Americans are notorious for changing jobs several times during a typical career. That leaves millions of workers in the position of having small 401(k) retirement account balances with a number of ex-employers, and many of those workers simply ignore those small balances and take no further action. Yet the practices that many companies use to deal with inactive 401(k) accounts from ex-employees end up costing those workers billions of dollars, in some cases making what could have become substantial retirement nest eggs simply disappear entirely.
Government Accountability Office: Protect workers from their ex-employers
A study late last year from the U.S. Government Accountability Office looked closely at a situation that too many workers face with 401(k) balances: dealing with an ex-employer that wants to stop dealing with small retirement accounts. Under current law, if a former employee has a balance of less than $5,000 in their 401(k) account, an employer can take steps to transfer those assets out of the 401(k). Moreover, even if the balance is more than $5,000, the employer can still transfer those assets if the amount that the employee directly contributed to the plan -- as opposed to rolling over balances from retirement accounts at previous jobs -- was less than $5,000.
When accounts are less than $1,000, then the employer has the right under retirement-plan regulations to cash out ex-employees' 401(k) balances, sending them a check and leaving it up to them to roll over the funds into an IRA or new 401(k) account. If they don't, then they'll owe taxes and possible penalties as if it were a deliberate early distribution that they asked to receive.
Accounts between $1,000 and $5,000, however, require that the employer give notice to the ex-worker asking for direction. If the ex-employee doesn't respond, then the employer has to set up what's known as a forced-transfer IRA. The default investment in these IRAs is typically a money market mutual fund or other low-return conservative fixed-income investment option.
What happens next is the most shocking part of the problem. The GAO found that once ex-workers' money is in the hands of a financial institution, the fees charged against the IRA often exceed any minimal income the account generates. Using various combinations of account setup fees, annual management fees, and return assumptions, more than two-thirds of the theoretical forced-IRA scenarios resulted in a $1,000 forced-IRA account being completely eaten away by fees within 30 years, and some saw funds disappear in as little as nine years. Indeed, the GAO's conclusion was that an account would have to earn annual returns of more than 7% just to hold even with inflation after taking out all the fees that typical financial institutions charge.
The scope of the problem
Given the small dollar amounts involved, this might seem like a big problem. But the sheer number of people that fall prey to these regulations is staggering. From 2004 to 2013, departing workers left 16 million such accounts in the hands of their former employers, representing $8.5 billion in total. Given the study's findings, it's likely that a large portion of that money will simply disappear in fees.
Yet that $8.5 billion is just the tip of the iceberg, because it ignores the lost returns from investing that money more prudently. The GAO compared what would have happened if regulations allowed ex-employers to invest forced-transfer IRAs in balanced target-date retirement funds, and it found that over 30 years, $1,000 would have grown to between $2,500 and $3,000 even after accounting for fairly hefty fees.
There are several potential solutions to the problem. Forcing employer-sponsored retirement plans to bear their own costs in transferring money to forced-transfer IRAs rather than charging accountholders large setup fees would take away part of the burden on retirement savings. Moreover, setting up rules that would allow ex-employers to better default investments in forced-transfer IRAs would help money grow larger over time.
One further suggestion that the GAO made involves tapping information available from the Social Security Administration that could help ex-employees keep a handle on retirement money at their former employers. By including notices in online Social Security statements, the SSA could give workers the information they need to take action to protect their money.
In addition, other countries have taken steps to solve their own versions of this problem. Some countries establish central funds for abandoned assets, while others seek to reconnect accountholders with their retirement funds. Some also use pension registries, which can also help ensure that workers don't neglect a forgotten retirement account at an old employer.
The best answer to the forced-transfer IRA issue is for workers to take responsibility for tracking their own retirement-plan money when they change jobs. Yet if the GAO's recommendations make that task a little easier, it could go a long way toward solving what has become a multi-billion dollar problem for retirement savers.