Staying Liquid via A Sidecar Account = Suboptimal Retirement Preparation?
Preparing for Emergencies Along the Way to Retirement
We are saving in uncertain times – employees may be uncertain about expenses and emergencies and uncertain about future employment and income.
Savings is a consequence of consumers rational expectation that they will experience a future decline in income.Savings smooths consumption. Savings is one part of a process that can optimally allocate lifelong income to meet lifelong consumption. The determinants of consumption are also the determinants of saving.1 That is, savings is a residual result of income minus consumption.
Macroeconomic models show uncertainty plays a significant role in consumption and saving decisions for most individuals.2 Uncertainty affects consumption decisions. Today’s financial, economic, and political turmoil has increased uncertainty about future income – affecting household decisions on consumption and saving. Prudent savers may seek protection from risk by reducing current consumption (increasing savings). Greater uncertainty may generate extra savings to meet liquidity needs - ‘precautionary savings’. However, there is no consensus among economists on how to measure uncertainty or the intensity of the ‘precautionary savings’ motive.
Federal Reserve data confirms that only half of workers say they have a “rainy day” fund to cover three months of expenses in case of income interruption due to sickness, job loss or economic downturn. Among all families with working heads, only 20.1% had three months of family income in accounts deemed liquid (“liquid” excludes individual account retirement savings plan assets, regardless of the plan’s actual liquidity provisions). However, families whose heads were DC participants were 84% more likely to have liquid savings of three months of family income compared to families whose heads were not DC plan participants (24.7% versus 13.4%).3
Importantly, the same Federal Reserve data study asks a question regarding an unanticipated $400 expense.4 There are two main reasons why many households live on tight budgets: they are less advantaged (recently lost a job, low income, modest education), and/or they have accumulated debt. So, some individuals are not able to pay their expected expenses, let alone any unexpected expenses. Again, there is a dramatic difference for those who participate in a DC plan – 16% of workers with a DC plan and 26% of those without a DC plan said they cannot pay some of their bills or will only make a partial payment – that is a 62.5% difference.
An EBRI analysis concludes: “Emergency savings programs could be directly beneficial to workers and indirectly beneficial to employers … addressing short-term financial issues could lead to even better long-term results through a reduced need for early withdrawals (and tax penalties) and potentially higher contributions to a DC plan after an account for short-term financial issues is funded.”5
I agree and I disagree. Yes, there is a need for savings to meet short-term needs. However, most DC plans need not be illiquid savings vehicles. Many 401(k) plans are more capable than a sidecar account when it comes to addressing liquidity needs for the “disadvantaged” or those “in debt.” Savings need not be sequential, nor must you have a separate account for every need.6 Further, contributions to a DC plan may include monies that can be easily accessed, such as a loan, Deemed Roth IRA assets, after-tax contributions, so as to maximize the tax preferences and employer match while minimizing penalty taxes that would apply to hardship withdrawals.7
As a plan sponsor, you can accomplish this now, today. Start by reviewing your plan’s liquidity provisions to ensure participants can meet their short-term liquidity needs while saving along the way to retirement.
1M. Kitces, Why (Prudent) Spending Rates Matter More Than Savings Rates, 9/5/18, Accessed 8/30/19 at: https://www.kitces.com/blog/spending-rate-matters-more-than-savings-rate...
2A. Lugilde, R. Bande, D. Riveiro, Precautionary Saving: A Review of the Theory and the Evidence, March 2017, MPRA Paper 77511, Accessed 8/30/19 at: https://mpra.ub.uni-muenchen.de/77511/1/MPRA_paper_77511.pdf
3C. Copeland, Emergency Savings: The Reality of Workers’ Liquid Savings – Evidence From the Survey of Consumer Finances, Employee Benefits Research Institute, 8/29/19, Accessed 8/30/19 at: https://www.ebri.org/docs/default-source/ebri-issue-brief/ebri_ib_490_em...
4A. Chen, Why Are So Many Households Unable to Cover a $400 Unexpected Expense? Center for Retirement Research at Boston College, July 2019, Accessed 8/30/19 at: https://crr.bc.edu/wp-content/uploads/2019/07/IB_19-11.pdf
5C. Copeland, Note iii, supra.
6Aspen Institute Financial Security Program, “Short-Term Financial Stability: A Foundation for Security and Well-Being,” The Aspen Institute, April 2019, Accessed 8/30/19 at: https://www.aspeninstitute.org/publications/short-term-financial-stabili.... See also: J. Hopkins, Roth IRA Does Double Duty As Emergency Fund and Retirement Account, 8/22/16, Accessed 8/30/19 at: https://www.forbes.com/sites/jamiehopkins/2016/08/22/roth-ira-does-doubl... See also: J. Towarnicky, A Bucket List for Retirement? 2/28/19, Accessed 8/30/19 at: https://www.psca.org/blog_jack_2019_12
7J. Towarnicky, Sidecar = Suboptimal, 7/30/18. “… Because the “sidecar” requires action by plan sponsors and because it would divert monies and attention from more significant issues affecting participation in the qualified plan, many, perhaps most plan sponsors won’t adopt these provisions. For comparison, most plan sponsors have not adopted existing “sidecar” accounts where monies would be more readily available for emergency purposes. Only a few adopted the Deemed IRA - available for the past sixteen years. Most 401(k) plans do not permit non-Roth, after-tax contributions. There are no limits on accessing funds from Deemed IRA “sidecar” accounts. And, plans that permit after-tax contributions will typically limit withdrawals of those monies to meet financial emergencies, sometimes subject to completing a specified period of service of as little as two years. So, deemed IRA and non-Roth, after-tax contributions can offer easy access to assets to respond to emergencies using existing 401(k) and IRA functionality - without the hassle of creating a separate, side-car account. More importantly, those “sidecar” accounts won’t divert monies or attention from the qualified plan, nor do they limit investments to capital preservation. So, “sidecar” accounts are already available. But some plans already offer a better alternative (plan loans) … liquidity via plan loans may increase retirement savings – because participants won’t have to restrict their contributions to what they believe they can afford to earmark for a distant, future retirement. Accessed 8/30/19 at: https://www.psca.org/blog_jack_2018_36 See also: J. Towarnicky, But I Repeat Myself Again: Sidecar = Suboptimal, Part 2, 1/28/19. “… Many workers live paycheck-to-paycheck. Many are unable to cope with any variability in expenses and/or income. When monies are set aside for specific purposes, too often what remains are unpaid bills or high-cost debt. … Compared to sidecar accounts, the 401(k) is more effective at accumulating assets, generating positive investment returns and providing liquidity while also avoiding leakage. …” Accessed 8/30/19 at: https://www.psca.org/blog_jack_2019_5 See also: J. Towarnicky, Qualified Plan Loans, Evil or Essential? Benefits Quarterly, 2nd Quarter 2017, Accessed 12/26/18 at: https://www.ifebp.org/inforequest/ifebp/0200570.pdf