By Thomas Hawkins | March 14, 2017
Over the past year, the Department of Labor’s Fiduciary Rule has been highly-visible, presenting major ramifications for the retirement industry and looming large on the radar screens of retirement services providers.
The underlying rationale for the rule, as stated by the Obama administration in an April 6, 2016 press briefing, was to save retirement investors $17 billion per year in lost retirement savings that result from conflicts of interest in retirement advice. Certainly, anything that protects $17 billion in retirement savings is a worthy goal, if it helps more Americans meet their retirement income needs.
However, there’s a larger hole in our retirement system – cash-out leakage – that inflicts far greater harm to American retirement savers, yet this threat continues to fly beneath our collective radar.
- A 2009 U.S. Government Accountability Office (GAO) report on retirement plan leakage reported that $74 billion is prematurely cashed out of retirement plans, on an annual basis. The GAO’s report, which was based on pre-recession 2006 data, didn’t include taxes and penalties paid on the withdrawals.
- In May 2012, the Employee Benefit Research Institute (EBRI) estimated that reducing cash-out leakage by just 50% would save Americans $94.5 billion per year, ballooning to $1.3 trillion over 10 years.
Despite these eye-popping statistics, we’ve continued to cast a blind eye to viable solutions to reduce cash-out leakage. Indeed, we often fail to adequately acknowledge the fundamental nature of the cash-out leakage problem itself.
Let’s examine three popular misconceptions about cash-out leakage:
- Loan defaults are the largest component of leakage. On the contrary, loan defaults account for only 10.8% of total leakage, while cash-out leakage represents 88.5%.
- The bulk of cash-out leakage results from unavoidable financial hardship. This is also a dangerous misunderstanding. A 2015 study of mobile workforce behaviors by Boston Research Technologies (BRT) found that only 37% of those who prematurely cashed out at least one retirement account indicated that the reason was an emergency.
- Cash-out leakage affects only “small” accounts and is therefore a “small” problem. It’s true that participants with accounts less than $5,000 cash-out at epidemic levels (see studies published by Aon Hewitt, Fidelity and Vanguard), with cash-out rates of almost 60% in the first year following a job change. However, when cash-outs occur early – and repeatedly – in a career, the long-term impact on retirement savings is devastating. For example, when a 30-year old 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 could end up with $17,926 at retirement.
Compounding the problem is the prevailing “best practice” by plan sponsors, who automatically cash-out separated participant balances with less than $1,000. While this practice helps plan sponsors shed expensive small accounts and fiduciary liability, it also destroys retirement readiness and delivers the wrong message to participants regarding the importance of saving for retirement.
Fortunately, a “stealth” solution to solving cash-out leakage has begun to emerge: auto portability.
Auto portability is the routine, automated movement of a participant’s retirement savings from a former employer’s plan to that employee’s current employer-sponsored plan as they change jobs. By making retirement savings portability the easiest choice for separated, small-balance participants, cash-outs can be dramatically reduced.
To illustrate the benefits of auto portability, Retirement Clearinghouse introduced the Auto Portability Simulation (APS) in 2016. In the simulation, where auto portability is widely adopted over a 10-year period for accounts under $5,000 subject to mandatory distributions / automatic cash-outs, small account cash-out leakage was reduced by two-thirds, generating more than $115 billion in new, multi-generational retirement savings. In a hypothetical scenario, where the mandatory distribution limit is increased to $10,000, auto portability would preserve $218 billion in retirement savings.
With strong, demonstrable benefits that directly address cash-out leakage, auto portability should be a fait accompli. Indeed, while Washington has started to take note, and the Department of Labor’s ERISA Advisory Council delivered its recommendation to the DOL explore to “encourage and support the development of a…clearinghouse” to enable retirement savings portability, auto portability has slowly-but-surely moved from a “stealth” solution into a more-visible solution with solid bipartisan support.
With new-found visibility, the implementation of auto portability could serve to plug cash-out leakage and greatly improve the retirement readiness of millions of Americans. Let’s hope that auto portability now receives the attention it deserves.