According to industry data, each year around 2.5 million 401(k) participants with balances less than $1,000 will change jobs, falling under the threshold where plan sponsors can automatically cash out their balances.
At first blush, automatic cashouts may seem like an expedient approach to rid a plan of small balances. In fact, the practice can be risky, as it carries undesirable side effects for both the plan and for its participants, including a high percentage of uncashed distribution checks requiring resolution, as well as massive amounts of unnecessary cashout leakage.
Fortunately, there are better solutions than automatic cashouts, which will not only deliver plan efficiencies, but also give affected participants a fighting chance to preserve and consolidate their retirement savings.
The History of Automatic Cashouts
As 401(k) plans experienced dramatic growth during the 1990’s, the combination of a highly mobile workforce, paired with little or no plan-to-plan portability, resulted in an explosion of small-balance accounts left behind by job-changing participants.
Plan sponsors needed relief, and that relief soon came in the form of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, where a provision allowed plans to automatically cash out terminated participants’ account balances of $1,000 or less, without their consent.
While that legislation also laid the groundwork for automatically rolling over terminated participant balances between $1,000 and $5,000 to an IRA, plan sponsors would have to wait until 2004 for the Department of Labor (DOL) to codify those rules. When the DOL finally exercised their rulemaking authority for automatic rollovers, they were “persuaded that application of the safe harbor to rollovers of mandatory distributions of $1,000 or less” was appropriate and these balances – at the plan sponsor’s discretion – could also be included in automatic rollover programs.
During that period from 2001 to 2004, many plan sponsors already embraced the practice of automatically cashing out sub-$1,000 balances, a legacy that continues to the present day. While the percentage of plan sponsors who automatically cash out sub-$1,000 balances is difficult to determine, past Plan Sponsor Council of America (PSCA) surveys have indicated that anywhere from 27% to 58% of responding plan sponsors automatically cash out these balances.
The Risks of Automatic Cashouts
From the plan sponsor’s perspective, automatic cashouts may seem like an expedient approach to “cleansing” a plan of small balances, but it comes with an unfortunate cost – a blizzard of uncashed checks.
Multi-year data from a mega-plan sponsor (250,000+ participants) reveals that around 10.5% of sub-$1,000 distribution checks go uncashed and must eventually be resolved. Because they are considered plan assets, large numbers of uncashed distribution checks can trigger plan audits, incur administration costs, and leave participants separated from their retirement savings.
Plan sponsors can compound their risk by having inadequate policies to deal with uncashed checks, or worse, by adopting unsound policies. For example, the practice of using a forfeiture expense account, often funded by uncashed checks, has recently become a target for litigation in ERISA class action lawsuits, exposing plan sponsors to a new source of fiduciary headaches if their plans are silent as to how uncashed check-funded forfeiture accounts prioritize spending on contribution offsets versus plan expenses.
From the participant’s perspective, even a sub-$1,000 automatic cashout can have a pronounced impact on retirement security. A 25-year-old who has their $750 plan balance automatically cashed out could forego $9,312 in retirement savings at age 65, if that balance was preserved and earned a 6.5% annual rate of return.
A Better (and Best) Way to Deal with Sub-$1,000 Balances
Rather than automatically cashing them out, a better approach would be to include these sub-$1,000 balances in an automatic rollover program, rolling over these balances (and others, up to $7,000) to a safe harbor IRA and dramatically reducing the downstream volume of uncashed checks. Upon the opening and funding of safe harbor IRAs, a plan sponsor is deemed to have fulfilled their fiduciary responsibilities.
By contrast, with uncashed distribution checks their problems are just beginning.
Now, the best way to deal with sub-$1,000 balances (and for all balances subject to an automatic rollover) is to adopt auto portability, which delivers all of the benefits but none of the flaws of old-school automatic rollovers – such as high fees, ongoing high cashout rates and sub-optimal investments. By default, auto portability facilitates the transfer of these balances to a current employer’s active account. This action promotes consolidation, lowers participant cashouts, more appropriately invests savings, and serves to close the racial wealth gap.
For an updated list of recordkeepers who have joined the Portability Services Network, an industry-led consortium dedicated to the widespread adoption of auto portability, visit this link.
