Each year, approximately five million Americans with small retirement accounts (currently defined as having balances of less than $7,000) change jobs – and at that point are forced to make a decision.
For many – more than half, according to the Employee Benefit Research Institute (EBRI) – that decision will result in taking their account balance in cash. Additionally, federal law allows employers to initiate mandatory distributions for employees with account balances of less than $7,000 when they leave the company – and most do, rather than absorb the time, effort and cost of keeping up with small accounts.
For those former participants, the cost of those decisions to retirement security can be significant due to taxes and, in most cases, early withdrawal penalties that combined can consume as much as half that account balance. Worse, it’s a trend that hits minority groups particularly hard. The cash-out rate among African-American participants is more than double the average rate among all defined contribution plan participants, and the rate among Hispanic participants is nearly as high.
This increased cash-out rate among African-American participants may well be a consequence of the average size of their retirement accounts, as the Urban Institute found that the average retirement savings of African-American families is only about one-sixth the size of average retirement savings of white families. Since African-American participants are more likely to have smaller account balances, they are likely disproportionately affected by mandatory distributions when changing jobs.
Worse, many participants simply lose track of their accounts due to the relatively small amounts, thus effectively abandoning their hard-earned savings.
Rollovers Role
In the ever-evolving landscape of retirement planning, Individual Retirement Accounts (IRAs) play a pivotal role. In 2023, the assets held in IRAs reached a staggering $13 trillion, surging from the $11.7 trillion held in mid-2022, according to the Investment Company Institute (ICI).
According to recent data, over 2.5 million IRA rollovers happen annually. That’s a tidal wave of assets shifting from employer-sponsored retirement plans (like 401(k)s) into individual IRAs. Indeed, a new report from the ICI finds that in mid-2023, nearly two-thirds (62 percent) of traditional IRA–owning households indicated that their IRAs contained rollovers from employer-sponsored retirement plans.
Moreover, according to “The Role of IRAs in U.S. Households’ Saving for Retirement, 2023”, among households with rollovers in their traditional IRAs, the vast majority – 86 percent – indicated they had rolled over the entire retirement account balance in their most recent rollover.
Good News, Bad News
The good news is that rollovers represent retirement savings that are still retirement savings. However, rollovers can still be a mixed bag for plan sponsors hoping to keep those balances in the plan, advisors that support those plans and the individual accounts inside them, and perhaps even the participants that have left the protections, support and institutional pricing of a workplace retirement plan.
The bad news – as noted at the beginning of this article – is that large numbers of retirement plan savers are not rolling over those balances. In most of those cases they are taking that distribution in cash, net of taxes, and in all likelihood net of early withdrawal penalties as well. In fact, odds are the individual will wind up with only half the distribution amount, and they’re likely to spend that.
In fact, this “leakage” — the premature withdrawal of retirement funds—poses a significant threat to retirement security, eroding retirement security and leaving individuals with less-than-adequate savings. As noted above, this tendency has a dramatic and disparate impact on minority groups.
How big is the problem? Based on a summary of cashouts across multiple studies by several large recordkeepers, the Savings Preservation Working Group reported that between 33 and 47 percent of plan participants withdraw part or all of their retirement plan assets following a job change. These lost savings due to cashouts amount to between $60 billion and $105 billion (1.4 percent to 2.4 percent of total DC assets) annually. Indeed, approximately 4.5 to 6.4 million participants cash out annually for approximately 6.5 to 9.5 percent of 401(k) plan participants.
Why so many? The Boston Research Group notes that most cashouts (63 percent) are not made for emergency purposes. The biggest culprit in driving cashouts? Friction caused by unfamiliar rollover procedures by the participants. Indeed, anyone who has ever struggled through the current process of trying to move a retirement account balance to an IRA knows how painfully time consuming and inefficient it can be.
Why It Matters to Employers and Advisors
For financial advisors and plan sponsors alike, this rollover “frenzy” presents both challenges and opportunities.
Having not only provided an environment for savings, but in many cases helping fund it with matching dollars, most employers feel a vested interest in helping preserve these account balances, if not by facilitating their remaining in the plan post-termination then in helping assure the accounts land in a place where they can be prudently managed in a cost-efficient manner. Indeed, part of a holistic financial wellness program should focus on facilitating a better and more knowledgeable awareness of these options by their workforce. Arguably this decision is the one most fraught with the potential for disaster for retirement security, subjecting those savings to large taxes, penalties and perhaps at the same time exposing individuals to the predations of rogue advisors.
As for advisors, those who have worked with individual participants while those balances were accumulated in the plan have a tangible interest in being able to continue to provide counsel or at least know that those balances won’t simply vanish into the spending ether or succumb to unscrupulous guidance.
Let’s face it. A well-executed rollover can tip the balance toward financial security. Conversely, missteps can lead to instability, to put it mildly. Today the “easy” path for participants is to simply take the money – net of taxes and penalties – and run. But that puts millions of participants and their retirements at risk. The challenge for the industry today is to develop secure, prudent pathways that make it easy for participants to do what’s best for their long-term retirement security – and the nation’s.
About the Author
Nevin E. Adams, JD is the former Chief Content Officer and Head of Retirement Research for the American Retirement Association. One of the retirement industry’s most prolific writers, these days he’s “retired”, which means he writes less, but continues to keep his eye on developments in, and threats to, the nation’s private retirement system. In addition to helping guide the agenda development for the NAPA 401(k) Summit, he’s also the “Nevin” in the Nevin & Fred podcast (along with renowned ERISA attorney Fred Reish), offering irreverent, but relevant perspectives on the critical issues confronting plan sponsors, advisors, and retirement industry professionals.
The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust©, its subsidiaries or affiliates.
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