steps to consider

To address the issue of leakage, plan sponsors may want to:

  • Make easy-to-understand educational materials available to departing employees that explain the options they have for ongoing management of their retirement savings
  • Let incoming employees know they can consolidate their retirement assets held in the plans of former employers into their new plan, if the plan accepts rollovers
  • Review plan design with an eye toward limiting opportunities for in-service withdrawals and loans
  • Consider broader financial education initiatives around personal money management skills and strategies that will help employees avoid the need to tap their retirement savings prematurely

Are Your Participants Paying Attention to Asset Allocation?

Participant reaction to the stock market gyrations in early February appears to have been something of a mixed bag, with some retirement plan sponsors and recordkeepers reporting few inquiries and muted trading activity and others observing an uptick in one or both.8 Although moving money in and out of equities in an attempt to "time the market" is generally discouraged for long-term retirement investors, the alternative—staying the course during market ups and downs—works best when participants have allocated their plan assets appropriately in the first place. In view of the recent stock market volatility, plan sponsors may want to step up their efforts to educate participants about the importance of maintaining an asset allocation that reflects their personal risk tolerance, time horizon and goals.

A look at the numbers

Ongoing analysis of 401(k) plan account data by the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI) indicates that the majority of plan assets were invested in equities at  the end of 2015, include the assets of participants in their 50s and 60s.9

401(k) Account Balances, 2015

Age Group

% in Equities*

20s

79.5

30s

78.0

40s

74.1

50s

65.3

60s

55.2

Among all the participants in the 2015 EBRI/ICI database, almost half (48%) had more than 80% of their account balances invested in equities (equity funds, company stock or the equity portion of balanced funds). As might be expected, asset allocation to equities varied by age, with younger participants being much more likely to have high equity concentrations. Still, about one-quarter of participants in their 50s and about one-fifth of participants in their 60s had allocated more than 80% of their account balances to equities.

401(k) Participants (%), 2015

 

Age Group

No Equities

> 80% of Balance in Equities*

20s

6.9

75.3

30s

7.0

69.9

40s

7.6

46.7

50s

8.7

25.7

60s

12.7

20.6

Too much risk?

As retirement approaches, participants need to be concerned about the adverse impact that an extended stock market downturn could have on their portfolios and retirement income. With a portfolio that is highly concentrated in equities, new retirees are exposed to potential "sequence of returns" risk. Should they experience a series of poor returns in early retirement after they have begun withdrawing money from savings, it may be very difficult to recover the losses, putting them at increased risk of running out of money in their later years.

Time to review

Despite its obvious upside, there’s also the possibility that the long bull market has lured some of your plan’s participants into the trap of overestimating their ability to tolerate risk. Now may be a good time to provide additional education regarding basic asset allocation principles and to encourage participants to review—and if necessary adjust—their asset allocations.

Survey Says: Americans Value Defined Contribution Plans

Given all the time and money spent in making a retirement savings plan available to your employees, you want the plan to be appreciated. If recent survey results are any indication, there’s little to worry about on that score. "American Views on Defined Contribution Plan Saving, 2017," a new research report from the Investment Company Institute, confirms that most U.S. households have favorable impressions of 401(k) and similar retirement plan accounts and appreciate the key features of these plans.10

The online survey, conducted last December, asked a representative sample of roughly 2,000 adults in the United States a series of questions regarding defined contribution account saving. Here are some of the key findings.

General feedback

A majority (74%) of the surveyed households held a "very favorable" or "somewhat favorable" opinion of these accounts. Appreciation was highest among the households that owned defined contribution or Individual Retirement Accounts, with 86% holding very or somewhat favorable opinions. However, almost half (49%) of the households that were not account owners had a positive impression as well. When asked to indicate their confidence in the ability of 401(k) and other employer-sponsored plan accounts to help individuals meet their retirement goals, 84% of account owners and 63% of those who didn’t own accounts expressed confidence in the defined contribution plan account approach.

Some specifics

For the most part, the surveyed defined contribution account owners were very positive about key features of their employer-sponsored retirement plans, agreeing that:

  • The plan helps them think about the long term, not just current needs (91%)
  • Payroll deduction makes it easier to save (92%)
  • The plan’s tax treatment is a big incentive to contribute (82%)
  • Having choice in and control of account investments is very important (94%)
  • The plan offers a good investment lineup (83%)
  • Saving from every paycheck makes short-term investment performance less worrisome (83%)

Close to half (48%) said they probably wouldn’t be saving for retirement if they didn’t have a retirement plan at work.

Your retirement plan is a tool

In today’s tight job market, it can be difficult to hire and retain the talented employees your organization needs. Leveraging employee benefits—including your retirement plan—can be helpful in those efforts. Along with healthcare benefits, retirement savings and planning benefits are frequently cited by human resources professionals as being important to a majority of their organization’s employees.11 To get the most mileage from your retirement plan, you’ll want to make sure you are effectively communicating its value to both prospective and current employees.