Recent JCT Report Shows Significant Retirement Savings Leakage
By Mike Rahn, CISP
Much has been said about the roughly 40 percent of American private sector workers who have no access to a retirement plan where they work. Less has been said about the so-called ”leakage,” the premature spending for nonretirement purposes of assets accumulated in employer-sponsored retirement plans or IRAs. The consequence of failing to preserve these assets is likely to result in a population of retirees inadequately prepared to live securely or comfortably during their “golden years.”
The congressional Joint Committee on Taxation (JCT) has released a report entitled, Estimating Leakage from Retirement Savings Accounts, in which it estimates the extent to which retirement accumulations are currently “leaking” from tax-advantaged savings arrangements and why.
The JCT and Its Methodology
The JCT is a bipartisan federal entity that provides statistical information and research to members of Congress, chiefly on matters having tax dimensions or implications. Because retirement savings accounts commonly defer taxation—or, in some cases, provide tax-free earnings—legislation pertaining to them is likely to have an impact on federal tax revenues. Consequently, the JCT is called upon by lawmakers and their staff to estimate potential revenue effects of proposed federal legislation with retirement provisions.
Several federal tax forms filed annually provide data on who participates in an employer-sponsored retirement plan, who has an IRA, and what transactions are taking place in these accounts. These tax forms include Form 5498, IRA Contribution Information, Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc., Form 1040, U.S. Individual Income Tax Return, and Form W-2, Wage and Tax Statement. The JCT examined data from these forms during the period of 2003 through 2018. It noted that its report and findings reflect some “140 million … observations” or data points taken from these forms.
The JCT based its conclusions on data from individuals age 50 and younger. The rationale for this age limitation is that some persons above age 50 could be reasonably expected to begin spending their accumulated savings for retirement. Consequently, withdrawals at age 50 and above should probably not be considered in a negative light as “leakage.”
How Much Is the Leakage?
The JCT compared annually the amounts recorded as retirement contributions on tax forms 5498, W-2, and 1040 against amounts reported on Form 1099-R as distributions from retirement accounts. The JCT interpreted the difference between the two as “leakage.” Using this approach, the JCT estimates that annual leakage from the tax-advantaged retirement system—in dollar terms—is currently about 22 percent of what is contributed by savers age 50 and younger. In simplest terms, for every dollar that is saved, 22 cents are removed by individuals in this age group.
Whose Savings Are Leaking?
There appears to be a pattern with leakage from these savings arrangements at the highest rates. The extent of leakage increases with age, between the ages of 25 and 50, then levels off. For example, the average leakage rate for a 25-year-old is about 12 percent, while that of a 50-year-old is about 22 percent. This may be a reflection of the need to use financial resources—including retirement accumulations—for other purposes during those years leading up to age 50.
What Events Result in Leakage?
While IRA and IRA-based employer-sponsored retirement plan assets are available on demand at any time, a participant in a qualified retirement plan, 403(b) plan, or governmental 457(b) plan must have a “triggering event”—a certain occurrence that gives a plan participant permission under the plan to request a withdrawal. In general, a certain age must be attained, there must be a plan provision that allows an “in-service” distribution of employer-made contributions, or there must be a severance from employment with that employer.
Severance from employment was found to be the event most responsible for leakage from employer-sponsored retirement plans, accounting for 26 percent of the annual leakage reported by the JCT. Severance is a standard trigger with most plans that gives plan participants access to their employer plan savings at any age. Severance is not in and of itself a “need,” but an opportunity to claim one’s savings—savings that might not be available if still working for that employer.
Ideally, the assets claimed when employment has terminated would be rolled over to an IRA or to another employer plan, and, thereby, preserved for retirement. But sometimes they’re needed for other life expenses, or the temptation to use the assets for something other than an urgent need—the expression “burning a hole in one’s pocket” comes to mind—is strong, and spending is the result.
“Negative income shock,” such as the sudden loss of a job, also accounted for spending before retirement, followed by divorce, home purchase, medical needs, and education expenses.
Notably, the Great Recession, which began in 2008, did not lead to as much retirement savings leakage as might have been expected; the JCT concluded that a greater impact from that event was felt in reduced retirement contributions.
Can the Leakage Be Reduced?
While it is not the JCT’s role in its relationship to Congress to advocate for changes to the tax-advantaged retirement system—including changes that might reduce retirement savings leakage—the group’s findings suggest that limiting access to retirement savings at the time of severance from employment could reduce leakage. Legislative proposals to require automatic portability of an account to another employer’s retirement plan or to an IRA have been made, though, thus far, they have not been acted upon.
Another factor noted by the JCT in the leakage equation is the practice of “forcing out” certain small balances. Forcing out is the distribution to a plan participant of his plan assets without his request. Employer plan rules permit a force-out of balances of $5,000 or less, an established practice for some plans. Importantly, if a force-out amount is $5,000 or less but more than $1,000—and if there is no affirmative participant election to receive it in cash—the employer must directly roll it over to an IRA on that participant’s behalf.
Amounts paid out in cash, with or without a participant’s election, represent a small but real variable in the retirement savings leakage equation. But the requirement to roll over an unrequested force-out amount greater than $1,000 to an IRA is at least a positive element in this equation.
Another Option?
One concept that has been proposed to potentially reduce leakage is an “emergency fund” incorporated into employer-sponsored retirement plans. Though legislative proposals and think-tank concepts have differed in just how it would be structured, the common theme is a small account within a plan that could be accessed without restriction or tax penalty at any time for certain reasons, coupled with perhaps tighter restrictions on accessing the bulk of a participant’s assets in the plan.
Surveys and studies of retirement saving have consistently revealed tension between saving for retirement and meeting other financial needs—or wants—during working years. This is unlikely to change. Perhaps the best that can be hoped for is to make it easier to meet unexpected life expenses, while reducing the temptations and opportunities to use retirement assets for non-essential, nonretirement things.
