The $210 Billion Risk In Your 401(k) (#GotBitcoin?)
Annual defaults on loans taken against investors’ 401(k)s threaten to reduce the wealth in U.S. retirement accounts by about $210 billion when the lost savings are compounded over employees’ careers. The $210 Billion Risk In Your 401(k) (#GotBitcoin?)
Annual defaults on loans taken against investors’ 401(k)s threaten to reduce the wealth in U.S. retirement accounts by about $210 billion when the lost savings are compounded over employees’ careers, according to an analysis by Deloitte Consulting LLP.
The projected future loss amounts to about 2.7% of the $7.8 trillion currently in 401(k)-style retirement accounts.
The numbers highlight the problem of tapping 401(k) savings before retirement, known in the industry as leakage.
Most leakage occurs because about 30% to 40% of people leaving jobs elect to cash out their accounts and pay taxes or penalties rather than leave the money or transfer it to another 401(k) or an individual retirement account.
But employees also take out loans, which about 90% of 401(k) plans offer. Workers can generally choose to borrow up to half of their 401(k) balance or $50,000, whichever is less.
About one-fifth of 401(k) participants with access to 401(k) loans take them, according to the Investment Company Institute, a mutual-fund industry trade group. While most 401(k) borrowers repay themselves with interest, about 10% default, or fail to repay their accounts, triggering taxes and often penalties, according to research by authors including Olivia Mitchell, an economist at the University of Pennsylvania’s Wharton School.
Failing to restore the funds typically occurs when employees with outstanding 401(k) loans leave companies before fully repaying their balances.
Money lost to 401(k) leakage, including loan defaults and cashouts, reduces the wealth in U.S. retirement accounts by an estimated 25% when the lost annual savings are compounded over 30 years, according to an analysis by economists at Boston College’s Center for Retirement Research.
Even those who successfully repay 401(k) loans can end up with less at retirement than they would have had. One reason is that many borrowers reduce their 401(k) contributions while repaying their loans.
While 401(k) loan defaults currently amount to about $7.3 billion a year, the impact is far greater given that many borrowers in default withdraw additional money to cover the taxes and early-withdrawal penalties they owe on their outstanding balances, says Gursharan Jhuty, senior manager at Deloitte Consulting.
About two-thirds of participants who default liquidate their accounts, he adds.
As a result, Deloitte projects that those who default on loans worth $7.3 billion this year will drain about $48 billion from their retirement accounts. If the $48 billion were to remain in their accounts, it would be worth $210 billion by retirement age, assuming a 6% annual return, Deloitte calculated.
Few employers are willing to eliminate 401(k) loans, in part because academic studies have shown that they encourage 401(k) plan participation.
But Deloitte, which offers consulting services to 401(k) and traditional pension plans, recommends that companies consider ways to reduce workers’ use of loans—steps many companies are starting to take.
401(k)s Aren’t Helping Americans Save Enough for Retirement. These Researchers Found Four Major Shortcomings
The rise of 401(k) plans over the past 40 years as a pension replacement hasn’t helped Americans save enough for retirement, thanks primarily to the relative immaturity of the system and a lack of access or participation for many workers.
In a new research paper from the Boston College Center for Retirement Research, Andrew Biggs, Alicia Munnell, and Anqi Chen argue that there are four reasons for 401(k)s’ shortcomings—the system’s youth (the plan has been around only since the early 1980s), the lack of universal coverage, so-called leakage where participants withdraw funds early, and fees.
To underscore their findings, the authors point out that most workers have 401(k) balances at retirement that are well below their potential. For example, they say, a 25-year-old median earner in 1981, if he or she contributed regularly, would have accumulated about $364,000 by age 60. But in reality, they found, the typical 60-year-old with a 401(k) in 2016 had less than $100,000.
The news isn’t all bad, however: While many of today’s retirees and near-retirees didn’t participate in the nascent 401(k) system when they were young workers and thus have minimal balances, that should improve over time. Future retirees who have been in the system and contributed throughout their working careers should accumulate larger balances, they say.
Still, the authors say that even if the factors it identified are addressed, the lack of universal coverage will continue to depress 401(k) balances.
Here, More Details About The Four Factors Cited In The Research:
Immaturity of the system: The 401(k) began as a profit-sharing plan in the late 1970s, and then morphed into a saving plan for more-ordinary workers in the early 1980s with the passage of the Revenue Act of 1978. In 1981, the IRS issued regulations allowing the use of salary-reduction plans for retirement-plan contributions, and plan formations began to surge. All of this means that many of today’s retirees didn’t have access to plans in their earliest working years.
Availability and access: Many employers still don’t make plans available or, when they do, they restrict participation. Further, some employees simply don’t participate even if they’re eligible to do so.
Leakage: Plan participants have a number of ways of accessing their savings before retirement. For example, they have the ability to cash out when they change jobs. Or they can take hardship withdrawals. The 10% penalty imposed on withdrawals before age 59½ hasn’t prevented considerable leakage, either. Vanguard Group data for 2013 shows an annual leakage rate of 1.2% per year, nearly half of which is attributed to cash-outs during a job change.
Fees: Finally, fund expenses contribute to lower balances for participants. Average bond-fund fees are 0.48%, while average stock-fund fees are 0.59%. Those figures represent a good decline from the 0.84% and 1.04% in 1996, but they still serve to reduce plan balances.
Eventually, the authors conclude, the system’s immaturity won’t be an issue. All workers will have begun working in an age when the 401(k) was the accepted retirement-savings plan. But that still won’t mean all workers will have access to one if all employers don’t offer one.
Congress Passes Sweeping Overhaul of Retirement System
Bill encourages 401(k) plans to offer products with guaranteed income payment.
Congress passed the most significant changes to the nation’s retirement system in more than a decade, a move designed to help Americans save more.
With the U.S. population aging and employers shifting responsibility for retirement saving to individuals, lawmakers have grown concerned that a significant portion of Americans are at risk of outliving their money. Americans between the ages of 35 and 64 face a retirement savings shortfall of $3.83 trillion, with 41% of households projected to run short of money in later life, according to the nonprofit Employee Benefit Research Institute.
One prominent provision of the legislation passed Thursday, which President Trump is expected to sign, encourages 401(k) plans to replicate a feature of old-fashioned pensions by offering products with guaranteed income payments.
The legislation also seeks to expand retirement plan coverage by making it easier for small companies to join together to offer 401(k) plans and share administrative costs. An estimated 30% of private-sector employees work for employers that don’t currently offer a way to save for the future.
Brokers, asset managers, 401(k) record-keepers and insurers are likely to benefit from these measures.
To help participants figure out how to make savings last, the legislation makes it easier for employers to offer annuities—which often guarantee a monthly stream of income, potentially for as long as a retiree lives—in 401(k)-type retirement plans. It protects employers that follow certain procedures from being sued if they select an insurance company to make annuity payments and that insurer later fails to pay claims.
While the insurance industry lobbied hard for the change, the provision has attracted criticism from consumer advocates.
“Given the prevalence of high cost, low-quality annuities, we don’t start with the thought that this is a great idea,” said Barbara Roper, director of investor protection at the nonprofit Consumer Federation of America.
On average, the fees that participants in the largest 401(k) plans pay for investments and administrative services fell to 0.25% of assets in 2016 from 0.34% in 2009, according to research firm BrightScope Inc. and the Investment Company Institute, a mutual-fund-industry trade group. In contrast, the average variable annuity in the retail market costs between 2.18% and 3.63%, depending on the product type and features selected, according to Morningstar Inc.
The House of Representatives overwhelmingly approved the retirement measures on May 23. But that bill, called the Setting Every Community Up for Retirement Enhancement, or Secure, Act, stalled in the Senate because of objections from a few lawmakers over a handful of narrow items. Backers of the legislation recently added it to the spending bill in an effort to gain passage by year-end.
The various provisions of the legislation are estimated to reduce federal revenue by $16 billion over a decade, according to the Joint Committee on Taxation, largely offset by changes related to inherited retirement accounts. The measure includes a provision that requires many people who inherit tax-advantaged retirement accounts after Dec. 31 to drain the accounts within a decade and pay any taxes due. Currently, many beneficiaries can liquidate those accounts, known as Stretch IRAs, over their own lifetimes.
The legislation paves the way for the growing number of Americans staying on the job into their 70s and beyond to continue saving in individual retirement accounts. Starting Jan. 1, it removes the age cap for contributing to traditional IRAs, currently 70 ½, for individuals with wage income. And it allows people with tax-deferred accounts to delay, until after turning 72, the minimum withdrawals the law currently requires starting after turning 70 ½. (The change applies to people who turn 70 ½ after Dec. 31, 2019.)
To encourage workers to save more, the legislation allows employers that automatically enroll workers in certain 401(k) plans to automatically raise employees’ savings rates to 15% of annual earnings over time, up from a 10% cap now.
Other features of the legislation include a provision requiring employers to allow certain part-time workers to participate in 401(k) plans.
“With Americans delaying retirement and increasingly working part time, these changes will allow workers to continue to save,” said Sen. Ron Wyden (D., Ore.) in a statement following the vote. “While we must do more to ensure financial security for older Americans, passage of this bill is an important step.”
For parents and others with 529 education savings accounts, the legislation allows tax-free withdrawals of as much as $10,000 for repayments of some student loans. Parents can also take penalty-free distributions from retirement accounts of as much as $5,000 within a year of the birth or adoption of a child.
Some changes, including those relating to annuities, are expected to take time to implement.
Though commonly offered by traditional pension plans, annuities are currently available in only 8% of 401(k)s administered by Vanguard Group.
While the legislation gives employers some legal protection for their choice of an insurer, that doesn’t mean “everyone is going to jump in and be comfortable offering traditional annuity products,” said Kelli Hueler, CEO of Hueler Cos. The Eden Prairie, Minn., company offers a service that allows 401(k) participants to purchase institutionally priced annuities when rolling money over to an IRA.
Citing a continuing wave of lawsuits over 401(k) fees, Ms. Hueler predicts employers, especially large ones that are typically the targets of fee litigation, will “take a cautious approach” to adding annuities to their 401(k) plans.
Jerome Schlichter, an attorney whose St. Louis-based firm has pioneered 401(k) fee litigation, said variable annuities, in particular, can be “overpriced.”
“Fiduciaries would have to make the case that having a variable annuity as opposed to a mutual fund offers something significantly more to justify the higher price,” he said. “Multiple commentators have said they do not.”
Andrew Kligerman, an analyst who follows the life insurance industry at Credit Suisse, expects financial services companies to reap benefits from a provision aimed at encouraging companies without retirement plans to join together to offer one using a so-called multiple employer plan, or MEP.
MEPs are allowed now, but only for businesses with a relationship such as a common owner. The legislation does away with that restriction. Mr. Kligerman expects the change to expand the $5.84 trillion 401(k) market by $1 trillion within about five years.
MEPs are potentially attractive to employers because they shift some of the administrative burden and fiduciary responsibility for a 401(k) plan to an administrator.
Peter Swisher, senior vice president of Pentegra Retirement Services, which manages MEPs for banks and credit unions, said that multiple-employer plans are likely to “initially attract smaller companies.”
But as MEPs grow in size, they may potentially drive down 401(k) fees and attract “mid-sized and even some large companies,” said Mr. Swisher.
Origins of The Pension Plan
In financial advisor and radio personality Ric Edelman’s book, The Truth About Retirement Plans and IRAs, he describes a monthly lifetime income benefit that was offered to soldiers during the American Revolution. If a soldier survived the war, the Continental Congress would reward them with income for life. It was called a pension, and it was offered again by the federal government in the Civil War and every U.S. war since.
The structure, however, was not new. Soldiers who served in Ancient Rome were also guaranteed income after they retired. There is also evidence of pensions being offered to public sector workers throughout history.
The First Modern U.S. Pension Plans
The American Express Company established the first corporate pension in the U.S. in 1875. Before that, most companies were small or family-run businesses. The plan applied to workers who had been with the company for 20 years, had reached age 60, had been recommended for retirement by a manager, and had been approved by a committee along with the board of directors. Workers who made it received half of their annual salary in retirement, up to a maximum of $500 per year, according to the Bureau of Labor Statistics.
Banking and railroad companies were among the first to offer pensions to their employees. But by the turn of the 20th century, several large corporations began to grow and offer pensions. These included Standard Oil, U.S. Steel, AT&T, Eastman Kodak, Goodyear, and General Electric, all of which had adopted pension plans before 1930. Manufacturing companies were the last to adopt the new retirement plans. The Internal Revenue Act of 1921 helped to spur growth by exempting contributions made to employee pensions from federal corporate income tax.
In the 1940s, labor unions became interested in pension plans and pushed to increase the benefits offered. By 1950, nearly 10 million Americans, or about 25% of the private sector workforce, had a pension. Ten years later, about half of the private sector workforce had one.
After a few pensions began to fail, the government enacted the Employee Retirement Income Security Act (ERISA), which made pension plans more secure by establishing legal participation, accountability, and disclosure requirements. It also included guidelines for vesting, limiting the vesting schedule to within 10 years or less. With ERISA came the Pension Benefit Guaranty Corporation, which ensures employee benefits should a pension plan fail.
The Rise of Defined Contribution Plans
This type of guaranteed pension came to be known as a defined benefits plan. Workers knew exactly how much they would get in retirement because it was a defined dollar amount or percentage of salary. This was something workers could plan a life around. Workers who wanted to save extra dollars of their own could do so, but private investment accounts were supplemental to pension and Social Security benefits.
Defined benefit plans are very different from what came after: defined contribution plans. In defined contribution plans, which include 401(k) plans, 403(b) plans, 457 plans, and Thrift Savings Plans, the employee makes the bulk of the contributions to the plan and directs the investments within. The employer may (or may not) match a portion of employee contributions.
These plans entered the picture in the early 1980s, a tax-deferred gift to highly compensated employees who wanted to shelter more of their paycheck from taxes. But as they gained popularity, 401(k)s and other defined contribution options quickly surpassed the defined benefit pension as the plan of choice for large private sector companies.
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