By Thomas Hawkins
Automatic rollover programs allow plan sponsors to force out of their plan separated participants with balances less than $5,000 into a Safe Harbor IRA. These programs can be quite effective at helping sponsors resolve many of the problems associated with housing small-balance accounts in-plan, such as: Higher levels of missing participantsIncreased administrative costs and workload Higher recordkeeping fees Lower average account balances While the benefits are well-known, there are some common misconceptions about automatic rollovers. To ensure that plan sponsors can adequately fulfill their fiduciary responsibility to participants, we’ve identified the five most important misconceptions that are important for sponsors to understand and avoid.
Misconception #1: It’s best to cash out participants with balances less than $1,000
Often times, plan sponsors believe that they should automatically distribute (cash out) separated participants with balances less than $1,000. After all, it’s quick & easy, it’s allowed, and those participants would likely have cashed out anyhow. Right? Not so fast.
This approach might seem like a quick fix, but all distribution checks remain a plan asset until cashed. The largest single source of uncashed distribution checks is from automatic cash outs. Through this policy, plan sponsors unwittingly create a big problem -- one which is tough to resolve, but must ultimately be dealt with .
Automatically roll over balances less than $1,000: Avoid uncashed distribution checks -- include separated participants with sub-$1,000 balances in the automatic rollover process. Select an automatic rollover services provider who will accept balances less than $1,000 into a safe harbor IRA.
Misconception #2 – Cash out rates aren’t important in an automatic rollover program
Somehow, we’re conditioned to believe this. EBRI reports that the average balance for separated participants with less than $5,000 is $1,679. Also, according to the three largest recordkeepers, it’s “routine” to see 60%+ cash out rates for this balance segment. Why be concerned about cash outs?
First, there’s higher employee turnover in the sub-$5,000 balance segment. EBRI estimates that this segment has an annual turnover rate of 28%. EBRI further estimates that the sub-$5,000 balance segment represents 28.5% of the total number of defined contribution participants. This works out to over 5 million annual job-changing participants with a balance of less than $5,000!
Second, even modest retirement savings balances can add up. If a 30-year old participant with a $1,679 balance cashes out, they’ll net $1,175 in cash, after taxes and penalties. That same participant who avoids cashing out and consolidates their balance into a new 401(k) plan could end up with $17,926 at retirement.
Improve the odds through participant counseling: Select an automatic rollover service provider who discourages participant cash out behavior by illustrating the high costs of cashing out. By adopting this practice, a study conducted by Boston Research Group found that a mega plan sponsor reduced cash outs in the sub-$5,000 segment by 50%, vs. industry averages.
Misconception #3 – Once in a safe harbor IRA, former participants “take charge” of their savings
If former participants manage to avoid cashing out, and have their savings moved to a safe harbor IRA, it’s natural for plan sponsors to believe that a substantial portion of them will “take charge” of their accounts, moving out of the default investment and into more-appropriate long-term investments, such as target date funds.
Based upon that belief, many plan sponsors (or their consultants) who evaluate automatic rollover service providers will place a heavy premium on the investment options that are made available to their former participants.
While choice is generally good, in reality less than 1% of all safe harbor IRA accountholders will take active control of their safe harbor IRA, and elect to move out of the default investment option selected by their former plan sponsor.
Focus on moving balances forward: More important than an extensive menu of investment choices is having an automatic rollover services provider with a strong commitment to moving safe harbor IRA balances forward and the ability to consolidate the safe harbor IRA balance with the participant’s new, qualified plan or an existing IRA.
Misconception #4 – Monthly and annual fee structures are comparable
If safe harbor IRA provider “A” has a $2.50 per month account maintenance fee, while provider “B” charges $30 per year, that’s essentially an equivalent fee structure, right? Not quite.
Monthly, pay-as-go fees are a better solution: The average duration of a safe harbor IRA is 168 days. For those former participants who are in a safe harbor IRA for a short time, a monthly fee structure is highly-preferable to an annual, upfront structure. For example, the “average” accountholder under a monthly fee structure would pay $15, while all accountholders paying an upfront, annual fee would immediately fork over the full $30. That’s an average savings of 50%. In fact, the equivalent monthly fee would have to reach $5 per month for the cost structure to be equivalent to a $30 annual fee.
Misconception #5 – Safe harbor IRA “decay rate” is key to selecting an automatic rollover service provided
When plan consultants evaluate automatic rollover service providers, it’s common to employ a spreadsheet-based analysis, using as input the default investment fund’s return, along with periodic account maintenance fees. The output is a hypothetical “decay rate” – forecasting how long various account balances could last, over time, and under certain yield assumptions. Presumably, preference is given to those providers whose slope of decay is the most gentle.
There’s a modicum of validity to a decay rate analysis, but only if one takes the view that safe harbor IRAs are a satisfactory vehicle for lifetime retirement savings. Given that so few accountholders actually take charge of their investment (see #3 above), safe harbor IRAs are best-viewed a temporary vehicle to house retirement savings, until former participants can move their balances forward.
Additionally, a decay rate can be very misleading when comparing one safe harbor IRA provider with a monthly fee, versus another with an annual fee. Also, if one IRA provider has a much shorter average holding period than the other, how accurate is the decay rate as a means of comparison? Certainly, fees are an important consideration when evaluating safe harbor IRA providers. However, other factors, such as the ability for a provider to find lost account holders and reunite them with their retirement assets, and move those assets forward, are arguably more critical.
Recycling beats a “landfill” every time: Ensure that your automatic rollover service provider has safe & solid default investment options, with no lock-in provisions. Most importantly, make sure that they can effectively assist participants in returning/recycling these retirement savings back into the qualified plan system, vs. forever consigning them to a safe harbor IRA “landfill."