Impediments to Saving for Retirement - Part 2 - The Solution? The Right Kind of Liquidity

What’s the best solution where saving for retirement is not a priority? Meet workers where they are with the right kind of liquidity! Don’t agree? Well, what about the next best solution? You guessed it: help workers avoid the wrong kind of liquidity!

No recent headline includes more hyperbole than the news reporting from Deloitte and its guesstimates of “leakage” from plan loans.¹  And, it only took a couple of days before vendors who sell expensive services (that are not needed by more than 98 percent of retirement savings plan participants) pounced on the histrionic headlines.²

Part 1 of this two-part series confirmed that most workers’ need not limit their retirement savings due to out-of-pocket medical expenses or student loan debt payments. And, industrywide, we’ve seen favorable results from adding automatic features for workers who live payday to payday.   

So, what is the largest remaining impediment when it comes to saving for retirement? Some would say workers’ financial priorities. My 30+ years of plan sponsor experience confirms it would be futile to try to change a worker’s financial priorities. That being said, if retirement preparation is not a priority, I believe the best solution is to meet workers where they are with the right kind of liquidity. The next best solution is to help workers avoid the wrong kind of liquidity.

Providing the “Right” Kind of Liquidity 
The right kind of liquidity involves marketing tax-efficient access while employed and after separation through qualified plan loans; using a line-of-credit methodology; savvy investment allocation processes; featuring behavioral economics tools and methods; and/or coupled with 21st Century electronic banking repayment functionality. Most plan sponsors will stop short of implementing every component of the “right” kind of liquidity. 

Marketing liquidity via plan loans? Heresy you say! However, without liquidity, many won’t save. Others will only save what they believe they can afford to earmark for retirement, what is not needed to defray existing and near-term financial obligations and needs. Limit access and most simply won’t save enough to financially prepare for retirement.³  

You must save before you can borrow. Saving is made easier by the combination of tax preferences and employer match. Plan assets are fungible: where there is liquidity, workers can develop a retirement savings habit without having to identify and predict specific financial needs, set aside specific amounts and select an appropriate savings vehicle for each need. And, where monies are concentrated in the retirement savings plan, there is no need to update projections and savings rates for each financial need. Liquidity enables the participant to address a cash shortfall when expenses exceed household income, exceeds the household’s ability to pay or where household income is variable.

Loans are not taxable events unless the loan is not repaid. However, approximately 90 percent of all plan loans are fully repaid. All others are at least partially repaid. And, when a loan defaults at separation, the remaining account balance will generally remain in the plan unless the participant makes a distribution election. 

Liquidity encourages savings.⁴  This isn’t new! As former PSCA Executive Director David Wray stated 25 years ago, citing a John Hancock survey, “Significantly, 37 percent of survey respondents who said they would use their retirement funds for nonretirement purposes would stop or reduce their plan contributions if they could not access their accumulations.”⁵

Yet, around 80 percent of participants have loan access but don’t have a loan outstanding. Here is the envisioned process- what I call the “Bank of Jack:”

Contribute, get the employer match, invest, accumulate, borrow if necessary to meet current needs, continue contributions whilerepaying the loan to rebuild the account for future, greater needs and repeat as needed up-to and throughout retirement. 

A line-of-credit structure? It is a single loan so only one transaction fee is charged when completing the loan application. A higher-than-average transaction fee is recommended, perhaps $100-$250, so workers think twice before borrowing. A service fee should be applied when there is an outstanding balance. Once the loan application is completed, a participant can easily move money to a personal bank account with the click of a mouse. Most plans use a $1,000 minimum amount per transaction so there is minimal abuse. Most workers are circumspect about borrowing- they know what sacrifice was needed to accumulate the monies. Finally, the plan should report activity to the credit bureaus to help the worker build credit and to discourage abuse. 

Many industry experts recommend inside limits to “avoid the endorsement effect-” designs that limit the number of loans to one for a specific dollar amount, require a “cooling off” period between plan loans, limit available monies only to employee contributions, create an “inside” maximum dollar limit on borrowing, suspend employee contributions and employer match while the loan is outstanding and/or limit the acceptable reasons for borrowing (e.g., specific purposes such as hardships.) All such limits are potentially counterproductive- they discourage saving. Such limits might also prompt participants to obtain liquidity outside the plan- expensive debt such as a credit card cash advance, a payday loan, etc.⁶  Instead, the plan should permit borrowing up to the tax code limits, themselves very modest and unchanged for the past 45 years since ERISA. The line-of-credit structure reconfirms what is available: money that can be borrowed for good reason, bad reason or no reason whatsoever. And, speaking of reasons, one of the best options for accelerated repayment of student loan debt could include leveraging the line of credit structure/capability. 

Savvy investment allocation processes? Plan loans are fixed income assets. Treat them that way. Plan provisions should always prompt participants to (re)confirm their desired investment allocations and, as necessary, rebalance after initiating a loan. Where a target date fund or target date model is used, loan assets should be included as part of the fixed income allocation. Assuming the participant maintains the same asset allocation (again, treating the plan loan as a fixed income asset,) there should be minimal impact on investment returns. Given current returns on bond investments and current loan interest rates, a plan loan may result in an increase of both household wealth and retirement savings, where plan loan interest rates are higher than bond investment returns but less than commercial loan interest rates.

Behavioral Economics tools and processes? Amend the plan as necessary to:

• Report loan activity to the credit bureaus;
• Require participant certification of sufficient liquidity to retire the outstanding loan should employment end prior to full repayment; and 
• Where there is a default of a plan loan, render the participant ineligible for:oFuture plan loans; and oPost-separation, pre-retirement (prior to age 65) distributions.⁷

Create a “commitment contract” by requiring borrowers to complete and sign paperwork initiating a loan which includes:

• Banking information and an authorization to take deductions, should repayment via payroll deduction cease for any reason;
• Commitment to repay the loan, regardless of whether employment ends prior to repayment;
• Acknowledgement that the loan is from assets, meaning a default will only hurt wealth accumulation; 
• Confirmation of the ability to access other funds to repay the outstanding loan, should employment end before repayment is completed; and 
• Confirmation that distributions after a default will often trigger income taxes and potentially a penalty tax. 

21st Century Electronic Banking? Most workers already pay at least one bill electronically. Why not post-separation plan loan repayments? Electronic banking reinforces the behavioral economics tools/processes. It enables inexpensive repayment post-separation. So, at separation, because plan loans need not default until the end of the calendar quarter following the calendar quarter when the last loan payment was made, there is more than enough time to set up electronic repayment of the outstanding loan balance. In turn, electronic banking enables term-vested participants to initiate loans after separation, avoiding taxable (and potentially penalty taxed) distributions. 

Avoiding the “Wrong” Kind of Liquidity
Three forms of liquidity are almost always wrong for retirement savers:

• Hardship withdrawals; 
• Post-separation, pre-retirement distributions that are not rolled over to an IRA or a subsequent employer’s retirement savings plan and, perhaps surprisingly,
• Plans that offer no liquidity while employed. 

Hardship Withdrawals
PSCA’s 60th Annual Survey shows that 80 percent of plans permit hardship withdrawals. Vanguard’s annual study, “How American Saves 2018,” shows that 85 percent of plans administered by Vanguard permit hardship withdrawals. President Trump has signed the Bipartisan Budget Act of 2018 into law which includes provisions that make hardship withdrawals more attractive- removing barriers, increasing available monies and removing the suspension of contributions. Those changes are effective after 2018. So, expect to see increases in the number and size of hardship withdrawals in 2019. Have you updated the provisions in your plan? My recommendation is to consider eliminating hardship withdrawals. Why? Two reasons:

• First, because hardship withdrawals are always leakage. In 1996 while in my last plan sponsor role, we removed hardship withdrawals- triggering minimal dislocation while dramatically reducing leakage; and 
• Second, other liquidity solutions like plan loans are a better match with workers’ retirement savings needs.⁸  

One exception may be when Congress offers generous relief after a catastrophe such as a hurricane, wildfire, tornado or other natural disaster. 

Post-separation, Pre-retirement Distributions
PSCA’s 60th Annual Survey also shows that approximately 23 percent of plans actively encourage participants to retain assets in the plan at or after separation. Of course, all participants can retain assets in the plan until the required beginning date where an account balance exceeds $5,000. Yet, Vanguard’s annual study, “How America Saves 2018” (which uses data from 2017,) shows that just more than half elected to remain in the plan, 18 percent chose to rollover and 30 percent cashed out. The same Vanguard study using 2008 data showed that 48 percent elected to remain in the plan, 21 percent chose to rollover and 30 percent cashed out. 

There are a number of options plan sponsors can deploy to minimize leakage from distributions following separation:

• Default at separation. This means retaining assets in the plan until the participant requests a distribution;
• Make account aggregation/consolidation a priority by adding Deemed IRAs and accepting rollovers into the plan even after separation;
• Adopt 21st Century Banking functionality (electronic banking,) so that separated participants have the same liquidity as active participants; and 
• Add annual installment payment processes designed to meet the requirements under:
  o IRC §72(t) – structured payouts based on life expectancy that will avoid early withdrawal penalty taxes; and 
  o IRC §401(a)(9) – minimum required distributions commencing no later than the required beginning date.

No Liquidity While Employed
Simply, as noted above, for workers to financially prepare for retirement, many need to save as much as 15 percent of their income throughout their working years, starting in their 20s and up to their mid-60s. Limits on liquidity will chill retirement savings as workers will save only what they believe they can afford to earmark for a distant, future retirement.⁹  

Your workers will appreciate your efforts to adjust plan provisions and liquidity processes so as to meet them where they are and to accommodate your workforce’s diverse financial needs and circumstances. 

¹Deloitte, Loan leakage: How can we keep loan defaults from draining $2 trillion from America’s 401(k) accounts? 2018, Accessed 10/22/18 at: https://www2.deloitte.com/us/en/pages/human-capital/articles/loan-leakag... But see: N. Adams, Multiplication “Fables”, 10/16/18, Accessed 10/24/18 at: https://www.napa-net.org/news/managing-a-practice/industry-trends-and-re... Deloitte introduces a new term to the retirement industry: “leakage opportunity cost” on their way to overstate, by a factor of more than 10, the potential (not actual) reduction in qualified plan assets upon retirement due to loan defaults. 
² Custodia Financial announces expansion of Retirement Loan Eraser program to prevent a broader range of 401(k) loan defaults and address retirement plan leakage, 10/23/18. “Addressing America’s $2 Trillion Loan Crisis” Accessed 10/24/18 at: https://www.prnewswire.com/news-releases/custodia-financial-announces-ex... Note that only ~20% of participants have loans and that ~90% of all plan loans are fully repaid, meaning that < 2% of participants might have a need for this service. See also: L. Barney, Retirement Loan Eraser Now Helps Those Who Voluntarily Terminate Employment, 10/24/18. The typical, estimated premium is ~3% per year, $1,500 for a five year loan of $10,000 – which would put quite a dent in retirement savings. Note that the coverage is full loan payoff in the event of death or disability, but only three months of loan payments for voluntary terminations. Accessed 10/25/18 at: https://www.plansponsor.com/retirement-loan-eraser-now-helps-voluntarily...
³ M. Wurtzel, David Laibson: 401(k)s are not just for retirement any more, 3/14/13. “… Defined contribution plans are becoming the main source of savings for Americans, as participants are using their accounts for down payments on homes, college tuition, home repairs and medical bills, among others. Accessed 10/24/18 at: http://www.pionline.com/article/20130314/ONLINE/130319948/david-laibson-... See also: A. Munnell, A. Webb, W. Hou, How Much Should People Save?, IB 14-11, July 2014, Boston College Center for Retirement Research. “(To maintain their pre-retirement standard of living) A typical household needs to save about 15% of earnings, with the low income requiring less and the high income more. … Currently, about half of working-age households are not saving enough to maintain their pre-retirement standard of living in retirement.” Accessed 10/24/18 at: http://crr.bc.edu/briefs/how-much-should-people-save/  
⁴ G. Li, P. Smith, Borrowing From Yourself: 401k Loans and Household Balance Sheets, 2008-42, Federal Reserve Board, Accessed 10/24/18 at: https://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf The authors examined 401k borrowing from 1992 – 2006 and concluded that households could have saved $3.3 billion in 2004, about $200 per household, by shifting existing debts to §401k loans. See also: D. John, J. M. Iwry, Strategies to Reduce Leakage in 401(k)s and Expand Saving Through Automatic IRAs, Testimony Before the Special Committee on Aging United States Senate, 7/16/08, Accessed 10/24/18 at: https://www.aging.senate.gov/imo/media/doc/hr198dj(1).pdf “… there is a tension between the goal of inducing contributions and the goal of preserving them for retirement. What is the minimum liquidity or access needed to maximize employee contributions? An optimal strategy may well be to provide just enough access – during employment and after – for employees to feel that they could withdraw their contributions if they really had to (e.g., in an emergency or other hardship).” See also: O. Mitchell, S. Utkus, T. Yang, Turning Workers into Savers? Incentives, Liquidity and Choice in 401(k) plan design. “Providing greater liquidity through a loan feature has no impact on plan participation, but it does raise plan contributions by about 10% among non-highly-paid participants”. Accessed 10/24/18 at: http://www.nber.org/papers/w11725 See also: S. Holden, J. VanDerhei, Contribution Behavior of 401(k) Plan Participants, “Giving employees the option of borrowing from their 401(k) accounts increased participant contribution rates. Accessed 10/24/18 at: https://www.ici.org/pdf/per07-04.pdf See also: A. Munnell, A. Sunden, C. Taylor, What Determined 401(k) Participation and Contributions, 2000. “On the plan side, the most important determinants are the availability of an employer match and the ability of employees to gain access to their funds before retirement through withdrawal or borrowing. Accessed 10/24/18 at: http://crr.bc.edu/working-papers/what-determines-401k-participation-and-...
⁵ D. Godofsky, D. Wray, Accessibility of Pension Funds, Contrasting Perspectives, ACA Journal, Spring/Summer 1993 
⁶ Note iv supra.  
⁷ Where a plan already allows participants to elect a distribution after separation, limiting distributions after default to payments upon reaching age 65 will generally be limited to monies that are contributed on or after the effective date of the change (plus earnings thereon) to comply with IRC §411(d)(6) anti-cutback provisions  
⁸ J. Towarnicky, Hardship Withdrawals – An Attractive Nuisance Becomes More Attractive, 02/09/18. Accessed 10/24/18 at: https://www.psca.org/blog_jack_2018_5  
⁹ Note ii, iii, iv supra.