By Tom Hawkins
America’s defined contribution system is unsustainable – urgently requiring an upgrade to effectively deliver on its intended goal – helping millions of Americans enjoy a timely and comfortable retirement.
The primary symptoms of unsustainability include:
- Rampant cash out leakage
- An explosion of small-balance accounts
- A surge in the number of participants who’ve lost track of their retirement savings.
The good news: our defined contribution system can be fixed.
The solution – auto portability – will deliver tremendous benefits, but will require collective action on the part of policymakers, service providers and plan sponsors to restore this pillar of our retirement system to health and create long-term sustainability.
Our Unsustainable Defined Contribution System
The concept of ‘sustainability’ is ubiquitous in our culture, and its principles have been broadly applied to large swaths of society, including our consumption patterns, housing, economic development, business models, agriculture and energy production. Sustainability’s goal is to “meet the needs of the present without compromising the ability of the future generations to meet their own needs.”
When examining our defined contribution system, three symptoms point to fundamental unsustainability:
1. Rampant Cashout Leakage
Every year, 14.8 million, or 22% of all active defined contribution participants change jobs, and will consider their options for retirement savings they’ve left behind with a previous employer. Six million, or over 40% of these job-changers, will choose to prematurely cash out $68 billion in savings.
Consider these cashout figures for a moment. That’s six million people – every year – who will effectively drop-out out of our defined contribution system. In fact, the defined contribution system’s cashout rate is 24% higher than America’s high school drop-out rate, a figure that brings shame to our educational system.
What gives rise to this level of cashouts? Contrary to conventional wisdom, only slightly more than one-third of these ‘retirement drop-outs’ need the funds for a true financial emergency. The rest are simply making poor decisions. Unfortunately for these bad decision makers, the defined contribution system perversely doubles-down on human nature by making the worst choice (cashing out) the easiest, while simultaneously making the best choice (consolidating retirement savings) the most difficult.
To add insult to injury, plan sponsors (and their consultants) will invest considerable time and money in financial wellness initiatives, improving plan choice, and a myriad of other features, but very few will bother to measure cashout leakage levels, to set goals for it, or attempt to actively manage the problem.
2. The Explosion of Small-Balance Accounts
Combining EBRI statistics with the Department of Labor’s Form 5500 data, we estimate that there are 5.1 million inactive defined contribution accounts with a balance less than $5,000. For accounts with a balance less than $10,000, this figure rises to 6.8 million.
Over 80% of these accounts are held by participants who have already enrolled in another defined contribution plan with their current employer, so these participants’ accounts are effectively stranded, where they will pay excess fees, earn sub-optimal returns or both.
Meanwhile, former employers are saddled with the cost, fiduciary risk and administrative burden of large numbers of small-balance accounts. Many plan sponsors will seek to minimize the small account burden by utilizing automatic rollovers, automatic cashouts, or both. This approach simply exacerbates the problem of cashout leakage, as identified in #1 above.
3. A Surge in Missing Participants
The problem of missing participants in defined contribution plans is pervasive, and has many causes, including:
- Frequent job-changing and the rise of the “gig” economy
- Geographic mobility
Additionally, defined contribution features such as auto-enrollment (particularly with low deferral rates) can play a role, resulting in ‘zombie’ accounts that former employees never realized they had.
For participants, the ultimate risk of going missing is not getting paid the benefits they’ve earned.
Plan fiduciaries, on the other hand, are the parties held responsible for locating missing participants, and can’t afford to assume that recordkeepers will ensure accurate participant contact information. It’s up to the plan sponsor to find missing participants, where they must cope with unclear guidance on when and how to locate them. If their plan is audited, they may also confront inconsistent enforcement actions.
How bad is the missing participant problem? Unfortunately, no one knows for certain as there are no credible statistics, studies or surveys that definitively address the scope of the problem. At present, the industry’s best guess is that approximately 6% of defined contribution participants are missing.
Auto Portability: The Missing Link in Creating Sustainability
Auto portability is the routine, standardized and automated movement of an inactive participant’s retirement account from a former employer’s retirement plan to their active account in a new employer’s plan.
There is a wealth of evidence demonstrating that auto portability would create a more-robust and sustainable defined contribution system. The most compelling evidence was delivered in March 2017, when the Employee Benefit Research Institute (EBRI) presented new research that $1.5 trillion of retirement savings would be retained through auto portability, when applied to accounts with less than $5,000.
For participants, auto portability overcomes systemic friction and as such, directly addresses poor decision-making by turning the best choice (consolidation) into the easiest choice for participants. This means greatly-reduced levels of cashouts and long-term preservation of retirement savings.
For plan sponsors, auto portability would result in fewer small balance accounts and sharply-reduced levels of missing participants. In addition, new participants would be more likely to roll-in balances from previous employers’ plans. Thus, average plan balances would rise, which generally translates into lower plan costs.
Finally, for service providers, including recordkeepers, fund managers, financial advisors and others – auto portability would result in increased retention of retirement assets, the foundation upon which their business models depend.
Moving Auto Portability Forward
The engine of auto portability is tested and ready, but to facilitate widespread adoption, collective action is required.
For policymakers, the primary action item is the delivery of guidance by the Department of Labor (DOL) -- guidance that would serve to mitigate any perception of fiduciary liability on the part of plan sponsors for the automatic roll-in of participants’ funds. We understand that this guidance is now a priority, and should be forthcoming in 2018 in the form of a Prohibited Transaction Exemption (PTE), an Advisory Opinion or both.
Service providers should embrace auto portability, due to the significant benefits that it offers for their business models. Detailed, long-term benefits have been incorporated in the latest version of the Auto Portability Simulation, and can now be individually prepared for large recordkeepers and fund managers to illustrate the specific benefits that they could realize.
Plan sponsors, too, need to understand and embrace auto portability for the benefits that it will deliver for their plans and for their plans’ participants. In the near-term, the best action that a plan sponsor can take is to let their recordkeeper know about their interest in, and support for auto portability.
By acting collectively and adopting auto portability, America will finally have a defined contribution system that it deserves, one which has long-term sustainability and will generate the retirement outcomes that were originally envisioned.