Preventing Leakage in the 401k Retirement System: Recent Legislation and Industry Partnerships

The 401k retirement system is a crucial component of the U.S. retirement landscape, providing tax-advantaged savings opportunities for millions of workers. However, a significant issue has emerged in recent years: the problem of 401k plan “leakage.” This refers to the billions of dollars that are withdrawn from the system each year when workers cash out their accounts upon changing jobs. This leakage can have detrimental consequences for individuals’ retirement savings and the overall retirement system.

According to the Employee Benefit Research Institute (EBRI), approximately 40% of workers who leave a job cash out their 401k plans each year, amounting to $92.4 billion in 2015. Research suggests that much of this loss is due to “friction” – the ease of taking a check instead of going through the multistep process of moving their money to a new 401k plan or an individual retirement account (IRA).

The 401k ecosystem would have almost $2 trillion more over a 40-year period if workers didn’t cash out their accounts, EBRI estimated. However, recent legislation and industry partnerships have emerged to help reduce friction and plug existing leaks.

One such piece of legislation is Secure 2.0, which has gained momentum in the last few years. This legislation aims to keep more money in the retirement system by disallowing employers from cashing out balances of $1,000 to $5,000 and instead requiring them to roll the funds to an IRA in the respective workers’ names. Secure 2.0 raised the upper limit to $7,000 starting in 2024.

While this IRA workaround preserves more money in the retirement system, it’s an imperfect solution. Rolled-over assets are generally held in cash-like investments, such as money market funds, until investors decide to invest those assets differently. There, they earn relatively little interest while fees whittle away at the balance. Moreover, many investors ultimately cash out those IRAs.

To further stem leakage, six of the largest administrators of 401k-type plans – Alight Solutions, Empower, Fidelity Investments, Principal, TIAA, and Vanguard Group – teamed up on an “auto portability” initiative in November 2023. This initiative aims to automatically transfer small balances – $7,000 or less – to workers’ new jobs, unless they elect otherwise. This way, workers’ savings left behind wouldn’t be cashed out or rolled to an IRA and potentially forgotten.

Auto portability is essentially a “very large exchange mechanism” within the 401k industry, said Spencer Williams, founder of Retirement Clearinghouse, which administers such accounts. It leverages the same hands-off approach of other popular 401k features, such as automatic enrollment, and takes advantage of workers’ tendency toward inaction in their favor.

At 70% market coverage, auto portability is expected to reconnect about 3 million people a year with 401k accounts they left behind upon job change. The largest benefits accrue to young workers, low earners, minorities, and women, the groups most likely to cash out and have the smallest balances.

Moreover, the U.S. Labor Department is also working on a “lost and found” for old, forgotten retirement accounts by the end of 2024. This public online registry will help workers locate plan benefits they may be owed and identify who to contact to access them.

In conclusion, the issue of 401k plan leakage is a significant concern for individuals’ retirement savings and the overall retirement system. Recent legislation and industry partnerships, such as Secure 2.0 and auto portability, have emerged to help reduce friction and plug existing leaks. These initiatives aim to keep more money in the retirement system and ultimately help more people have more money when they retire.