401(k) Specialist Issue 3 - 2024 - 38

401(k) PROVIDER PERSPECTIVE
The Risky Business of Cashing Out Plan
Balances Below $1,000
By Tom Hawkins
ACCORDING TO INDUSTRY data, each year
around 2.5 million 401(k) participants with balances
less than $1,000 will change jobs, falling
under the threshold where plan sponsors can
automatically cash out their balances.
At first blush, automatic cashouts may seem
like an expedient approach to rid a plan of small
balances. In fact, the practice can be risky, as
it carries undesirable side effects for both the
plan and for its participants, including a high
percentage of uncashed distribution checks
requiring resolution, as well as massive amounts
of unnecessary cashout leakage.
Fortunately, there are better solutions
than automatic cashouts, which will not only
deliver plan efficiencies, but also give affected
participants a fighting chance to preserve and
consolidate their retirement savings.
The History of Automatic Cashouts
As 401(k) plans experienced dramatic
growth during the 1990s, the combination of a
highly mobile workforce, paired with little or no
plan-to-plan portability, resulted in an explosion
of small-balance accounts left behind by
job-changing participants.
Plan sponsors needed relief, and that relief
soon came in the form of the Economic Growth
and Tax Relief Reconciliation Act (EGTRRA)
of 2001, where a provision allowed plans to
automatically cash out terminated participants'
account balances of $1,000 or less, without
their consent.
While that legislation also laid the groundwork
for automatically rolling over terminated
participant balances between $1,000 and $5,000
to an IRA, plan sponsors would have to wait
until 2004 for the Department of Labor (DOL) to
codify those rules. When the DOL finally exercised
their rulemaking authority for automatic
rollovers, they were " persuaded that application
of the safe harbor to rollovers of mandatory
distributions of $1,000 or less " was appropriate
and these balances-at the plan sponsor's
discretion-could also be included in automatic
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ISSUE 3 2024 | 401kSpecialist.com
rollover programs.
During that period from 2001 to 2004, many
plan sponsors already embraced the practice of
automatically cashing out sub-$1,000 balances,
a legacy that continues to the present day. While
the percentage of plan sponsors who automatically
cash out sub-$1,000 balances is difficult to
determine, past Plan Sponsor Council of America
(PSCA) surveys have indicated that it's anywhere
from 27% to 58%.
The Risks of Automatic Cashouts
From the plan sponsor's perspective, automatic
cashouts may seem like an expedient approach
to " cleansing " a plan of small balances,
but it comes with an unfortunate cost-a blizzard
of uncashed checks.
Multi-year data from a mega-plan sponsor
(250,000+ participants) reveals that around
10.5% of sub-$1,000 distribution checks go
uncashed and must eventually be resolved.
Because they are considered plan assets, large
numbers of uncashed distribution checks can
trigger plan audits, incur administration costs,
and leave participants separated from their
retirement savings.
Plan sponsors can compound their risk by
having inadequate policies to deal with uncashed
checks, or worse, by adopting unsound
policies. For example, the practice of using a
forfeiture expense account, often funded by
uncashed checks, has recently become a target
for litigation in ERISA class action lawsuits,
exposing plan sponsors to a new source of
fiduciary headaches if their plans are silent as to
how uncashed check-funded forfeiture accounts
prioritize spending on contribution offsets versus
plan expenses.
From the participant's perspective, even
a sub-$1,000 automatic cashout can have a
pronounced impact on retirement security. A
25-year-old who has their $750 plan balance
automatically cashed out could forego $9,312
in retirement savings at age 65, if that balance
was preserved and earned a 6.5% annual rate
of return.
A Better (and Best) Way to Deal with
Sub-$1,000 Balances
Rather than automatically cashing them out,
a better approach would be to include these
sub-$1,000 balances in an automatic rollover
program, rolling over these balances (and others,
up to $7,000) to a safe harbor IRA and dramatically
reducing the downstream volume of uncashed
checks. Upon the opening and funding
of safe harbor IRAs, a plan sponsor is deemed to
have fulfilled their fiduciary responsibilities.
By contrast, with uncashed distribution
checks their problems are just beginning.
Now, the best way to deal with sub-$1,000
balances (and for all balances subject to an automatic
rollover) is to adopt auto portability, which
delivers all of the benefits but none of the flaws
of old-school automatic rollovers-such as high
fees, ongoing high cashout rates and sub-optimal
investments. By default, auto portability
facilitates the transfer of these balances to a
current employer's active account. This action
promotes consolidation, lowers participant
cashouts, more appropriately invests savings,
and serves to close the racial wealth gap.
Tom Hawkins is Senior Vice President, Marketing and
Research with Retirement Clearinghouse.
401(k) Specialist Issue 3 - 2024

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