It’s called leakage. But it’s better termed a deluge. Every year, hundreds of millions of dollars spill out of defined contribution (DC) plans. Participants roll over the bulk of these funds into traditional Individual Retirement Accounts (IRAs), often when they retire or terminate employment. Yet retaining 401(k) participants’ assets may yield big cost benefits – both for sponsors and investors. In an era of increased focus on fees and fiduciary obligations, we suggest that plan sponsors actively consider whether to encourage retirees to stay in their plans. Regardless of the decision, sponsors need to make sure their plans are appropriately structured for retirees.
Plans with more participants and assets generally can benefit by commanding better pricing on investment management and services. According to current data from BrightScope, based chiefly on 2011 government filings, the average total cost for the largest 401(k) plans, with more than 5,000 participants, was 62 basis points (bps). In contrast, the average cost for the smallest plans, with fewer than 200 individuals, was 131 bps - more than double. Because they do not share the benefits of scale in purchasing services, it stands to reason that IRA costs may be similar to those of the smallest 401(k) plans. The difference can add up: Compounded over years of performance, a reduction in fees from 100 bps to 50 bps could extend by several years the potential of participants’ 401(k)s to provide retirement income.
In addition, retirees who stay in 401(k) plans may access stable value, custom target date and other strategies that are not available in IRAs. They may also enjoy the investment due diligence and oversight of the plan sponsor fiduciary. What’s more, as ERISA-qualified plans, 401(k)s may offer superior asset protection from creditors for retirees and beneficiaries. While assets in both qualified and non-qualified accounts cannot be pursued in bankruptcy proceedings, outside of bankruptcy the extent to which creditors can pursue assets held in IRAs varies by state.
Without doubt, the vast majority of plans do not force out participants at age 65, even though the Department of Labor gives them this right. Indeed, more than four of five plan sponsors prefer to retain retiree assets, according to consultants polled in the PIMCO 2013 Defined Contribution Consulting Support and Trends Survey.
Nonetheless, plans do little to actively encourage asset retention, the consultants said. One reason: Some plan sponsors may be concerned about extending their fiduciary responsibilities to additional participants. It’s a reasonable concern. However, given that most plans already keep many participants beyond retirement, it would only be prudent to make sure that plans meet the needs of retirees.
As plan sponsors consider whether and how to retain retiree assets, we suggest they address seven questions:
- Will retaining retiree assets improve economies of scale? Fees tend to fall steadily as the number of participants increases. Whereas the smallest plans (<200 participants) paid 131 bps in fees, those with 200 to 999 members paid 111 bps, while those with 1,000 to 4,999 paid 87 bps and the largest plans paid just 62 bps, according to BrightScope. Sponsors should consider the total cost to their plan of retaining retirees, including whether an annual fee or transaction costs are imposed and passed to retirees.
- Do participants have access to their money? For retirees to remain in the plan, they should have the ability to take partial withdrawals and set up installment payments. PSCA reports that only 61% of all plans allow installment payments; among those with more than 5,000 participants, the figure is 71%. Plans that seek to retain retiree assets should ask their record keeper about these distribution features.
- Do you offer sufficient investment choice? Plan fiduciaries should seek to offer participants sufficient choice in an effort to meet investment objectives and minimize the risk of large losses. We believe the core lineup should provide access to capital-preservation-focused, global fixed income, inflation hedging and global equity strategies. Plan sponsors also may wish to supplement their lineup with income- and dividend-focused strategies. In addition, a brokerage window may provide optimal investment flexibility. (Note: costs may be higher in the window than the plan, yet are typically fully borne by the brokerage window participant.)
- Does the plan adequately balance risk and return? Among risks to consider, we believe market volatility and sudden shocks, inflation and longevity should be priorities. These considerations are especially important for the default option, which many participants blindly trust. It’s also essential to consider core lineup offerings for participants who desire to build their own asset allocation. Given the propensity of participants to allocate assets on an equal-weighted basis (i.e., “naïve diversification” or the 1/n assumption), the following questions are key:
Is guidance or advice available? Retirees may need hand-holding to understand how to structure their investment income at retirement. Offering access to unbiased financial planners may be desirable as they can help address a range of issues – from retirement income and taxation to home ownership, health care insurance and investments.
- What is the potential return for the investment?
- What is the volatility embedded in the investment?
- What is the risk of loss?
- How inflation-responsive is the investment?
- How long may the money last?
Managed account solutions should be evaluated similarly. Ask providers how they would allocate assets for retirees if they had no information other than their age. This allocation and the underlying investment selections should be evaluated over time.
Can retirees consolidate DC, IRA and spousal assets into the plan? Take a look at whether plan rules allow participants to roll-in DC and IRA assets. PSCA reports that while 98.1% of plans allow participants to roll-in profit sharing/401(k) plan balances, only 53.8% of them accept IRA assets. Does the plan offer Roth accounts that can consolidate external Roth assets and accommodate additional after-tax contributions? You may also want to consider adding a “deemed IRA,” which allows contributory IRA as well as even spousal IRA assets to be commingled under the institutional plan umbrella. Deemed IRAs were part of the “The Economic Growth and Tax Relief Reconciliation Act of 2001” (EGTRRA).
Are retirees aware of the ability and value of remaining in the plan? Naturally, communicating the value of your program relative to retail offerings is critical. But as noted above, few plan sponsors actively encourage participants to remain, according to the PIMCO 2013 Defined Contribution Consulting Support and Trends Survey.
Take a look at how the roll-over process is managed, including via a benefit website, a call center or paper form. Is the retiree being made aware of the value the plan offers? Does the call center help retirees understand its value or encourage the retiree to roll over to an IRA? Consider using webcasts, seminars and other ways to educate retirees on plan benefits and how to manage assets during retirement.
Retaining retirement assets in a DC plan may offer significant benefits to both retirees and plan sponsors. By raising retiree awareness of the many benefits of remaining in the plan, more retirees are likely to retain their money in the plan and potentially increase the life of their retirement assets. More retirees will likely respond, “Thank you, I think I will stay.”