Americans now have much more money in IRAs than in 401(k) accounts. Why this makes workers more vulnerable. – Center for Retirement Research
Our system is also much less efficient because there are fewer protections and guardrails.
The most extraordinary development in the U.S. private sector retirement system is not the shift from old-fashioned defined benefit plans that began around 1980 and is almost complete, but the shift from 401(k) plans, which replaced defined benefit plans, to individual retirement accounts (IRAs). Total IRA assets now exceed the funds held in 401(k)s by $7 trillion (see Figure 1).
The transition from 401(k)s to IRAs moves employee funds into a different regulatory environment. 401(k) plans are covered by the Employee Retirement Income Security Act of 1974 (ERISA), which requires plan sponsors to operate as fiduciaries and act at all times in the best interests of plan participants. By contrast, the standards of conduct for broker-dealers selling IRA investments are far less protective than ERISA's fiduciary duties of loyalty and prudence, which courts have consistently described as “the highest standard known to the law.” Additionally, in a 401(k) environment, there is greater emphasis on disclosing expenses in an easy-to-understand format than in an IRA. And, most importantly, a 401(k) puts more emphasis than an IRA on keeping funds in the plan until retirement.
In fact, all withdrawals from 401(k) plans and traditional IRAs before an employee reaches age 59½ are subject to a 10% penalty (in addition to federal and state income taxes). Exceptions include distribution of large medical expenses, hardship caused by permanent and total disability, and periodic payments over a lifetime. However, IRAs provide withdrawals for three other reasons: to pay for higher education; up to $10,000 to purchase a new home; and to pay for health insurance if you have been unemployed for more than 12 weeks.
In addition to being exempt from the 10% penalty tax, the barriers to accessing funds for an IRA are much lower than for a 401(k). Importantly, 401(k) withdrawals can only be made due to a job change or hardship, whereas IRA withdrawals can be made at any time and without good cause. Additionally, 401(k) hardship withdrawals involve interaction with plan administrators, filing of documents, and, at least in theory, justification for the withdrawal. The emotional and practical burden of this multi-stage process can hinder withdrawals. In contrast, IRA providers typically do not prevent withdrawals before reaching retirement age. Finally, although Congress in 1992 imposed a 20% withholding tax on 401(k) withdrawals, no such withholding tax exists on IRA transactions.
The growing role of IRAs has made the retirement system far less efficient. Without a fiduciary to act as a buffer between participants and the market, investing would be suboptimal. As options for withdrawing money from accounts become more available, leakage will increase. Additionally, IRAs offer less protection than 401(k)s. They protect fewer assets in the event of bankruptcy or litigation and provide fewer guarantees for a spouse—a 401(k) names a spouse as the default beneficiary and requires notarized consent to name others, whereas an IRA allows the owner to name any beneficiary.
The bottom line is this. Wise minds used to think the Employee Retirement Income Security Act was cool because it protected the benefits of workplace retirement plan participants. Even those who agree that its administrative burdens and costs could lead to the demise of defined benefit plans still praise its protective measures. Shouldn't we be concerned that only 45% of the private sector's assets are protected by ERISA? What should we do?
