Americans Now Have More Money in IRAs than in 401(k)s. Why That Leaves Workers More Vulnerable. – Center for Retirement Research
With minimal protection and monitoring devices, we have a very slow system.
The most dramatic development in the US private sector retirement system is not the move from the old defined benefit plans, which began around 1980 and are ending today, but rather the move from 401(k) plans, which replaced defined benefit plans, to Individual Retirement Accounts (IRAs). Total IRA assets now exceed funds in 401(k)s by $7 trillion (see Figure 1).
Switching from 401(k)s to IRAs moves employees’ money into a different jurisdiction. 401(k) plans are subject to the Employee Retirement Income Security Act of 1974 (ERISA), which requires plan sponsors to act as fiduciaries who always act in the best interests of plan participants. In contrast, the ethical standards of brokers who sell IRA investments are less protective than ERISA’s fiduciary and prudent duties, which courts have consistently characterized as “the highest recognized in the law.” Additionally, in the 401(k) environment, there is a greater emphasis on financial disclosure in an understandable format than in the case of IRAs. And, most importantly, 401(k)s place more emphasis than IRAs on keeping funds in the plan until retirement.
Almost all withdrawals from 401(k) plans and traditional IRAs made before the employee reaches age 59½ are subject to a 10 percent penalty tax (in addition to federal and state income taxes). Exceptions include the distribution of major health care costs, due to difficulties caused by complete and total disability, and periodic payments throughout life. IRAs, however, offer withdrawals for three additional reasons: to cover post-secondary education expenses; up to $10,000 to pay for the purchase of a new home; and paying medical insurance costs for those who are out of work for 12 weeks or more.
In addition to being exempt from the 10 percent penalty tax, the barriers to accessing funds are much lower for IRAs than for 401(k)s. Importantly, 401(k) withdrawals can only be made upon job changes or for hardship reasons, while IRA withdrawals can be made at any time without reason. In addition, 401(k) withdrawal difficulties include dealing with plan administrators, filing paperwork, and, at least in theory, the reason for the withdrawal. The emotional and practical burden of this multi-stage process can discourage withdrawal. In contrast, providers of IRAs generally discourage withdrawals before reaching retirement age. Finally, while in 1992 Congress imposed a 20 percent withholding on 401(k) withdrawals, no such withholding exists on IRA transactions.
The growing role of IRAs has resulted in a more inefficient retirement system. Without fiduciaries acting as a buffer between the participant and the market, the investment will be much less. With more and more options for withdrawing money from accounts, leakages will increase. In addition, IRAs offer less protection than 401(k)s. They protect fewer assets in the event of bankruptcy or lawsuits and provide less protection for spouses — a 401(k) designates a spouse as the default beneficiary, requiring certified consent to name another person, while IRAs allow the owner to name any beneficiary.
The bottom line is this. Smart people used to think that ERISA was cool because it protected the benefits of participants in workplace retirement plans. Even those who agree that its administrative burden and costs may have contributed to the collapse of defined benefit plans still recommend its protection. Shouldn’t we care that only 45 percent of assets in the private sector are protected by ERISA? And what should we do about it?
