Protecting Workers’ Retirement Savings

As defined contribution retirement plans become the dominant retirement savings vehicle for American workers, policymakers and plan fiduciaries must embrace necessary changes to make these plans work better for more workers. While we’ve made great progress in helping workers save for retirement through auto-enrollment, auto-escalation and qualified default investment alternatives, we still have gaps that have allowed retirement plan loan default leakage to become a more than $2 trillion problem. The two most significant sources of leakage identified by the non-partisan Employee Benefits Research Institute are cash-outs and loan defaults when workers leave their jobs. Fortunately, there is an opportunity for industry and plan leaders to address both issues.

Automatic account portability ensures that retirement savings follow workers to their new employers or are transferred to an individual retirement account, significantly reducing the risk of “cashing out” or losing track of retirement accounts left behind with previous employers. The good news is that several large recordkeepers are joining forces and implementing automatic portability as a new option for plan sponsors to use with smaller account balances that otherwise get left behind.

There is little doubt that these portability efforts will improve participant outcomes. However, to fully achieve the goals of automatic portability, its implementation should also consider how to address the reality that many affected workers also have outstanding loans from their 401(k) plans. When their existing accounts are distributed—including through automatic portability—any outstanding loans default.

These defaults result in a qualified plan loan offset, taxes, penalties and a loss of any future investment earnings on those funds. The leakage of these defaulted loan assets significantly reduces the retirement savings that employees would otherwise accumulate, creating potential fiduciary exposure and a practical challenge for those implementing automatic portability. Put simply, automatic portability does a great job of addressing part of the leakage problem, but it needs to be coupled with loan default prevention to be fully effective.

Plan loans appeal to many workers—despite their negative effect on savings and their risk of default—because of easy accessibility and competitive interest rates compared to commercial lending options. About 20% of plan participants borrow against their retirement savings. According to a landmark 2012 Aon study and several industry studies since, the use of plan loans is even higher for many minority workers, more than double the national average. This makes the problem of loan defaults particularly acute for some minority worker populations, reducing the benefit automatic portability alone can provide.

Unfortunately, data shows that nearly two-thirds of borrowers who default on their loans also cash out their full remaining retirement account balances before the minimum distribution age of 59 1/2. Efforts to prevent these defaults—which have included allowing separated participants to continue to repay outstanding loans after they leave their employers, educating participants about loan risks, enhancing disclosure requirements, limiting the number or amount of loans, increasing loan fees and extending the time by which participants must repay their loans to their tax filing deadline—have not made a material change in loan default rates. This is likely because of the simple truth that most workers who lose their jobs lack the funds to repay their loans.

Plan sponsors can address these problems and fully protect workers’ retirement savings by combining loan insurance with automatic portability. Loan insurance repays participants’ outstanding 401(k) loans when they lose their jobs involuntarily, such as due to downsizing or disability, ensuring their entire account balances are replenished and remain tax-deferred and invested for future growth. By incorporating loan insurance into automatic portability programs, plan sponsors and recordkeepers can address the two most significant causes of plan leakage, giving at-risk workers a better chance for a secure retirement.

As with any plan feature or service, fiduciaries must prudently evaluate loan insurance options, and many are finding flexible designs with various premium methods and coverage amounts. For example, the insurance could be offered to individual participants, with or without an opt-out option. Alternatively, the coverage could be incorporated into the plan’s design, with premiums paid out of plan assets or by the plan sponsor. The median participant loan is about $5,000, so relatively low levels of coverage could materially address loan defaults by at-risk workers.

Most plan sponsors offer loans to encourage participation in the plan, but many are also concerned about high levels of loan utilization and loan default. Adding loan insurance can help fiduciaries fulfill their obligations under ERISA Section 408(b)(1) for their loan programs, “… to preserve plan assets in the event of such default.”

Combining automatic portability with automatic 401(k) loan insurance could be a game-changer for at-risk participants, effectively preventing the most common forms of retirement plan leakage. Retirement plan fiduciaries, advisers and service providers should consider comprehensive plan designs that benefit workers in both good and bad times. Evaluating the sensibility and prudence of implementing new financial wellness capabilities, such as automatic portability and 401(k) loan insurance, should be a top priority.

As an advocate who has dedicated the past two decades to improving retirement outcomes for ERISA plan participants, both in policymaking and in the private sector, I am genuinely excited about the success of automatic plan features in making plans more effective in the real world. While we cannot ignore the occurrence of layoffs and economic downturns, we do have the power to prevent them from destroying American workers’ hard-earned retirement savings.

Bradford Campbell is a partner at Faegre Drinker Biddle & Reath LLC and a former U.S. Assistant Secretary of Labor for Employee Benefits. He won the 2022 Vision Award from our sister publication, PlanAdviser magazine, for his work on automatic enrollment in defined contribution plans. He is a member of the Strategic Advisory Council of Custodia Financial, a retirement plan loan insurance provider. The views expressed here are his own and do not represent those of Faegre Drinker or its clients.

This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.