Let’s Rescue the 401(k) & 457 Plans Before It’s Too Late

Everyday, we see a new article or study telling us of the shortcomings of IRC Section 401(k), 457, and 403(b) plans.  On June 23, 2018, the Wall Street Journal published an excellent article titled  “Time Bomb Looms for Aging America”. As with many others, this is an excellent article.

The bottom line (again) is that design flaws in the legislation, lack of a coherent national pension policy, and overall poor savings habits of Americans are combining to create a perfect storm that will lead to poverty in retirement for millions of Americans.  It’s time to fix the structure of retirement in America, and the first step is to change the design of defined contribution plans.

Pension Plans Instead of Savings Plans

There have been lots of legislative changes over the past 20 years that focused at putting money into these plans, and encouraging saving.  While auto-enrollment and default savings options have certainly helped, they have not addressed the fundamental weakness of defined contribution plans.  That weakness is the easy ability to get money out of these plans before retirement.  Pension plans are for retirement, and they should be designed that way.

Unfortunately, Congress, the retirement industry, and plan sponsors have encouraged all sorts of legislation making it easier to get money out of these plans before retirement.   That has been a tragic mistake. Loans, financial hardship, availability of cash upon termination of employment and a number of other features have clearly given most American the impression these plans can be used as a piggy bank for savings instead of long term pension plans.

It’s time to change the laws so all defined contribution plans become pension plans instead of savings plans:

  1. Eliminate loans. If an employee needs cash for certain needs then they should go to a bank or other institution to take care of that need.  Loaning out a portion of your future retirement income never made any sense. The argument was that employees are more likely to join these plans if they know they can get the money out when they need it.  Think about it.  Does that really make any sense?  If this is a pension plan for retirement, employees should know that when they sign up and not be enticed to join on the premise the funds will be available before they retire.

 

  1. Eliminate Financial Hardship and Unforeseeable Emergency Withdrawals.  Yes, I know it sounds cruel, but in my 40 years in the pension business I have seen all manner of silly and irresponsible requests for withdrawals from savings plans that were totally unnecessary.  That fact that getting a withdrawal from your retirement account is easier than getting money from a bank makes no sense at all.  Everyone encounters hardships, financial or otherwise in their life.  I have seen hundreds of examples of a person making a hardship withdrawal because they just couldn’t say no to their kid, their spouse, or other relative who knew they could help them out by making a withdrawal from their retirement account.  If such withdrawals weren’t possible, employees wouldn’t feel pressured by relatives or family to take money from their retirement savings. That simply would not be an option, which is a good deal for the employee in the pension plan.

 And, consider the time and expense plan sponsors have to devote to considering    hardship applications, and the often humiliating financial and personal disclosure that goes with it for the employee. Surely there must be a better way.  Banks, credit  unions and other options exist in the public and private sector which would be better suited to dealing with such hardships or emergencies.

  1. No Cash Option at Termination of Employment.  Rollovers to another plan upon subsequent employment would be the only option. Alternatively, a special type of Rollover IRA would be available but the ONLY way money can be taken from a Rollover IRA would be to combine it with an account from a future employer, or begin making withdrawals at age 65 or later.

 

  1. Account Available at Full Retirement. Lastly, any withdrawals from these accounts would be at normal retirement age or later.  Normal retirement age should be defined as the full normal retirement age under Social Security.  The only exception would be for disability, using the Social Security definition of disability.  So, if Social Security (or your public employee pension plan) certified your disability for purposes of income from the pension plan or Social Security, then your defined contribution funds would be available concurrently.

 

  1. Reduced Taxes for Withdrawals Over Life Expectancy.  Payouts during retirement would be subject to ordinary income tax, EXCEPT for payments made out over a period of time that is at least 2/3 of your life expectancy. The goal here is to encourage steady payments from your defined contribution plans that would help you budget your income over a reasonable period of time somewhat correlated to your life expectancy.  If you do that, then a portion of your income each year is not subject to tax.

Gee, These Changes Seem Pretty Extreme!  

Yes, in a sense they are, but let’s remember that Americans need pension plans, not savings plans or short-term piggy banks. The rules would be very similar to those that apply to defined benefit pension plans.  One of the great features of a defined benefit pension plan is that the funds are not available until retirement.  That’s the whole point.

We’ve spent too much time making defined contribution plans as leaky as a sieve.  And let’s remember that the changes above will make these plans much less expensive to administer.  Without loans, hardship applications and costly IRA rollovers upon separation of service, expenses for administration and service will reduce over time.

The fact is that defined contribution plans can’t work effectively unless we design them as actual pension plans, and not savings plans or piggy banks.

 

This article is for information purposes only.  It is not legal or tax advice.  Readers should seek the advice of their legal and tax counsels before contemplating action on this information. 

Copyright Gregory Seller Consulting, LLC