Skip to page content
Employee Benefits Security Administration
Bookmark and Share

Report of the Working Group on Retirement Plan Leakage:
Are We Cashing Out Our Future?

November 13, 1998
Final Version

The Working Group Report, submitted to the ERISA Advisory Council on Nov. 13, 1998, was approved by the full body and subsequently forwarded to the Secretary of Labor. The ERISA Advisory Council was established by Section 512(a)(1) of the Employee Retirement Income Security Act to advise the Secretary with respect to carrying out his/her functions under ERISA.


Table of Contents

  1. Are We Cashing Out Our Future?

  2. Recommendations

  3. Introduction

  4. The Working Group’s Purpose and Scope

  5. The Working Group’s Proceedings

  6. Background and Analysis

    1. The Critical Need for Research
    2. Annuitization of Benefits
    3. Rollovers of Lump Sum Distributions
    4. Mandatory Cash-Outs
    5. Participant Loans
    6. Hardship Withdrawals
    7. Portability
    8. Educational Initiatives
  7. Appendices

    1. Chart 1: Distribution of Pension Recipients by Type of Benefit, 1989 and 1994 [PDF]
    2. Chart 2: Poverty Rates by Age and Sex, 1992 [PDF]
    3. Chart 3: Pension Plan Participation, 1975 - 1994 [PDF]
    4. Chart 4: Uses of Lump Sum Distributions from Retirement Plans, 1996 [PDF]
    5. Chart 5: Pension Plan Distributions Rolled Over Into Tax-Qualified Plans, 1988 - 1992 By Distribution Size and Age at Distribution [PDF]
    6. Members of the Working Group
    7. Summaries of Testimony
    8. Index of Exhibits

The Issue

“To state the argument in its simplest terms, if you come down too hard on the capacity to access this money, it won’t be there in the first place and, so, that would be potentially something of a pyrrhic victory. We would have stopped leakage simply by stopping the accumulation in the first place.

“I don’t personally place a great deal of weight on that, but as I said, there have been some fairly reputable economists that have argued in favor of that.”

Richard Hinz
U.S. Department of Labor
May 5, 1998 (Tr., p. 45)

“Quite frankly, there’s a lot of time and a lot of attention given to, in the realms of 401(k) plans, focusing on workers’ participation, getting workers to contribute money, the amount that they contribute, how they allocate that money, are they too conservative, etc.

“All very important issues, but at the end of the day, if the money doesn’t make it to retirement, in some sense who cares…”

Dr. Paul Yakoboski
EBRI
May 5, 1998 (Tr., pp. 73-74)


I. Are We Cashing Out Our Future?

Blame it on the Social Security crisis, the aging of the baby boomers or the gyrations of the stock market – retirement security is the subject of daily conversation from bus stops to cocktail parties. Many believe that they are saving more than ever due to their opportunities under 401(k) plans. Many believe that they are better investors due to educational programs at their workplaces. Many believe that they are on the road to a comfortable retirement due to their pattern of regular savings and diversified investments. The statistics, however, show that most Americans spend their retirement savings far in advance of retirement. The most recent Current Population Survey determined that only 20 percent of individuals who received lump sum distributions rolled the entire sum into another tax-qualified vehicle. Leakage from retirement plans is a serious threat. Popular notions of the dangers of participant loans and hardship withdrawals are overstated. The real culprit is the temptation to spend lump sum distributions, particularly smaller distributions and distributions made at an early age. Also, overly restrictive rules unnecessarily inhibit retirement preservation. This Report documents the sources of leakage from retirement plans and recommends simple measures to stop the leaks.

Our recommendations begin with a request for further research and end with a demand for education. Further government study is warranted to track the trends in retirement leakage so that we can fine tune measures to maintain retirement savings. Education is critical in its content and its timing. Participants need to understand the impact of the premature spending of retirement dollars. This advice should be delivered throughout the working years and at the time of any benefit payment.

Our strongest recommendations attack the common practice of handing over a retirement check to a participant who retires or otherwise leaves his or her job. This practice encourages spending rather than saving, and it is time to reverse the trend. We recommend that defined contribution plans offer annuities as the primary form of benefit for distributions in excess of $5,000. The benefits would be subject to the joint and survivor rules, including spousal consent. The participant, with the consent of his or her spouse, could elect a lump sum distribution, but would have the opportunity to choose a lifetime annuity if he or she finds that form of payment more suitable. Should the participant choose a lump sum distribution from the defined contribution plan or from a defined benefit plan, a second recommendation would come into play. The plan sponsor would be required to send the lump sum distribution directly to an IRA or to another qualified plan as specified by the participant. We have fashioned a de minimis exception for balances valued at under $2,000, and exceptions for financial hardship and in-kind distributions. We recognize that participants can withdraw the funds from the IRAs, but this action requires an affirmative step. The primal force of inertia should be directed in favor of savings.

We further recommend that all defined contribution plans be required to accept rollovers of cash from other qualified plans. Furthermore, rollovers of post-tax contributions should be permitted into qualified plans and IRAs to facilitate the management of retirement holdings by participants. We recommend further study of in-service withdrawals of employee after-tax contributions and vested company contributions for appropriate limitations; unfettered access to these funds has made some retirement plans resemble revolving savings accounts.

We have made a recommendation to modify the mandatory cash-out rules to promote the rollover of these lump sum distributions to another retirement vehicle. Today, plan sponsors can “cash out” any participant with a benefit or balance valued under $5,000 when the participant terminates employment, and this remains unchanged. However, if the cash-out is valued at $2,000 or more, the plan sponsor would be required to roll over the distribution to an IRA or another qualified plan, or the plan sponsor could purchase an annuity for the participant.

Although plan sponsors are permitted to “cash-out” any distribution valued at under $5,000, there are some who retain these balances and benefits on behalf of terminated participants. This practice preserves the benefit for retirement and should be encouraged. To this end, the Working Group recommends the alleviation of the obligation of defined benefit plan sponsors to pay Pension Benefit Guaranty Corporation (PBGC) premiums on the benefits of separated participants that are valued at under $5,000. PBGC coverage would continue to apply.

Loans and hardship withdrawals are necessary safety valves to a long-term savings objective. Surprisingly, the availability of loans and hardships actually increases the levels of participation and contribution in defined contribution plans. Participant loans create leakage when a default occurs, and defaults occur most commonly when a participant changes employers. Accordingly, we recommend that all defined contribution plans that have a participant loan program accept the rollover of a participant loan from new employees. We also recommend that participants with balances over $5,000 who chose to leave their account balance in the plan when they terminate employment be permitted to continue to repay the loan. With respect to hardship withdrawals, we recommend that the twelve-month suspension of contribution rule be stricken. It is an unnecessary interruption in the retirement savings habit. Participants who request hardship withdrawals have a genuine need for the funds, and should not be deterred in further savings efforts.

To facilitate portability among defined contribution plans, we recommend loosening the IRA rules so that distributions from different types of qualified retirement plans can be combined in one IRA. This would allow a participant who has distributions from a 401(k) plan, a Section 457 plan (for governmental entities) and Section 403(b) plan (for non-profit organizations) to manage his or her retirement savings in a single IRA. We also recommend greater portability among defined contribution plan accounts in similar fashion. In this regard, we endorse the provisions of H.R. 3503, “The Retirement Account Portability Act of 1998.”

Yes, we are cashing out our future. The shift in retirement funding from the protective sphere of defined benefit plans to the empowering environment of defined contribution plans has resulted in increased retirement leakage. Defined contribution plan balances are a tempting target for consumption. Without education about the need for retirement savings to last a lifetime, we will continue on the path of early spending. Leakage can be slowed with reasonable measures that are narrowly drafted to foster benefit preservation rather than consumption. By stemming the opportunities for leakage, retirement security will be more readily attainable for all Americans.


II. Recommendations

A. The Critical Need for Research

Recommendation: Fundamental research should be undertaken by the Census Bureau and other governmental entities to provide data and analysis on all aspects of plan leakage. Furthermore, the Department of Labor should utilize the Current Population Survey to identify the magnitude and trends of all aspects of plan leakage.

B. Annuitization of Benefits

Recommendation: Require that all defined contribution plans offer annuities as the primary form of benefit for all distributions in excess of $5,000 and comply with the joint and survivor rules, unless the participant elects otherwise in conformance with the joint and survivor rules, including spousal consent.

C. Rollovers of Lump Sum Distributions

Recommendation: Require that lump sum distributions in excess of $2,000 be rolled over directly to an IRA or other qualified plan except in the case of financial hardship of the recipient. To the extent such distributions consist of assets other than cash, a qualified plan or IRA provider would not be required to accept such assets.

Recommendation: Require all defined contribution plans be amended to accept rollovers from other qualified plans, provided that the rollovers are made in the form of cash.

Recommendation: Permit rollovers of post-tax contributions to qualified plans and IRAs in the form of cash.

Recommendation: Further study is needed of the rules permitting in-service withdrawals of employee after-tax contributions and vested company contributions for appropriate limitations.

D. Mandatory Cash-Outs and Other Small Payments

Recommendation: Modify the mandatory cash-out provisions so that any benefits or balances that are valued over $2,000 be rolled over to an IRA or other qualified plan or used to purchase an annuity.

Recommendation: Eliminate PBGC premiums (but not PBGC coverage) for defined benefit plans that retain the benefits of separated participants whose vested pension benefit has a value of less than $5,000.

E. Participant Loans

Recommendation: Require that all plans that permit participant loans be required to accept outstanding loans as part of a rollover by new participants.

Recommendation: Require that plans permit former participants who chose to leave their account balance in their former employer’s plan to continue to repay the installments of their outstanding loan balances after termination of employment. Participants would be required to establish an electronic funds transfer from the participant’s checking or savings account to the plan to facilitate loan repayment. This rule would not apply if the value of the total account balance is less than $5,000.

Recommendation: The Internal Revenue Service should monitor Form 5500 filings and Form 1099-R filings to identify the magnitude and trends of qualified plan distributions attributable to defaulted loans.

F. Hardship Withdrawals

Recommendation: Eliminate the suspension of participation rule for hardship withdrawals (Reg. 1.401(k)-1(d)(2)(iv)(B)(4)).

G. Portability

Recommendation: Allow portability of balances under all types of defined contribution plans so that balances under plans offered by for-profit organizations (Section 401(a) and 401(k) plans), plans offered by non-profit organizations (Section 403(b) plans) and plans offered by state and local government entities (Section 457 plans) can be combined by in any one defined contribution plan. In this regard, the Council endorses the provisions of H.R. 3503, the “Retirement Account Portability Act of 1998,” introduced by Congressmen Earl Pomeroy (D-ND), Jim Kolbe (R-AZ) and others earlier this year.

Recommendation: The use of IRAs as rollover vehicles should be expanded. In this regard, the Council endorses the provisions of H.R. 3503, the “Retirement Account Portability Act of 1998.

H. Educational Initiatives

Recommendation: Require participant education on the harmful effects of leakage. Specifically, require plan sponsors to provide plan participants with an explanation of the impact on a participant’s retirement security of spending the distribution currently versus rolling the distribution into a tax-qualified savings vehicle.

Recommendation: The Department of Labor should issue a pamphlet on leakage that illustrates the adverse effect of leakage on retirement savings and retirement lifestyle.

Recommendation: The Department of Labor should issue a report on the societal and individual advantages of defined benefit plans, particularly with respect to leakage, to plan sponsors, plan participants and Congress.


III. Introduction

Retirement savings has become a focus of national attention, with the National Savers Summit as a prominent recent example. Surely savings are vital to the financial health of Americans, particularly retirees. Without regular contributions to retirement savings vehicles, financial security becomes a precarious strategy and an elusive goal. However, savings – in terms of regularly putting aside funds for retirement – is only half the battle. Maintaining the funds until and through retirement is just as important. Findings have shown that retirement funds are often consumed by Americans throughout their working years, cashing out the future for the sake of the present. Despite tax incentives, well over half of American job changers cash out their plan distributions rather than roll them into another tax-qualified savings vehicle.

Implications of the Shift to Defined Contribution Plans

The shift in retirement savings from defined benefit plans to defined contribution plans is well documented. Between 1983 and 1993, the ratio of full-time private workers covered by 401(k) plans increased from 3 percent to 27 percent, while coverage under defined benefit plans decreased from 47 percent to 33 percent (AFL-CIO testimony based on DOL statistics). The defined contribution numbers are still rising with over 40 percent of today’s workers covered by defined contribution plans. For half of all workers, the 401(k) plan is the only retirement vehicle offered by their employers.

In giving workers greater freedom to build their retirement nest eggs, defined contribution plans are less protective of workers’ retirement security. The 401(k) plan is the predominant form of defined contribution plan. In a 401(k) plan, the worker reduces his or her salary to contribute to the plan. Many plan sponsors match some of these contributions or make a separate contribution to the plan. Nevertheless, the burden of plan contributions falls heavily on the worker. Furthermore, the investment risk falls upon the participant in defined contribution plans. Also, the predominant form of benefit is a lump sum distribution. Defined contribution plans are not required to comply with the joint and survivor rules and the spousal consent rules. Many defined contribution plans do not provide a life annuity payment option. If the value of a benefit is under $5,000, the recently-expanded mandatory cash-out rules apply. A plan sponsor can require that the participant take the distribution in the form of a lump sum payment rather than leaving the retirement monies in the plan. Clearly, defined contribution plans place the obligation for the management of retirement security squarely upon the shoulders of the participant.

Defined benefit plans, by contrast, provide greater retirement security for workers. In defined benefit plans, virtually all of the contributions are made by the employer. The employer bears the investment risk. Should the employer default on the payment obligation, the Pension Benefit Guaranty Corporation steps in and assumes a certain amount of the payments. The normal form of benefit is a stream of annuity payments, which spread the benefit over the life of the retiree and, often, his or her spouse. Under the mandatory cash-out rules, benefits with a present value under $5,000 can be paid to terminated participants in a lump sum. Except for lump sum distributions, defined benefit plans pose no significant source of leakage.

Leakage is largely a defined contribution phenomenon because the normal form of benefit is a lump sum distribution. This form of distribution invites leakage by giving the participant a choice between spending the distribution or rolling it over to another tax-qualified savings vehicle. Defined contribution plans permit participant loans, hardship withdrawals and in-service withdrawals, which are not available under defined benefit plans.

Savings vs. Access

It is critical to note at the outset that an inherent conflict exists between the conditions needed to encourage contributions to retirement plans and the conditions needed to encourage accumulation of retirement savings. David L. Wray, President of the Profit Sharing/401(k) Council of America, testified that some leakage is necessary to allow lower-paid employees access to their pension assets during times of emergency. Younger and lower-paid employees have little or no savings, and many are living from paycheck to paycheck. If these employees are to commit part of their earnings to a tax-qualified savings program, they must have access to their funds in case of emergency. Hardship withdrawals and participant loans are two avenues of access to retirement savings for workers. In fact, the General Accounting Office (GAO) has issued a report which shows that participation rates and contribution rates are significantly higher for plans that have loan and hardship provisions than for plans that do not have these provisions.

On the other hand, qualified plans were never intended to replace savings accounts. Generous tax deferrals and deductions for workers and employers, respectively, encourage retirement savings. Unlimited access to tax-deferred savings makes a mockery of the tax subsidy. More importantly, even small amounts of money compounded over working years will create sizable retirement nest eggs. Early distributions that are consumed during working years drastically reduce the amount available for retirement; this presents an increased risk of impairing the quality of life in a worker’s advanced years, and ultimately, a burden on society.

Lump Sum Distributions – The Largest Source of Leakage

The 1993 Current Population Survey (CPS) determined that only 20 percent of the individuals who received lump sum distributions rolled the entire sum into another tax-qualified vehicle. Forty percent of the individuals rolled over a portion of the lump sum distribution. On a dollar basis, about two-thirds of the money was rolled over to a tax-favored vehicle, which demonstrates that individuals with larger balances are more likely to keep funds tax sheltered.

An analysis of the CPS prepared by two witnesses from the Federal Reserve further details the uses of lump sum distributions as follows:

Consumption

29% of recipients

Debt reduction

17% of recipients

Investment in savings or other financial instruments

11% of recipients

Purchase of a house or payment of a mortgage

7% of recipients; and

Business, education or health

8% of recipients.

The witnesses also testified that workers with higher incomes, larger distributions, and a college education are more likely to roll over their distributions into another tax-qualified savings vehicle. Also, but to a lesser extent, older workers, homeowners, single workers and childless workers are more likely to roll over their distribution.

A study of the 1996 Hewitt database revealed that 40 percent of all distributions made to workers upon job termination were rolled over to a tax-qualified savings vehicle. This represents an increase from 35 percent in the 1993 Hewitt database. When the dollar amount of the rollovers is examined, it is found that 79 percent of the amount of the 1996 distributions was rolled over, which is up from 73 percent in the 1993 database. A mere 20 percent of distributions under $3,500 was rolled over, whereas 95 percent of distributions over $100,000 was rolled over. The larger the amount of the distribution, the more likely it will be rolled into another tax- qualified savings vehicle. The propensity to roll over distributions is also positively correlated with the age of the recipient. The rollovers range from 26 percent of distributions made to individuals in their 20s to 89 percent for individuals aged 60 and over.

The positive correlation of age and size with the propensity to roll over distributions is encouraging, but it does not solve the retirement security problem. A worker is likely to change jobs several times during his or her career, and these job changes result in a series of relatively small distributions. What is the impact of cashing out the earlier distributions? The Employee Benefit Research Institute (EBRI) gives an example of the impact of spending relatively small distributions that are made when the recipient is young. It assumes four $3,500 distributions made at ages 25, 35, 45 and 55. Cashing out the first $3,500 distribution at age 25 reduces the retirement nest egg from $135,125 to $59,098, assuming an 8 percent return. This is due to the power of compound interest in a tax deferred savings vehicle.

Further evidence on lump sum distributions was provided by Fidelity Investments based on their universe of over $300 billion in defined contribution assets of six million plan participants. In terms of the account balances, 73 percent of the balances remained in the plan after the event of termination and another 23 percent were rolled over to an IRA or another qualified plan. Only four percent of the dollars was distributed in the form of cash to participants. In terms of numbers of participants, 55 percent of participants kept their balances in the plan upon termination, and another 21 percent of participants rolled the account balances into an IRA or another qualified plan. Twenty-three percent of participants received a cash distribution. The relatively low rate of plan leakage is attributed to two factors. First, education programs explain the importance of retirement savings to participants throughout their years of participation. Second, the interests of the plan participants are aligned with the interests of the service provider in preserving the assets in the qualified plan.

Participant Loans and Hardship Withdrawals

The consensus of our witnesses is that participant loans jeopardize retirement savings to the extent of loan defaults and the interdiction of continued contributions by participants during periods of loan repayment. Unfortunately, there is virtually no comprehensive data available at this time on the scope or trends with respect to loan defaults or the interdiction of contributions. Many loans are repaid with interest, which replenishes the retirement savings. The most efficient and effective method of loan repayment is through payroll deduction. In many cases loan defaults were attributed to terminated participants who could not afford to repay their entire outstanding loan balance when they leave their jobs.

Hardship withdrawals, by definition, are available under very limited circumstances and have tax consequences that serve as an effective deterrent. Specifically, hardship withdrawals are subject to federal income tax and, if the participant is under age 59 ½, a 10 percent premature redemption penalty. While, again, in this area there is little comprehensive data available on the scope and trend of plan hardship withdrawals, based upon the testimony received, the major concern about hardship withdrawals is the 12-month suspension of participation rule which interrupts the habit of retirement saving.

Other Concerns

Certain forms of leakage also create skepticism about the appropriateness of tax incentives for retirement savings. Furthermore, certain aspects of our tax laws seem to be fanning the flames of leakage. Our laws should reflect a sound and consistent public policy that promotes the accumulation of retirement assets to and through the retirement years of workers.

Participant education on the effect of pre-retirement plan withdrawals is a key to the success of retirement savings. Whether mandated or merely encouraged, providing plan participants with information about the impact of spending their retirement distributions will increase benefit preservation. Simple charts and graphs can be highly effective in demonstrating the ultimate retirement nest egg for a participant who rolls over his or her distribution to a qualified plan. Post-retirement security can be advanced by giving workers the choice of an annuity form of benefit payment, and by extending the spousal consent rules.

Conclusion

With the shift in retirement savings to defined contribution plans, measures to stop the leakage of plan assets become increasingly more important. Concerns about the viability of the social security system further underscore the need for each worker’s retirement savings to last a lifetime. Many plan sponsors have education programs and communication campaigns designed to increase the awareness for retirement savings. However, the burden of retirement savings, planning and management rests more and more on the worker.

The studies indicate that most participants do not roll over lump sum distributions to other tax-qualified savings vehicles. Testimony from the AFL-CIO indicated that there is pressure to permit lump sum distributions for their members who are covered under defined benefit plans. With these potential changes in the form of distribution under defined benefit plans, the increasing dominance of defined contribution plans and the mobility of the workforce, the number of lump sum distributions will increase. It is critical that the leakage of lump sum distributions from retirement plans be slowed.

There are some promising signs. The larger the amount of the distribution and the older the participant, the more likely it is that a distribution will be rolled over into another retirement vehicle. There should be a natural boost to the rollover rates as the baby boomers age and the average account balances rise. Also, the federal income tax withholding requirement has helped to increase the propensity to rollover distributions to other tax-qualified savings vehicles. On the education front, Fidelity’s program provides a model for future benefit preservation. Although some trends are positive, additional measures are needed to preserve benefits through retirement.

All available sources indicate that loan defaults and hardship withdrawals are relatively small sources of leakage. Notably, loan and hardship provisions tend to increase the levels of plan participation and contribution. Although more study is needed, it appears that loans and hardship withdrawals provide needed access to retirement savings.

Public policy demands that retirement savings be safeguarded for their intended use. The achievement of retirement security requires both the encouragement of retirement contributions and the long-term accumulation of retirement assets. A balance must be struck, monitored and maintained in order to achieve optimal retirement savings. This Working Group’s Report highlights some of the inconsistencies in our retirement system and recommends changes consistent with a long-term commitment to retirement security.


IV. The Working Group’s Purpose and Scope

This Working Group of the ERISA Advisory Council was formed to study the levels, sources and trends of leakage from qualified plans. Leakage was examined during both pre- retirement and post-retirement periods for workers covered under both defined contribution and defined benefit plans. The Working Group chose this topic because the members believe that leakage from retirement vehicles undercuts the effectiveness of long-term savings, which impedes retirement security. The Working Group has developed recommendations that are designed both to impede leakage and to mitigate its effects. This Report sets forth the Working Group’s findings on the patterns of leakage from retirement plans, and sets forth recommendations for greater retirement security.


V. The Working Group’s Proceedings

The Working Group held seven public meetings. Sixteen witnesses testified before the Working Group. Seven witnesses represented the governmental entities of the Department of Labor, the General Accounting Office, the Department of Treasury and the Federal Reserve Bank of New York. Four witness represented industry groups, namely, the Employee Benefit Research Institute, the American Academy of Actuaries, and the Profit Sharing Council of America. A representative from the AFL-CIO provided the perspective of organized labor. Four witnesses represented three employee benefit service providers, who are Fidelity Investments, KPMG Peat Marwick LLP and EFI Actuaries. Finally, U.S. Representative Earl Pomeroy gave valuable insights on legislative proposals that are designed to preserve retirement benefits. The testimony was recorded in verbatim transcripts of the Working Group. Additionally, written testimony was provided in the form of statistical surveys, scholarly treatises, periodical articles, government reports and industry pamphlets. Summaries of the testimony appear at the end of this document, and a summary of exhibits is attached as well. Charts are also included to illustrate key concepts addressed in the Report.


VI. Background and Analysis

A. The Critical Need for Research

Recommendation: Fundamental research should be undertaken by the Census Bureau and other governmental entities to provide data and analysis on all aspects of plan leakage. Furthermore, the Department of Labor should utilize the Current Population Survey to identify the magnitude and trends of all aspects of plan leakage.

Most Americans spend their lump sum retirement distributions well in advance of retirement. The billions of thwarted savings dollars has not even been measured. Its impact on the lifestyle of retirees is understood only in the broadest of terms. Reasons given for the leakage of funds from the tax haven of qualified plans are merely our best guesses at this point. Participant loans, hardship withdrawals and lump sum distributions create a complex environment that must balance the commitment to savings with the need for access to funds. Better information about the amount, source and trends of leakage is critical so that we can establish measures to buttress retirement savings. The retirement income security of American workers depends upon it.

It is clear that both size and age matter. The smaller the distribution and the younger the recipient, the more likely it will leak from the retirement bucket. This information alone is both troublesome and encouraging. The later a worker begins serious retirement saving, the less likely he or she will have a comfortable retirement. Also, those with smaller distributions and fewer financial resources are more likely to have financial difficulties in retirement. Since workers are likely to have several jobs (estimates range from five to eight jobs over the course of working years), those covered by retirement plans will receive a series of smaller distributions. Missing the opportunity to save those early distributions has a significant impact on retirement savings and lifestyles. It is imperative that we begin to save early, and that we save even small sums.

On the bright side, the trends favor our aging population as the baby boomers advance through their fifties. Just as older workers are more likely to rollover their lump sum retirement distributions, workers with larger distributions are more likely to choose a rollover. With average 401(k) balances rising, the trends show promise for financial security in retirement for some.

B. Annuitization of Benefits

Recommendation: Require that all defined contribution plans offer annuities as the primary form of benefit for all distributions in excess of $5,000 and comply with the joint and survivor rules, unless the participant elects otherwise in conformance with the joint and survivor rules, including spousal consent.

Leakage occurs both pre-retirement and post-retirement. If leakage occurs early in one’s career, one can work longer, increase savings or scale down lifestyle. If leakage occurs later in life, particularly during retirement, options are fewer. Census Bureau data shows that poverty rates for individuals aged 65-74 is about 10 percent. Poverty rates rise to 16 percent for individuals over age 74, and for elderly women, rise to nearly 20 percent. Many people outlive their means and nearly one in five elderly women live in poverty.

Joint and survivor annuities, which extend retirement payments over the lifetime of the retiree and his or her surviving spouse, are becoming less prevalent. The number of pensioners receiving annuities has decreased from 60 percent in 1989 to 48 percent in 1994. There has been a corresponding increase in the number of pensioners receiving lump sum distributions. This shift in the form of benefit mirrors the shift away from defined benefit plans where the normal form of benefit is the joint and survivor annuity. Clearly, the longer a retiree’s actual life expectancy, the more he or she would receive under an annuity. Those retirees in good health are likely to derive better value from annuities. Retirees in poor health may derive greater benefit from a lump sum payment. Similarly, retirees with disciplined spending and investent habits are more like ly to manage a lump sum distribution well. Those retirees without financial discipline would likely be better served by annuities. Today, workers do not have a choice in the form of their benefit under most defined contribution plans, and receive a lump sum distribution.

A critical feature that hinges on the form of benefit payment is spousal consent. In plans where a joint and survivor annuity is the normal form of benefit, the participant’s spouse must consent in writing to any other form of benefit payment. In this way, both members of the financial unit make a decision together about their retirement benefits. Let’s face it: it’s difficult to manage retirement income, and the spousal consent rules encourage couples to have conversations about their retirement income. Spousal consent is not required in defined contribution plans where a lump sum distribution is the normal form of benefit. Accordingly, the spouse has no voice in the couple’s retirement security. Furthermore, the retiree is not given an optional form of benefit that, for many, is more protective of lifetime income needs.

The Working Group recognizes that defined contribution plans may need to involve a financial intermediary to provide annuity payments to participants. Our recommendation is limited to distributions with a value over $5,000. The Working Group found that annuities are readily available in the marketplace for amounts over $5,000.

Under the Working Group’s recommendation, no one would be forced to take a joint and survivor benefit under a defined contribution plan. Rather, all would be given the opportunity to consider the annuity form of payment, along with their spouses. Together, they could decide upon the form of benefit that is most suitable to their retirement years. With the alarming increase in poverty rates of elderly Americans, particularly women, this small change in the law could have a huge impact.

C. Rollovers of Lump Sum Distributions

Lump sum distributions made under a defined contribution plan can be rolled over into another tax-qualified savings vehicle without incurring taxes or penalties. Distributions that are not rolled over are subject to federal income tax, 20% tax withholding, and a 10% penalty; the penalty does not apply to workers who have reached age 59 ½.

Messrs. Rodrigues and Fleming of the Federal Reserve Bank testified that nearly half of all workers have received a lump sum distribution from a retirement plan from a previous job. Only 28% of the recipients who receive lump sum distributions from a 401(k) plan before retirement roll the amounts into another tax-qualified savings vehicle. These distributions represent 56% of the value of the lump sum distributions. Other uses of the distributions are consumption (29% of recipients), reduction of debt (17% of recipients), investment in savings or other financial instruments (11% of recipients), purchase of a house or payment of a mortgage, (7% of recipients) and other investment including business, education or health (8% of recipients).

The witnesses also testified that workers with higher incomes, larger distributions, and a college education are more likely to roll over their distributions into a tax-qualified savings vehicle. Also, but to a lesser extent, older workers, homeowners, single workers and childless workers are more likely to roll over their distributions.

Recommendation: Require that lump sum distributions in excess of $2,000 be rolled over directly to an IRA or other qualified plan except in the case of financial hardship of the recipient. To the extent such distributions consist of assets other than cash, a qualified plan would not be required to accept such assets.

Should annuities become the normal form of benefit under defined contribution plans, participants would retain the ability to request a lump sum distribution, with the consent of a spouse. Lump sum distributions are also available under some defined benefit plans. Should a lump sum election be made, the Working Group recommends that the distribution be rolled over into an IRA or the new qualified plan of the participant. If the participant wants access to the funds, he or she could choose the IRA option and take withdrawals. The withdrawals may be immediate for some participants, but inertia would be on the side of savings.

Appropriate technical changes would be adopted to overcome possible legal constraints under state or federal law.

Distributions of benefits or balances with a value of $2,000 or less could be distributed directly to the participant for ease of administration. In addition to the de minimis exception, a direct distribution could be made to any participant who demonstrates financial hardship in accordance with the safe harbors prescribed under Section 401(k) without further investigation by the plan sponsor. Both the hardship distributions and the de minimis distributions would be subject to tax withholding. This rule would apply to partial lump sums, short-term installment payments and similar payout forms of the type subject to Section 417(e) actuarial assumptions.

Finally, non-cash distributions would be made directly to the participant in-kind. The exception for non-cash distributions is based on two reasons. First, there are administrative difficulties in dealing with non-cash distributions by both IRA providers and other qualified plans. Second, employer securities are afforded favorable tax treatment that would be lost if the employer securities were flushed through an IRA.

Recommendation: Require all defined contribution plans be amended to accept rollovers from other qualified plans, provided that the rollovers are made in the form of cash.

When the roof is leaking, you can never have too many buckets. So, too, with retirement leakage. IRAs work well as rollover vehicles, but often not as well as qualified plans. Qualified plans provide participants with investment management expertise, either in the form of specific investment choices or through a prudent investment manager. Rollovers into qualified plans also give participants greater ability to keep their retirement nest egg in one place, which facilitates planning. Qualified plans often allow loans to participants, which are not permitted under IRAs. For these reasons, many workers prefer to rollover a lump sum distribution to their new employer’s qualified plan. Although defined contribution plans can be amended to accept rollovers from other qualified plans, many do not accept these rollovers. If defined contribution plans were required to accept rollovers from other qualified plans, workers would be in a better position to manage their retirement security.

Some rollovers are not in the form of cash. Employer securities are the predominant exception to cash. Due to the administrative complexities of dealing with non-cash rollover assets, the Working Group believes that an exception is necessary. Accordingly, defined contribution plans would be required to accept only cash as rollovers from other qualified plans.

Recommendation: Permit rollovers of post-tax contributions to qualified plans and IRAs in the form of cash.

Participants can make contributions to qualified plans on both a pre-tax and post-tax basis. At present, only the pre-tax contributions, employer contributions, and the earnings thereon qualify for a rollover to another qualified plan or to an IRA. Post-tax contributions must be made directly to the participant. Today’s methodology promotes leakage of retirement savings.

The greater the amount of funds that remain in retirement vehicles, the greater the retirement security of the American worker. Although there would be some administrative cost for the future employer in accounting for the post-tax contributions from a participant’s prior plan, the Working Group believes that the advantages for retirement security outweigh the cost.

Again, any post-tax contribution that is not in the form of cash need not be accepted as a rollover due to administrative complexities.

Recommendation: Review the rules concerning in-service withdrawals of employee after- tax contributions and vested company contributions for appropriate limitations.

Some testimony was heard concerning plans that offer unlimited access to after-tax contributions and vested company contributions. It is felt that these provisions create too great an opportunity for leakage. In some cases, the participants use the plans as revolving savings accounts. This not only complicates the administration of these plans, but it defeats the purpose of long-term retirement savings. The Working Group believes that withdrawals of after-tax contributions and vested company contributions should be limited, but did not have sufficient information to construct a sound, specific recommendation. Accordingly, the Working Group recommends further study of in-service withdrawals with a view toward imposing restrictions on access to these funds.

D. Mandatory Cash-Outs and Other Small Payments

Recommendation: Modify the mandatory cash-out provisions so that any benefits or balances that are valued over $2,000 be rolled over to an IRA or other qualified plan, or used to purchase an annuity.

ERISA allows plan sponsors to require a plan participant to take a distribution from a qualified plan in the form of a lump sum distribution when the participant terminates employment. The mandatory cash-out rules apply to both defined contribution plans and defined benefit plans when the value of the balance or benefit is under $5,000. The rationale behind allowing plan sponsors to cash-out these distributions is that it is very costly to administer small benefits for individuals who no longer work for the plan sponsor.

The Working Group recommends that the cash-out rules dovetail with the newly proposed lump sum rollover rules so that mandatory cash-out distributions of benefits or balances with a value over $2,000 be rolled over directly to an IRA or a qualified plan. Alternatively, the plan sponsor could purchase an annuity for the participant. Research done by the Working Group demonstrates that deferred annuities are commercially available with a minimum premium of $2,000 or more. Also, IRAs for sums of $2,000 or more are widely available in the marketplace.

The Working Group considered, but ultimately rejected, a recommendation to roll back the mandatory cash-out limit because the Working Group does not want to increase burdens on plan sponsors. Instead, it focused on requiring the non-consensual distribution to be in the form of an IRA or a commercial deferred annuity so that the funds stay within the retirement system. We recognize that former participants may later seek a distribution from the IRA or surrender the commercial annuity, but at least that will require affirmative action on their part. In aggregate, there should be substantially less leakage of mandatory cash-out amounts from the retirement system.

Recommendation: Eliminate PBGC premiums (but not PBGC coverage) for defined benefit plans that retain the benefits of separated participants whose vested pension benefit has a value of less than $5,000.

This recommendation is designed to provide relief to plan sponsors who voluntarily support retirement benefit preservation by retaining the small balances of separated (terminated) participants in their plans. PBGC coverage is fundamental to the security of pension benefits. We do not recommend that the coverage be reduced in any way. However, the minimum annual premium that must be paid by a defined benefit plan sponsor for each participant is $19 per year. Additional amounts are due if the plan has unfunded vested liabilities. PBGC premiums are not related to the size of the benefit or the age of the participant. The PBGC premiums and other costs of administration are why plan sponsors wish to force out small benefits.

Some plan sponsors do not take advantage of the cost-savings afforded by the mandatory cash-out rule, and allow benefits valued at under $5,000 to remain in the plan. Under these circumstances, the plan sponsor has increased the likelihood that the funds will be available at retirement. If we wish a coherent public policy that preserves retirement benefits and stops the leakage that is rampant among small distributions and distributions made to younger workers, it is recommended that we alleviate the PBGC premium obligation of the plan sponsor for small benefits payable to terminated participants. The plan sponsor would support retirement security by continuing to pay for the administration of these small benefits. The PBGC would support retirement security by waiving the premium obligation for these benefits. Since the benefits in question are small by definition, the actual PBGC coverage liability should be minimal.

E. Participant Loans

Loans are an obvious source of leakage, at least at first glance. In the final analysis, however, most loans are repaid on time and with interest. More importantly, the availability of loans is key to encouraging participation in plans. Most impressively, the availability of plan loans significantly raises contribution levels. The Working Group has concluded that restrictions on the availability of plan loans are not the solution. Rather, our recommendations are structured to help participants repay their loans in an orderly fashion, particularly when they change jobs. These measures will enhance the preservation of benefits without inhibiting plan participation or dampening contribution levels.

The law allows participants to borrow the lesser of $50,000 or half of their vested account balance. For participants with vested account balances under $10,000, a loan of up to the full value of their account balance is permitted. Within these limitations on the overall amount of loans, multiple loans are permitted. The term of the loan cannot exceed five years unless the loan is used to purchase a principal residence. The loan must be repaid in substantially equal installments and bear a reasonable rate of interest. There are neither taxes nor penalties associated with the grant of the loan. However, if the loan is not repaid, the outstanding balance is treated as a taxable distribution and, further, is subject to a 10 percent early withdrawal penalty if the participant is under age 59 ½. Defaulted loans are reported to the IRS on Form 1099-R. Loans in default are also reported on a separate schedule to the Form 5500.

In October 1997, the GAO released a report entitled, “401(k) Pension Plans: Loan Provisions Enhance Participation But May Affect Income Security For Some.” This study, which we will refer to as the “GAO Report,” showed that over half of all 401(k) plans allow participants to borrow from their accounts. Larger plans are more likely to permit loans. This fact is supported by a 1998 KPMG study of mid to large plans entitled, “Retirement Benefits in the 1990s.” The KPMG data shows that 90 percent of employees are in plans that allow participant loans. Fidelity Investments, which services 5,000 plans covering all size categories, reported that 90 percent of their plans offer participant loans. Participant loan provisions are a common feature of defined contribution plans.

Although loan provisions are prevalent, fewer than eight percent of all participants had one or more outstanding loans from their plan, according to the GAO. The data underlying the GAO Report showed that black Americans and Hispanics are twice as likely to borrow from their 401(k) plans as white Americans. No significant relationship was found between the decision to borrow and the sex, age or marital status of the participant. Attitudes of borrowers and non- borrowers vary in that more borrowers feel it is appropriate to borrow from their retirement plan to finance a car or for living expenses than non-borrowers. Neither group, however, felt that it was appropriate to borrow for a vacation or a luxury item. Surely there are some participants who squander their retirement savings in this manner. Statistical evidence, however, does not support this picture of participants borrowing for frivolous expenditures.

Both participation rates and contribution levels are higher in plans that allow participant loans. The GAO Report reveals that participation rates for plans that allow loans are about six percentage points higher than the plans that do not allow loans. Furthermore, average employee contributions are 35 percent higher in 401(k) plans with loan provisions than the contribution rates of 401(k) plans without loan provisions.

Borrowing from a 401(k) plan can reduce the ultimate retirement nest egg. The GAO developed a simulation of retirement income that compared retirement funds available for those who borrow from their 401(k) plan and those who do not borrow. The simulation assumes a $40,000 loan that is repaid over a 10-year period at a 7 percent interest rate. The simulation further assumes that the account otherwise earned an average of 11 percent. The results show that the participant’s retirement nest egg was reduced by 5.5 percent if the participant continued to make contributions during the repayment period and by 27 percent if the participant suspended contributions over the repayment period.

Recommendation: Require that all plans that permit participant loans be required to accept outstanding loans as part of a rollover by new participants.

The testimony on defaulted loans was encouraging insofar as it demonstrated that few participants default on plan loans. Furthermore, the key causes of default can be addressed without inhibiting the growth of retirement savings. Fidelity Investments provided testimony that defaulted loans constitute less than one-tenth of one percent of the plan assets in their universe. The incidence of defaulted loans appears to be low, and job changes seem to be the primary catalyst for the defaults. Several sources testified that loans are defaulted upon termination of employment because the participant does not have the option to continue to make monthly payments. Instead, most participants must either pay off the loan balance completely or default on the loan. Very few plans currently permit a rollover of outstanding loan balances from a prior plan. The Working Group believes that the default rate would improve significantly if participants were able to roll over their loan balances to another qualified plan. Accordingly, we recommend that defined contribution plans that have a participant loan program be required to accept participant loans from the prior plan of a participant. In this way, a participant would continue to pay the plan of his or her new employer for the plan loan originated under the plan of his or her former employer. The outstanding balance of the loan would simply roll over to the new plan. Of course, if the new employer’s plan does not have a participant loan provision, the Working Group would not require the plan to accept a rollover loan.

Recommendation: Require that plans permit former participants who chose to leave their account balance in their former employer’s plan to continue to repay the installments of their outstanding loan balances after termination of employment. Participants would be required to establish an electronic funds transfer from the participant’s checking or savings account to the plan to facilitate loan repayment. This rule would not apply it the value of the total account balance is less than $5,000.

In order to minimize loan defaults, a remedy is also needed for participants who terminate employment without a new job or with a new employer who either does not sponsor a plan or does not provide a participant loan program. These former participants should be able to continue to repay their outstanding loan in installments. To ease the administration of this provision for plan sponsors, participants would be required to establish an electronic funds transfer for the loan payments. Also, it would be confirmed that plan sponsors do not have to undertake additional collection efforts.

Recommendation: The Internal Revenue Service should monitor Form 5500 filings and Form 1099-R filings to identify the magnitude and trends of qualified plan distributions attributable to defaulted loans.

There is little information on the extent of loan defaults. Surely, we would benefit from more comprehensive information on magnitude and trends of qualified plan distributions attributable to defaulted loans. Accordingly, we have recommended that the IRS review the Form 5500 filings and the Form 1099R filings to procure broad-based data and analyze the leakage that is due to defaulted loans.

In conclusion, the Working Group supports participant loans because of their positive impact on plan participation and contribution levels. Little if any leakage occurs when loans are allowed to be repaid, particularly if the participant continues to make contributions to the plan. Our recommendations focus on research to better understand the extent of any leakage, on measures to better ensure consistent loan repayments, and on measures to prevent loan defaults at termination of employment.

F. Hardship Withdrawals

Hardship withdrawals can be made available to meet the immediate and heavy financial needs of the participant for which no other resources are available. The safe harbor reasons for hardship are (1) medical expenses; (2) the purchase of a principal residence; (3) tuition for post- secondary education; and (4) the prevention of eviction from or foreclosure of a principal residence. Hardship withdrawals can be made only from a participant’s pre-tax contributions, and not from the earnings thereon.

In contrast to participant loans, hardship withdrawals are not repaid. Moreover, a participant who takes a hardship withdrawal is not permitted to make contributions to the plan for the 12-months following the withdrawal. This restriction is found in the safe harbor provisions of IRS Reg. 1.401(k)-1(d)(2)(iv)(B)(4), which is widely used by plan sponsors.

The GAO reported that 43 percent of defined contribution plans permit hardship withdrawals (“Plan Features Provided by Employers That Sponsor Only Defined Contribution Plans,” December 1997). The 1998 KPMG study of mid to large size plans showed that 94 percent of employees are covered by plans that permit hardship withdrawals. Of the plans in the Fidelity universe, 93 percent offer hardship withdrawals. Fidelity has tracked the outflow of funds due to hardship withdrawals, and found it considerably under one percent (0.13%). The Working Group did not find hardship withdrawals to be a significant source of leakage.

Hardship withdrawals do tend to encourage participation in plans. Again, participants are more likely to participate in a plan if they can access their money, especially for emergencies. In the Fidelity universe, participation rates average 68 percent for plans that do not allow hardship withdrawals and the average participation rate rises to 76 percent for plans that allow hardship withdrawals.

Recommendation: Eliminate the suspension of participation rule for hardship withdrawals (Reg. 1.401(k)-1(d)(2)(iv)(B)(4)).

Systematic retirement savings throughout a working career is the surest route to financial security. The 12-month suspension of participation requirement for those who a hardship withdrawals is an unnecessary interruption of the savings habit. The suspension provision was enacted to deter hardship withdrawals. Hardship withdrawals have other deterrents, not the least of which is human nature. The Working Group heard testimony about the embarrassment and sense of urgency exhibited by participants when they request hardship withdrawals. Also, hardship withdrawals are subject to tax and tax withholding. The suspension provisions are more detrimental to retirement savings in delaying new contributions than they are beneficial in deterring withdrawals. We, therefore, recommend the elimination of the 12-month suspension of participation rule for hardship withdrawals.

G. Portability

Recommendation: Allow portability of balances under all types of defined contribution plans so that balances under plans sponsored by for-profit organizations (Section 401(a) and 401(k) plans), plans offered by non-profit organizations (Section 403(b) plans), and plans offered by state and local government entities (Section 457 plans) can be combined in any one defined contribution plan. Portability by means of a rollover to another plan, a rollover through a conduit IRA as well as a direct transfer should be permitted among defined contribution plans.

The type of employer sponsoring a plan should not impede an employee’s right to transfer his or her pension benefits. Current law constraints that prohibit or impede portability among different types of defined contribution retirement savings plans should be removed. Increasingly, employees change jobs during the normal course of their career. Since ERISA was enacted in 1974, the Internal Revenue Code has had provisions to encourage portability among plans and IRAs of retirement benefits so that workers can take their benefits with them as they move from job to job. Portability should be relatively easy to accomplish as workers move from one employer sponsoring a defined contribution plan to another employer sponsoring a defined contribution plan. Yet due to historical and artificial distinctions based on the type of employer sponsoring a defined contribution plan, employees are not permitted under current law to transfer their pension benefits when they change jobs. Congressmen Pomeroy, Kolbe and others have proposed eliminating these historical and artificial impediments to portability. This is a common sense reform. It brings greater rationality to the retirement plan system, enhances retirement security and gives enhanced control over their retirement savings to plan participants. In this regard, the Council endorses the provisions of H.R. 3503, the “Retirement Account Portability Act of 1998,” introduced by Congressmen Earl Pomeroy (D-ND), Jim Kolbe (R-AZ) and others earlier this year.

Recommendation: The use of IRAs as rollover vehicles should be expanded.

There continue to be a number of artificial impediments on the use of IRAs as a rollover vehicle. IRA rules should be broadened so that workers from any employment sector, public, private or non-profit, could use an IRA as a “conduit” for their retirement money until they are prepared to roll the money into a subsequent employer’s retirement plan. Also, IRAs that contain tax deductible contributions should be eligible for rollovers into a retirement plan. And finally, the Treasury Department should be given authority to waive for good cause the inflexible current law requirement that rollovers occur within 60 days. Unfortunately, the 60-day requirement has sometimes acted as a tax trap for the unsophisticated participants and frustrated good faith efforts on their part to achieve portability. In this regard, the Council endorses the provisions of H.R. 3503, the “Retirement Account Portability Act of 1998,” introduced by Congressmen Earl Pomeroy (D-ND), Jim Kolbe (R-AZ) and others earlier this year.

H. Educational Initiatives

“Education about basic retirement planning and financial information pays off.” This is the opening remark on education in the 1998 KPMG Study, and many witnesses reinforced this concept with the Working Group. It is no surprise that 401(k) participation rates are 17 points higher in plans that offer educational seminars. Contribution levels are higher as well. Another recent study shows 70% of plan sponsors rank employee education as the most pressing issue facing them over the next five to ten years (BARRA Rogers Casey/IOMA June 1998). The types of employee education include investment seminars for active and retired employees, retirement planning software, audio and video planning tapes, and financial counseling. Fidelity Investments attributes the success of its benefit preservation efforts to education and communication. Throughout the period of employment, workers are advised of the need to save for retirement and the benefits of a qualified plan as the lynchpin of retirement security.

Recommendation: Require participant education on the harmful effects of leakage. Specifically, require plan sponsors to provide plan participants with an explanation of the impact on a participant’s retirement security of spending the distribution currently versus rolling the distribution into a tax-qualified savings vehicle.

Suicide prevention signs are posted every 100 yards along the Coronado Bay Bridge, defying the adage, “Advice always comes too early or too late.” Inspired by such creativity, the Working Group recommends that plan participants be told of the future value of any distribution that they receive before retirement just as they are about to receive that payment. The notice would tell the participant, basically, that you can have this $5,000 now, pay taxes and possibly penalties on it, and spend the remaining $3,000 on whatever you desire today. Then, the notice would urge the participant to consider that the $5,000 distribution today would likely grow to a certain projected sum, for example $50,000, at retirement. Perhaps the notice would state the obvious, which many people seem to ignore: when you retire, you will be older and you will not be working – you will need this money to live comfortably. Simple charts or a graphical illustration could be added to help a worker understand the difference that the rollover will make to his or her financial future.

Concern was expressed that plan sponsors and service providers do not wish to be seen as guaranteeing investment results. To mitigate that concern, the Department of Labor would be required to issue guidelines to plan sponsors and service providers that would give safe harbor parameters for the notice. The DOL guidance, in the form of model language, would alleviate any liability issues for plan sponsors and service providers. The distribution notice could provide very timely advice to those who are tempted to spend their retirement savings at a young age.

Recommendation: The Department of Labor should issue a pamphlet on leakage that illustrates the adverse effect of leakage on retirement savings and retirement lifestyle.

This leaflet would be designed for distribution to workers directly and/or through their employers. The employer could distribute the pamphlet periodically to all plan participants, but particularly at the time of a distribution. The pamphlet could be posted on the DOL Website as well.

The pamphlet would describe the impact of leakage on retirement savings in simple terms. Charts and graphs depicting the value of tax-deferred savings and the power of compound interest should be included. IRA rollover opportunities would be explained. Encouragement could be provided to plan borrowers to continue to contribute to the plan. The pamphlet would also describe the effect of leakage on retirement lifestyles. Examples of the economic security of savers and spenders would be particularly meaningful.

Recommendation: The Department of Labor should issue a report on the societal and individual advantages of defined benefit plans, particularly with respect to leakage, to plan sponsors, plan participants and Congress.

Defined benefit plans are far more protective of workers in their retirement years than defined contribution plans. All investment risk and often the entire contribution obligation are borne by the employer. There are fewer opportunities for pre-retirement leakage. Retirement benefits are normally spread over the lifetime of the participant and his or her spouse. In the event of employer default, the PBGC guarantees payment of the benefit. For these reasons, we recommend that the DOL highlight the advantages of defined benefit plans to its constituencies.


Chart


Chart


Chart


Chart


Chart


Members of the Working Group on Retirement Plan Leakage

Barbara Ann Uberti, Esq. -- Chair
Vice President
Wilmington Trust Company
Wilmington, DE

Michael R. Fanning, Esq. -- Vice-Chair
Chief Executive Officer
Central Pension Fund International
Union of Operating Engineers and Participating Employers
Washington, DC

Ms. Rose Mary Abelson
Assistant Treasurer/Director
Investments and Trust Management
Northop Grumman Corporation
Hawthorn, CA

Mr. Eddie C. Brown
President
Brown Capital Management
Baltimore, MD

Kenneth S. Cohen, Esq.
(ERISA Advisory Council Vice Chair)
Senior Vice President/Deputy General Counsel
Massachusetts Mutual Life Insurance Co.
Springfield, MA

Neil M. Grossman, Esq.
William M. Mercer
Washington, DC

Mr. Michael J. Gulotta
President & CEO
Actuarial Sciences Associates
Somerset, NJ

Janie Greenwood Harris, Esq.
Mercantile Bancorporation Inc.
St. Louis, MO

Mrs. Marilee P. Lau
(ERISA Advisory Council Chair)
Partner
KPMG Peat Marwick LLP
San Francisco, CA

Dr. Thomas J. Mackell, Jr.
Executive Vice President
Simms Capital Management, Inc.
Greenwich, CT

Judith F. Mazo, Esq.
Senior Vice President and Director of Research
The Segal Company
Washington, DC

Mr. Richard Tani
Actuary and Retirement Consultant (Retired)
Mt. Prospect, IL

James O. Wood, Esq.
Executive Director
Louisiana State Employee’s
Retirement System (LASERS)
Baton Rouge, LA

Executive Secretary of the ERISA Advisory Council
Ms. Sharon Morrissey
Executive Secretary
ERISA Advisory Council
Washington, DC


Summaries of Testimony

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of May 5, 1998
Summary of Testimony of Dr. Paul Yakoboski
Employee Benefit Research Institute (EBRI)

Paul Yakoboski is a senior research associate with the Employee Benefit Research Institute. His current research focuses on lump sum distributions, benefit preservation and the future retirement income security of today’s workers. Dr. Yakoboski is Director of Research for the American Savings Education Council and a member of the National Academy of Social Insurance. Much of Dr. Yakoboski’s testimony is based on an EBRI Issue Brief published in August 1997 entitled “Large Plan Lump-Sums: Rollovers and Cashouts,” a copy of which is included in the record.

The study examined the 1996 Hewitt database, which consists of 87,318 distributions totaling $2.3 billion. Of this total, 71,736 distributions were made to workers upon job termination, 13,868 distributions were made to disabled persons and retirees, and 1,714 were made to the beneficiaries of deceased participants. The 1996 data was compared to the 1993 Hewitt database of 138,088 distributions. Information is provided by both the total number of distributions and the total amount of distributions.

Forty percent of all distributions made to workers upon job termination were rolled over into another tax-qualified savings vehicle. This represents an increase from 35% in the 1993 database. When the dollar amount of the rollovers are examined, it is found that 79% of the amount of the 1996 distributions was rolled over, which is up from 73% in the 1993 database. A mere 20% of distributions under $3,500 was rolled over, whereas 95% of distributions over $100,000 were rolled over. The larger the amount of the distribution, the more likely it will be rolled into another tax-qualified savings vehicle. The propensity to roll over distributions is also positively correlated with the age of the recipient. The rollovers range from 26% of distributions made to persons in their 20s to 51% for persons aged 60 and over.

The positive correlation of age and size with the propensity to roll over distributions is encouraging. However, it is also evidence of the fact that the rollover of smaller distributions at young ages need to be incentivized. A worker is likely to change jobs a number of times during his or her career, and these job changes could result in a series of relatively small distributions. What is the impact of cashing out the earlier distributions? The Issue Brief gives an example of the impact of spending relatively small distributions that are made when the recipient is young. It assumes four $3,500 distributions made at ages 25, 35, 45 and 55. Cashing out the distribution at age 25 reduces the retirement nest egg from $135,125 to $59,098, assuming an 8% return. This is due to the power of compound interest.

Distributions to retirees and disabled persons showed more positive results than distributions to job changers. Here, 52% of the number of distributions and 87% of the amount of distributions were rolled over into a tax-qualified savings vehicle. On the other hand, rollover rates are lower overall in the event of death. Only 27% of the number and 56% of the amount of distributions were rolled over into a tax-qualified savings vehicle. It is important to note, however, that distributions to non-spousal beneficiaries are not eligible for roll over.

The trend toward increasing numbers and amounts of rollovers is encouraging. This positive development may be attributed to two changes that took effect in 1993. First, a mandatory 20% federal income tax withholding was applied to any distribution that was not rolled over into another tax-qualified savings vehicle. Second, participants can instruct their plans to roll their distribution to another plan or an IRA with ease – the participant need not touch or see the money. However, much work is left to be done since only 40% of distributions are rolled over. Education was cited as the primary method for improving rollover rates. Dr. Yakoboski suggested that job changers be given basic information about the impact of rolling over a small distribution versus spending it. Simple charts or a graphical illustration can help a worker understand that difference that the rollover will make to his or her retirement lifestyle, versus the present pleasure of a current use of funds.

Meeting of May 5, 1998
Summary of Testimony of Richard Hinz and Daniel Beller
Pension and Welfare Benefits Administration

Richard Hinz is the Director of Policy and Research for the Pension and Welfare Benefits Administration. Dan Beller is the Manager of Statistical and Data Development with the PWBA.

Retirement plan leakage involves the complex interactions of funds flowing into retirement savings, the behavior of funds in the retirement system, and funds flowing out of the retirement system. Overall, there is not a lot of information on leakage. Further study should be encouraged. Messrs. Hinz and Beller summarized the following four studies:

  1. The Employee Benefits Supplement to the Current Population Survey

    The Employee Benefits Supplement (EBS) to the Current Population Survey covers 30,000 households. Reports are issued every 5 years: 1983, 1988, 1993. The 1993 report is the most recent. The survey asked whether any member of the household received a lump sum distribution upon a change in jobs, and what did the household member do with the distribution. Twenty to forty percent of households reported that they rolled the distribution into another qualified plan or an IRA. Twenty percent rolled over all of it and 40% rolled over a portion of the distribution. On a dollar basis, about two-thirds of the money remained tax sheltered, which indicates that persons with larger distributions were more likely to keep money tax sheltered. The propensity to roll over the distribution to a tax-favored vehicle was also more likely with increases in the age and the income of the recipient. The survey did not cover those distributions that remained with the plan, so actual preservation rates are somewhat higher than reported. Subsequent reports will include information on distributions that remain with the plan. Most promisingly, the percentage of lump sum distribution that was preserved has increased from the 1988 EBS to the 1993 EBS.

  2. Hewitt Study

    A Hewitt Study (discussed at length in other testimony, including Dr. Yakoboski) covers distributions made under larger defined contribution plans. The Hewitt results were similar to the EBS survey result. About 40% of the individuals preserved the tax-favored status of their retirement plan distributions. The Hewitt study also found a positive correlation between the likelihood to preserve the distribution and the dollar amount of the distribution.

  3. Urban Institute (Len Burman): “What Happens When You Show Them the Money”

    The Urban Institute Study is now underway and will analyze role of marginal tax rates, early withdrawal penalties and mandatory withholding, on the propensity to keep money tax sheltered. It will examine the effect of many changes in tax laws over the last ten years. The study will use data from the Health and Retirement Survey (HRS) sponsored by the National Institute of Aging, which follows individuals age 50-60 over extended periods of time.

  4. Rand Corporation (Lee Lillard and Mr. Panis): “Cashing Out Tax Protected Retirement Accounts”

    The Rand Study also is just starting. It will look at cash out decisions in the context of a life cycle savings and consumption model. The Rand Study will test the hypotheses that the propensity to cash out accounts increases with mortality risk, discount rates, and liquidity restraints, and decreases when risk aversion increases. The Rand Study will focus on individuals who are age 56 to 66, using information from the Health and Retirement Survey.

    In closing, Mr. Hinz testified that there is a need to consider importance of access (e.g., loans and distributions) to retirement savings because of the impact on the likelihood and degree of plan participation. Constraining access will reduce participation, especially for younger people who have greater and more uncertain liquidity needs. In closing, Mr. Hinz pointed out that 401(k) plans are relatively new, and current economic times may not be typical; in view of these limitation, long term projections on current information may be difficult.

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of June 9, 1998
American Academy of Actuaries

Ron Gebhardtsbauer is the Senior Pension Fellow at the American Academy of Actuaries. In this role, Gebhardtsbauer represents pension actuaries among federal regulators and legislators. Gebhardtsbauer also served as the chief pension actuary for the Federal Employee Retirement System at the U.S. Office of Personnel and Management. Before joining the Academy, Gebhardtsbauer managed the retirement practice at the New York office of William Mercer. He also served as former chief actuary with the Pension Benefit Guaranty Corporation.

Gebhardtsbauer’s testimony focused on recommendations that would encourage lifetime retirement income. Accordingly, he discussed pre-retirement and post-retirement leakage. If leakage occurs early in one’s career, you can work longer, increase savings or scale down lifestyle. If leakage occurs later in life, particularly during retirement, options are fewer. Census bureau data shows that poverty rates have improved since the 1950’s from an average of 35% to an average of 11%. However poverty among those over age 75 is very high, particularly among women. Nearly 20% of elderly women have incomes below the poverty line.

Gebhardtsbauer discussed ways to stem the spending of retirement savings by imposing further limits on participant loans, hardship withdrawals and lump sum distributions. He offered the following options for consideration (and also noted their disadvantages):

  • Limit hardship withdrawals to severe hardship: exclude home purchase as an eligible condition for a hardship withdrawal.
  • Allow hardship withdrawals to be returned to the plan by the due date of the next federal tax return of the recipient.
  • Reduce the maximum loan to $25,000.
  • Eliminate the $10,000 loan minimum, which essentially allows participants to borrow their full account balances up to $10,000.
  • Require that all participant loans, even home loans, be repaid over a 5-year period.
  • Convert loans at termination of employment to charge accounts.
  • Provide incentives to employers and employees to reduce cash-outs such as: reduced PBGC premiums for terminated employees, elimination of lump sum provisions in plans, and employee education.
  • Allow portability to all types of plans, including 403(b), 457, 401(k), and IRAs.
  • Extend the 60-day rollover period to the due date of the recipient’s federal income tax return.
  • Exempt the first $10,000 of pensions from taxation.
  • Require that lump sum distributions be paid directly to an IRA rollover account so that inertia is on the side of savings rather than spending.
  • Increase both tax withholding and excises taxes on lump sum distributions.
  • Require some annuitization of all qualified plan distributions.
  • Require automatic joint and survivor option in all plans.

Gebhardtsbauer suggested that using incentives to preserve benefits would be better than mandates, for example, increase the maximum allowable contributions for plans that comply.

Gebhardtsbauer addressed the relative advantages and disadvantages of lifetime pensions or annuities as an alternative to lump sum distributions. Because of the design of annuities, they can often provide greater income over all retirement years than the minimum distribution rules of the Internal Revenue Code. One key factor in this design is the lack of a residual beneficiary. When payments are made under the minimum distribution rules, the balance in the account is paid to the retiree’s beneficiary after the retiree’s death. With an annuity, these balances are available to lower the overall costs of the annuities and increase benefits for a large pool of individuals.

Among the disadvantages of annuities are sales commissions, the lack of liquidity, and the issuers’ administrative charges. Also, with stock investments minimum required distributions can be larger (in some years) than annuity payments, but at the risk of high volatility. Thus, minimum required distributions are primarily valuable if you want to pass your money to your heirs. They are not good if you need a lifetime income. Lifetime pensions or annuities are better for this.

Gebhardtsbauer stressed the need for legislation and education that favors lifetime retirement income to promote financial security to workers throughout their retirement years.

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of June 9, 1998
Summary of Testimony of Edward H. Friend
EFI Actuaries

Mr. Friend is the President and CEO of EFI Actuaries, which is the first national employee benefits firm dedicated to the public sector. Mr. Friend is known throughout the employee benefits community for his actuarial expertise. He is a fellow in the Society of Actuaries and is a contributing author and founding member of the International Association of Consulting Actuaries.

Mr. Friend advanced the position that society is entitled to some value for providing tax shelters for retirement savings. The benefit for society is that the individual will not become a burden on the rest of society in retirement. The tax subsidy should not be abused. “Tax shelter for the accumulation of retirement funds should be used for exactly for that purpose, including the annuitization of the retirement benefit upon maturity.”

Mr. Friend cited an instance where a Florida worker terminated her job solely to receive the lump sum distribution from the defined contribution plans. The Florida municipality changed its retirement program to a defined benefit plan to eliminate this source of leakage.

Mr. Friend raised concerns about the public perception of the extent of retirement plan leakage. He is concerned that professional publications may paint a rosier picture about the amount of funds that remain in the retirement system and trends in this regard. He points out that “a preponderance of employee participants in defined contribution systems elect to take a significant portion of their retirement monies before retirement.” Advantages of portability in defined contribution plans are undercut by those distributions that are not rolled into IRAs. He concludes that, “Society will pay twice, once to contribute to the defined contribution system and once to support these imprudent employees at the time of retirement.

Summary of Testimony of June 9, 1998
Martha Priddy-Patterson
KPMG Compensation & Benefits Practice

Martha Priddy-Patterson is a director of Employees Benefit Policy and Analysis for KPMG Peat Marwick compensation and benefits practice. She is an experienced attorney and employee benefit consultant and she has worked with Congress and federal agencies throughout her career. Ms. Priddy-Patterson co-authored KPMG’s employee benefits law changes in 1997, she compiled KPMG’s Employee Benefits Plan Diagnostic Review Guide, and she conducted and authored the report for KPMG’s annual survey series, Retirement Benefits in the 90’s, which surveys over 1,000 employers with 200 or more employees. Finally, Martha Priddy-Patterson is the author of the Working Woman’s Guide to Retirement Planning.

In response to questions concerning areas of leakage in retirement savings Ms. Priddy- Patterson spoke on the issue of loans and hardship withdrawals. According to Priddy-Patterson, persons who make hardship withdrawals “really need the money.” The problem is, whether employees need the money or not, once hardship withdrawals are made, the money is gone from retirement savings and there is no way to get it back.

Ms. Priddy-Patterson stated that loans are different because money is presumably restored to the retirement plan via loan payments. Priddy-Patterson supports the intention of the IRS to go after plan sponsors who do not enforce loan rules or require repayment. She stated that, although we have not seen it to date, this kind of enforcement is much needed.

Ms. Priddy-Patterson identified another problem with loans. She stated that even if there is repayment, the low interest rates that are normally offered on loans means that retirement plans lose a great deal of earnings that they would otherwise have. Therefore, according to Ms. Priddy- Patterson, there are two areas of leakage outside of failure to roll over that plan sponsors and plan participants need to consider: hardship withdrawals and loans. Priddy-Patterson expressed a particular concern over hardship withdrawals, stating that it “is very bad” to have retirement plans being used as savings accounts.

Priddy-Patterson recognized the need to offer incentives to lower paid workers (via using retirement plans as savings vehicles) to get them to participate in retirement plans. However, she stated that a balance must be struck between offering incentives and leakage from hardship withdrawals. She stated that even though hardship withdrawals are “the worst type of leakage”, employers prefer them because there are fewer administrative requirements; i.e., keeping up with loan balances and payments, etc.

When asked about rollovers, Priddy-Patterson responded positively to the data that employees, and especially older employees, preserve large lump sums in some type of retirement plan. On the other hand, she expressed concern for young employees who lose the time value of money when they withdraw funds - that they can never be returned - from retirement plans. With this concern in mind, Ms. Priddy-Patterson expressed support for federal legislation that would provide for catch-up contributions.

Subsequent to Ms. Priddy-Patterson’s testimony she provided the Council with a written summary regarding the leakage problem to amplify her oral comments. In that summary she provided a table from the 1997 edition of KPMG Retirement Benefits in the 1990swhich indicated that hardship withdrawals outpace participant loans by approximately 5% and that the widest gap is centered in the mid-size organizations.

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of July 8, 1998
Summary of Testimony of David L. Wray
President, Profit Sharing/401(k) Council of America

David L. Wray is President of the Profit Sharing/401(k) Council of America, a non-profit association representing over 1,200 companies. He testified that all qualified pension plans have leakage of assets and some leakage is necessary to allow lower-paid employees access to their pension assets during times of emergency. Younger, lower-paid employees have little or no savings because many are living from paycheck to paycheck. If these employees are to commit part of their earnings to a savings program, they must have access to their funds in case of emergency. Instead of permitting emergency withdrawals, Mr. Wray advocates plan loan programs as a substitute for in-service distributions.

Today’s employees are likely to change jobs at least five times during their careers. In order for them to live in dignity in their retirement, they must preserve accumulated retirement assets when they change jobs. In addition, they must refrain from taking in-service distributions.

To help maintain retirement assets, significant roles are to be played by employers, service providers and the federal government. Mr. Wray believes plan sponsors should continue to enhance employee education efforts. Better-informed employees are more likely to roll over assets from qualified plans into IRAs. Estimates are that over $150 billion were rolled over from qualified plans to IRAs in 1996. In addition, plan sponsors should be willing to accept plan rollovers from other qualified plans.

To ease the rollover process, plan sponsors and service providers should work together to make the preservation of retirement assets easier. For example, service providers should develop uniform rollover packets that will handle the rollover process just by completing one short form, and plan sponsors should give them to terminating employees. Financial service providers should also provide low-cost or no-cost IRA accounts that can be opened with minimal account balances.

The government can make a significant contribution by easing movement of funds and information between different types of qualified plans. This ease of transfer between different types of qualified plans would make the system more fluid. The IRS should allow employees to roll over all after-tax contributions into IRAs beyond the current 60-day limitation. Mr. Wray concluded his testimony by stating there should be an unlimited rollover capability between all types of defined contribution plans.

Meeting of July 8, 1998
Summary of Testimony of Shaun O’Brien
AFL-CIO

Shaun O’Brien is a Retirement Policy Specialist for the AFL-CIO. He has also served as a staff attorney with the Pension Rights Center.

Mr. O’Brien urged the Advisory Council to adopt a broad definition of “leakage,” including loans and the failure to annuitize benefits, as well as pre-retirement lump sum distributions. However, his comments focused on pre-retirement lump sum distributions.

Mr. O’Brien found little solace in statistics that most of the money distributed from plans before retirement is rolled over to other retirement arrangements. He pointed out that only a relatively small number of the workers—28 percent—roll over their distributions and that the decision is related to family income, with those who opt not to roll over having average incomes of $20,000 less. For poorer workers, these assets may be a meaningful part of their ultimate retirement benefits. He also noted that age is an important factor in the leakage analysis. For younger workers, even small distributions can represent significant benefits at the time of retirement.

Mr. O’Brien expressed concern that workers have come to recognize the availability of lump sum distributions upon termination of employment and demand them. He sees this demand beginning to influence defined benefit plan design, with some plans adding lump sum features. Potential solutions should address the source of the demand – for example, whether pre- retirement distributions are used to purchase luxuries or to supplement income during periods of unemployment. In the latter case, providing education about retirement savings or increasing premature distribution excise taxes may not be effective. Policy-makers also should consider the extent to which leakage results from involuntary cash-outs in determining how best to address the issues, Mr. O’Brien observed.

Mr. O’Brien tied the problem of leakage in the private retirement system to the debate over Social Security reform, especially proposals calling for the creation of individual savings accounts. He wondered whether any prohibitions on early access to Social Security accounts could withstand political pressures, given Congress’ past willingness to make individual retirement account (IRA) funds more readily available for non-retirement purposes.

Meeting of July 8, 1998
Summary of Testimony of Francis P. Mulvey
General Accounting Office

Francis Mulvey is the Assistant Director of the Health, Education and Human Services Division of the General Accounting Office. He spoke about the results of a GAO Report entitled, “401(k) Pension Plans: Loan Provisions Enhance Participation But May Affect Income Security for Some.” Senator Judd Gregg requested this research because Congress is concerned about the retirement income of older Americans, particularly in light of the difficulties with the social security system. The GAO Report was issued in October 1997 and is based on data gathered in the 1992 Survey of Consumer Finances prepared by the Federal Reserve and the 1992 Internal Revenue Service Form 5500 filings.

Participation rates for plans that allow loans are about 6 percentage points higher than the plans that do not allow loans. The average participation rate for plans that allow borrowing rises from 55% to 61% for plans that do not offer an employer match. For plans with an employer match, the average participation rate rises from 78% to 83% with a loan provision. Furthermore, average employee contributions are 35% higher in 401(k) plans with loan provisions than the contribution rates of 401(k) plans without loan provisions.

Fewer than 8% of all participants had one or more loans from their plan. The data underlying the GAO Report showed that black Americans and Hispanics are twice as likely to borrow from their 401(k) plans as white Americans are. No significant relationship was found between the decision to borrow the sex, age or marital status of the participant. Attitudes of borrowers and non-borrowers vary in that more borrowers feel it is appropriate to borrow from their retirement plan to finance a car or for living expenses than non-borrowers. Neither group, however, felt that it was appropriate to borrow for a vacation or a luxury item.

Borrowing from a 401(k) plan can reduce the ultimate retirement nest egg. The GAO developed a simulation of retirement income that compared retirement funds available for those who borrow from their 401(k) plan and those who do not borrow. The simulation assumes a $40,000 loan that is repaid over a 10-year period at a 7% interest rate. The simulation further assumes that the account earned an average of 11% otherwise. The results show that the participant’s retirement nest egg was reduced by 5.5% if the participant continued to make contributions during the repayment period and by 27% if the participant suspended contributions over the repayment period.

In conclusion, the loan provision in 401(k) plans is a double-edged sword. Loan provisions increase participation and significantly increase contribution levels. However, the funds available at retirement will likely be lower for plan borrowers, particularly if they suspend plan contributions during the period of loan repayment.

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of August 12, 1998
Summary of Testimony of William Bortz
U.S. Department of Treasury

William Bortz is an Associate Benefits Tax Counsel in the Office of Tax Policy at the Treasury Department. Before joining the Treasury, Mr. Bortz was a partner with the law firm of Dewey Ballentine in New York City. Mr. Bortz has a law degree and a Ph.D. in philosophy from the University of Wisconsin. He has published a number of articles in professional journals on employee benefits.

Mr. Bortz testified on the topic of distributions from qualified plans, and particularly, participant loans from defined contribution plans. He outlined the complicated set of distribution rules as follows:

  • Both defined benefit and defined contribution plans generally prohibit in-service distributions.
  • Both types of plans permit participant loans, although loan provisions rarely are found in defined benefit plans.
  • Profit sharing and stock bonus plans permit in-service distributions upon the attainment of a certain age or the occurrence of a stated event.
  • 401(k) plans permit hardship distributions.
  • Distributions are subject to federal income tax unless they qualify as lump sum distributions and are rolled over into an IRA or another qualified plan.
  • A ten- percent excise tax is imposed on distributions made to a person who has not reached age 59-1/2. Limited exceptions to the penalty are available.
  • Unless the present value of the benefit is less than $5,000, an individual can defer his or her distribution from the plan until they reach normal retirement age. If the present value of the benefit is less than $5,000, the plan sponsor can “force out” the distribution so that the plan sponsor does not have to maintain records of small benefit obligations.

Mr. Bortz noted that Congress has continually tried to “fine tune and tinker” with the law to strike a balance between the availability of funds to participants and appropriate penalties for pre-retirement leakage.

With respect to participant loans, Mr. Bortz outlined the following restrictions:

  • Both ERISA and the Internal Revenue Code provide parallel provisions for loans, including prohibited transaction sanctions for failure to comply with the rules.
  • Loans to substantial owners of companies are not allowed.
  • The disclosure provisions of the Fair Credit Act apply.
  • The law is unsettled as to whether ERISA preempts state usury laws.
  • Loans must have terms that are commercially reasonable.
  • A loan is a taxable distribution if the requirements as set forth in I.R.C. Section 72 (p) are not met.
  • A loan must be repaid over a five-year period in substantially equal installments that are made at least quarterly. A longer term is available for loans secured by a principal residence.
  • The repayment rule is suspended for up to one year during a participant’s leave of absence.
  • Loans cannot exceed one-half the value of the participant’s account balance, with an exception for loans under $10,000.
  • Loans cannot exceed $50,000. This rule is applied by aggregating the outstanding loan balance over a 12-month period.
  • The failure to repay a loan results in a taxable distribution to the participant.
  • A defaulted loan must be reported to the IRS on Form 1099-R.
  • Unless there is a pattern of abuse, the plan is not disqualified solely by reason of defaulted loans, which would otherwise violate the in-service distribution rules.

Mr. Bortz further testified that most loans are repaid through payroll deduction. Accordingly, there are few defaults before termination of employment. In cases where payroll deduction is not used for loan repayments, there is little data about the extent to which defaults occur. The witness speculated that there is a wide range of default rates under these circumstances. Since the participant is repaying his or her own account balance, the normal incentives of a lender to collect the outstanding balance do not apply.

Meeting of August 12, 1998
Summary of Testimony of Billy Beaver
U.S. Department of Labor

Billy Beaver is Chief of the Division of Field Operations for the PWBA’s Office of Enforcement. Mr. Beaver reported that the enforcement program finds problems from time to time concerning participant loans. The types of problems include the following:

  • Lack of compliance with the terms of the plan documents;
  • Incomplete record keeping and/or documentation with respect to the loans;
  • Lack of follow-up in the collection of delinquent loans; and
  • Improper treatment of defaulted loans.

Mr. Beaver testified that most violations are handled through the voluntary compliance program. Litigation by the DOL is infrequent in cases involving loans. Statistical information and trend data concerning violations in the area of participant loans were not available at the time of the meeting.

Mr. Beaver testified that participant loan violations are not a high enforcement priority of the Department at this time. The review of participant loans is not a standard part of every investigation, but violations related to participant loans are frequently detected by PWBA investigations. From time to time, a review of the Form 5500 data reveals a large receivable that is pursued by an investigator. The statistical database of the Department would include answers to Question 27b on Form 5500 which addresses delinquent loans. A targeting run could be made on this data to provide further insight into trends and levels of loan defaults in the future.

A discussion ensued concerning the need for a plan fiduciary to sue a plan participant in order to collect defaulted loan proceeds. The particular issue involved plans that issued a Form 1099-R for the defaulted loan, and did not pursue collection efforts further. Mr. Beaver testified that the issuance of the Form 1099-R is “ a viable way to resolve” the default situation.

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of September 9, 1998
Summary of Testimony of Peter Smail and James McKinney
Fidelity Institutional Retirement Services Company

Peter Smail is President of Fidelity Institutional Retirement Services Company (“Fidelity”). James McKinney is a Senior Vice President of Fidelity. Fidelity is the industry leader in the management and administration of defined contribution plans, with a 10 percent market share of all managed assets. The statistical information presented to the Working Group is based on Fidelity’s 5,000 record keeping clients covering six million plan participants with $316 billion in plan assets (referred to as the “Fidelity universe” for purposes of this summary). Unless otherwise stated, the information covers the twelve-month period ended July 31, 1998.

The account balances of all terminated participants in the Fidelity universe were analyzed. In terms of the account balances, 96 percent of the balances remained in the plan after the event of termination or was rolled over to an IRA or another qualified plan. Only four percent of the dollars was distributed in the form of cash to participants. In terms of numbers of participants, 76 percent of participants either kept their balances in the plan upon termination or rolled the account balances into an IRA or another qualified plan. Twenty-three percent of participants received a cash distribution. In response to questions, Mr. Smail explained that the relatively low rate of plan leakage is attributed to two factors. First, Fidelity has a series of programs in place that educate plan participants about the importance of retirement savings. Second, the interests of the plan participants are aligned with the interests of Fidelity in preserving the assets in the qualified plan.

Fidelity surveyed a sample of plans in the Fidelity universe and found that 93 percent offer hardship withdrawals. Over the three-year period of 1996, 1997 and 1998 (projected), the dollar amount of hardship withdrawals for the entire Fidelity universe has been $462 million, $416 million and $419 million, respectively. The number of hardship withdrawals has been 259 thousand, 327 thousand and 329 thousand, respectively for the same period. Fewer than five percent of all participants take hardship distributions, and less than one percent of plan assets (0.13%) are withdrawn as hardship distributions. As compared to the cash flow into plans from contributions and loan repayments of $33.9 billion, the $419 million in outflow due to hardship distributions is very small. In response to questions, the witnesses explained that participants who call in to the Fidelity service center to request a hardship distribution are often expressing serious financial need for the funds.

Ninety percent of plans in the Fidelity survey offer participant loans. In 1997, the entire Fidelity universe experienced 68,000 loan defaults that represented a total plan outflow of $263 million. For 1998, it is projected that there will be 73,000 loan defaults with a plan outflow of $294 million. These statistics represent one percent of all plan participants in the Fidelity universe and less than one-tenth of one percent of all plan assets (0.09%). Asset leakage is small because virtually all plan sponsors use payroll deduction for loan repayments. Most defaulted loans occur in the accounts of terminated participants because payments are no longer taken as payroll deductions. Nevertheless, only six percent of the total number of loans is defaulted, and less than five percent of the amount of outstanding loans is defaulted. Finally, the amount of cash outflow due to defaulted loans is a tiny percentage of the cash inflow due to contributions and loan repayments.

In summary, 93.35 percent of plan participants have neither a defaulted loan nor a hardship distribution during the course of a year. Less than one quarter of one percent of total assets is leaked from the plan due to hardship distributions or defaulted loans each year. Fidelity found that when they compared similar plans that did and did not offer loans and hardship withdrawals, those that did offer loans and hardship withdrawals generally had a greater participation rate.

The retention efforts at Fidelity stem from a strong emphasis on communication and education of the participants in the plan throughout their period of participation. A separate group of service representatives help participants through the decision-making process when the participant is eligible to receive a distribution. Fidelity makes it easy for participants to roll their account balances into IRAs. It was noted several times that the interests of Fidelity in maintaining the assets is aligned with the policy interests of the government and the savings goals of participants to preserve retirement assets. When asked for recommendations, it was noted that the safe harbor rule which prohibits contributions from a participant for a period of twelve months following a hardship withdrawal is inconsistent with the primary goal of promoting retirement savings, and in light of the information provided, is not needed as a deterrent to withdrawals.

Meeting of September 9, 1998
Summary of Testimony of Anthony P. Rodrigues and Michael J. Fleming
Federal Reserve Bank of New York

Anthony P. Rodrigues and Michael J. Fleming are economists with the Research and Market Analysis Group of the Federal Reserve Bank of New York. Together with William F. Bassett of Brown University, they have published a paper entitled, “How Workers Use 401(k) Plans: The Participation, Contribution, and Withdrawal Decisions.” Their work uses data from the April 1993 Current Population Survey and its Employee Benefits Supplement (CPS). Messrs. Rodrigues and Fleming presented testimony that was based on their research and findings in the area of distributions from pension plans.

The witnesses discussed the trend in employer-sponsored retirement plans from the traditional defined benefit plans to the defined contribution plans. The 401(k) plan is the most prevalent of the defined contribution plans. Over 40 percent of the workforce now are offered defined contribution plans. For half of all workers, the 401(k) plan is the only retirement vehicle offered by their employers. Defined contribution plans have salary reduction features that shift retirement savings decisions from the employer to the worker. Participation in these plans by eligible employees increases with income, age, job tenure, and education. Matching contributions by employers also increases participation.

Defined contribution plans allow pre-retirement distributions. These distributions present to the worker the opportunity to spend or save the distribution. If the distribution is consumed before retirement, it impedes the retirement security of the worker. Defined contribution plans allow workers to take loans from the plans against the account balance. These loans are not considered distributions in the study because they usually are repaid to the plan. On the other hand, hardship distributions are available for immediate needs, and are not repaid to the plan.

Distributions that are made at job separation can be rolled over into another tax-qualified savings vehicle. No taxes or penalties apply to distributions that are rolled over as such. Distributions that are not rolled over are subject to federal income tax, 20% tax withholding, and a 10% penalty; the penalty does not apply to workers who have reached age 59 ½.

Nearly half of all workers report that they have received a lump sum distribution from a retirement plan from a previous job. Only 28% of the recipients who receive lump sum distributions from a 401(k) plan before retirement roll the amounts into another tax-qualified savings vehicle. These distributions represent 56% of the value of the lump sum distributions. Other uses of the distributions are consumption (29% of recipients), reduction of debt (17% of recipients), investment in savings or other financial instruments (11% of recipients), purchase of a house or payment of a mortgage, (7% of recipients) and other investment including business, education or health (8% of recipients).

The witnesses also testified that workers with higher incomes, larger distributions, and a college education are more likely to roll over their distributions into a tax-qualified savings vehicle. Also, but to a lesser extent, older workers, homeowners, single workers and childless workers are more likely to roll over their distributions.

In conclusion, a large fraction of workers who receive distributions do not roll the distributions into other tax-advantaged plans. Workers with higher incomes, larger lump-sum distributions, or a college degree are more likely to roll over their distributions. Many workers do not use their defined contribution plans for retirement savings. In view of the shift in retirement savings to defined contribution plans, consumption of pre-retirement distributions raises concerns about the retirement security of the workforce.

ERISA Advisory Council Working Group on Retirement Plan Leakage

Meeting of October 6, 1998
Summary of Testimony of Congressman Earl Pomeroy (D-ND)
U.S. House of Representatives

Congressman Pomeroy was invited to testify on the issue of portability and, in particular, to discuss H.R. 3503, “The Retirement Account Portability Act of 1998 ” (RAP), which Congressman Pomeroy originally co-sponsored with Congressman Jim Kolbe (R-AR), and which had 54 House co-sponsors. In addition, a companion bill was sponsored in the Senate.

Congressman Pomeroy said that the government has an obligation not only to encourage people to save for retirement, but to help preserve retirement savings for retirement. He became frustrated with provisions in the Internal Revenue Code which make it easier to distribute retirement savings currently rather than to continue to hold the funds for retirement.

Congressman Pomeroy thought a good starting point for improvement was facilitating portability within the defined contribution universe, which is simpler than facilitating portability among defined benefit plans. Currently the type of employer often determines whether defined contribution plans are portable. As an example, Congressman Pomeroy described a nurse from Bismarck, North Dakota who worked for a non-profit hospital which sponsored a Tax Code Section 403(b) tax-deferred annuity retirement savings plan, then worked for the state health department where she continued her retirement savings with a Section 457 deferred compensation retirement savings plan and then went on to work for a private sector for profit hospital which sponsored a Section 401(k) defined contribution retirement savings plan. All three plans are contribution-type plans, with similar objectives, yet under current law none of the plans permit transfers to the others. So, the nurse must maintain three little accounts instead of be afforded the opportunity to consolidate them into a single retirement account. In this situation, Congressman Pomeroy concluded, it is more tempting to cash out and spend the money in relatively small accounts, rather than coordinate or roll them into a single consolidated account.

The primary components of the RAP Act that effect portability are:

  • Allow rollovers of retirement benefits between and among Code Section 457, 403(b), and 401(k) plans and certain types of IRAs, when employees switch jobs;
  • While permitting expanded rollovers, RAP contains no mandate requiring employers to accept rollovers from their new employees.
  • Expand the use of “conduit” IRAs, by allowing workers to move any kind of defined contribution money (pre- or post- tax) into a conduit IRA and then allowing this money to be rolled back into a variety of defined contribution plans.
  • Allow individuals to transfer their deductible IRA funds into their workplace retirement savings accounts.
  • Permit the rollover of after tax employee contributions to a new employer plan or IRA, if the plan or IRA provider agrees to track and report the after-tax portion of the rollover for the individual.
  • Permit the 60 day deadline for rollovers to be extended in cases of natural disaster or military service so that individuals avoid incurring taxes and a 10% premature distribution penalty tax from missing the 60 day rollover deadline.
  • Relax the so-called anti-cutback rule so that a successor employer’s defined contribution plan need not have the same benefit options as the old employer’s plan in order to transfer funds.

In addition to the rollover proposals, RAP calls for faster vesting of employer matching contributions to defined contribution plans. Under current law, employers must be 100% vested after 5 years (5 year “cliff” vesting) or gradually vested increments over 7 years (7 year “graded” vesting). The RAP bill calls for employer contributions to defined contribution plans to vest 100% after 3 years or gradual vesting in increments over 6 years. Because women have shorter job tenure than men (3.5 vs. 4 years), according to Congressman Pomeroy, the portability and vesting provisions would be of particular benefit to women workers.

In response to questions from the Work Group members, Congressman Pomeroy testified that the RAP bill would not have a significant revenue impact. Congressman Pomeroy also stated that the RAP bill did not mandate that employers accept rollover contributions because mandates are politically unacceptable to many in Congress and he was seeking to craft a bill which would attract broad bipartisan support.