Small Accounts: The Root of Many Problems

By Spencer Williams | August 9, 2017

If you’re like most homeowners during these dog days of summer, you’re not just basking in the sunshine or swimming in the pool with your family. You also have a fight on your hands—the war against the dandelions that invade and attempt to occupy your entire lawn every year at this time.

As every experienced gardener knows, you can’t get rid of dandelions by picking their stems. This tactic offers a mere temporary solution to the problem. People may not be able to see dandelions on your lawn for a while, but the roots of those weeds are still in the soil, so they’ll quickly grow back, and might return in greater numbers than before.

You have to attack the root of a problem if you want to win an entire war instead of just individual battles. And what’s true in the war against dandelions is also true for the war against the administrative headaches posed by small retirement accounts owned by terminated participants. These administrative hassles may seem trivial at first, but if left unchecked, can lead to serious problems for defined contribution plan sponsors, such as high expenses and inadvertent fiduciary liability.

Many sponsors have tried to address these issues, but their tactics don’t target the roots of the proverbial dandelions in their plan gardens. For example, some sponsors have attempted to lower their plan expenses and increase their average account size by rolling small accounts with under $5,000 stranded by terminated participants into safe harbor IRAs, and automatically cashing out stranded accounts with less than $1,000.

These tactics may reduce plan expenses and raise average account sizes, but they also create difficulties of their own, since lost or missing participants might not actually cash the checks for less-than-$1,000 balances that are automatically cashed out, and may not pay attention to the notices that their less-than-$5,000 balances have been rolled over to safe harbor IRAs (which can eat away at retirement savings over time). With penalties for missing participants increasing, plan sponsors may feel that these “solutions” are the equivalent of pushing sand, as reductions in recordkeeping expenses from purging these small accounts in this way could drive up other administrative costs.

The root of these and other challenges for sponsors, as well as participants, is the seemingly endless creation of small, inactive accounts—and the friction in the U.S. retirement system that makes it difficult to seamlessly transfer the balances from plan to plan as participants change jobs. The well-reported increase in the mobility of America’s workforce, along with the advent of auto enrollment under the Pension Protection Act (PPA) of 2006, has led to a surge in small, stranded accounts in defined contribution plans and so-called safe harbor IRAs across the retirement system. In the five years after the above-mentioned law went into effect, our nation’s retirement plans found themselves dealing with an estimated 40.5 million inactive accounts left behind by terminated participants, up from 38 million in 2006, according to data provided by the Employee Benefit Research Institute (EBRI). And this increase has occurred despite the safe harbor IRAs provided for mandatory distributions for accounts with less than $5,000. The proliferation of small accounts due to auto enrollment, combined with the highly mobile nature of the modern workforce and the absence of a system-wide clearinghouse for moving 401(k) savings from plan to plan, have combined to guarantee that plans continue to be overwhelmed with stranded accounts from terminated participants.

According to EBRI, about 22% of the country’s 66.2 million defined contribution plan participants change jobs every year, and 31% of these job-changers (roughly 4.6 million participants) will cash out within one year after changing jobs.

Given the complexity and expense of DIY plan-to-plan portability, many of these job-changers continue to leave behind small, inactive accounts as they move from employer to employer. EBRI data indicates that 47% of all retirement savings accounts have less than $15,000, and the mean balance among all these accounts is a mere $4,642. Furthermore, Vanguard’s “How America Saves 2017” report stated that a whopping 30% of all participants in Vanguard-administered plans had separated from their employers in the past year or in prior years. In other words, even after allowing for involuntary cash-outs, mandatory distributions, and voluntary cash-outs, nearly one-third of accounts in plans administered by one of America’s largest plan administrators are inactive, stranded ones.

Auto Portability is the Most Effective Weed Killer

To attack the root of the small-account weed overrunning the gardens of retirement plans and the retirement system as a whole, sponsors can adopt auto portability—the routine, standardized, and automated movement of a plan participant’s 401(k) savings account from their former employer’s plan to an active account in their current employer’s plan.

The Auto Portability Simulation (APS) that we developed with Dr. Ricki Ingalls of Texas State University found that under a scenario where auto portability is widely adopted over the course of a generation, there would 40 million fewer job-changers with less than $5,000 in their accounts at the time of their employment switch by the year 2045. This is a dramatic change from recent experience, and presents the potential for relief from the administrative burdens and potential fiduciary liability that have been creeping up on plan sponsors for the past several decades. Furthermore, the widespread adoption of auto portability would preserve up to $1.5 trillion in savings, measured in today’s dollars, in the U.S. retirement system, a healthy contribution to retirement readiness.

Fortunately for sponsors, the technology enabling auto portability is now live. The first fully automated, end-to-end transfer of retirement savings from a safe harbor IRA into a participant’s active account for one large plan sponsor client was recently completed, adding to the potential for a nationwide system of automated plan-to-plan transfers to ameliorate the long-standing issues of small-account leakage and related administrative burdens and expenses.

Auto portability provides an effective long-term solution to the many issues affecting plan sponsors and participants by addressing the common root of all these challenges. Now that the weed killer is available, sponsors no longer have to continue picking the stems of the dandelions in their plan gardens.