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Leaks are not only a problem with pipes.
Billions of dollars a year are trickling out of the U.S. retirement system as investors cash out their 401(k) plan accounts, potentially crippling their chances of growing an adequate nest egg.
The problem particularly affects job changers – especially those with small accounts – who often empty their accounts rather than keep them running. They lose their savings and future income from that money.
According to the Employee Benefit Research Institute, about 40% of employees who leave their jobs pay into their 401(k) plans each year. According to the group's most recent data, such “leaks” amounted to $92.4 billion in 2015.
Research shows that much of that loss is due to “friction” — it's easier for people to accept a check than go through the multi-step process of rolling their money into their new 401(k). plan or an individual retirement account.
The 401(k) ecosystem would have nearly $2 trillion more over 40 years if workers didn't cash out their accounts, EBRI estimates.
However, recent legislation — Secure 2.0 — and partnerships among some of the nation's largest 401(k) administrators have coalesced to help reduce friction and close existing leaks, experts say.
The movement “has really gained momentum in recent years,” says Craig Copeland, director of EBRI's wealth benefits research. 'If you can keep it [the money] there without it leaking, it will ensure more people have more money when they retire.”
85% of employees who cash out deplete their 401(k).
U.S. policy has many mechanisms in place to try to keep money in the tax-preferred retirement system.
For example, savers who withdraw money before age 59.5 usually have to pay a 10% tax penalty in addition to any income tax. There are also few ways for workers to access 401(k) savings before retirement, such as loans or hardship withdrawals, which are also technically sources of leakage.
But changing jobs is another entry point, and one that worries policymakers: At that point, workers can choose a check (minus taxes and penalties) among other options.
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The average baby boomer changed jobs about 13 times between the ages of 18 and 56, according to a U.S. Labor Department analysis of Americans born between 1957 and 1964. About half of the jobs were held before age 25.
A recent survey found that 41.4% of workers cash out approximately 401(k) savings when they leave their job – and 85% of these individuals have depleted their entire balance.
“Was that necessary? It's hard to know for sure, but it is by no means a logical conclusion that cashing out is a good or necessary response to leaving or losing a job,” write the authors – John Lynch, Yanwen Wang and Muxin Zhai. — wrote about their research in Harvard Business Review.
It's not all the employees' fault
However, it's not all the employees' fault. The law allows employers to cash out the small account balances of former employees who leave behind their 401(k) accounts. They can do this without the employees' consent and send them a check.
Before 2001, employers could do this for bills of $5,000 or less.
However, a law passed that year – the Economic Growth and Tax Relief Reconciliation Act – was one of the first steps toward keeping more of those funds in the pension system.
It prohibited employers from paying out balances of $1,000 to $5,000; instead, companies that want to take these balances out of their company 401(k) must transfer the funds to an IRA in the names of the respective employees. Secure 2.0 increased that upper limit to $7,000 from 2024.
While this IRA solution saves more money in the retirement system, it's an imperfect solution, experts say. For example, when rolled over, assets are typically held in cash-like investments, such as money market funds, until investors decide to invest these assets otherwise. They earn relatively little interest there, while the costs on the balance decrease.
Many investors also end up cashing out those IRAs, says Spencer Williams, founder of Retirement Clearinghouse, which manages such accounts.
Furthermore, although employers notify their employees of such IRA rollovers, employees who do not take immediate action may forget about their accounts completely.
Why a new 401(k) 'exchange mechanism' could help
In November 2023, six of the largest 401(k)-type plan administrators – Alight Solutions, Empower, Fidelity Investments, Principal, TIAA and Vanguard Group – collaborated on an “autoportability” initiative to further reduce leakage.
In principle, small balances – $7,000 or less – would automatically follow their owners to their new jobs unless they choose otherwise. This way, the employees' remaining savings would not be cashed out or rolled into an IRA and possibly forgotten.
The concept uses the same hands-off approach as other now-popular 401(k) features, such as auto-enrollment, using employees' propensity for passivity to their advantage.
Car portability is essentially a “very large exchange mechanism” within the 401(k) industry, says Williams, who is also president and CEO of Portability Services Network, the entity that facilitates these transactions. (Retirement Clearinghouse manages the infrastructure.)
A word of caution: One of the six participating providers must manage the employee's 401(k) plan with both their old and new employers for the transition to work, meaning not all employees will be covered. The companies collectively manage 401(k)-type accounts for more than 60 million people, or about 63% of the market, Williams said. More people are invited to join the consortium.
At 70% market coverage, car portability is expected to reconnect about 3 million people per year with 401(k) accounts they left behind when they changed jobs, Williams said. The biggest benefits will accrue to young workers, low-income earners, minorities and women, the groups most likely to earn money and have the smallest balances, he said.
It's not just employees who benefit: Trustees keep more money in the 401(k) ecosystem, likely boosting their profits.
Secure 2.0 also gave a legal boon to the concept of autoportability, providing a “safe harbor” for the automatic transfer of assets, experts said.
A 401(k) “lost and found” is in the works
Raja Islam | Moment | Getty Images
That law also separately directed the U.S. Labor Department to create a “lost and found” file for old, forgotten retirement accounts by the end of 2024. The public online register will help employees locate the pension benefits they may be entitled to and determine who to contact to access them. According to a spokesperson for the Ministry of Labor.
“Millions of dollars people earn go unpaid every year because the plans have lost track of the employees and their beneficiaries to whom they owe money,” the spokesperson said. “This is an important step forward in tackling the problem.”
The Technology Modernization Fund, a government program, announced in November an investment of nearly $3.5 million from the Department of Labor to help build the database.
In the meantime, workers who suspect they have been left behind have a number of options to reclaim it, the Labor spokesperson said:
- Check old records such as benefit statements or summary descriptions of plans to refresh your memory about benefits. You can also use an online Labor Department search to see if your former employer or union has a retirement plan. Former colleagues may also be able to remind you of the company's retirement plans, or whether the company has since been acquired or changed its name.
- Contact former employers or unions to ask if you have earned retirement benefits. Contacts can be a plan administrator, human resources, the employee benefits department, the business owner (if it is a small business), or a union.
- For assistance, contact Employee Benefits Security Administration advisors at askebsa.dol.gov or by calling 1-866-444-3272.
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