By Spencer Williams
President and CEO of Retirement Clearinghouse
April 15 is just around the corner. While many Americans dread Tax Day, April 15 presents defined contribution plan sponsors with an opportunity to demonstrate their value as fiduciaries, and as financial wellness advocates.
Anyone who is 18 or older, not a full-time student, and not claimed as a dependent on someone else’s tax return is eligible for a retirement savings contributions credit (also known as a saver’s credit). This tax credit rewards people for making eligible contributions to their IRAs or employer-sponsored retirement plans.
To help plan participants adopt better saving habits, and also improve their retirement outcomes, sponsors can proactively encourage participants who receive a saver’s credit to avoid the temptation to spend that refund—and, instead, invest it in a Roth IRA account so it can be preserved in the U.S. retirement system. If possible, sponsors can also advise participants on how they can roll their saver’s credits into their active 401(k) savings accounts.
Incubation is like exercise—it feels better the more you do it. By educating participants about the importance of incubating saver’s credits in the retirement system, sponsors can hopefully make the former less likely to cash out their 401(k) account balances when they change jobs. Cash-outs are responsible for 89% of all asset leakage from our country’s retirement system, according to the U.S. Government Accountability Office, and seriously undermine participants’ chances of achieving a financially secure retirement.
Just how much does cashing out hurt the average participant? Our calculations indicate that a hypothetical 30-year-old who cashes out a $5,000 401(k) savings balance today would, by age 65, forfeit up to $52,000 in lost earnings and appreciations! According to Aon Hewitt, a hypothetical participant who cashes out on three occasions before retiring would reduce their retirement savings from over 6 times pay to 1.25 times pay.
And speaking of Tax Day, participants who cash out suffer not one, but two hits to their wallets. In addition to being subject to taxes and early withdrawal penalties which reduce the overall sum they receive, participants also forgo future growth and potential retirement income on the amount withdrawn.
Reducing cash-outs is an urgent imperative because younger participants are more likely to make this harmful decision than their older counterparts. A 2015 study of mobile workforce behaviors conducted by Boston Research Technologies found that 34% of Millennials and 34% of Generation-Xers had cashed out at least one retirement savings account during their working lives, compared to 24% of Baby Boomers.
Furthermore, findings from E*TRADE Financial’s StreetWise quarterly study, made public in August 2018, revealed that the majority (59%) of young investors between ages 18 and 34 have made an early withdrawal from a retirement savings account. The number of investors in that age range who have withdrawn retirement savings grew from nearly one-third to more than half in just three years.
This is why plan sponsors need to proactively encourage younger participants, and especially Millennials, to develop the habit of keeping their hard-earned retirement savings incubated in the retirement system for as long as possible. Advising and assisting participants with incubating their 2019 saver’s credit goes hand in hand with any financial wellness program.
Why FIRE Adherents Will Love Auto Portability
The Financial Independence, Retire Early (FIRE) movement has been “catching fire,” no pun intended, among Millennials eager to achieve a financially secure retirement as quickly as possible. Auto portability—the routine, standardized, and automated movement of a retirement plan participant’s 401(k) savings account from their former employer’s plan to an active account in their current employer’s plan—is vital for enabling Millennials to increase their income in retirement as they move from job to job, regardless of the age when they retire.
If broadly adopted, auto portability can preserve an estimated $1.5 trillion in retirement savings, measured in today’s dollars, in the U.S. retirement system, according to the Employee Benefit Research Institute (EBRI).
However, Millennials can benefit from auto portability more than other participants. EBRI research published in February 2019 examined the accrual rates required for defined benefit plans to generate the same projected retirement income as 401(k) plans with auto enrollment and auto portability. EBRI found that men and women with the lowest income, and the lowest number of years in the workforce, would receive the highest amount of projected income from 401(k) plans with auto enrollment and auto portability.
In addition to EBRI’s conclusions, there is another reason why auto portability is important for helping Millennials achieve their retirement-saving goals. If a 401(k) account is stranded in a prior-employer plan, or automatically rolled into a safe-harbor IRA, accountholders have to pay fees on those extra accounts, and they can add up.
Using data from New England Pension Consultants, which reported that the median record-keeping fee for defined contribution plan participants was $70 in 2014, a hypothetical worker who leaves a 401(k) savings account behind in a former-employer plan at age 30 would lose $2,520 in fees on that account by age 65, if we assume the account has a 5% annual rate of return. But that’s not all the hypothetical worker would forfeit—they would also give up future earnings from compound interest on the $2,520 in fees. If we again assume 5% annual growth for the account, the $2,520 would increase to $6,708.54 by the time the worker turns 65.
Failing to transport and consolidate even one 401(k) savings account during their working lives can cost Millennials nearly $7,000 in retirement income.
This fact underscores the importance of educating plan participants, and especially Millennials, about why they should keep their assets consolidated and incubated in the U.S. retirement system. Start the conversation—remind eligible participants to claim for a saver’s credit on their tax returns, and advise them to invest that refund in the retirement system.