Millennials and Retirement

In today’s changing economic climate, younger generations are facing new obstacles in saving for retirement. In contrast to previous generations, Millennials are set to have fewer Social Security benefits, as well as less personal retirement savings from a 401(k) or other defined contribution plan, due today’s low returns market, and increasing medical costs. As a result of these obstacles, many Millennials worry about the security of their retirement future.

A recent study has shown that more than 60% of Millennials are unsure about when they will be able to retire, if they even get the chance at all. While 59% or millennials making $150k+ a year believe that will be financially secure enough to retire when they choose, only 19% of those making less than $35k a year feel this same level of security.

A large portion of this lack of retirement preparedness stems from an imminent decrease in pension and Social Security benefits. This lack of faith in government-sponsored benefits is understandable, considering that the Social Security Old-Age and Survivors Insurance (OASI) trust fund is set to run out in 2035, eight years before the first Millennials reach retirement age. Furthermore, the Disability Income (DI) and the Health Insurance (HI) trust funds are both set to run out in 2023, a full twenty years before the first Millennials reach retirement age.[1] While there is a good chance that these programs will be officially retained throughout Millennial retirement, they will all have to be restructured to make up for the lack of funds. This means that the program benefits will be decreased, while workforce taxes are increased over the coming years. This means not only fewer benefits in retirement, but also less pocketed income for today’s workforce, potentially forcing some to reduce their annual retirement contributions.

Also, despite the reduced government benefits, increasing healthcare costs, and low-returns market, close to half (46%) of Millennials have not yet started saving for retirement for various reasons, the largest of which is wanting to pay off current debts before starting retirement saving[2].

In contrast to this, in an effort to combat the current economic conditions, close to two-thirds (63%) of Millennials have actively sought out information to guide their financial decisions and retirement planning, in comparison to only 34% of Baby Boomers.[3] When seeking financial guidance, Millennials tend to ask for the most help with calculating their needed retirement savings (32%), finding strategies to help pay off their debt (32%), creating a retirement savings strategy (31%), and determining appropriate investments to boost their savings (28%).[4]

Sidecar Accounts

Before the retirement community shifted to a pretax 401(k) system in the 1980s, many companies offered a supplemental savings account (to be used for short-term emergencies) to complement the defined benefit (DB) plans of their employees. These supplemental savings accounts are nearly identical to what are known today as “sidecar accounts.” A sidecar account is essentially an additional savings account that is directly linked to an employee’s existing retirement account. Under the sidecar system, funds are set aside in a short-term savings account to be used in times of emergency, in an effort to prevent the harsh tax penalties associated with hardship withdrawals from an employee’s retirement plan. Under these accounts, money will be taken from an employee’s paycheck and set aside until certain “buffer” threshold is reached. After this “buffer” amount is reached, all future funds will go directly into the employee’s retirement account, just as they would normally. To ensure a consistent, adequate amount of emergency funds between the employee and his or her retirement account, the funds will be replenished each time a withdrawal is made.

Unlike with a DB account, a participant in a defined contribution (DC) plan has the option of using some or all of his/her funds for non-retirement related expenses, mainly in times of hardship. Because these emergency funds are more readily available, one in four DC plan participants will, at some point during his or her career, use some or all of his/her savings for non-retirement based needs. This is known as leakage. Because of the increasing amount of leakage from DC accounts, a survey was conducted by LIMA, which showed that 2/3 of workers in today’s market have some interest in setting up an automatic emergency savings account in addition to their retirement account. Furthermore, 89% of employers have shown interest in offering this product. There have been further studies conducted, revealing that if an account can be psychologically associated with future income and long-term assets, with less availability for withdrawal, account holders will be more successful in resisting the temptation of making a hardship withdrawal or cash out. They will thus be more likely to prevent retirement leakage. For all of these reasons, sidecar accounts are gaining ground as a viable solution to combat account leakage in today’s retirement community.

Although these accounts come with many benefits, there are many financial and regulatory concerns surrounding them. The first among these is: who should be responsible for delivering the account to customers? Due to their already-established payroll-based structure for retirement contributions, employers seem to be the most logical option for delivering these accounts. An employer would be able to package the 401(k) and sidecar accounts together and enroll workers in both simultaneously. As simple as it may sound, many employers may not be ready to take on the added responsibility and administrative costs associated with this new plan benefit.

So, if linking the two accounts is not a viable option for a company, there are still several other paths to choose from:

  • Individually sold accounts: While still a viable option, this path is rarely chosen because linking the sidecar account with the normal retirement account can be complicated. Secondly, it can be difficult to integrate the second account with the employer’s payroll system so that savings are automatically deducted from paychecks, just like they would be with normal retirement deferral percentages.
  • MyRA: This plan option was offered by the US Treasury Department and is set up in such a way that it could be split up into both long-term and sidecar accounts. Under this system employers could more easily fund their employees’ accounts through payroll deduction.
  • Secure Choice: These retirement programs are state-led, but privately managed, and automatically enroll workers into their own IRA. Oregon, a Secure Choice state, has expressed interest in offering this form of sidecar account as an option to retirement savers. These programs use Roth IRAs, meaning they can more easily be treated as hybrid accounts in order to serve both short-and long-term needs. A downside to this is that transfers from an IRA can take up to three business days, so they may not be the best option in times of sudden hardship where funds would be needed immediately.

These options offer a lot of food for thought when it comes to helping employees protect their retirement savings. But, once an account structure has been chosen, the next step is to decide whether or not to offer automatic enrollment. If this turns out to be the best option, there are several ways to go about it, but each has its own set of serious disadvantages.[1] In an effort to combat these issues, one might look to active choice as the most viable option. Especially since research has shown that forcing employees into an active choice can greatly increase participation (even if not quite to the same levels achieved by automatic enrollment).

 

 

We believe the time is right to move from theoretical discussions about sidecar accounts into concrete action and real-world testing. Indeed, many researchers and policymakers are answering the call, actively exploring the possibility of pilot testing sidecar models. As they grapple with next steps, we hope that this analysis can help illuminate the key design choices they will face and the main considerations that should inform their decisions. We acknowledge that a sidecar account, if designed poorly, could be yet another complicated, parallel savings structure in the sea of 401(k)s, 403(b)s, IRAs, HSAs, and 529s. But if done well, we strongly believe that a sidecar account could improve the financial well-being and security of Americans in both the short and long term — an outcome that is good not only for families, but for the economy overall.

The Aspen Institute: Financial Security Program

[1] Aspen Institute: Financial Security Program. Driving Retirement Innovation: Can Sidecar Accounts Meet Consumers’ Short and Long-Term Financial Needs? Pg. 7

Hardship Withdrawals from 401(k) and 403(b) Plans

On February 23, 2017, the Internal Revenue Service released its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans. And on March 7, 2017 they released a similar memorandum regarding section 403(b) plans. These two statements outlined the requirements for safe harbor hardships in an effort to better inform the public about which events allow a plan participant to qualify for such a distribution. They also outlined steps to follow for determining whether or not a participant is eligible for a hardship distribution. Under these regulations, section 403(b) plans are subject to the same rules as the 401(k) guidelines outlined below.

The IRS gives two main steps when determining whether or not a distribution request meets the “immediate and heavy” financial need requirement:

Step 1:

  • Determine whether the employer or third-party administrator, prior to making a distribution, obtains: (a) source documents (such as estimates, contracts, bills and statements from third parties); or (b) a summary (in paper, electronic format, or telephone records) of the information contained in source documents.
    • If a summary of information on source documents is used, determine whether the employer or third-party administrator provides the employee notifications required on Attachment I prior to making a hardship distribution.

Step 2:

  • If the employer or third-party administrator obtains source documents under Step 1(i)(a), review the documents to determine if they substantiate the hardship distribution.
  • If the employer or third-party administrator obtains a summary of information on source documents under Step 1(i)(b), review the summary to determine whether it contains the relevant items listed on Attachment I.
  • If the notification provided to employees in Step 1(ii) or the information reviewed in Step 2(ii) is incomplete or inconsistent on its face, you may ask for source documents from the employer or third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.
  • If the summary of information reviewed in Step 2(ii) is complete and consistent but you find employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for source documents from the employer or third-party administrator to substantiate the distributions. Examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.
  • If a third-party administrator obtains a summary of information contained in source documents under Step 1(i)(b), determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.

In an article, entitled Do’s and Don’ts of Hardship Distributions, the IRS gives further advice regarding what to do and what not to do when determining hardship eligibility. They first suggest reviewing the terms of hardship distribution outlined in the plan document, including:

  • Whether or not the plan allows for hardship distributions
  • The procedures the employee must follow to make the distribution request
  • The plan’s definition of what qualifies as a hardship
  • Any limits to the amount/type of funds eligible for hardship distribution

 

After taking all necessary precautions to make sure the plan allows for the type of withdrawal being requested, the employee must then make sure the distribution is on account of an “immediate and heavy financial need” as defined under § 1.401(k)-1(d)(3)(iii)(B) of the Income Tax Regulations. The distribution will be considered in compliance with these regulations if it is for one or more of the following:

  • Expenses for medical care deductible under section 213(d) for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
      • Costs directly related to the purchase of a principal residence;
      • Payment of tuition, related educational fees, room and board expenses for up to the next 12 months of post-secondary education for the employee or the employee’s spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan;
      • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
      • Payments for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents (as defined in section 152) or primary beneficiary under the plan; or
      • Expenses for the repair of damages to the employee’s principal residence that would qualify for the casualty deduction under section 165,

and the employee has provided written representation that the need cannot be adequately addressed from other sources such as:

  • Through reimbursement or compensation by insurance or otherwise;
      • By liquidating the employee’s assets;
      • By ceasing elective deferrals or employee contributions under the plan; or
      • By other distributions or nontaxable loans from plans maintained by the employer or by another employer, or by borrowing from commercial sources on reasonable commercial terms in an amount sufficient to satisfy the need,

or if a need can’t be relieved by one of the actions listed above without increasing the amount of need. For example, a plan loan can’t reasonably relieve the need for funds to purchase a principal residence if the loan would disqualify the employee from obtaining other necessary financing.

 

Once it has been determined that the plan allows for hardship distributions, and the sources available for distribution have been determined, the following steps should be taken to begin the distribution process:

  • Obtain a statement/verification of the employee’s hardship as required by the plan document’s terms
      • Determine that the exact nature of the employee’s hardship qualifies for a distribution under the plan
      • Document (following plan’s guidelines) that the employee has exhausted all other options outside of the hardship distribution
      • Document the employee’s lack of other resources (spousal/minor children’s assets) if applicable
      • Make sure the distribution amount does not exceed amount required to satisfy the employee’s immediate financial need (may be adjusted to account for any taxes or penalties at time of distribution)
      • Make sure the amount of distribution does not exceed any limits under the plan, and consists only of eligible amounts
      • Let the employee know if receival of the distribution will suspend them from making contributions to the plan for at least six months

If your plan is not properly making hardship distributions, go here to correct any mistakes: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-hardship-distributions-were-not-made-properly

 

The IRS also released a list of responses to some FAQs regarding hardship withdrawals, such as:

  • What is the maximum amount of elective contributions that can be distributed as a hardship distribution from a 401(k) plan?
      • Cannot be more than the amount of the employee’s total elective contributions, including designated Roth contributions, as of the date of distribution reduced by the amount of previous distributions of elective contributions
      • Generally does not include earnings, qualified non-elective contributions, or qualified matching contributions unless the plan specifically allows for certain grandfathered amounts to be included
      • If provided by the plan, other amounts such as regular matching contributions and discretionary profit-sharing contributions can also be distributed in times of hardship
    • What are the consequences of taking a hardship distribution of elective contributions from a 401(k) plan?
      • Hardship distributions are eligible to be included in gross income (unless they consist of designated Roth contributions) and may be subject to additional taxes on early distributions of elective contributions
      • Unlike loans, hardship distributions are not repaid to the plan, so they will result in a permanent reduction in the employee’s account balance under the plan
      • A hardship distribution cannot be rolled over into an IRA or other qualified plan (§ 402(c)(4))
      • Hardship distributions may be subject to the 10% early distribution tax on distributions made prior to reaching age 59 ½
    • Are hardship distributions allowed from an IRA?
      • There is generally no limit when an IRA owner may take a distribution from his/her IRA, but there may be unfavorable tax consequences including an additional tax on early distributions
      • Certain distributions from an IRA that are used for expenses similar to those that may be eligible for hardship distributions from a retirement plan are exempt from the additional tax on early distributions
      • Any distribution from an IRA for higher education expenses or to finance a first-time home purchase is exempt from the early distribution tax (§ 72(t)(2)(E),(F))

In its Substantiation Guidelines for Safe-Harbor Distributions from Section 401(k) Plans, the IRS also gave a more detailed outline of the types of documentation required for each hardship distribution:

  • Notifications the Employer/Administrator must provide to the employee:
        • Notification that the distribution is taxable, and additional taxes could apply
        • The distribution amount cannot be more than the amount required to solve the “immediate and heavy financial need”
        • Earnings on elective contributions from QNEC or QMAC accounts are not eligible for hardship distribution
        • The recipient must preserve all source documents and make them available at any time, upon request, to the employer or administrator
      • General information required for a hardship request:
        • Participant name
        • Total cost of the event causing hardship
        • Amount of distribution being requested
        • Certification (provided by participant) that all information provided is true and accurate
        • Specific information required on deemed hardships
      • Medical care:
        • Name of individual who incurred the medical expenses
        • Above’s relationship to the participant
        • The purpose of medical care provided
        • Name and address of service provider
        • Total cost of medical expenses not covered by insurance
      • Purchase of principal residence:
        • Will this be the participant’s principal residence?
        • Residence address
        • Purchase price
        • Types of costs/expenses covered by withdrawal (down-payment, closing costs, and/or title fees)
        • Name and address of lender
        • Purchase/sale agreement date
        • Date of closing
      • Educational payments:
        • Name of individual on whose behalf the payments are being made
        • Above individual’s relationship to the participant
        • Name and address of educational institution
        • Categories of payments involved
        • Period covered by the educational payments (beginning and end dates of up to 12 months)
      • Foreclosure/eviction from principal residence:
        • Is this the participant’s principal residence?
        • Residence address
        • Is this a foreclosure or eviction?
        • Name and address of party that issued foreclosure/eviction notice
        • Date of foreclosure/eviction notice
        • Payment due date in order to avoid foreclosure/eviction
      • Funeral and burial expenses:
        • Name of deceased
        • Relationship to participant
        • Date of death
        • Name and address of service provider (funeral home, cemetery, etc.)
      • Damage repairs to principal residence:
        • Is this the principal residence of the participant?
        • Address of residence that sustained damage
        • Description of cause of damage, including date of the casualty loss
        • Describe repairs required, including date(s) of repair (whether still in progress or already completed)

 

Lastly, in their 401(k) Plan Fix-It Guide: Hardship distributions weren’t made properly article, the IRS also gave some helpful pointers in determining whether or not a company’s hardship distribution program is being abused or poorly managed. The first warning sign is that too many hardship requests are being made by one group or division; the second is that requests for distributions from multiple employees appear identical, because each situation should have its own individual circumstances; the third and last warning that they offer is to beware of instances where only the highly compensated employees have hardship distributions, because this may be a sign that the rank-and-file employees have not been properly notified of the availability of hardship distributions under their plan.

 

 

 

 

https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-hardship-distributions-were-not-made-properly

https://www.irs.gov/retirement-plans/dos-and-donts-of-hardship-distributions

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions

Better Solutions for Today’s Retirement

With the introduction of 401(k) plans in 1980, the responsibility for retirement contributions shifted from the employer to the employee. Unfortunately, the employee had no way of gauging what those contributions should be, or how the contributions should be invested. Thirty-six years later, little has changed.

As we near the first wave of retirement for those whose retirement will be funded largely through 401(k) contribution plans, it’s useful to ask: How did we get here? and What can improve the situation?

Mid-Century Workers and Pension Plans

Pension plans, more precisely called defined benefit plans, were very effective for employees because they did exactly that: They defined the benefit. The employer was responsible for funding the future obligation of providing a stated benefit, or pension, to retired employees. The funding obligation was based on actuarial assumptions and expected investment returns. Lower expected investment returns meant that employers needed to make larger contributions to meet the benefit obligation. Of course, higher investment returns reduced the employer’s funding obligation.

Employers certainly had an incentive to reduce their contribution cost. Aggressive employers utilized an aggressive investment strategy, resulting in wide fluctuations of investment returns. Those fluctuations meant less stability in long-term funding expectations.

In a complex, competitive business environment, the challenge of meeting future obligations with the addition of each new employee meant less short-term flexibility—in other words, available cash—to quickly adapt an ever-changing business climate.

Next: Profit-Sharing

Profit-sharing plans were the first step for employers to alleviate the funding obligation of defined benefit plans. Instead of defining the benefit, employers could define the contribution as a fixed cost, regardless of investment returns.

Initially the employer’s contribution was similar to that of the defined benefit plan. The primary difference was the unfunded liability, created either by market fluctuations or failed aggressive investment strategies.

401(k): Employees Take the Reins

Under a 401(k) plan, the employee is tasked with defining their income needs in retirement, determining the inputs (inflation, expected market returns, etc.), calculating the necessary contribution, and periodically recalculating and adjusting based on ever-changing assumptions. Even for the most financially astute employee-investor, this can be a daunting task that can quickly break down, leaving the retiree in a precarious situation. Unfortunately, this is where most employees have ended up.

Maintaining the status-quo will continue to produce failed outcomes. Progressive employers who realize and appreciate the value of their employees will take action to clearly define a path to retirement, and alleviate the planning burden employees face. Transitioning a 401(k) plan to a defined benefit-styled plan can

  • simplify the retirement planning process,
  • produce sustainable retirement outcomes, and
  • empower employees to make the decisions that are right for them.

This approach focuses on what’s needed to achieve retirement readiness, and less on the employer’s match. flexComp provides a framework and management platform that benefits employers, advisers, and employees. Using flexComp, employers can make more informed decisions for the betterment of their workforce. flexComp helps advisers effectively manage investment portfolios that focus on outcomes. Employees using flexComp can be empowered to make lifestyle decisions on their terms, instead of forced decisions at retirement.

Better outcomes require better solutions.

Employee Investment Outcomes and the New Fiduciary Standard

When Section 401(k) became a permanent provision of the Internal Revenue Code in 1980, a seismic shift occurred in American workers’ preparation for retirement. The responsibility for contribution and investment decisions shifted from employers to employees.

Before 1980, companies that offered a retirement plan were required to fund them. That meant that the employer alone bore the contribution and investment responsibilities.

In those defined benefit plans, if the investment returns were less than expected, then the employer’s funding obligation increased, to offset the shortfall on investment returns. The employer was tasked with achieving sustainable investment outcomes to support their employees throughout their retirement years.

With the introduction of 401(k) plans, contributions became the responsibility of the employee. Moreover, they have had to decide an adequate savings rate and become investment savvy.

Employee-directed Retirement Investment Falls Short

Employees have, overall, not been up to these tasks. This shift to a 401(k) retirement world thus ushered in an era in which employees were inadequately prepared to face the tasks at hand.

Early on, participants had no guidance on the how much they should be saving for retirement or how those funds should be invested.

The Department of Labor has created numerous regulations over the past 36 years to ensure employees have the information and resources needed to make informed and educated decisions about their retirement savings.

Not surprisingly, insurance companies and financial services firms jumped into the void of information, and developed slide rules, websites, online calculators, glide path funds, target date funds, custom QDIAs, and a plethora of other tools and products to serve the fledging 401(k) investor.

The outcome of these endeavors has been disappointing, to say the least.  With the first generation of 401(k) participants approaching retirement, the reality of inadequate preparation of is beginning to set in.

Retirement Unpreparedness Meets New Fiduciary Duties

The average account balance for the typical participant lies far below the threshold needed for a sustainable retirement income. The education, tools, and resources provided by employers, their advisors, and the industry have left many ill-prepared for retirement. This void is being addressed by longer working careers, government intervention, and an opportunistic legal system. [is this common knowledge in the industry? If not, spell out what are you referring to here re the legal system]

Public school systems have been sued over failed outcomes by their students, but the courts have been reluctant to rule in favor of the parents and students in such cases. The potential liability would not be in the best interest of school systems and the public good.

While a standard of care is mandated by law and periodic achievement test can demonstrate some level of proficiency in the public education system, it is doubtful the 401(k) industry will be afforded the same latitude.

Against this background, we have the passage of the new fiduciary rule for investment advisors. It elevates the standard of care investment advisors must use to the highest level. No longer should the products and services simply be suitable; they must also be in the best interest of plan participants.

“In the best interest of plan participants” implies a quantifiable outcome. To protect themselves, and help their employees make wiser investment and saving decisions, employers would be well served to quantify the progress participants are making toward retirement.

Education alone is not enough. Tools and resources alone are not enough.

The new fiduciary rule is only the beginning of accountability standards employers and service providers can expect in the future. Plan sponsors need to ensure that they have appropriate, quantifiable measures in place, so they can demonstrate that participants have a path to achieving retirement readiness.

Defining and achieving sustainable outcomes mitigates the employer’s liability while improving productivity and employee morale.

Employees & Short-Term Value

In today’s world of instant gratification, it’s no wonder that workers value short-term benefits the most. According to a worldwide study of more than 10,000 workers conducted by Mercer, a salary increase was preferred over all types of benefits.

While saving for retirement may seem to some like saving for a stranger, U.S. workers did rank DC plans and DC matches as the second and third most popular benefit — topped only by health care. In all, 74% of American workers were concerned about retirement. This is not surprising given the fact that 72% defer less than 10%. Levels of concerned varied widely depending on gender, age, ethnicity and industry.

The trend setters in the DC market are generally larger companies, but smaller employers create more jobs. Most small business owners are more concerned about the uncertain economy and taxes than about providing benefits to employees.

While DC plans are important, other than fiduciary liability and some administrative work — much of which can be outsourced — they cost the employer virtually nothing compared with the cost of providing health benefits. That’s important too.

With concern about retirement high among workers — most of whom are not on track to replace healthy percentages of income in retirement — the Mercer research shows that employers can attract better workers by not only making DC plans available at minimal or no cost and with limited effort and liability, but also by providing some sort of financial incentive, like a match that appeals to workers’ growing need for instant gratification — but also to their longer-term concerns about their retirement years.