Catherine Reilly is a retirement and investment expert with a particular focus on retirement income, fintech, and public policy.
The US defined contribution retirement system already has a largely-automated template for how to save for retirement in an employer plan, but how it handles spending one’s retirement money is a different matter. This is because the automation typically breaks down when the worker retires.
Why things are changing
Traditionally, most retirement plan participants rolled their money out of their employer-based plans and into individual retirement accounts (IRA) at retirement. Nevertheless, we believe this is starting to change. In part, this is because increasing numbers of employers seek to retain participant assets even after the workers have retired. Also, regulators continue to raise the fiduciary bar for advice to roll assets out of a 401(k) plan to an IRA.
In our recent research paper “The pros and cons of remaining in a 401(k) plan after retirement,” Olivia S. Mitchell, John Turner, and I evaluate whether and which retirees would be likely to benefit from remaining in their employer’s 401(k) plans, rather than rolling over to IRAs. As there are pros and cons associated with both options, we took the perspective of different types of retirees, with a particular focus on those with low or moderate levels of financial literacy.
Advantages of staying put
One of the major advantages of a 401(k) plan is that it has a fiduciary – the plan sponsor – obligated to act in participants’ best interests. The plan menu and the default investment option selected by the fiduciary may be considered implicit advice, which the participant receives for no extra fee. The landing asset allocation of most target date glidepaths is likely to be appropriate for a retired participant to hold during retirement and use as a source of drawdown income.
Also, plan sponsors are also increasingly integrating guaranteed income into their plan menus. For unsophisticated participants with low balances, who could struggle to receive affordable advice outside the employer plans, the availability of institutionally priced, ready-made solutions for generating income during retirement within their employer plans is a clear advantage.
Yet some need more help
While many 401(k)s are ideally placed to offer a low-cost, standardized retirement income option, such a framework may not suit retirees with more sophisticated advice, tax planning, and investment needs. Moreover, people will have access to a wider range of investment and advice options outside the retirement plan, prompting some to roll over.
Yet another reason that some participants roll their assets to an IRA at retirement is to consolidate multiple retirement accounts; since people can accumulate 5-7 retirement accounts during their working years, it can be easier and more efficient to keep track of all the assets in a single account. While rolling from a 401(k) to an IRA is relatively easy, consolidating multiple 401(k) accounts into a single one can be considerably more difficult.
Comparing costs and benefits
Comparing the costs of IRAs and 401(k)s is not always straightforward. Many 401(k) investors will pay lower fees than do IRA investors, yet costs of 401(k) plans do depend on plan size. For instance, the total cost for a mega 401(k) plan with $5 billion in assets may be only 8 bps, but a small plan[1] with under $1 million in AUM can cost over 120 bps.
Naturally, IRA fees also vary widely, depending on the investment and advice options selected. A sophisticated IRA participant can use extremely low-cost index funds at a price comparable to or even below those at a large employer plan. Digital advice offerings can also be inexpensive, even for participants with balances below levels where human advisors are likely to be interested. Nevertheless, retirees with low/moderate levels of financial literacy are likely to lack the skills to find the lowest cost investment or advice options, or to do a good job constructing their portfolios without advice. Accordingly, our research concludes that the large employer 401(k) plan is likely to be more cost-effective for the majority of unsophisticated participants; conversely, those in high-cost small employer plans may find an IRA less expensive, even including the cost of advice.
Conclusions
IRAs offer many valuable features, particularly for participants with sophisticated advice and investment needs. Unless retirees are in very high-cost small plans, those with low/moderate levels of financial literacy are likely to benefit from remaining in their 401(k)s plan even after leaving their jobs.
To make this an attractive and more viable option, it will be important to improve the technological capabilities of 401(k) platforms to allow seamless purchase of guaranteed income and flexible drawdown options. Making it easier for participants to consolidate all their 401(k) savings into a single account will also be important. Plan sponsors, technology providers and regulators are already seeking to enhance these features, but there is still work to be done before 401(k) plans can easily be used to provide income in retirement.
[1] While the average cost for small employer plans is very high, some digital providers also offer low-cost options for small plans.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
