I'm a big fan of 401(k) plan consultants, who’ve been forceful advocates for the adoption of best practices at leading retirement plan sponsors. So, it’s surprising to me that, when it comes to automatic rollover programs, consultants sometimes miss the mark, at least in terms of participant outcomes.
The Problem with Automatic Rollovers
In every plan consultant’s DNA is the awareness that, when participants are provided with good choices that also happen to be the easiest choices, they act much more virtuously than they would otherwise – achieving higher levels of participation, savings, and diversification.
However, when it comes to automatic rollover programs, that grounding in sound behavioral science goes out the window when terminated participants are forced out of their plan, and predictably bad participant outcomes result.
Based on industry data, for every 1,000 participants who are subject to an automatic rollover process:
- 550, or 55% will choose the easiest option, which is to cash out completely. No counseling is provided to discourage cashouts and no assistance is offered to help them move their retirement savings forward.
- 60, or 6% will proactively move their funds to another IRA or to a new employer’s plan.
- 390, or 39% are automatically rolled over to a safe harbor IRA, with their balances invested in a money market fund.
- When the 390 “survivors” do bother to act, each year 6-12% of them will continue to cash out or will eventually allow fees to erode their balance to zero.
- Only 4, or 1% of these new safe harbor IRA accountholders will bother to move their balances out of the default investment fund.
Where 401(k) Plan Consultants Miss the Mark
Plan consultants miss the mark by catering to the needs of the rarest of breeds -- the 4 of 1,000 “savvy safe harbor IRA investors” identified above who remain in their safe harbor IRA but manage to act proactively, while ignoring the massive cashout carnage and sub-optimal investment performance that plagues the rest.
They do this by hyper-focusing on certain characteristics of the safe harbor IRA, assuming that the most “plan-like” safe harbor IRA represents the most fiduciary-friendly alternative.
A short list of safe harbor IRA features that consultants tend to focus on includes:
- Account fees, including annual maintenance, distribution, and add-on fees
- Yield of the default investment fund, as well as the menu of optional investments, in the unlikely event former participants move their funds out of the default investment
- Other safe harbor IRA features, including online self-service capabilities, etc.
These criteria, while important to consider, make little material difference to retirement outcomes, and exclusive reliance upon them provides a false sense of comfort to plan sponsors that their choice will truly be in their participants’ best interests.
To further illustrate, for a safe harbor IRA with an average balance of $1,679, a 100-basis point increment in the default investment return would yield just $16.79 per year, which is dwarfed by the $500+ paid in taxes and penalties following a cashout. By contrast, a 25-year-old who preserves a $1,679 account and consolidates that balance into their new employer’s plan in a target date fund with a 5% annual return would have $11,820 at retirement.
Applying Behavioral Science to Automatic Rollovers
The reality is that safe harbor IRAs were never meant to be long-term retirement savings vehicles. Rather, safe harbor IRAs were meant to temporarily (but safely) house small, forced-out balances only for as long as they could be efficiently consolidated into an existing IRA or to a new employer’s plan.
The same behavioral science principle that works in plans – making the best choice the default, easiest choice – also applies to automatic rollover programs. Incorporating simple but powerful features that discourage cashouts and make it easy for participants to consolidate their balances into a more appropriate long-term retirement savings vehicle will preserve far more retirement savings than grossly under-utilized features of safe harbor IRAs.
Specifically, when evaluating automatic rollover IRA programs, consultants should understand:
- During the pre-rollover “force out” phase, are participants offered one-on-one education about the high cost of cashing out and provided expert assistance in consolidating their balances?
- Are participants whose balances are forced out into safe harbor IRAs offered the same ongoing education and assistance?
- Is support for auto portability incorporated into the automatic rollover process?
- Are metrics on cashouts, account consolidations and average duration of safe harbor IRAs tracked and reported? How do they compare vs. industry averages?
If these questions can be answered affirmatively, then cashout rates in automatic rollover programs easily decline by over 50%, and rates of consolidation will soar. Time spent by former participants in dead-end safe harbor IRAs will also decline dramatically.
Improving Participant Outcomes
401(k) plan consultants know that the name of the game is improving participant outcomes, and their ongoing efforts have been commendable. When it comes to automatic rollover programs, plan consultants should extend their analysis to include those program components that help participants avoid cashing out, move their retirement savings forward, and keep their stay in safe harbor IRAs as brief as possible.