Safe-harbor IRAs should not be a long-term retirement solution
Fifteen years ago, when safe-harbor IRAs were first proposed as a destination for small, stranded 401(k) accounts that can be automatically rolled out of plans, then-U.S. Assistant Secretary of Labor Ann L. Combs spelled out what these investment vehicles were supposed to accomplish.
In a March 3, 2004 press release from the U.S. Department of Labor, she stated: “Preservation of retirement savings when workers change jobs is key to ensuring retirement security. The proposed rule changes the landscape from one where workers cash out and spend small distributions to one where savings accumulate over time and are available when needed at retirement.”
As Combs pointed out, safe-harbor IRAs were established with good intentions — to help plan participants avoid cashing out their 401(k)s and instead preserve those savings in the U.S. retirement system, where they could grow until they retire. Unfortunately, and despite all good intentions, the cash-out rates for accounts subject to a mandatory distribution are well over 55%, and total small account cash-outs represent three-quarters of all cash-out leakage from defined contribution plans.
For the “lucky” ones that don’t cash out and whose assets are “preserved” in safe-harbor IRAs, a slow decay of savings awaits them if they don’t move these balances. By dint of regulation, participants are forced into principal-protected products, the only safe-harbor IRA default investment choices allowed under the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. Given the historically low-interest-rate environment of the past decade, these products have yielded extremely low returns.
On top of that, many safe-harbor IRAs come with high fees. Based on publicly available product information, some safe-harbor IRAs charge as much as $50 or more for annual administration, well over two times the interest earned on an average $1,600 account balance at a 1% yield. This combination of poor returns and high fees inexorably depletes participants’ savings.
Clearly, safe-harbor IRAs weren’t designed to serve as long-term investment vehicles for the incubation and accumulation of retirement savings. They were designed to be temporary vessels for the storage of participants’ 401(k) account balances after they were rolled out of former-employer plans.
J. Mark Iwry, formerly the U.S. Treasury’s Deputy Assistant Secretary for Retirement and Health Policy, confirmed this several years ago at a Women’s Institute for a Secure Retirement (WISER) conference. In a policy panel, he noted that when the EGTRRA legislation was passed in 2001, he and other policymakers “never meant for safe-harbor IRAs to be permanent retirement savings vehicles,” and added: “We always envisioned them as a conduit to an employer-sponsored plan. The mandatory distributions of small accounts were meant to be a benefit for plan sponsors,” relieving them of the headaches that arise from the administration of small accounts left behind in their plans.
However, relief for sponsors should not come at the expense of participant outcomes — a plan sponsor’s fiduciary obligation under ERISA to act in the best interest of the participant does not have an account-balance-size filter. Taking one example, if sponsors and record-keepers don’t have current mailing addresses for terminated plan participants whose small accounts are automatically rolled over to safe-harbor IRAs and the participants don’t receive the notices informing them of the move, the sponsors — as fiduciaries — could potentially be held liable when participants discover that their savings have been depleted in safe-harbor IRAs they didn’t know existed.
A similar set of circumstances arises for participants whose less-than-$1,000 balances are automatically cashed out. If the check isn’t sent to a participant’s current mailing address and they never receive it, the sponsor could be held liable for not only the cashed-out balance, but the extra savings the balance could have accrued had it remained invested in the U.S. retirement system.
The good news for plan sponsors with mandatory distribution programs is they can now add a feature to their programs to preserve retirement savings and improve participant outcomes — auto portability. And the benefits of auto portability can be extended even to those accounts that have less than $1,000, as long as sponsors amend their plans to change the current practice of automatically cashing out these small, stranded accounts.
Auto portability was developed to plug leaks in the U.S. retirement system by creating an infrastructure that enables sponsors and their record-keepers to seamlessly move participants’ small 401(k) accounts from one plan to another at the point of job-change. Designed to function within the existing platforms and data flows that serve qualified plans, auto portability’s key “locate” technology and “match” algorithm identify inactive participant accounts — often belonging to lost or missing participants — and begin the process of moving those accounts into participants’ current-employer plans.
By automating the process, auto portability removes the roadblocks which historically made the roll-in process cumbersome, time-consuming, and expensive, and enables plans and their record-keepers to prevent participants from going lost and missing in the first place and ensure safe-harbor IRAs are truly temporary placeholders for small account holders’ assets.
With auto portability, plan sponsors no longer have to consider trading participant outcomes for administrative convenience — a difficult trade-off that they don’t want to make.
Fortunately for sponsors and record-keepers, auto portability has been live for more than two years. By taking the necessary steps to implement auto portability today, sponsors as well as their record-keepers can enable participants to improve retirement outcomes by seamlessly and quickly moving their assets out of safe-harbor IRAs and into accounts in their current-employer plans — where they can invest in target-date funds and other long-term investment options.
Safe-harbor IRAs should be living up to their stated purpose as temporary accounts. Under a scenario where auto portability is broadly adopted across the U.S. and safe-harbor IRAs are used as intended, up to $1.5 trillion in retirement savings (measured in today’s dollars) would be preserved in our nation’s retirement system, according to estimates by the Employee Benefit Research Institute (EBRI). Preserving that level of savings through auto portability is a major step forward to resolving our country’s retirement savings crisis.