Safe-harbor IRAs don't offer a long-term saving solution

During the past several years, much progress has been made to simplify the process of enabling defined contribution plan participants to transfer their savings from one plan to another when they change jobs. These strides have been made thanks to an ongoing partnership between the private and public sectors, and between Democrats and Republicans in Congress. 

In November 2023, we saw the launch of the Portability Services Network (PSN), with our nation's leading retirement plan record-keepers – Alight Solutions, Empower, Fidelity Investments, Principal, TIAA and Vanguard – on board as founding members. The PSN makes the digital auto portability solution a reality for helping Americans keep their retirement savings invested in the system and working for them.  

Auto portability is on track to revolutionize the automatic rollover from a landfill to recycling operation. But some in the retirement services industry continue to cling to the safe-harbor IRA – the financial vehicle into which 401(k) accounts subject to automatic rollovers have historically been placed – as their solution of choice. 

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Reflecting on their history, Congress created safe-harbor IRAs as a temporary solution to the problem of too many small, stranded accounts in defined contribution plans. However, safe-harbor IRAs can't provide the long-term solution that plan participants in a highly mobile workforce need to ensure they can preserve, move, consolidate, and not lose, their savings as they move from job to job. 

Twenty years ago when safe-harbor IRAs were first proposed as a destination for small 401(k) accounts from former participants eligible to be automatically rolled out of plans, their temporary nature was clearly specified. In a U.S. Department of Labor press release from March 3, 2004, then-U.S. Assistant Secretary of Labor Ann L. Combs stated: "Preservation of retirement savings when workers switch jobs is key to ensuring retirement security. The proposed rule changes the landscape from one where workers cash out and spend small distributions to one where savings accumulate over time and are available when needed in retirement." 

Safe-harbor IRAs were created to help terminated plan participants, whose small accounts are eligible to be automatically rolled out of plans, keep their savings invested in the retirement system. And they were also established to help these participants avoid cashing out their accounts after they leave their employers. 

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But they weren't meant to house those savings permanently. 

Think about it. According to our Retirement Clearinghouse research, a safe-harbor IRA with a balance of $1,679, and a default investment return of 100 basis points, would generate only $16.79 every year. These investment vehicles are principal-protected money market funds that were returning small returns for the long low-interest-rate environment we experienced and can charge as much as $50 or more in annual administrative fees.

On the other hand, this $16.79 sum is considerably smaller than the more than $500 in taxes and penalties that a premature cash-out of a 401(k) account with $1,679 would force participants to pay. 

In short, safe-harbor IRAs need to generate a certain minimum yield, depending on the balances, to prevent the savings stored in them from being depleted. That's not a solution designed to keep 401(k) balances subject to automatic distributions in a "safe harbor" for the long term. 

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It's also not a solution that can curb cash-outs responsible for as much as $92 billion (according to the Employee Benefit Research Institute) in hard-earned savings leaking out of the U.S. retirement system every year. 

The PSN established as an industry utility makes it possible for plan participants to leverage safe-harbor IRAs as the transition account it was designed to be, allowing participants to seamlessly transfer their assets through these accounts and into their new employers' plans at the point when they actually switch jobs. 

The network is powered by the technology algorithms that underpin auto portability – the automated, routine and standardized movement of an employee's retirement savings account (with less than $7,000) from their former employer's plan into an active account in their current employer's plan. The auto portability transfer doesn't require participant action, so the default process is to preserve these balances in the retirement system, rather than cash out (particularly balances of under $1,000, which can be automatically cashed out) or have the balance depleted by fees in a safe-harbor IRA.

In revisiting that $1,679 account, let's say a 25-year-old plan participant chooses to consolidate a $1,679 401(k) account balance into their new employer's plan within a target-date fund that has a 5% annual return. That decision would give that individual $11,820 when he or she retires. 

Safe-harbor IRAs do serve a good purpose, but they do not allow participants to optimize their retirement outcomes. Nor do they serve as a viable substitute for account consolidation, or as a solution to the problem of cash-out leakage. That is why the PSN and auto portability service the industry utility powers, allow participants to maximize the time retirement savings are invested in their plan accounts. It also minimizes the time those balances are languishing in underperforming safe-harbor IRAs along the journey to retirement.