The Case for Automatically Moving Mandatory Distributions Forward
The mandatory distribution-to-Safe Harbor IRA plan feature as commonly utilized today was conceived in 2001 and launched in 2005 with good intentions, and for valid reasons. A mobile workforce, combined with a lack of retirement savings portability, had created a burgeoning problem for plan sponsors: an explosion of small-balance (less than $5,000) accounts left “stranded” in-plan, resulting in rampant cashouts, missing participants, uncashed distribution checks and the like. These problems only accelerated with the widespread adoption of auto enrollment, beginning in 2009.
While automatic rollover programs provided a measure of relief to the problems faced by plan sponsors, they inadvertently consigned their former plan participants to Safe Harbor IRA “landfills” – where cashouts continue and account fees erode their balances.
Fortunately, there’s a more-responsible answer: to systemically “recycle” these Safe Harbor IRA balances back into the defined contribution system.
First, Some History and Simple Math
In 2001, when Congress passed The Economic Growth and Tax Relief Reconciliation Act (EGTRRA), it gave birth to the Safe Harbor IRA by amending the Internal Revenue Code to add a requirement that mandatory distributions in excess of $1,000 must be paid in a direct rollover to an IRA. At this time, T-Bill rates were over 6%. In March 2006, when the Department of Labor issued safe harbor regulations launching the automatic rollover, T-Bill rates were 2.6%. Today, T-Bill rates are .075%. This is material because the IRA agreement the plan fiduciary must enter into as per the regulations must provide that the investments “will be those designed to minimize risk, preserve principal while providing a reasonable rate of return, and maintain liquidity, such as money market funds, interest-bearing savings accounts, certificates of deposit and fully benefit-responsive stable value funds.”
In today’s market, most of these products generate returns that approximate T-Bills. For example, a $5,000 account invested in T-Bills would earn $3.75 in annual return. The average Safe Harbor IRA annual fee charged by the providers of these products ranges from $20-$45 per year, far greater than the return generated. Over time, this will decay the account balance to zero.
Select a Better Safe Harbor IRA
To alleviate this decay, plan sponsors can exercise their fiduciary duty and select a Safe Harbor IRA provider that:
- Provides lost & missing participant search services and has a solid record for finding unresponsive account holders
- Works with account holders to consolidate their Safe Harbor IRA with their other retirement assets (compare average holding period)
- Offers a monthly account fee structure, so account holders are only charged for the time they are in the Safe Harbor IRA
- Offers a progressively priced account charge so that for low balances, fees are reduced to ensure the account fee is always less than the balance
Automatically Move Balances Forward: Auto Portability
Ultimately, the best solution is one that’s now arriving on the scene: the full implementation of a “recycling” ecosystem for Safe Harbor IRAs, where participants’ balances that were forced out of their prior plan are automatically “located and matched” and then consolidated back into the defined contribution system. Known as Auto Portability, this mechanism is a better systemic solution, where mandatory distributions automatically follow the participant to their new employer’s plan, instead of languishing in a Safe Harbor IRA landfill.
Dr. Alicia Munnell, Director of the Boston College Center for Retirement Research thinks so, and opines on Auto Portability in a recent article in MarketWatch titled, A Clearinghouse For Small 401(k) Accounts.
The reduction in cash outs and fees through consolidation are certainly better outcomes that result from automatically moving mandatory distributions forward.
Maintaining ERISA protections for these assets is another benefit.
But perhaps the most valuable -- and least discussed -- benefit of Auto Portability is the more appropriate investment allocation. The Pension Protection Act on 2006 approved both automatic enrollment for 401(k) plans and the use of target date funds and professionally managed accounts as the default investment option. According to the PSCA 57th Annual Survey, 98% of plan sponsors have a target date fund, target risk fund, a balanced fund, or a professionally managed account as the default investment option for an automatic contribution. An automatic roll in of a mandatory distribution from a prior employer plan would be treated as an automatic contribution and placed in such a default investment option, thus bypassing the Safe Harbor IRA investment restrictions and annual fees decaying these balances currently. This creates better retirement outcomes for participants, and a better retirement system overall when lifetime participation in plans is promoted and automatically maintained.