Retirement in America Part III: Plugging the Leaks in the Hull of American Retirement

Anyone who has been paying attention to coverage of the retirement crisis has likely heard the term “leakage.” In the context of our retirement system, leakage refers to any type of pre-retirement withdrawal that permanently removes funds from a retirement savings account.

In a March 2019 report, the Government Accountability Office found that in 2013 Americans in their prime working years (ages 25-55) removed at least $69 billion of their retirement savings early. That figure was split between IRAs ($39.5 billion) and employer-sponsored plans ($29.2 billion). According to the IRS, for every $1 contributed to retirement accounts by or on behalf of savers under age 55, $0.40 leaks out.

The long-term impact of these withdrawals is substantial. A 35-year old worker that withdraws $5,000 at age 35 could lose upwards of $30,000 from their final account balance due to missing compounding earnings.

When discussing avoidable leakage, the conversation hinges on two different types of leakage: Early withdrawals made voluntarily by the participant, and involuntary cash-outs of low-balance accounts executed by plan sponsors.

Voluntary Early Withdrawals

The reasons for these early withdrawals vary. Some are withdrawn to support other investments, like buying a home or paying for higher education. Others are for more need-based situations, such as paying a medical bill, covering a major home or car repair, or an unexpected pay cut or job loss.

The latter expenses – called “financial shocks” by The Aspen Institute Financial Security Program – and their subsequent impact on retirement savings highlight the lack of adequate savings among American families. According to research from the Federal Reserve in 2016, 44% of Americans said they could not cover an emergency expense of $400 without borrowing or selling something.

These financial shocks are driving the momentum behind the idea of emergency savings and “sidecar” accounts as part of employee benefits, both in the public and private sector.

Companies like Levi Strauss and Home Depot are helping their employees to fund emergency accounts, in some cases incentivizing them with cash to participate. Other businesses are giving employees the option to save a portion of their paycheck into emergency funds in addition to contributing to their 401(k). BlackRock has pledged $50 million to help low- to moderate-income workers build emergency savings.

According to the LIMRA Secure Retirement Institute, 89% of employers are interested in offering an automatic emergency savings account that could be funded to a desired amount, and after meeting that threshold the money would go directly to retirement savings.

This inertia is reflected in the public sector as well, most notably in the form of The Saving for the Future Act, a piece of legislation introduced in 2019 by Senators Amy Klobuchar (D-MN) and Chris Coons (D-DE) that would:

• Require businesses with more than 10 employees to contribute at least 50 cents in an employee’s savings/retirement plan for every hour an employee worked

• Automatically enroll workers at 4%

• Provide a tax credit of 50% of minimum contribution to impacted businesses

This proposed legislation reflects an increasing awareness of the barriers that Americans face when saving for retirement.

Involuntary Cash Outs

Retirement plan sponsors are able to distribute accounts with balances of $1,000 to $5,000 that belong to non-responsive former participants, via a transfer to a Safe Harbor IRA or by cashing out the account and mailing a check for accounts with balances of $1,000 or less.

The option to transfer to a Safe Harbor IRA, otherwise known as an automatic rollover, came about as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. This change created needed relief for plan sponsors while also keeping those participants’ assets in a tax-deferred account, thus limiting leakage.

Yet according to the Plan Sponsor Council of America’s 61st Annual Survey of Profit Sharing and 401(k) Plans, only 53.7% of all plans transfer balances between $1,000 and $5,000 to an IRA, and 81.6% pay out balances less than $1,000. Increasing the usage of automatic rollovers across the industry, and including accounts of less than $1,000, may help prevent some of the involuntary leakage currently hindering our retirement system.

One attempt to expand the usage of automatic rollovers is the Retirement Plan Modernization Act, which proposes raising the automatic rollover limit to $7,600 and adjusting that number with inflation over time. This proposed legislation would expand relief for plan sponsors, protect the tax-deferred status of more participant accounts and perhaps prevent some leakage before it starts.  

Though not yet sinking, the American retirement system has enough small holes that it requires structural attention. If these leaks are not properly addressed, it could eventually transform into an “all-hands-on-deck” situation.

Catch up on Retirement in America Part II: Americans Lack Savings.

The material in this blog is presented for informational purposes only. Millennium Trust Company performs the duties of a directed custodian, and as such does not sell investments or provide investment, legal or tax advice.