Outdated 401(k) Rules Are Shortchanging Americans
Many company 401(k) retirement savings plans could use a swift kick into the 21st century, according to a new report from the U.S. Government Accountability Office.
A number of longtime 401(k) plan designs fail to reflect a new, more mobile workforce, hurting employees’ ability to save, according to the report (PDF). Among the arguably outmoded practices: a requirement at some plans that workers be 21 before becoming eligible to join a 401(k), that employees finish one year of service before being eligible to join a plan and then wait an additional year to be eligible for company matching funds, and that employees wait up to six years before laying claim to all those contributions.
Some of those practices save companies administrative hassles when workers leave after only a short time, and others help reduce turnover, employers and retirement experts told the GAO. But as the report notes, Bureau of Labor Statistics data show the median tenure for private sector workers in 2014 sits at 4.1 years, and federal data found that for workers aged 18 to 48, the average number of jobs held was more than 11 1 .
“Being ineligible to save in a new employer’s plan for 1 year on 11 occasions, especially occurring more frequently early in a worker’s career, may result in $411,439 less retirement savings ($111,454 in 2016 dollars),” according to the GAO’s projections.
Readers could take issue with some of those projections. The GAO assumed that someone works continuously from age 18 to 66 and that the stock market’s nominal long-term return will be 9.1 percent. It arrived at that by adding the Social Security Trustee’s projected annual trust fund real interest rate of 2.9 percent to an inflation projection of 2.7 percent, topping it off with an “estimated long-term premium of 3.5 percentage points.” 2 The GAO stresses that its report focused on a limited number of 401(k) plans—80 in total—ranging from ones with fewer than 100 participants to some with more than 5,000.
But many of the observations taken from the 80 funds were echoed in industry data from sources that included Vanguard Group and the Plan Sponsor Council of America.
Here are a few other hypothetical price tags calculated by the GAO:
- The potential cost 3 to an 18-year-old worker of having to wait until age 21 to join a 401(k) plan, since he or she is deprived of a 3 percent employee match from age 18 to 20, could be $134,456 less in savings by the time the worker turns 67, or $36,422 in 2016 dollars.
- One practice the GAO also examined was the rule that workers be employed on the last day of the year to get an employer’s matching contribution. A hypothetical person making around $71,000, who at age 30 left a job before the last day of the year with a 401(k) that matched 3 percent of employee contributions, could give up an estimated $29,297 by the age of 67, or $8,150 in 2016 dollars.
- Vesting policies, where you might own 20 percent of your company’s match after two years—and gradually vest over five years—can have a big effect on projected retirement savings. An even greater impact comes when companies use the “cliff” style of vesting, by which employees must wait a full three years to be vested. If they leave before then, they don’t get any of the company match. Say an employee left a job with such a plan at age 20 after having worked there for only two years and then left a second job with cliff vesting after only two years at age 40. If the plans require three years of service to vest in any matching contributions, the amount forfeited by an employee could add up to $81,743 by retirement, or $22,142 in 2016 dollars, the GAO projects. 4
The rules on vesting for employer matching contributions are now 15 years old, the GAO said, and “a re-evaluation of these caps would help to assess whether they unduly reduce the retirement savings of today’s mobile workers.” Seventy of the 80 plans in the GAO report hadn’t changed their vesting policy in the past five years. Vanguard data showed that more than 55 percent of its plans have vesting policies for matching contributions, with the most common being a five-year requirement.
Vesting policies may appeal to employers for reasons that aren’t immediately obvious. If an employee leaves before they are fully vested in an employer match, that forfeited amount of money can, and often does, go to either lessen the amount the company needs to contribute to the company match or to lessen employer expenses for the plan.
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This was for the period from 1978 to 2012.
Indeed, that's 6.4 percent when you factor in inflation, but it's still a lot higher than many stock market experts are forecasting.
The GAO assumed employees would defer 5.3 percent of salary, an employer match of 3 percent, contributions from both the employer and employee on a per-pay period basis, "and a return reflecting a mixed portfolio adjusted annually to decrease the allocation to equities over time."
From the report: "In 2016 dollars, the forfeited employer contributions at age 20 could be worth $8,634 at retirement and those forfeited at age 40 could be worth $13,509 at retirement, for a total of $22,143. For this illustration we assumed: the individual worked during ages 19 and 20 and ages 39 and 40; a cliff vesting policy because it is simpler to illustrate than a graduated policy; and a three-year vesting policy, which is the most commonly used cliff vesting policy, according to the Plan Sponsor Council of America survey for plan year 2013."