The amount available to fund people’s retirement in a defined contribution (DC) plan depends on two factors: how much they save over the course of their working lives and whether they withdraw the money prior to retirement. Public policies can help people preserve their savings for retirement. For example, they can make it easier for workers to leave assets in retirement plans when they change jobs or to transfer their savings to another plan at their current employer.
Millions of Americans jeopardize their future financial security by spending their retirement savings before retirement. Most of this “leakage” takes place when DC plan participants change jobs. At that time, they must decide how to handle their retirement savings. They can roll over funds to a plan at their new employer or to an individual retirement account (IRA). However, this process can be complex, and many plan participants choose to cash out their accounts instead. According to the Census Bureau, only about 45 percent of the millions of people who reported receiving a lump-sum distribution from their own retirement assets, or as a survivor of a family member with such a plan, reported using all or part of the distribution for tax-qualified savings. Policymakers have already taken some steps to discourage people from prematurely cashing out their retirement accounts. Early withdrawals from many retirement accounts are subject to a 20 percent withholding tax as well as a 10 percent tax penalty unless the money is transferred directly to an IRA. Employers can automatically roll over balances of less than $5,000 into an IRA when an employee leaves unless the employee requests a distribution.
Decisions about leaving a job can also affect the value of benefits from defined benefit (DB) plans. The amount of these benefits depends in part on the number of years a worker participates in the plan. Changing jobs reduces the number of years the person participates in any single plan. The resulting pension benefits will, therefore, be lower than otherwise. In addition, benefits from DB plans are fixed at the point when the worker leaves the organization. The benefit does not increase with inflation and, therefore, can lose a considerable amount of value over time.
At retirement, workers in both defined benefit (DB) and DC plans must decide how to receive money from their retirement plan. These choices vary depending on the type of retirement plan and can create complexity and confusion. They can also result in significant tax consequences. In the past, most DB plans paid benefits in the form of annuities. An annuity provides a guaranteed monthly income for life. More often now, DB plans also allow participants to receive their benefits as a lump sum. Only a fraction of DC plans allow participants to elect to receive their benefits as an annuity. Some employers also allow their workers to make periodic withdrawals. However, relatively few workers choose the annuity option.
Annuities can be an important and reliable source of income for retirees; however, concerns over adverse selection and their complex characteristics make annuities an expensive product. People that expect to live longer are more likely to purchase annuities which drives up the price of annuity products. Even for those that purchase them, annuity income will fall short of meeting retirees’ income needs since most annuities are not inflation-indexed. It is important that annuities meet the suitability criteria before being purchased or integrated into 401(k) portfolios. An annuity is less suitable for younger adults entering the workforce compared to those nearing retirement because the former would benefit from an investment portfolio that helps accumulate retirement assets, while the latter would benefit from converting accumulated assets into retirement income streams. The highly complex structure of annuities and differences between annuity terms raise concerns over portability when employees change jobs. Employers that include annuities should consider how including such products impacts their fiduciary responsibilities under the Employee Retirement Income Security Act of 1974. Based on the current state of the annuity market, it is not recommended that annuities become the default option in 401(k)s.
Two additional factors can negatively affect the retirement benefits available to workers in retirement. First, some workers are unable to locate a former employer’s plan. This is especially true for DC plan participants. Finding a plan is more difficult if the employer went out of business or was taken over by another company. Second, workers may lose some of their DB pension benefits if an employer files for bankruptcy.
PORTABILITY, PRESERVATION, AND DISTRIBUTIONS: Policy
PORTABILITY, PRESERVATION, AND DISTRIBUTIONS: Policy
Policymakers should facilitate greater portability of retirement plans for workers who change jobs.
Rollovers of lump-sum retirement benefits into another retirement vehicle should be automatic. Regulations should discourage access to such funds before retirement.
Retirement plan participants should be afforded greater protections when a plan sponsor is in bankruptcy proceedings.
Defined benefit pension plan participants should be included in Chapter 11 creditors’ committees as a matter of right. Collective-bargaining agreement plan participants and non-agreement participants should be represented separately.
A public- or private-sector agency should be created to record current retirement plans through a central registry. The agency should assist employees in finding lost benefits.
Distribution and withdrawal options
Retirement plan distribution rules should be simplified to improve long-term economic security.
Policymakers should explore options for increasing the share of retirement wealth that is annuitized.
Fixed annuities or similar options should be inexpensive, transparent, cost-effective, and safe. Recipients should receive information regarding how plan rules may influence payouts, the value of underlying assets, or economic conditions.
The Department of Labor should strictly enforce employers’ fiduciary duty when choosing a provider for delivering annuity payments to plan beneficiaries.
There should be an effective insurer of last resort to protect beneficiaries if insurance companies providing annuities fail.
Policymakers should require employers to provide retiring workers with several options for the assets accumulated in their retirement savings plan. These include:
- leaving the assets in the account,
- taking their benefits in the form of an annuity or similar lifetime income vehicle, or
- withdrawing a portion of the assets through one-time or periodic distributions.
Policymakers should forbid employers from pressuring retiring workers to take a lump-sum distribution.