November 13, 1998
The Working Group Report, submitted to the ERISA
Advisory Council on Nov. 13, 1998, was approved by the full body and
subsequently forwarded to the Secretary of Labor. The ERISA Advisory
Council was established by Section 512(a)(1) of the Employee Retirement
Income Security Act to advise the Secretary with respect to carrying out
his/her functions under ERISA.
TABLE OF CONTENTS
I.Are We Cashing Out Our Future?
II. Recommendations
III. Introduction
IV. The Working Group’s Purpose and Scope
V. The Working Group’s Proceedings
VI. Background and Analysis
The Critical Need for Research
Annuitization of Benefits
Rollovers of Lump Sum Distributions
Mandatory Cash-Outs
Participant Loans
Hardship Withdrawals
Portability
Educational Initiatives
Appendices
Chart 1: Distribution of Pension Recipients by Type of
Benefit, 1989 and 1994
Chart 2: Poverty Rates by Age and Sex, 1992
Chart 3: Pension Plan Participation, 1975 - 1994
Chart 4: Uses of Lump Sum Distributions from Retirement
Plans, 1996
Chart 5: Pension Plan Distributions Rolled Over Into
Tax-Qualified Plans, 1988 -1992 By Distribution Size and Age at
Distribution
Members of the Working Group
Summaries of Testimony
Index of Exhibits
THE ISSUE
“To state the argument in its simplest terms, if you
come down too hard on the capacity to access this money, it won’t be
there in the first place and, so, that would be potentially something of a
pyrrhic victory. We would have stopped leakage simply by stopping the
accumulation in the first place. “I don’t personally place a great
deal of weight on that, but as I said, there have been some fairly
reputable economists that have argued in favor of that.” Richard Hinz
U.S. Department of Labor
May 5, 1998 (Tr., p. 45)
“Quite frankly, there’s a lot of time and a lot of
attention given to, in the realms of 401(k) plans, focusing on workers’
participation, getting workers to contribute money, the amount that they
contribute, how they allocate that money, are they too conservative, etc.
“All very important issues, but at the end of the day, if the money
doesn’t make it to retirement, in some sense who cares…”Dr. Paul
Yakoboski
EBRI
May 5, 1998 (Tr., pp. 73-74)
I. Are We Cashing Out Our Future?
Blame it on the Social Security crisis, the aging of
the baby boomers or the gyrations of the stock market – retirement
security is the subject of daily conversation from bus stops to cocktail
parties. Many believe that they are saving more than ever due to their
opportunities under 401(k) plans. Many believe that they are better
investors due to educational programs at their workplaces. Many believe
that they are on the road to a comfortable retirement due to their pattern
of regular savings and diversified investments. The statistics, however,
show that most Americans spend their retirement savings far in advance of
retirement. The most recent Current Population Survey determined that only
20 percent of individuals who received lump sum distributions rolled the
entire sum into another tax-qualified vehicle. Leakage from retirement
plans is a serious threat. Popular notions of the dangers of participant
loans and hardship withdrawals are overstated. The real culprit is the
temptation to spend lump sum distributions, particularly smaller
distributions and distributions made at an early age. Also, overly
restrictive rules unnecessarily inhibit retirement preservation. This
Report documents the sources of leakage from retirement plans and
recommends simple measures to stop the leaks.Our recommendations begin
with a request for further research and end with a demand for education.
Further government study is warranted to track the trends in retirement
leakage so that we can fine tune measures to maintain retirement savings.
Education is critical in its content and its timing. Participants need to
understand the impact of the premature spending of retirement dollars.
This advice should be delivered throughout the working years and at the
time of any benefit payment.
Our strongest recommendations attack the common
practice of handing over a retirement check to a participant who retires
or otherwise leaves his or her job. This practice encourages spending
rather than saving, and it is time to reverse the trend. We recommend that
defined contribution plans offer annuities as the primary form of benefit
for distributions in excess of $5,000. The benefits would be subject to
the joint and survivor rules, including spousal consent. The participant,
with the consent of his or her spouse, could elect a lump sum
distribution, but would have the opportunity to choose a lifetime annuity
if he or she finds that form of payment more suitable. Should the
participant choose a lump sum distribution from the defined contribution
plan or from a defined benefit plan, a second recommendation would come
into play. The plan sponsor would be required to send the lump sum
distribution directly to an IRA or to another qualified plan as specified
by the participant. We have fashioned a de minimis exception for balances
valued at under $2,000, and exceptions for financial hardship and in-kind
distributions. We recognize that participants can withdraw the funds from
the IRAs, but this action requires an affirmative step. The primal force
of inertia should be directed in favor of savings.
We further recommend that all defined contribution
plans be required to accept rollovers of cash from other qualified plans.
Furthermore, rollovers of post-tax contributions should be permitted into
qualified plans and IRAs to facilitate the management of retirement
holdings by participants. We recommend further study of in-service
withdrawals of employee after-tax contributions and vested company
contributions for appropriate limitations; unfettered access to these
funds has made some retirement plans resemble revolving savings accounts.
We have made a recommendation to modify the mandatory
cash-out rules to promote the rollover of these lump sum distributions to
another retirement vehicle. Today, plan sponsors can “cash out” any
participant with a benefit or balance valued under $5,000 when the
participant terminates employment, and this remains unchanged. However, if
the cash-out is valued at $2,000 or more, the plan sponsor would be
required to roll over the distribution to an IRA or another qualified
plan, or the plan sponsor could purchase an annuity for the
participant. Although plan sponsors are permitted to “cash-out”
any distribution valued at under $5,000, there are some who retain these
balances and benefits on behalf of terminated participants. This practice
preserves the benefit for retirement and should be encouraged. To this
end, the Working Group recommends the alleviation of the obligation of
defined benefit plan sponsors to pay Pension Benefit Guaranty Corporation
(PBGC) premiums on the benefits of separated participants that are valued
at under $5,000. PBGC coverage would continue to apply. Loans and
hardship withdrawals are necessary safety valves to a long-term savings
objective. Surprisingly, the availability of loans and hardships actually
increases the levels of participation and contribution in defined
contribution plans. Participant loans create leakage when a default
occurs, and defaults occur most commonly when a participant changes
employers. Accordingly, we recommend that all defined contribution plans
that have a participant loan program accept the rollover of a participant
loan from new employees. We also recommend that participants with balances
over $5,000 who chose to leave their account balance in the plan when they
terminate employment be permitted to continue to repay the loan. With
respect to hardship withdrawals, we recommend that the twelve-month
suspension of contribution rule be stricken. It is an unnecessary
interruption in the retirement savings habit. Participants who request
hardship withdrawals have a genuine need for the funds, and should not be
deterred in further savings efforts.
To facilitate portability among defined contribution
plans, we recommend loosening the IRA rules so that distributions from
different types of qualified retirement plans can be combined in one IRA.
This would allow a participant who has distributions from a 401(k) plan, a
Section 457 plan (for governmental entities) and Section 403(b) plan (for
non-profit organizations) to manage his or her retirement savings in a
single IRA. We also recommend greater portability among defined
contribution plan accounts in similar fashion. In this regard, we endorse
the provisions of H.R. 3503, “The Retirement Account Portability Act of
1998.”Yes, we are cashing out our future. The shift in retirement
funding from the protective sphere of defined benefit plans to the
empowering environment of defined contribution plans has resulted in
increased retirement leakage. Defined contribution plan balances are a
tempting target for consumption. Without education about the need for
retirement savings to last a lifetime, we will continue on the path of
early spending. Leakage can be slowed with reasonable measures that are
narrowly drafted to foster benefit preservation rather than consumption.
By stemming the opportunities for leakage, retirement security will be
more readily attainable for all Americans.
II. Recommendations
A. The Critical Need for Research
Recommendation: Fundamental research should be
undertaken by the Census Bureau and other governmental entities to provide
data and analysis on all aspects of plan leakage. Furthermore, the
Department of Labor should utilize the Current Population Survey to
identify the magnitude and trends of all aspects of plan leakage.
B. Annuitization of Benefits
Recommendation: Require that all defined contribution
plans offer annuities as the primary form of benefit for all distributions
in excess of $5,000 and comply with the joint and survivor rules, unless
the participant elects otherwise in conformance with the joint and
survivor rules, including spousal consent.
C. Rollovers of Lump Sum Distributions
Recommendation: Require that lump sum distributions in
excess of $2,000 be rolled over directly to an IRA or other qualified plan
except in the case of financial hardship of the recipient. To the extent
such distributions consist of assets other than cash, a qualified plan or
IRA provider would not be required to accept such assets.
Recommendation: Require all defined contribution plans
be amended to accept rollovers from other qualified plans, provided that
the rollovers are made in the form of cash.
Recommendation: Permit rollovers of post-tax
contributions to qualified plans and IRAs in the form of cash.
Recommendation: Further study is needed of the rules
permitting in-service withdrawals of employee after-tax contributions and
vested company contributions for appropriate limitations.
D. Mandatory Cash-Outs and Other Small Payments
Recommendation: Modify the mandatory cash-out
provisions so that any benefits or balances that are valued over $2,000 be
rolled over to an IRA or other qualified plan or used to purchase an
annuity.
Recommendation: Eliminate PBGC premiums (but not PBGC
coverage) for defined benefit plans that retain the benefits of separated
participants whose vested pension benefit has a value of less than $5,000.
E. Participant Loans
Recommendation: Require that all plans that permit
participant loans be required to accept outstanding loans as part of a
rollover by new participants.
Recommendation: Require that plans permit former
participants who chose to leave their account balance in their former
employer’s plan to continue to repay the installments of their
outstanding loan balances after termination of employment. Participants
would be required to establish an electronic funds transfer from the
participant’s checking or savings account to the plan to facilitate loan
repayment. This rule would not apply if the value of the total account
balance is less than $5,000.Recommendation: The Internal Revenue Service
should monitor Form 5500 filings and Form 1099-R filings to identify the
magnitude and trends of qualified plan distributions attributable to
defaulted loans.
F. Hardship Withdrawals
Recommendation: Eliminate the suspension of
participation rule for hardship withdrawals (Reg. 1.401(k)-1(d)(2)(iv)(B)(4)).
G. Portability
Recommendation: Allow portability of balances under all
types of defined contribution plans so that balances under plans offered
by for-profit organizations (Section 401(a) and 401(k) plans), plans
offered by non-profit organizations (Section 403(b) plans) and plans
offered by state and local government entities (Section 457 plans) can be
combined by in any one defined contribution plan. In this regard, the
Council endorses the provisions of H.R. 3503, the “Retirement Account
Portability Act of 1998,” introduced by Congressmen Earl Pomeroy (D-ND),
Jim Kolbe (R-AZ) and others earlier this year. Recommendation: The use of
IRAs as rollover vehicles should be expanded. In this regard, the Council
endorses the provisions of H.R. 3503, the “Retirement Account
Portability Act of 1998.H. Educational Initiatives
Recommendation: Require participant education on the
harmful effects of leakage. Specifically, require plan sponsors to provide
plan participants with an explanation of the impact on a participant’s
retirement security of spending the distribution currently versus rolling
the distribution into a tax-qualified savings vehicle. Recommendation: The
Department of Labor should issue a pamphlet on leakage that illustrates
the adverse effect of leakage on retirement savings and retirement
lifestyle.
Recommendation: The Department of Labor should issue a
report on the societal and individual advantages of defined benefit plans,
particularly with respect to leakage, to plan sponsors, plan participants
and Congress.
III. Introduction
Retirement savings has become a focus of national
attention, with the National Savers Summit as a prominent recent example.
Surely savings are vital to the financial health of Americans,
particularly retirees. Without regular contributions to retirement savings
vehicles, financial security becomes a precarious strategy and an elusive
goal. However, savings – in terms of regularly putting aside funds for
retirement – is only half the battle. Maintaining the funds until and
through retirement is just as important. Findings have shown that
retirement funds are often consumed by Americans throughout their working
years, cashing out the future for the sake of the present. Despite tax
incentives, well over half of American job changers cash out their plan
distributions rather than roll them into another tax-qualified savings
vehicle. Implications of the Shift to Defined Contribution Plans
The shift in retirement savings from defined benefit
plans to defined contribution plans is well documented. Between 1983 and
1993, the ratio of full-time private workers covered by 401(k) plans
increased from 3 percent to 27 percent, while coverage under defined
benefit plans decreased from 47 percent to 33 percent (AFL-CIO testimony
based on DOL statistics). The defined contribution numbers are still
rising with over 40 percent of today’s workers covered by defined
contribution plans. For half of all workers, the 401(k) plan is the only
retirement vehicle offered by their employers. In giving workers greater
freedom to build their retirement nest eggs, defined contribution plans
are less protective of workers’ retirement security. The 401(k) plan is
the predominant form of defined contribution plan. In a 401(k) plan, the
worker reduces his or her salary to contribute to the plan. Many plan
sponsors match some of these contributions or make a separate contribution
to the plan. Nevertheless, the burden of plan contributions falls heavily
on the worker. Furthermore, the investment risk falls upon the participant
in defined contribution plans. Also, the predominant form of benefit is a
lump sum distribution. Defined contribution plans are not required to
comply with the joint and survivor rules and the spousal consent rules.
Many defined contribution plans do not provide a life annuity payment
option. If the value of a benefit is under $5,000, the recently-expanded
mandatory cash-out rules apply. A plan sponsor can require that the
participant take the distribution in the form of a lump sum payment rather
than leaving the retirement monies in the plan. Clearly, defined
contribution plans place the obligation for the management of retirement
security squarely upon the shoulders of the participant. Defined benefit
plans, by contrast, provide greater retirement security for workers. In
defined benefit plans, virtually all of the contributions are made by the
employer. The employer bears the investment risk. Should the employer
default on the payment obligation, the Pension Benefit Guaranty
Corporation steps in and assumes a certain amount of the payments. The
normal form of benefit is a stream of annuity payments, which spread the
benefit over the life of the retiree and, often, his or her spouse. Under
the mandatory cash-out rules, benefits with a present value under $5,000
can be paid to terminated participants in a lump sum. Except for lump sum
distributions, defined benefit plans pose no significant source of
leakage.
Leakage is largely a defined contribution phenomenon
because the normal form of benefit is a lump sum distribution. This form
of distribution invites leakage by giving the participant a choice between
spending the distribution or rolling it over to another tax-qualified
savings vehicle. Defined contribution plans permit participant loans,
hardship withdrawals and in-service withdrawals, which are not available
under defined benefit plans.
Savings vs. Access
It is critical to note at the outset that an inherent
conflict exists between the conditions needed to encourage contributions
to retirement plans and the conditions needed to encourage accumulation of
retirement savings. David L. Wray, President of the Profit Sharing/401(k)
Council of America, testified that some leakage is necessary to allow
lower-paid employees access to their pension assets during times of
emergency. Younger and lower-paid employees have little or no savings, and
many are living from paycheck to paycheck. If these employees are to
commit part of their earnings to a tax-qualified savings program, they
must have access to their funds in case of emergency. Hardship withdrawals
and participant loans are two avenues of access to retirement savings for
workers. In fact, the General Accounting Office (GAO) has issued a report
which shows that participation rates and contribution rates are
significantly higher for plans that have loan and hardship provisions than
for plans that do not have these provisions.
On the other hand, qualified plans were never intended
to replace savings accounts. Generous tax deferrals and deductions for
workers and employers, respectively, encourage retirement savings.
Unlimited access to tax-deferred savings makes a mockery of the tax
subsidy. More importantly, even small amounts of money compounded over
working years will create sizable retirement nest eggs. Early
distributions that are consumed during working years drastically reduce
the amount available for retirement; this presents an increased risk of
impairing the quality of life in a worker’s advanced years, and
ultimately, a burden on society. Lump Sum Distributions – The Largest
Source of Leakage The 1993 Current Population Survey (CPS) determined that
only 20 percent of the individuals who received lump sum distributions
rolled the entire sum into another tax-qualified vehicle. Forty percent of
the individuals rolled over a portion of the lump sum distribution. On a
dollar basis, about two-thirds of the money was rolled over to a
tax-favored vehicle, which demonstrates that individuals with larger
balances are more likely to keep funds tax sheltered.
An analysis of the CPS prepared by two witnesses from
the Federal Reserve further details the uses of lump sum distributions.
The witnesses also testified that workers with higher
incomes, larger distributions, and a college education are more likely to
roll over their distributions into another tax-qualified savings vehicle.
Also, but to a lesser extent, older workers, homeowners, single workers
and childless workers are more likely to roll over their distribution.
A study of the 1996 Hewitt database revealed that 40
percent of all distributions made to workers upon job termination were
rolled over to a tax-qualified savings vehicle. This represents an
increase from 35 percent in the 1993 Hewitt database. When the dollar
amount of the rollovers is examined, it is found that 79 percent of the
amount of the 1996 distributions was rolled over, which is up from 73
percent in the 1993 database. A mere 20 percent of distributions under
$3,500 was rolled over, whereas 95 percent of distributions over $100,000
was rolled over. The larger the amount of the distribution, the more
likely it will be rolled into another tax- qualified savings vehicle. The
propensity to roll over distributions is also positively correlated with
the age of the recipient. The rollovers range from 26 percent of
distributions made to individuals in their 20s to 89 percent for
individuals aged 60 and over.
The positive correlation of age and size with the
propensity to roll over distributions is encouraging, but it does not
solve the retirement security problem. A worker is likely to change jobs
several times during his or her career, and these job changes result in a
series of relatively small distributions. What is the impact of cashing
out the earlier distributions? The Employee Benefit Research Institute (EBRI)
gives an example of the impact of spending relatively small distributions
that are made when the recipient is young. It assumes four $3,500
distributions made at ages 25, 35, 45 and 55. Cashing out the first $3,500
distribution at age 25 reduces the retirement nest egg from $135,125 to
$59,098, assuming an 8 percent return. This is due to the power of
compound interest in a tax deferred savings vehicle.
Further evidence on lump sum distributions was provided
by Fidelity Investments based on their universe of over $300 billion in
defined contribution assets of six million plan participants. In terms of
the account balances, 73 percent of the balances remained in the plan
after the event of termination and another 23 percent were rolled over to
an IRA or another qualified plan. Only four percent of the dollars was
distributed in the form of cash to participants. In terms of numbers of
participants, 55 percent of participants kept their balances in the plan
upon termination, and another 21 percent of participants rolled the
account balances into an IRA or another qualified plan. Twenty-three
percent of participants received a cash distribution. The relatively low
rate of plan leakage is attributed to two factors. First, education
programs explain the importance of retirement savings to participants
throughout their years of participation. Second, the interests of the plan
participants are aligned with the interests of the service provider in
preserving the assets in the qualified plan.
Participant Loans and Hardship Withdrawals
The consensus of our witnesses is that participant
loans jeopardize retirement savings to the extent of loan defaults and the
interdiction of continued contributions by participants during periods of
loan repayment. Unfortunately, there is virtually no comprehensive data
available at this time on the scope or trends with respect to loan
defaults or the interdiction of contributions. Many loans are repaid with
interest, which replenishes the retirement savings. The most efficient and
effective method of loan repayment is through payroll deduction. In many
cases loan defaults were attributed to terminated participants who could
not afford to repay their entire outstanding loan balance when they leave
their jobs.
Hardship withdrawals, by definition, are available
under very limited circumstances and have tax consequences that serve as
an effective deterrent. Specifically, hardship withdrawals are subject to
federal income tax and, if the participant is under age 59 ½, a 10
percent premature redemption penalty. While, again, in this area there is
little comprehensive data available on the scope and trend of plan
hardship withdrawals, based upon the testimony received, the major concern
about hardship withdrawals is the 12-month suspension of participation
rule which interrupts the habit of retirement saving.
Other Concerns
Certain forms of leakage also create skepticism about
the appropriateness of tax incentives for retirement savings. Furthermore,
certain aspects of our tax laws seem to be fanning the flames of leakage.
Our laws should reflect a sound and consistent public policy that promotes
the accumulation of retirement assets to and through the retirement years
of workers.
Participant education on the effect of pre-retirement
plan withdrawals is a key to the success of retirement savings. Whether
mandated or merely encouraged, providing plan participants with
information about the impact of spending their retirement distributions
will increase benefit preservation. Simple charts and graphs can be highly
effective in demonstrating the ultimate retirement nest egg for a
participant who rolls over his or her distribution to a qualified plan.
Post-retirement security can be advanced by giving workers the choice of
an annuity form of benefit payment, and by extending the spousal consent
rules.
Conclusion
With the shift in retirement savings to defined
contribution plans, measures to stop the leakage of plan assets become
increasingly more important. Concerns about the viability of the social
security system further underscore the need for each worker’s retirement
savings to last a lifetime. Many plan sponsors have education programs and
communication campaigns designed to increase the awareness for retirement
savings. However, the burden of retirement savings, planning and
management rests more and more on the worker. The studies indicate that
most participants do not roll over lump sum distributions to other
tax-qualified savings vehicles. Testimony from the AFL-CIO indicated that
there is pressure to permit lump sum distributions for their members who
are covered under defined benefit plans. With these potential changes in
the form of distribution under defined benefit plans, the increasing
dominance of defined contribution plans and the mobility of the workforce,
the number of lump sum distributions will increase. It is critical that
the leakage of lump sum distributions from retirement plans be slowed.
There are some promising signs. The larger the amount
of the distribution and the older the participant, the more likely it is
that a distribution will be rolled over into another retirement vehicle.
There should be a natural boost to the rollover rates as the baby boomers
age and the average account balances rise. Also, the federal income tax
withholding requirement has helped to increase the propensity to rollover
distributions to other tax-qualified savings vehicles. On the education
front, Fidelity’s program provides a model for future benefit
preservation. Although some trends are positive, additional measures are
needed to preserve benefits through retirement. All available sources
indicate that loan defaults and hardship withdrawals are relatively small
sources of leakage. Notably, loan and hardship provisions tend to increase
the levels of plan participation and contribution. Although more study is
needed, it appears that loans and hardship withdrawals provide needed
access to retirement savings.
Public policy demands that retirement savings be
safeguarded for their intended use. The achievement of retirement security
requires both the encouragement of retirement contributions and the
long-term accumulation of retirement assets. A balance must be struck,
monitored and maintained in order to achieve optimal retirement savings.
This Working Group’s Report highlights some of the inconsistencies in
our retirement system and recommends changes consistent with a long-term
commitment to retirement security. IV. The Working Group’s Purpose and
Scope This Working Group of the ERISA Advisory Council was formed to study
the levels, sources and trends of leakage from qualified plans. Leakage
was examined during both pre- retirement and post-retirement periods for
workers covered under both defined contribution and defined benefit plans.
The Working Group chose this topic because the members believe that
leakage from retirement vehicles undercuts the effectiveness of long-term
savings, which impedes retirement security. The Working Group has
developed recommendations that are designed both to impede leakage and to
mitigate its effects. This Report sets forth the Working Group’s
findings on the patterns of leakage from retirement plans, and sets forth
recommendations for greater retirement security.V. The Working Group’s
Proceedings The Working Group held seven public meetings. Sixteen
witnesses testified before the Working Group. Seven witnesses represented
the governmental entities of the Department of Labor, the General
Accounting Office, the Department of Treasury and the Federal Reserve Bank
of New York. Four witness represented industry groups, namely, the
Employee Benefit Research Institute, the American Academy of Actuaries,
and the Profit Sharing Council of America. A representative from the
AFL-CIO provided the perspective of organized labor. Four witnesses
represented three employee benefit service providers, who are Fidelity
Investments, KPMG Peat Marwick LLP and EFI Actuaries. Finally, U.S.
Representative Earl Pomeroy gave valuable insights on legislative
proposals that are designed to preserve retirement benefits. The testimony
was recorded in verbatim transcripts of the Working Group. Additionally,
written testimony was provided in the form of statistical surveys,
scholarly treatises, periodical articles, government reports and industry
pamphlets. Summaries of the testimony appear at the end of this document,
and a summary of exhibits is attached as well. Charts are also included to
illustrate key concepts addressed in the Report.
VI. Background and Analysis
A. The Critical Need for Research
Recommendation: Fundamental research should be
undertaken by the Census Bureau and other governmental entities to provide
data and analysis on all aspects of plan leakage. Furthermore, the
Department of Labor should utilize the Current Population Survey to
identify the magnitude and trends of all aspects of plan leakage.
Most Americans spend their lump sum retirement
distributions well in advance of retirement. The billions of thwarted
savings dollars has not even been measured. Its impact on the lifestyle of
retirees is understood only in the broadest of terms. Reasons given for
the leakage of funds from the tax haven of qualified plans are merely our
best guesses at this point. Participant loans, hardship withdrawals and
lump sum distributions create a complex environment that must balance the
commitment to savings with the need for access to funds. Better
information about the amount, source and trends of leakage is critical so
that we can establish measures to buttress retirement savings. The
retirement income security of American workers depends upon it.
It is clear that both size and age matter. The smaller
the distribution and the younger the recipient, the more likely it will
leak from the retirement bucket. This information alone is both
troublesome and encouraging. The later a worker begins serious retirement
saving, the less likely he or she will have a comfortable retirement.
Also, those with smaller distributions and fewer financial resources are
more likely to have financial difficulties in retirement. Since workers
are likely to have several jobs (estimates range from five to eight jobs
over the course of working years), those covered by retirement plans will
receive a series of smaller distributions. Missing the opportunity to save
those early distributions has a significant impact on retirement savings
and lifestyles. It is imperative that we begin to save early, and that we
save even small sums.
On the bright side, the trends favor our aging
population as the baby boomers advance through their fifties. Just as
older workers are more likely to rollover their lump sum retirement
distributions, workers with larger distributions are more likely to choose
a rollover. With average 401(k) balances rising, the trends show promise
for financial security in retirement for some.
B. Annuitization of Benefits
Recommendation: Require that all defined contribution
plans offer annuities as the primary form of benefit for all distributions
in excess of $5,000 and comply with the joint and survivor rules, unless
the participant elects otherwise in conformance with the joint and
survivor rules, including spousal consent.
Leakage occurs both pre-retirement and post-retirement.
If leakage occurs early in one’s career, one can work longer, increase
savings or scale down lifestyle. If leakage occurs later in life,
particularly during retirement, options are fewer. Census Bureau data
shows that poverty rates for individuals aged 65-74 is about 10 percent.
Poverty rates rise to 16 percent for individuals over age 74, and for
elderly women, rise to nearly 20 percent. Many people outlive their means
and nearly one in five elderly women live in poverty. Joint and survivor
annuities, which extend retirement payments over the lifetime of the
retiree and his or her surviving spouse, are becoming less prevalent. The
number of pensioners receiving annuities has decreased from 60 percent in
1989 to 48 percent in 1994. There has been a corresponding increase in the
number of pensioners receiving lump sum distributions. This shift in the
form of benefit mirrors the shift away from defined benefit plans where
the normal form of benefit is the joint and survivor annuity. Clearly, the
longer a retiree’s actual life expectancy, the more he or she would
receive under an annuity. Those retirees in good health are likely to
derive better value from annuities. Retirees in poor health may derive
greater benefit from a lump sum payment. Similarly, retirees with
disciplined spending and investment habits are more likely to manage a
lump sum distribution well. Those retirees without financial discipline
would likely be better served by annuities. Today, workers do not have a
choice in the form of their benefit under most defined contribution plans,
and receive a lump sum distribution. A critical feature that hinges on the
form of benefit payment is spousal consent. In plans where a joint and
survivor annuity is the normal form of benefit, the participant’s spouse
must consent in writing to any other form of benefit payment. In this way,
both members of the financial unit make a decision together about their
retirement benefits. Let’s face it: it’s difficult to manage
retirement income, and the spousal consent rules encourage couples to have
conversations about their retirement income. Spousal consent is not
required in defined contribution plans where a lump sum distribution is
the normal form of benefit. Accordingly, the spouse has no voice in the
couple’s retirement security. Furthermore, the retiree is not given an
optional form of benefit that, for many, is more protective of lifetime
income needs. The Working Group recognizes that defined contribution plans
may need to involve a financial intermediary to provide annuity payments
to participants. Our recommendation is limited to distributions with a
value over $5,000. The Working Group found that annuities are readily
available in the marketplace for amounts over $5,000.
Under the Working Group’s recommendation, no one
would be forced to take a joint and survivor benefit under a defined
contribution plan. Rather, all would be given the opportunity to consider
the annuity form of payment, along with their spouses. Together, they
could decide upon the form of benefit that is most suitable to their
retirement years. With the alarming increase in poverty rates of elderly
Americans, particularly women, this small change in the law could have a
huge impact.C. Rollovers of Lump Sum Distributions
Lump sum distributions made under a defined
contribution plan can be rolled over into another tax-qualified savings
vehicle without incurring taxes or penalties. Distributions that are not
rolled over are subject to federal income tax, 20% tax withholding, and a
10% penalty; the penalty does not apply to workers who have reached age 59
½.
Messrs. Rodrigues and Fleming of the Federal Reserve
Bank testified that nearly half of all workers have received a lump sum
distribution from a retirement plan from a previous job. Only 28% of the
recipients who receive lump sum distributions from a 401(k) plan before
retirement roll the amounts into another tax-qualified savings vehicle.
These distributions represent 56% of the value of the lump sum
distributions. Other uses of the distributions are consumption (29% of
recipients), reduction of debt (17% of recipients), investment in savings
or other financial instruments (11% of recipients), purchase of a house or
payment of a mortgage, (7% of recipients) and other investment including
business, education or health (8% of recipients).
The witnesses also testified that workers with higher
incomes, larger distributions, and a college education are more likely to
roll over their distributions into a tax-qualified savings vehicle. Also,
but to a lesser extent, older workers, homeowners, single workers and
childless workers are more likely to roll over their distributions.
Recommendation: Require that lump sum distributions in
excess of $2,000 be rolled over directly to an IRA or other qualified plan
except in the case of financial hardship of the recipient. To the extent
such distributions consist of assets other than cash, a qualified plan
would not be required to accept such assets.
Should annuities become the normal form of benefit
under defined contribution plans, participants would retain the ability to
request a lump sum distribution, with the consent of a spouse. Lump sum
distributions are also available under some defined benefit plans. Should
a lump sum election be made, the Working Group recommends that the
distribution be rolled over into an IRA or the new qualified plan of the
participant. If the participant wants access to the funds, he or she could
choose the IRA option and take withdrawals. The withdrawals may be
immediate for some participants, but inertia would be on the side of
savings.
Appropriate technical changes would be adopted to
overcome possible legal constraints under state or federal law.
Distributions of benefits or balances with a value of
$2,000 or less could be distributed directly to the participant for ease
of administration. In addition to the de minimis exception, a direct
distribution could be made to any participant who demonstrates financial
hardship in accordance with the safe harbors prescribed under Section
401(k) without further investigation by the plan sponsor. Both the
hardship distributions and the de minimis distributions would be subject
to tax withholding. This rule would apply to partial lump sums, short-term
installment payments and similar payout forms of the type subject to
Section 417(e) actuarial assumptions.
Finally, non-cash distributions would be made directly
to the participant in-kind. The exception for non-cash distributions is
based on two reasons. First, there are administrative difficulties in
dealing with non-cash distributions by both IRA providers and other
qualified plans. Second, employer securities are afforded favorable tax
treatment that would be lost if the employer securities were flushed
through an IRA.
Recommendation: Require all defined contribution plans
be amended to accept rollovers from other qualified plans, provided that
the rollovers are made in the form of cash.
When the roof is leaking, you can never have too many
buckets. So, too, with retirement leakage. IRAs work well as rollover
vehicles, but often not as well as qualified plans. Qualified plans
provide participants with investment management expertise, either in the
form of specific investment choices or through a prudent investment
manager. Rollovers into qualified plans also give participants greater
ability to keep their retirement nest egg in one place, which facilitates
planning. Qualified plans often allow loans to participants, which are not
permitted under IRAs. For these reasons, many workers prefer to rollover a
lump sum distribution to their new employer’s qualified plan. Although
defined contribution plans can be amended to accept rollovers from other
qualified plans, many do not accept these rollovers. If defined
contribution plans were required to accept rollovers from other qualified
plans, workers would be in a better position to manage their retirement
security. Some rollovers are not in the form of cash. Employer securities
are the predominant exception to cash. Due to the administrative
complexities of dealing with non-cash rollover assets, the Working Group
believes that an exception is necessary. Accordingly, defined contribution
plans would be required to accept only cash as rollovers from other
qualified plans.
Recommendation: Permit rollovers of post-tax
contributions to qualified plans and IRAs in the form of cash.
Participants can make contributions to qualified plans
on both a pre-tax and post-tax basis. At present, only the pre-tax
contributions, employer contributions, and the earnings thereon qualify
for a rollover to another qualified plan or to an IRA. Post-tax
contributions must be made directly to the participant. Today’s
methodology promotes leakage of retirement savings. The greater the amount
of funds that remain in retirement vehicles, the greater the retirement
security of the American worker. Although there would be some
administrative cost for the future employer in accounting for the post-tax
contributions from a participant’s prior plan, the Working Group
believes that the advantages for retirement security outweigh the cost.
Again, any post-tax contribution that is not in the form of cash need not
be accepted as a rollover due to administrative complexities.
Recommendation: Review the rules concerning in-service
withdrawals of employee after- tax contributions and vested company
contributions for appropriate limitations.
Some testimony was heard concerning plans that offer
unlimited access to after-tax contributions and vested company
contributions. It is felt that these provisions create too great an
opportunity for leakage. In some cases, the participants use the plans as
revolving savings accounts. This not only complicates the administration
of these plans, but it defeats the purpose of long-term retirement
savings. The Working Group believes that withdrawals of after-tax
contributions and vested company contributions should be limited, but did
not have sufficient information to construct a sound, specific
recommendation. Accordingly, the Working Group recommends further study of
in-service withdrawals with a view toward imposing restrictions on access
to these funds.
D. Mandatory Cash-Outs and Other Small Payments
Recommendation: Modify the mandatory cash-out
provisions so that any benefits or balances that are valued over $2,000 be
rolled over to an IRA or other qualified plan, or used to purchase an
annuity.
ERISA allows plan sponsors to require a plan
participant to take a distribution from a qualified plan in the form of a
lump sum distribution when the participant terminates employment. The
mandatory cash-out rules apply to both defined contribution plans and
defined benefit plans when the value of the balance or benefit is under
$5,000. The rationale behind allowing plan sponsors to cash-out these
distributions is that it is very costly to administer small benefits for
individuals who no longer work for the plan sponsor.
The Working Group recommends that the cash-out rules
dovetail with the newly proposed lump sum rollover rules so that mandatory
cash-out distributions of benefits or balances with a value over $2,000 be
rolled over directly to an IRA or a qualified plan. Alternatively, the
plan sponsor could purchase an annuity for the participant. Research done
by the Working Group demonstrates that deferred annuities are commercially
available with a minimum premium of $2,000 or more. Also, IRAs for sums of
$2,000 or more are widely available in the marketplace.
The Working Group considered, but ultimately rejected,
a recommendation to roll back the mandatory cash-out limit because the
Working Group does not want to increase burdens on plan sponsors. Instead,
it focused on requiring the non-consensual distribution to be in the form
of an IRA or a commercial deferred annuity so that the funds stay within
the retirement system. We recognize that former participants may later
seek a distribution from the IRA or surrender the commercial annuity, but
at least that will require affirmative action on their part. In aggregate,
there should be substantially less leakage of mandatory cash-out amounts
from the retirement system.
Recommendation: Eliminate PBGC premiums (but not PBGC
coverage) for defined benefit plans that retain the benefits of separated
participants whose vested pension benefit has a value of less than $5,000.
This recommendation is designed to provide relief to
plan sponsors who voluntarily support retirement benefit preservation by
retaining the small balances of separated (terminated) participants in
their plans. PBGC coverage is fundamental to the security of pension
benefits. We do not recommend that the coverage be reduced in any way.
However, the minimum annual premium that must be paid by a defined benefit
plan sponsor for each participant is $19 per year. Additional amounts are
due if the plan has unfunded vested liabilities. PBGC premiums are not
related to the size of the benefit or the age of the participant. The PBGC
premiums and other costs of administration are why plan sponsors wish to
force out small benefits.
Some plan sponsors do not take advantage of the
cost-savings afforded by the mandatory cash-out rule, and allow benefits
valued at under $5,000 to remain in the plan. Under these circumstances,
the plan sponsor has increased the likelihood that the funds will be
available at retirement. If we wish a coherent public policy that
preserves retirement benefits and stops the leakage that is rampant among
small distributions and distributions made to younger workers, it is
recommended that we alleviate the PBGC premium obligation of the plan
sponsor for small benefits payable to terminated participants. The plan
sponsor would support retirement security by continuing to pay for the
administration of these small benefits. The PBGC would support retirement
security by waiving the premium obligation for these benefits. Since the
benefits in question are small by definition, the actual PBGC coverage
liability should be minimal.
E. Participant Loans
Loans are an obvious source of leakage, at least at
first glance. In the final analysis, however, most loans are repaid on
time and with interest. More importantly, the availability of loans is key
to encouraging participation in plans. Most impressively, the availability
of plan loans significantly raises contribution levels. The Working Group
has concluded that restrictions on the availability of plan loans are not
the solution. Rather, our recommendations are structured to help
participants repay their loans in an orderly fashion, particularly when
they change jobs. These measures will enhance the preservation of benefits
without inhibiting plan participation or dampening contribution levels.
The law allows participants to borrow the lesser of
$50,000 or half of their vested account balance. For participants with
vested account balances under $10,000, a loan of up to the full value of
their account balance is permitted. Within these limitations on the
overall amount of loans, multiple loans are permitted. The term of the
loan cannot exceed five years unless the loan is used to purchase a
principal residence. The loan must be repaid in substantially equal
installments and bear a reasonable rate of interest. There are neither
taxes nor penalties associated with the grant of the loan. However, if the
loan is not repaid, the outstanding balance is treated as a taxable
distribution and, further, is subject to a 10 percent early withdrawal
penalty if the participant is under age 59 ½. Defaulted loans are
reported to the IRS on Form 1099-R. Loans in default are also reported on
a separate schedule to the Form 5500.
In October 1997, the GAO released a report entitled,
“401(k) Pension Plans: Loan Provisions Enhance Participation But May
Affect Income Security For Some.” This study, which we will refer to as
the “GAO Report,” showed that over half of all 401(k) plans allow
participants to borrow from their accounts. Larger plans are more likely
to permit loans. This fact is supported by a 1998 KPMG study of mid to
large plans entitled, “Retirement Benefits in the 1990s.” The KPMG
data shows that 90 percent of employees are in plans that allow
participant loans. Fidelity Investments, which services 5,000 plans
covering all size categories, reported that 90 percent of their plans
offer participant loans. Participant loan provisions are a common feature
of defined contribution plans. Although loan provisions are prevalent,
fewer than eight percent of all participants had one or more outstanding
loans from their plan, according to the GAO. The data underlying the GAO
Report showed that black Americans and Hispanics are twice as likely to
borrow from their 401(k) plans as white Americans. No significant
relationship was found between the decision to borrow and the sex, age or
marital status of the participant. Attitudes of borrowers and non-
borrowers vary in that more borrowers feel it is appropriate to borrow
from their retirement plan to finance a car or for living expenses than
non-borrowers. Neither group, however, felt that it was appropriate to
borrow for a vacation or a luxury item. Surely there are some participants
who squander their retirement savings in this manner. Statistical
evidence, however, does not support this picture of participants borrowing
for frivolous expenditures.
Both participation rates and contribution levels are
higher in plans that allow participant loans. The GAO Report reveals that
participation rates for plans that allow loans are about six percentage
points higher than the plans that do not allow loans. Furthermore, average
employee contributions are 35 percent higher in 401(k) plans with loan
provisions than the contribution rates of 401(k) plans without loan
provisions.
Borrowing from a 401(k) plan can reduce the ultimate
retirement nest egg. The GAO developed a simulation of retirement income
that compared retirement funds available for those who borrow from their
401(k) plan and those who do not borrow. The simulation assumes a $40,000
loan that is repaid over a 10-year period at a 7 percent interest rate.
The simulation further assumes that the account otherwise earned an
average of 11 percent. The results show that the participant’s
retirement nest egg was reduced by 5.5 percent if the participant
continued to make contributions during the repayment period and by 27
percent if the participant suspended contributions over the repayment
period. Recommendation: Require that all plans that permit participant
loans be required to accept outstanding loans as part of a rollover by new
participants.
The testimony on defaulted loans was encouraging
insofar as it demonstrated that few participants default on plan loans.
Furthermore, the key causes of default can be addressed without inhibiting
the growth of retirement savings. Fidelity Investments provided testimony
that defaulted loans constitute less than one-tenth of one percent of the
plan assets in their universe. The incidence of defaulted loans appears to
be low, and job changes seem to be the primary catalyst for the defaults.
Several sources testified that loans are defaulted upon termination of
employment because the participant does not have the option to continue to
make monthly payments. Instead, most participants must either pay off the
loan balance completely or default on the loan. Very few plans currently
permit a rollover of outstanding loan balances from a prior plan. The
Working Group believes that the default rate would improve significantly
if participants were able to roll over their loan balances to another
qualified plan. Accordingly, we recommend that defined contribution plans
that have a participant loan program be required to accept participant
loans from the prior plan of a participant. In this way, a participant
would continue to pay the plan of his or her new employer for the plan
loan originated under the plan of his or her former employer. The
outstanding balance of the loan would simply roll over to the new plan. Of
course, if the new employer’s plan does not have a participant loan
provision, the Working Group would not require the plan to accept a
rollover loan. Recommendation: Require that plans permit former
participants who chose to leave their account balance in their former
employer’s plan to continue to repay the installments of their
outstanding loan balances after termination of employment. Participants
would be required to establish an electronic funds transfer from the
participant’s checking or savings account to the plan to facilitate loan
repayment. This rule would not apply it the value of the total account
balance is less than $5,000.In order to minimize loan defaults, a remedy
is also needed for participants who terminate employment without a new job
or with a new employer who either does not sponsor a plan or does not
provide a participant loan program. These former participants should be
able to continue to repay their outstanding loan in installments. To ease
the administration of this provision for plan sponsors, participants would
be required to establish an electronic funds transfer for the loan
payments. Also, it would be confirmed that plan sponsors do not have to
undertake additional collection efforts.
Recommendation: The Internal Revenue Service should
monitor Form 5500 filings and Form 1099-R filings to identify the
magnitude and trends of qualified plan distributions attributable to
defaulted loans.
There is little information on the extent of loan
defaults. Surely, we would benefit from more comprehensive information on
magnitude and trends of qualified plan distributions attributable to
defaulted loans. Accordingly, we have recommended that the IRS review the
Form 5500 filings and the Form 1099R filings to procure broad-based data
and analyze the leakage that is due to defaulted loans.
In conclusion, the Working Group supports participant
loans because of their positive impact on plan participation and
contribution levels. Little if any leakage occurs when loans are allowed
to be repaid, particularly if the participant continues to make
contributions to the plan. Our recommendations focus on research to better
understand the extent of any leakage, on measures to better ensure
consistent loan repayments, and on measures to prevent loan defaults at
termination of employment.
F. Hardship Withdrawals
Hardship withdrawals can be made available to meet the
immediate and heavy financial needs of the participant for which no other
resources are available. The safe harbor reasons for hardship are (1)
medical expenses; (2) the purchase of a principal residence; (3) tuition
for post- secondary education; and (4) the prevention of eviction from or
foreclosure of a principal residence. Hardship withdrawals can be made
only from a participant’s pre-tax contributions, and not from the
earnings thereon. In contrast to participant loans, hardship withdrawals
are not repaid. Moreover, a participant who takes a hardship withdrawal is
not permitted to make contributions to the plan for the 12-months
following the withdrawal. This restriction is found in the safe harbor
provisions of IRS Reg. 1.401(k)-1(d)(2)(iv)(B)(4), which is widely used by
plan sponsors.
The GAO reported that 43 percent of defined
contribution plans permit hardship withdrawals (“Plan Features Provided
by Employers That Sponsor Only Defined Contribution Plans,” December
1997). The 1998 KPMG study of mid to large size plans showed that 94
percent of employees are covered by plans that permit hardship
withdrawals. Of the plans in the Fidelity universe, 93 percent offer
hardship withdrawals. Fidelity has tracked the outflow of funds due to
hardship withdrawals, and found it considerably under one percent (0.13%).
The Working Group did not find hardship withdrawals to be a significant
source of leakage. Hardship withdrawals do tend to encourage participation
in plans. Again, participants are more likely to participate in a plan if
they can access their money, especially for emergencies. In the Fidelity
universe, participation rates average 68 percent for plans that do not
allow hardship withdrawals and the average participation rate rises to 76
percent for plans that allow hardship withdrawals.
Recommendation: Eliminate the suspension of
participation rule for hardship withdrawals (Reg. 1.401(k)-1(d)(2)(iv)(B)(4)).
Systematic retirement savings throughout a working
career is the surest route to financial security. The 12-month suspension
of participation requirement for those who a hardship withdrawals is an
unnecessary interruption of the savings habit. The suspension provision
was enacted to deter hardship withdrawals. Hardship withdrawals have other
deterrents, not the least of which is human nature. The Working Group
heard testimony about the embarrassment and sense of urgency exhibited by
participants when they request hardship withdrawals. Also, hardship
withdrawals are subject to tax and tax withholding. The suspension
provisions are more detrimental to retirement savings in delaying new
contributions than they are beneficial in deterring withdrawals. We,
therefore, recommend the elimination of the 12-month suspension of
participation rule for hardship withdrawals.
G. Portability
Recommendation: Allow portability of balances under all
types of defined contribution plans so that balances under plans sponsored
by for-profit organizations (Section 401(a) and 401(k) plans), plans
offered by non-profit organizations (Section 403(b) plans), and plans
offered by state and local government entities (Section 457 plans) can be
combined in any one defined contribution plan. Portability by means of a
rollover to another plan, a rollover through a conduit IRA as well as a
direct transfer should be permitted among defined contribution plans.
The type of employer sponsoring a plan should not
impede an employee’s right to transfer his or her pension benefits.
Current law constraints that prohibit or impede portability among
different types of defined contribution retirement savings plans should be
removed. Increasingly, employees change jobs during the normal course of
their career. Since ERISA was enacted in 1974, the Internal Revenue Code
has had provisions to encourage portability among plans and IRAs of
retirement benefits so that workers can take their benefits with them as
they move from job to job. Portability should be relatively easy to
accomplish as workers move from one employer sponsoring a defined
contribution plan to another employer sponsoring a defined contribution
plan. Yet due to historical and artificial distinctions based on the type
of employer sponsoring a defined contribution plan, employees are not
permitted under current law to transfer their pension benefits when they
change jobs. Congressmen Pomeroy, Kolbe and others have proposed
eliminating these historical and artificial impediments to portability.
This is a common sense reform. It brings greater rationality to the
retirement plan system, enhances retirement security and gives enhanced
control over their retirement savings to plan participants. In this
regard, the Council endorses the provisions of H.R. 3503, the “Retirement
Account Portability Act of 1998,” introduced by Congressmen Earl Pomeroy
(D-ND), Jim Kolbe (R-AZ) and others earlier this year. Recommendation: The
use of IRAs as rollover vehicles should be expanded.
There continue to be a number of artificial impediments
on the use of IRAs as a rollover vehicle. IRA rules should be broadened so
that workers from any employment sector, public, private or non-profit,
could use an IRA as a “conduit” for their retirement money until they
are prepared to roll the money into a subsequent employer’s retirement
plan. Also, IRAs that contain tax deductible contributions should be
eligible for rollovers into a retirement plan. And finally, the Treasury
Department should be given authority to waive for good cause the
inflexible current law requirement that rollovers occur within 60 days.
Unfortunately, the 60-day requirement has sometimes acted as a tax trap
for the unsophisticated participants and frustrated good faith efforts on
their part to achieve portability. In this regard, the Council endorses
the provisions of H.R. 3503, the “Retirement Account Portability Act of
1998,” introduced by Congressmen Earl Pomeroy (D-ND), Jim Kolbe (R-AZ)
and others earlier this year.H. Educational Initiatives
“Education about basic retirement planning and
financial information pays off.” This is the opening remark on education
in the 1998 KPMG Study, and many witnesses reinforced this concept with
the Working Group. It is no surprise that 401(k) participation rates are
17 points higher in plans that offer educational seminars. Contribution
levels are higher as well. Another recent study shows 70% of plan sponsors
rank employee education as the most pressing issue facing them over the
next five to ten years (BARRA Rogers Casey/IOMA June 1998). The types of
employee education include investment seminars for active and retired
employees, retirement planning software, audio and video planning tapes,
and financial counseling. Fidelity Investments attributes the success of
its benefit preservation efforts to education and communication.
Throughout the period of employment, workers are advised of the need to
save for retirement and the benefits of a qualified plan as the lynchpin
of retirement security. Recommendation: Require participant education on
the harmful effects of leakage. Specifically, require plan sponsors to
provide plan participants with an explanation of the impact on a
participant’s retirement security of spending the distribution currently
versus rolling the distribution into a tax-qualified savings vehicle.
Suicide prevention signs are posted every 100 yards along the Coronado Bay
Bridge, defying the adage, “Advice always comes too early or too late.”
Inspired by such creativity, the Working Group recommends that plan
participants be told of the future value of any distribution that they
receive before retirement just as they are about to receive that payment.
The notice would tell the participant, basically, that you can have this
$5,000 now, pay taxes and possibly penalties on it, and spend the
remaining $3,000 on whatever you desire today. Then, the notice would urge
the participant to consider that the $5,000 distribution today would
likely grow to a certain projected sum, for example $50,000, at
retirement. Perhaps the notice would state the obvious, which many people
seem to ignore: when you retire, you will be older and you will not be
working – you will need this money to live comfortably. Simple charts or
a graphical illustration could be added to help a worker understand the
difference that the rollover will make to his or her financial future.
Concern was expressed that plan sponsors and service providers do not wish
to be seen as guaranteeing investment results. To mitigate that concern,
the Department of Labor would be required to issue guidelines to plan
sponsors and service providers that would give safe harbor parameters for
the notice. The DOL guidance, in the form of model language, would
alleviate any liability issues for plan sponsors and service providers.
The distribution notice could provide very timely advice to those who are
tempted to spend their retirement savings at a young age.
Recommendation: The Department of Labor should issue a
pamphlet on leakage that illustrates the adverse effect of leakage on
retirement savings and retirement lifestyle.
This leaflet would be designed for distribution to
workers directly and/or through their employers. The employer could
distribute the pamphlet periodically to all plan participants, but
particularly at the time of a distribution. The pamphlet could be posted
on the DOL web site as well.
The pamphlet would describe the impact of leakage on
retirement savings in simple terms. Charts and graphs depicting the value
of tax-deferred savings and the power of compound interest should be
included. IRA rollover opportunities would be explained. Encouragement
could be provided to plan borrowers to continue to contribute to the plan.
The pamphlet would also describe the effect of leakage on retirement
lifestyles. Examples of the economic security of savers and spenders would
be particularly meaningful.
Recommendation: The Department of Labor should issue a
report on the societal and individual advantages of defined benefit plans,
particularly with respect to leakage, to plan sponsors, plan participants
and Congress.
Defined benefit plans are far more protective of
workers in their retirement years than defined contribution plans. All
investment risk and often the entire contribution obligation are borne by
the employer. There are fewer opportunities for pre-retirement leakage.
Retirement benefits are normally spread over the lifetime of the
participant and his or her spouse. In the event of employer default, the
PBGC guarantees payment of the benefit. For these reasons, we recommend
that the DOL highlight the advantages of defined benefit plans to its
constituencies.
Members of the Working Group on Retirement Plan Leakage
Barbara Ann Uberti, Esq. -- Chair
Vice President
Wilmington Trust Company
Wilmington, DE
Michael R. Fanning, Esq. -- Vice-Chair
Chief Executive Officer
Central Pension Fund International
Union of Operating Engineers and Participating
Employers
Washington, DC
Ms. Rose Mary Abelson
Assistant Treasurer/Director
Investments and Trust Management
Northop Grumman Corporation
Hawthorn, CA
Mr. Eddie C. Brown
President
Brown Capital Management
Baltimore, MD
Kenneth S. Cohen, Esq.
(ERISA Advisory Council Vice Chair)
Senior Vice President/Deputy General Counsel
Massachusetts Mutual Life Insurance Co.
Springfield, MA
Neil M. Grossman, Esq.
William M. Mercer
Washington, DC
Mr. Michael J. Gulotta
President & CEO
Actuarial Sciences Associates
Somerset, NJ
Janie Greenwood Harris, Esq.
Mercantile Bancorporation Inc.
St. Louis, MO
Mrs. Marilee P. Lau
(ERISA Advisory Council Chair)
Partner
KPMG Peat Marwick LLP
San Francisco, CA
Dr. Thomas J. Mackell, Jr.
Executive Vice President
Simms Capital Management, Inc.
Greenwich, CT
Judith F. Mazo, Esq.
Senior Vice President and Director of Research
The Segal Company
Washington, DC
Mr. Richard Tani
Actuary and Retirement Consultant (Retired)
Mt. Prospect, IL
James O. Wood, Esq.
Executive Director
Louisiana State Employee’s
Retirement System (LASERS)
Baton Rouge, LAExecutive Secretary of the ERISA
Advisory Council
Ms. Sharon Morrissey
Executive Secretary
ERISA Advisory Council
Washington, DC
Summaries of Testimony
ERISA Advisory Council Working Group on Retirement Plan
Leakage
Meeting of May 5, 1998
Summary of Testimony of Dr. Paul Yakoboski
Employee Benefit Research Institute (EBRI)
Paul Yakoboski is a senior research associate with the
Employee Benefit Research Institute. His current research focuses on lump
sum distributions, benefit preservation and the future retirement income
security of today’s workers. Dr. Yakoboski is Director of Research for
the American Savings Education Council and a member of the National
Academy of Social Insurance. Much of Dr. Yakoboski’s testimony is based
on an EBRI Issue Brief published in August 1997 entitled “Large Plan
Lump-Sums: Rollovers and Cashouts,” a copy of which is included in the
record. The study examined the 1996 Hewitt database, which consists of
87,318 distributions totaling $2.3 billion. Of this total, 71,736
distributions were made to workers upon job termination, 13,868
distributions were made to disabled persons and retirees, and 1,714 were
made to the beneficiaries of deceased participants. The 1996 data was
compared to the 1993 Hewitt database of 138,088 distributions. Information
is provided by both the total number of distributions and the total amount
of distributions.
Forty percent of all distributions made to workers upon
job termination were rolled over into another tax-qualified savings
vehicle. This represents an increase from 35% in the 1993 database. When
the dollar amount of the rollovers are examined, it is found that 79% of
the amount of the 1996 distributions was rolled over, which is up from 73%
in the 1993 database. A mere 20% of distributions under $3,500 was rolled
over, whereas 95% of distributions over $100,000 were rolled over. The
larger the amount of the distribution, the more likely it will be rolled
into another tax-qualified savings vehicle. The propensity to roll over
distributions is also positively correlated with the age of the recipient.
The rollovers range from 26% of distributions made to persons in their 20s
to 51% for persons aged 60 and over.
The positive correlation of age and size with the
propensity to roll over distributions is encouraging. However, it is also
evidence of the fact that the rollover of smaller distributions at young
ages need to be incentivized. A worker is likely to change jobs a number
of times during his or her career, and these job changes could result in a
series of relatively small distributions. What is the impact of cashing
out the earlier distributions? The Issue Brief gives an example of the
impact of spending relatively small distributions that are made when the
recipient is young. It assumes four $3,500 distributions made at ages 25,
35, 45 and 55. Cashing out the distribution at age 25 reduces the
retirement nest egg from $135,125 to $59,098, assuming an 8% return. This
is due to the power of compound interest.
Distributions to retirees and disabled persons showed
more positive results than distributions to job changers. Here, 52% of the
number of distributions and 87% of the amount of distributions were rolled
over into a tax-qualified savings vehicle. On the other hand, rollover
rates are lower overall in the event of death. Only 27% of the number and
56% of the amount of distributions were rolled over into a tax-qualified
savings vehicle. It is important to note, however, that distributions to
non-spousal beneficiaries are not eligible for roll over.
The trend toward increasing numbers and amounts of
rollovers is encouraging. This positive development may be attributed to
two changes that took effect in 1993. First, a mandatory 20% federal
income tax withholding was applied to any distribution that was not rolled
over into another tax-qualified savings vehicle. Second, participants can
instruct their plans to roll their distribution to another plan or an IRA
with ease – the participant need not touch or see the money. However,
much work is left to be done since only 40% of distributions are rolled
over. Education was cited as the primary method for improving rollover
rates. Dr. Yakoboski suggested that job changers be given basic
information about the impact of rolling over a small distribution versus
spending it. Simple charts or a graphical illustration can help a worker
understand that difference that the rollover will make to his or her
retirement lifestyle, versus the present pleasure of a current use of
funds. Meeting of May 5, 1998
Summary of Testimony of Richard Hinz and Daniel Beller
Employee Benefits Security Administration
Richard Hinz is the Director of Policy and Research for
the Pension and Welfare Benefits Administration. Dan Beller is the Manager
of Statistical and Data Development with the EBSA.
Retirement plan leakage involves the complex
interactions of funds flowing into retirement savings, the behavior of
funds in the retirement system, and funds flowing out of the retirement
system. Overall, there is not a lot of information on leakage. Further
study should be encouraged. Messrs. Hinz and Beller summarized the
following four studies:
1. The Employee Benefits Supplement to the Current
Population Survey
The Employee Benefits Supplement (EBS) to the Current
Population Survey covers 30,000 households. Reports are issued every 5
years: 1983, 1988, 1993. The 1993 report is the most recent. The survey
asked whether any member of the household received a lump sum distribution
upon a change in jobs, and what did the household member do with the
distribution. Twenty to forty percent of households reported that they
rolled the distribution into another qualified plan or an IRA. Twenty
percent rolled over all of it and 40% rolled over a portion of the
distribution. On a dollar basis, about two-thirds of the money remained
tax sheltered, which indicates that persons with larger distributions were
more likely to keep money tax sheltered. The propensity to roll over the
distribution to a tax-favored vehicle was also more likely with increases
in the age and the income of the recipient. The survey did not cover those
distributions that remained with the plan, so actual preservation rates
are somewhat higher than reported. Subsequent reports will include
information on distributions that remain with the plan. Most promisingly,
the percentage of lump sum distribution that was preserved has increased
from the 1988 EBS to the 1993 EBS.
2. Hewitt Study
A Hewitt Study (discussed at length in other testimony,
including Dr. Yakoboski) covers distributions made under larger defined
contribution plans. The Hewitt results were similar to the EBS survey
result. About 40% of the individuals preserved the tax-favored status of
their retirement plan distributions. The Hewitt study also found a
positive correlation between the likelihood to preserve the distribution
and the dollar amount of the distribution.
3. Urban Institute (Len Burman): “What Happens When
You Show Them the Money” The Urban Institute Study is now underway and
will analyze role of marginal tax rates, early withdrawal penalties and
mandatory withholding, on the propensity to keep money tax sheltered. It
will examine the effect of many changes in tax laws over the last ten
years. The study will use data from the Health and Retirement Survey (HRS)
sponsored by the National Institute of Aging, which follows individuals
age 50-60 over extended periods of time.
4. Rand Corporation (Lee Lillard and Mr. Panis): “Cashing
Out Tax Protected Retirement Accounts” The Rand Study also is just
starting. It will look at cash out decisions in the context of a life
cycle savings and consumption model. The Rand Study will test the
hypotheses that the propensity to cash out accounts increases with
mortality risk, discount rates, and liquidity restraints, and decreases
when risk aversion increases. The Rand Study will focus on individuals who
are age 56 to 66, using information from the Health and Retirement Survey.
In closing, Mr. Hinz testified that there is a need to
consider importance of access (e.g., loans and distributions) to
retirement savings because of the impact on the likelihood and degree of
plan participation. Constraining access will reduce participation,
especially for younger people who have greater and more uncertain
liquidity needs. In closing, Mr. Hinz pointed out that 401(k) plans are
relatively new, and current economic times may not be typical; in view of
these limitation, long term projections on current information may be
difficult.
ERISA Advisory Council Working Group on Retirement Plan
Leakage
Meeting of June 9, 1998
American Academy of Actuaries
Ron Gebhardtsbauer is the Senior Pension Fellow at the
American Academy of Actuaries. In this role, Gebhardtsbauer represents
pension actuaries among federal regulators and legislators. Gebhardtsbauer
also served as the chief pension actuary for the Federal Employee
Retirement System at the U.S. Office of Personnel and Management. Before
joining the Academy, Gebhardtsbauer managed the retirement practice at the
New York office of William Mercer. He also served as former chief actuary
with the Pension Benefit Guaranty Corporation.
Gebhardtsbauer’s testimony focused on recommendations
that would encourage lifetime retirement income. Accordingly, he discussed
pre-retirement and post-retirement leakage. If leakage occurs early in one’s
career, you can work longer, increase savings or scale down lifestyle. If
leakage occurs later in life, particularly during retirement, options are
fewer. Census bureau data shows that poverty rates have improved since the
1950’s from an average of 35% to an average of 11%. However poverty
among those over age 75 is very high, particularly among women. Nearly 20%
of elderly women have incomes below the poverty line. Gebhardtsbauer
discussed ways to stem the spending of retirement savings by imposing
further limits on participant loans, hardship withdrawals and lump sum
distributions. He offered the following options for consideration (and
also noted their disadvantages):
Limit hardship withdrawals to severe hardship: exclude
home purchase as an eligible condition for a hardship withdrawal.
Allow hardship withdrawals to be returned to the plan
by the due date of the next federal tax return of the recipient.
Reduce the maximum loan to $25,000.
Eliminate the $10,000 loan minimum, which essentially
allows participants to borrow their full account balances up to $10,000.
Require that all participant loans, even home loans, be
repaid over a 5-year period.
Convert loans at termination of employment to charge
accounts.
Provide incentives to employers and employees to reduce
cash-outs such as: reduced PBGC premiums for terminated employees,
elimination of lump sum provisions in plans, and employee education.
Allow portability to all types of plans, including
403(b), 457, 401(k), and IRAs.
Extend the 60-day rollover period to the due date of
the recipient’s federal income tax return. Exempt the first $10,000 of
pensions from taxation.
Require that lump sum distributions be paid directly to
an IRA rollover account so that inertia is on the side of savings rather
than spending.
Increase both tax withholding and excises taxes on lump
sum distributions.
Require some annuitization of all qualified plan
distributions.
Require automatic joint and survivor option in all
plans.
Gebhardtsbauer suggested that using incentives to
preserve benefits would be better than mandates, for example, increase the
maximum allowable contributions for plans that comply.
Gebhardtsbauer addressed the relative advantages and
disadvantages of lifetime pensions or annuities as an alternative to lump
sum distributions. Because of the design of annuities, they can often
provide greater income over all retirement years than the minimum
distribution rules of the Internal Revenue Code. One key factor in this
design is the lack of a residual beneficiary. When payments are made under
the minimum distribution rules, the balance in the account is paid to the
retiree’s beneficiary after the retiree’s death. With an annuity,
these balances are available to lower the overall costs of the annuities
and increase benefits for a large pool of individuals. Among the
disadvantages of annuities are sales commissions, the lack of liquidity,
and the issuers’ administrative charges. Also, with stock investments
minimum required distributions can be larger (in some years) than annuity
payments, but at the risk of high volatility. Thus, minimum required
distributions are primarily valuable if you want to pass your money to
your heirs. They are not good if you need a lifetime income. Lifetime
pensions or annuities are better for this. Gebhardtsbauer stressed the
need for legislation and education that favors lifetime retirement income
to promote financial security to workers throughout their retirement
years.
ERISA Advisory Council Working Group on Retirement Plan
Leakage
Meeting of June 9, 1998
Summary of Testimony of Edward H. Friend
EFI Actuaries
Mr. Friend is the President and CEO of EFI Actuaries,
which is the first national employee benefits firm dedicated to the public
sector. Mr. Friend is known throughout the employee benefits community for
his actuarial expertise. He is a fellow in the Society of Actuaries and is
a contributing author and founding member of the International Association
of Consulting Actuaries.
Mr. Friend advanced the position that society is
entitled to some value for providing tax shelters for retirement savings.
The benefit for society is that the individual will not become a burden on
the rest of society in retirement. The tax subsidy should not be abused.
“Tax shelter for the accumulation of retirement funds should be used for
exactly for that purpose, including the annuitization of the retirement
benefit upon maturity.” Mr. Friend cited an instance where a Florida
worker terminated her job solely to receive the lump sum distribution from
the defined contribution plans. The Florida municipality changed its
retirement program to a defined benefit plan to eliminate this source of
leakage.
Mr. Friend raised concerns about the public perception
of the extent of retirement plan leakage. He is concerned that
professional publications may paint a rosier picture about the amount of
funds that remain in the retirement system and trends in this regard. He
points out that “a preponderance of employee participants in defined
contribution systems elect to take a significant portion of their
retirement monies before retirement.” Advantages of portability in
defined contribution plans are undercut by those distributions that are
not rolled into IRAs. He concludes that, “Society will pay twice, once
to contribute to the defined contribution system and once to support these
imprudent employees at the time of retirement. Summary of Testimony of
June 9, 1998
Martha Priddy-Patterson
KPMG Compensation & Benefits Practice
Martha Priddy-Patterson is a director of Employees
Benefit Policy and Analysis for KPMG Peat Marwick compensation and
benefits practice. She is an experienced attorney and employee benefit
consultant and she has worked with Congress and federal agencies
throughout her career. Ms. Priddy-Patterson co-authored KPMG’s employee
benefits law changes in 1997, she compiled KPMG’s Employee Benefits Plan
Diagnostic Review Guide, and she conducted and authored the report for
KPMG’s annual survey series, Retirement Benefits in the 90’s, which
surveys over 1,000 employers with 200 or more employees. Finally, Martha
Priddy-Patterson is the author of the Working Woman’s Guide to
Retirement Planning. In response to questions concerning areas of leakage
in retirement savings Ms. Priddy- Patterson spoke on the issue of loans
and hardship withdrawals. According to Priddy-Patterson, persons who make
hardship withdrawals “really need the money.” The problem is, whether
employees need the money or not, once hardship withdrawals are made, the
money is gone from retirement savings and there is no way to get it back.
Ms. Priddy-Patterson stated that loans are different because money is
presumably restored to the retirement plan via loan payments. Priddy-Patterson
supports the intention of the IRS to go after plan sponsors who do not
enforce loan rules or require repayment. She stated that, although we have
not seen it to date, this kind of enforcement is much needed.
Ms. Priddy-Patterson identified another problem with
loans. She stated that even if there is repayment, the low interest rates
that are normally offered on loans means that retirement plans lose a
great deal of earnings that they would otherwise have. Therefore,
according to Ms. Priddy- Patterson, there are two areas of leakage outside
of failure to roll over that plan sponsors and plan participants need to
consider: hardship withdrawals and loans. Priddy-Patterson expressed a
particular concern over hardship withdrawals, stating that it “is very
bad” to have retirement plans being used as savings accounts. Priddy-Patterson
recognized the need to offer incentives to lower paid workers (via using
retirement plans as savings vehicles) to get them to participate in
retirement plans. However, she stated that a balance must be struck
between offering incentives and leakage from hardship withdrawals. She
stated that even though hardship withdrawals are “the worst type of
leakage”, employers prefer them because there are fewer administrative
requirements; i.e., keeping up with loan balances and payments, etc. When
asked about rollovers, Priddy-Patterson responded positively to the data
that employees, and especially older employees, preserve large lump sums
in some type of retirement plan. On the other hand, she expressed concern
for young employees who lose the time value of money when they withdraw
funds - that they can never be returned - from retirement plans. With this
concern in mind, Ms. Priddy-Patterson expressed support for federal
legislation that would provide for catch-up contributions.
Subsequent to Ms. Priddy-Patterson’s testimony she
provided the Council with a written summary regarding the leakage problem
to amplify her oral comments. In that summary she provided a table from
the 1997 edition of KPMG Retirement Benefits in the 1990s which indicated
that hardship withdrawals outpace participant loans by approximately 5%
and that the widest gap is centered in the mid-size organizations. ERISA
Advisory Council Working Group on Retirement Plan Leakage
Meeting of July 8, 1998
Summary of Testimony of David L. Wray
President, Profit Sharing/401(k) Council of America
David L. Wray is President of the Profit Sharing/401(k)
Council of America, a non-profit association representing over 1,200
companies. He testified that all qualified pension plans have leakage of
assets and some leakage is necessary to allow lower-paid employees access
to their pension assets during times of emergency. Younger, lower-paid
employees have little or no savings because many are living from paycheck
to paycheck. If these employees are to commit part of their earnings to a
savings program, they must have access to their funds in case of
emergency. Instead of permitting emergency withdrawals, Mr. Wray advocates
plan loan programs as a substitute for in-service distributions.
Today’s employees are likely to change jobs at least
five times during their careers. In order for them to live in dignity in
their retirement, they must preserve accumulated retirement assets when
they change jobs. In addition, they must refrain from taking in-service
distributions. To help maintain retirement assets, significant roles are
to be played by employers, service providers and the federal government.
Mr. Wray believes plan sponsors should continue to enhance employee
education efforts. Better-informed employees are more likely to roll over
assets from qualified plans into IRAs. Estimates are that over $150
billion were rolled over from qualified plans to IRAs in 1996. In
addition, plan sponsors should be willing to accept plan rollovers from
other qualified plans.
To ease the rollover process, plan sponsors and service
providers should work together to make the preservation of retirement
assets easier. For example, service providers should develop uniform
rollover packets that will handle the rollover process just by completing
one short form, and plan sponsors should give them to terminating
employees. Financial service providers should also provide low-cost or
no-cost IRA accounts that can be opened with minimal account balances.
The government can make a significant contribution by
easing movement of funds and information between different types of
qualified plans. This ease of transfer between different types of
qualified plans would make the system more fluid. The IRS should allow
employees to roll over all after-tax contributions into IRAs beyond the
current 60-day limitation. Mr. Wray concluded his testimony by stating
there should be an unlimited rollover capability between all types of
defined contribution plans.
Meeting of July 8, 1998
Summary of Testimony of Shaun O’Brien
AFL-CIOShaun O’Brien is a Retirement Policy
Specialist for the AFL-CIO. He has also served as a staff attorney with
the Pension Rights Center. Mr. O’Brien urged the Advisory Council to
adopt a broad definition of “leakage,” including loans and the failure
to annuitize benefits, as well as pre-retirement lump sum distributions.
However, his comments focused on pre-retirement lump sum distributions.
Mr. O’Brien found little solace in statistics that most of the money
distributed from plans before retirement is rolled over to other
retirement arrangements. He pointed out that only a relatively small
number of the workers—28 percent—roll over their distributions and
that the decision is related to family income, with those who opt not to
roll over having average incomes of $20,000 less. For poorer workers,
these assets may be a meaningful part of their ultimate retirement
benefits. He also noted that age is an important factor in the leakage
analysis. For younger workers, even small distributions can represent
significant benefits at the time of retirement. Mr. O’Brien expressed
concern that workers have come to recognize the availability of lump sum
distributions upon termination of employment and demand them. He sees this
demand beginning to influence defined benefit plan design, with some plans
adding lump sum features. Potential solutions should address the source of
the demand – for example, whether pre- retirement distributions are used
to purchase luxuries or to supplement income during periods of
unemployment. In the latter case, providing education about retirement
savings or increasing premature distribution excise taxes may not be
effective. Policy-makers also should consider the extent to which leakage
results from involuntary cash-outs in determining how best to address the
issues, Mr. O’Brien observed. Mr. O’Brien tied the problem of leakage
in the private retirement system to the debate over Social Security
reform, especially proposals calling for the creation of individual
savings accounts. He wondered whether any prohibitions on early access to
Social Security accounts could withstand political pressures, given
Congress’ past willingness to make individual retirement account (IRA)
funds more readily available for non-retirement purposes. Meeting of July
8, 1998
Summary of Testimony of Francis P. Mulvey
General Accounting Office
Francis Mulvey is the Assistant Director of the Health,
Education and Human Services Division of the General Accounting Office. He
spoke about the results of a GAO Report entitled, “401(k) Pension Plans:
Loan Provisions Enhance Participation But May Affect Income Security for
Some.” Senator Judd Gregg requested this research because Congress is
concerned about the retirement income of older Americans, particularly in
light of the difficulties with the social security system. The GAO Report
was issued in October 1997 and is based on data gathered in the 1992
Survey of Consumer Finances prepared by the Federal Reserve and the 1992
Internal Revenue Service Form 5500 filings. Participation rates for plans
that allow loans are about 6 percentage points higher than the plans that
do not allow loans. The average participation rate for plans that allow
borrowing rises from 55% to 61% for plans that do not offer an employer
match. For plans with an employer match, the average participation rate
rises from 78% to 83% with a loan provision. Furthermore, average employee
contributions are 35% higher in 401(k) plans with loan provisions than the
contribution rates of 401(k) plans without loan provisions.
Fewer than 8% of all participants had one or more loans
from their plan. The data underlying the GAO Report showed that black
Americans and Hispanics are twice as likely to borrow from their 401(k)
plans as white Americans are. No significant relationship was found
between the decision to borrow the sex, age or marital status of the
participant. Attitudes of borrowers and non-borrowers vary in that more
borrowers feel it is appropriate to borrow from their retirement plan to
finance a car or for living expenses than non-borrowers. Neither group,
however, felt that it was appropriate to borrow for a vacation or a luxury
item.
Borrowing from a 401(k) plan can reduce the ultimate
retirement nest egg. The GAO developed a simulation of retirement income
that compared retirement funds available for those who borrow from their
401(k) plan and those who do not borrow. The simulation assumes a $40,000
loan that is repaid over a 10-year period at a 7% interest rate. The
simulation further assumes that the account earned an average of 11%
otherwise. The results show that the participant’s retirement nest egg
was reduced by 5.5% if the participant continued to make contributions
during the repayment period and by 27% if the participant suspended
contributions over the repayment period. In conclusion, the loan provision
in 401(k) plans is a double-edged sword. Loan provisions increase
participation and significantly increase contribution levels. However, the
funds available at retirement will likely be lower for plan borrowers,
particularly if they suspend plan contributions during the period of loan
repayment.
ERISA Advisory Council Working Group on Retirement Plan
Leakage
Meeting of August 12, 1998
Summary of Testimony of William Bortz
U.S. Department of Treasury
William Bortz is an Associate Benefits Tax Counsel in
the Office of Tax Policy at the Treasury Department. Before joining the
Treasury, Mr. Bortz was a partner with the law firm of Dewey Ballentine in
New York City. Mr. Bortz has a law degree and a Ph.D. in philosophy from
the University of Wisconsin. He has published a number of articles in
professional journals on employee benefits.
Mr. Bortz testified on the topic of distributions from
qualified plans, and particularly, participant loans from defined
contribution plans. He outlined the complicated set of distribution rules
as follows:
Both defined benefit and defined contribution plans
generally prohibit in-service distributions.
Both types of plans permit participant loans, although
loan provisions rarely are found in defined benefit plans.
Profit sharing and stock bonus plans permit in-service
distributions upon the attainment of a certain age or the occurrence of a
stated event.
401(k) plans permit hardship distributions.
Distributions are subject to federal income tax unless
they qualify as lump sum distributions and are rolled over into an IRA or
another qualified plan.
A ten- percent excise tax is imposed on distributions
made to a person who has not reached age 59-1/2. Limited exceptions to the
penalty are available.
Unless the present value of the benefit is less than
$5,000, an individual can defer his or her distribution from the plan
until they reach normal retirement age. If the present value of the
benefit is less than $5,000, the plan sponsor can “force out” the
distribution so that the plan sponsor does not have to maintain records of
small benefit obligations. Mr. Bortz noted that Congress has continually
tried to “fine tune and tinker” with the law to strike a balance
between the availability of funds to participants and appropriate
penalties for pre-retirement leakage. With respect to participant loans,
Mr. Bortz outlined the following restrictions:
Both ERISA and the Internal Revenue Code provide
parallel provisions for loans, including prohibited transaction sanctions
for failure to comply with the rules.
Loans to substantial owners of companies are not
allowed.
The disclosure provisions of the Fair Credit Act apply.
The law is unsettled as to whether ERISA preempts state
usury laws.
Loans must have terms that are commercially reasonable.
A loan is a taxable distribution if the requirements as
set forth in I.R.C. Section 72 (p) are not met.
A loan must be repaid over a five-year period in
substantially equal installments that are made at least quarterly. A
longer term is available for loans secured by a principal residence.
The repayment rule is suspended for up to one year
during a participant’s leave of absence. Loans cannot exceed one-half
the value of the participant’s account balance, with an exception for
loans under $10,000.Loans cannot exceed $50,000. This rule is applied by
aggregating the outstanding loan balance over a 12-month period.
The failure to repay a loan results in a taxable
distribution to the participant.
A defaulted loan must be reported to the IRS on Form
1099-R.
Unless there is a pattern of abuse, the plan is not
disqualified solely by reason of defaulted loans, which would otherwise
violate the in-service distribution rules.
Mr. Bortz further testified that most loans are repaid
through payroll deduction. Accordingly, there are few defaults before
termination of employment. In cases where payroll deduction is not used
for loan repayments, there is little data about the extent to which
defaults occur. The witness speculated that there is a wide range of
default rates under these circumstances. Since the participant is repaying
his or her own account balance, the normal incentives of a lender to
collect the outstanding balance do not apply.
Meeting of August 12, 1998
Summary of Testimony of Billy Beaver
U.S. Department of Labor
Billy Beaver is Chief of the Division of Field
Operations for the EBSA’s Office of Enforcement. Mr. Beaver reported
that the enforcement program finds problems from time to time concerning
participant loans. The types of problems include the following: Lack of
compliance with the terms of the plan documents;
Incomplete record keeping and/or documentation with
respect to the loans;
Lack of follow-up in the collection of delinquent
loans; and
Improper treatment of defaulted loans.
Mr. Beaver testified that most violations are handled
through the voluntary compliance program. Litigation by the DOL is
infrequent in cases involving loans. Statistical information and trend
data concerning violations in the area of participant loans were not
available at the time of the meeting.
Mr. Beaver testified that participant loan violations
are not a high enforcement priority of the Department at this time. The
review of participant loans is not a standard part of every investigation,
but violations related to participant loans are frequently detected by
EBSA investigations. From time to time, a review of the Form 5500 data
reveals a large receivable that is pursued by an investigator. The
statistical database of the Department would include answers to Question
27b on Form 5500 which addresses delinquent loans. A targeting run could
be made on this data to provide further insight into trends and levels of
loan defaults in the future.
A discussion ensued concerning the need for a plan
fiduciary to sue a plan participant in order to collect defaulted loan
proceeds. The particular issue involved plans that issued a Form 1099-R
for the defaulted loan, and did not pursue collection efforts further. Mr.
Beaver testified that the issuance of the Form 1099-R is “ a viable way
to resolve” the default situation. ERISA Advisory Council Working Group
on Retirement Plan Leakage
Meeting of September 9, 1998
Summary of Testimony of Peter Smail and James McKinney
Fidelity Institutional Retirement Services Company
Peter Smail is President of Fidelity Institutional
Retirement Services Company (“Fidelity”). James McKinney is a Senior
Vice President of Fidelity. Fidelity is the industry leader in the
management and administration of defined contribution plans, with a 10
percent market share of all managed assets. The statistical information
presented to the Working Group is based on Fidelity’s 5,000 record
keeping clients covering six million plan participants with $316 billion
in plan assets (referred to as the “Fidelity universe” for purposes of
this summary). Unless otherwise stated, the information covers the
twelve-month period ended July 31, 1998.The account balances of all
terminated participants in the Fidelity universe were analyzed. In terms
of the account balances, 96 percent of the balances remained in the plan
after the event of termination or was rolled over to an IRA or another
qualified plan. Only four percent of the dollars was distributed in the
form of cash to participants. In terms of numbers of participants, 76
percent of participants either kept their balances in the plan upon
termination or rolled the account balances into an IRA or another
qualified plan. Twenty-three percent of participants received a cash
distribution. In response to questions, Mr. Smail explained that the
relatively low rate of plan leakage is attributed to two factors. First,
Fidelity has a series of programs in place that educate plan participants
about the importance of retirement savings. Second, the interests of the
plan participants are aligned with the interests of Fidelity in preserving
the assets in the qualified plan.
Fidelity surveyed a sample of plans in the Fidelity
universe and found that 93 percent offer hardship withdrawals. Over the
three-year period of 1996, 1997 and 1998 (projected), the dollar amount of
hardship withdrawals for the entire Fidelity universe has been $462
million, $416 million and $419 million, respectively. The number of
hardship withdrawals has been 259 thousand, 327 thousand and 329 thousand,
respectively for the same period. Fewer than five percent of all
participants take hardship distributions, and less than one percent of
plan assets (0.13%) are withdrawn as hardship distributions. As compared
to the cash flow into plans from contributions and loan repayments of
$33.9 billion, the $419 million in outflow due to hardship distributions
is very small. In response to questions, the witnesses explained that
participants who call in to the Fidelity service center to request a
hardship distribution are often expressing serious financial need for the
funds.
Ninety percent of plans in the Fidelity survey offer
participant loans. In 1997, the entire Fidelity universe experienced
68,000 loan defaults that represented a total plan outflow of $263
million. For 1998, it is projected that there will be 73,000 loan defaults
with a plan outflow of $294 million. These statistics represent one
percent of all plan participants in the Fidelity universe and less than
one-tenth of one percent of all plan assets (0.09%). Asset leakage is
small because virtually all plan sponsors use payroll deduction for loan
repayments. Most defaulted loans occur in the accounts of terminated
participants because payments are no longer taken as payroll deductions.
Nevertheless, only six percent of the total number of loans is defaulted,
and less than five percent of the amount of outstanding loans is
defaulted. Finally, the amount of cash outflow due to defaulted loans is a
tiny percentage of the cash inflow due to contributions and loan
repayments.
In summary, 93.35 percent of plan participants have
neither a defaulted loan nor a hardship distribution during the course of
a year. Less than one quarter of one percent of total assets is leaked
from the plan due to hardship distributions or defaulted loans each year.
Fidelity found that when they compared similar plans that did and did not
offer loans and hardship withdrawals, those that did offer loans and
hardship withdrawals generally had a greater participation rate.
The retention efforts at Fidelity stem from a strong
emphasis on communication and education of the participants in the plan
throughout their period of participation. A separate group of service
representatives help participants through the decision-making process when
the participant is eligible to receive a distribution. Fidelity makes it
easy for participants to roll their account balances into IRAs. It was
noted several times that the interests of Fidelity in maintaining the
assets is aligned with the policy interests of the government and the
savings goals of participants to preserve retirement assets. When asked
for recommendations, it was noted that the safe harbor rule which
prohibits contributions from a participant for a period of twelve months
following a hardship withdrawal is inconsistent with the primary goal of
promoting retirement savings, and in light of the information provided, is
not needed as a deterrent to withdrawals.
Meeting of September 9, 1998
Summary of Testimony of Anthony P. Rodrigues and
Michael J. Fleming
Federal Reserve Bank of New York
Anthony P. Rodrigues and Michael J. Fleming are
economists with the Research and Market Analysis Group of the Federal
Reserve Bank of New York. Together with William F. Bassett of Brown
University, they have published a paper entitled, “How Workers Use
401(k) Plans: The Participation, Contribution, and Withdrawal Decisions.”
Their work uses data from the April 1993 Current Population Survey and its
Employee Benefits Supplement (CPS). Messrs. Rodrigues and Fleming
presented testimony that was based on their research and findings in the
area of distributions from pension plans. The witnesses discussed the
trend in employer-sponsored retirement plans from the traditional defined
benefit plans to the defined contribution plans. The 401(k) plan is the
most prevalent of the defined contribution plans. Over 40 percent of the
workforce now are offered defined contribution plans. For half of all
workers, the 401(k) plan is the only retirement vehicle offered by their
employers. Defined contribution plans have salary reduction features that
shift retirement savings decisions from the employer to the worker.
Participation in these plans by eligible employees increases with income,
age, job tenure, and education. Matching contributions by employers also
increases participation.
Defined contribution plans allow pre-retirement
distributions. These distributions present to the worker the opportunity
to spend or save the distribution. If the distribution is consumed before
retirement, it impedes the retirement security of the worker. Defined
contribution plans allow workers to take loans from the plans against the
account balance. These loans are not considered distributions in the study
because they usually are repaid to the plan. On the other hand, hardship
distributions are available for immediate needs, and are not repaid to the
plan.
Distributions that are made at job separation can be
rolled over into another tax-qualified savings vehicle. No taxes or
penalties apply to distributions that are rolled over as such.
Distributions that are not rolled over are subject to federal income tax,
20% tax withholding, and a 10% penalty; the penalty does not apply to
workers who have reached age 59 ½.
Nearly half of all workers report that they have
received a lump sum distribution from a retirement plan from a previous
job. Only 28% of the recipients who receive lump sum distributions from a
401(k) plan before retirement roll the amounts into another tax-qualified
savings vehicle. These distributions represent 56% of the value of the
lump sum distributions. Other uses of the distributions are consumption
(29% of recipients), reduction of debt (17% of recipients), investment in
savings or other financial instruments (11% of recipients), purchase of a
house or payment of a mortgage, (7% of recipients) and other investment
including business, education or health (8% of recipients).
The witnesses also testified that workers with higher
incomes, larger distributions, and a college education are more likely to
roll over their distributions into a tax-qualified savings vehicle. Also,
but to a lesser extent, older workers, homeowners, single workers and
childless workers are more likely to roll over their distributions.
In conclusion, a large fraction of workers who receive
distributions do not roll the distributions into other tax-advantaged
plans. Workers with higher incomes, larger lump-sum distributions, or a
college degree are more likely to roll over their distributions. Many
workers do not use their defined contribution plans for retirement
savings. In view of the shift in retirement savings to defined
contribution plans, consumption of pre-retirement distributions raises
concerns about the retirement security of the workforce.
ERISA Advisory Council Working Group on Retirement Plan
Leakage
Meeting of October 6, 1998
Summary of Testimony of Congressman Earl Pomeroy (D-ND)
U.S. House of Representatives
Congressman Pomeroy was invited to testify on the issue
of portability and, in particular, to discuss H.R. 3503, “The Retirement
Account Portability Act of 1998 ” (RAP), which Congressman Pomeroy
originally co-sponsored with Congressman Jim Kolbe (R-AR), and which had
54 House co-sponsors. In addition, a companion bill was sponsored in the
Senate. Congressman Pomeroy said that the government has an obligation not
only to encourage people to save for retirement, but to help preserve
retirement savings for retirement. He became frustrated with provisions in
the Internal Revenue Code which make it easier to distribute retirement
savings currently rather than to continue to hold the funds for
retirement.
Congressman Pomeroy thought a good starting point for
improvement was facilitating portability within the defined contribution
universe, which is simpler than facilitating portability among defined
benefit plans. Currently the type of employer often determines whether
defined contribution plans are portable. As an example, Congressman
Pomeroy described a nurse from Bismarck, North Dakota who worked for a
non-profit hospital which sponsored a Tax Code Section 403(b) tax-deferred
annuity retirement savings plan, then worked for the state health
department where she continued her retirement savings with a Section 457
deferred compensation retirement savings plan and then went on to work for
a private sector for profit hospital which sponsored a Section 401(k)
defined contribution retirement savings plan. All three plans are
contribution-type plans, with similar objectives, yet under current law
none of the plans permit transfers to the others. So, the nurse must
maintain three little accounts instead of be afforded the opportunity to
consolidate them into a single retirement account. In this situation,
Congressman Pomeroy concluded, it is more tempting to cash out and spend
the money in relatively small accounts, rather than coordinate or roll
them into a single consolidated account.
The primary components of the RAP Act that effect
portability are:
Allow rollovers of retirement benefits between and
among Code Section 457, 403(b), and 401(k) plans and certain types of
IRAs, when employees switch jobs;
While permitting expanded rollovers, RAP contains no
mandate requiring employers to accept rollovers from their new employees.
Expand the use of “conduit” IRAs, by allowing
workers to move any kind of defined contribution money (pre- or post- tax)
into a conduit IRA and then allowing this money to be rolled back into a
variety of defined contribution plans. Allow individuals to transfer their
deductible IRA funds into their workplace retirement savings accounts.
Permit the rollover of after tax employee contributions
to a new employer plan or IRA, if the plan or IRA provider agrees to track
and report the after-tax portion of the rollover for the individual.
Permit the 60 day deadline for rollovers to be extended
in cases of natural disaster or military service so that individuals avoid
incurring taxes and a 10% premature distribution penalty tax from missing
the 60 day rollover deadline.
Relax the so-called anti-cutback rule so that a
successor employer’s defined contribution plan need not have the same
benefit options as the old employer’s plan in order to transfer funds.
In addition to the rollover proposals, RAP calls for faster vesting of
employer matching contributions to defined contribution plans. Under
current law, employers must be 100% vested after 5 years (5 year “cliff”
vesting) or gradually vested increments over 7 years (7 year “graded”
vesting). The RAP bill calls for employer contributions to defined
contribution plans to vest 100% after 3 years or gradual vesting in
increments over 6 years. Because women have shorter job tenure than men
(3.5 vs. 4 years), according to Congressman Pomeroy, the portability and
vesting provisions would be of particular benefit to women workers. In
response to questions from the Work Group members, Congressman Pomeroy
testified that the RAP bill would not have a significant revenue impact.
Congressman Pomeroy also stated that the RAP bill did not mandate that
employers accept rollover contributions because mandates are politically
unacceptable to many in Congress and he was seeking to craft a bill which
would attract broad bipartisan support.
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