The hidden threat to 401(k)s
Many workers are unaware of the looming threat disability could pose to their retirement savings, but a recent change in IRS regulations has made it possible for long-term disability insurance to cover retirement plan contributions in the event of a participant’s disability.
Anna Rappaport, a noted author, former member of the Department of Labor’s ERISA Advisory Council, and expert on the risks long term disability poses to America’s retirement savers, has noted on numerous occasions that even a brief disability often puts a stop to 401(k) contributions, which can take a substantial toll on a worker’s financial security both before and after retirement.
As a consequence of steady shift from defined benefit plans since the 1980s, millions of Americans now rely solely on their 401(k) for retirement savings. In contrast to defined-benefit plans, defined-contribution plans such as 401(k)s have no provisions to protect retirement security in the event that a worker becomes disabled. When workers become disabled for extended periods, they are effectively barred from making continued contributions to their 401(k), and sometimes are compelled to dip into their retirement savings to cover current expenses and medical bills. Up until the late 1990s, employers were not legally allowed to continue making contributions to a disabled worker’s 401(k), even if they wanted to do so.
Also see: “These young savers have big, fat 401(k)s.”
Along with the loss of employer and employee contributions, employees also lose any interest that would have been earned on those contributions. Other family members may need to curtail or abandon their own careers to act as caregivers, putting further strain on a family’s financial stability. This is especially true when the disabled employee has no long-term disability insurance.
A vulnerability most Americans vastly underestimate
The situation is exacerbated by the fact that far too many Americans underestimate the risk of becoming disabled, and underappreciate the consequences. The Council for Disability Awareness says 1 in 8 workers will be disabled for five or more years during their working career. Rather than the trauma or work-related injury many people associate with disability, 90% of disability is due to illness or chronic conditions. Moreover, disability is becoming more frequent. According to the Social Security Administration, 1 in 4 of today’s 20-year-old individuals will become disabled before reaching retirement age.
The consequences of becoming disabled can be devastating for workers and their families. The poverty rate for disabled workers is 2.5 times that of those who are not disabled.
Long-term disability is one of the greatest financial risks individuals face, and is particularly detrimental to retirement security. Not only does it result in lost income and missed contributions to retirement savings, but, in the absence of adequate coverage, families often also must dip into their savings to pay for current expenses and medical bills, depleting retirement accounts even further.
While roughly 30% of workers are covered by long-term disability insurance, this insurance does not provide any coverage to replace 401(k) contributions that are missed when a worker goes on disability. If a disability is severe enough, preventing the worker from performing “any substantial gainful activity,” he may receive Social Security Disability Insurance, though these payments average just over $1,100 a month.
For many families, that amount is not enough. If the disabled worker was the household’s major earner, it can wreak havoc on an entire family, stripping the older generation of their financial independence and derailing the future plans of their dependents. Severe disability can also lead the spouse to reduce his or her own work schedule to become a caregiver, causing both financial and emotional strain.
A long period of disability may leave a family with no savings at all. As Rappaport states, if disability occurs shortly before retirement (ages 51 to 64), poverty rates more than double. Any period during which a participant cannot continue contributing to his or her account balance can have a significant impact on the participant’s savings at retirement. An employee who is disabled from ages 50 to 55 will lose five years of retirement savings that she will not be able to restore over her remaining working career.
For younger workers, disability can mean an exit from the workforce altogether: It is the most common reason for early exit for both men and women. A study by the Congressional Budget Office found that workers not in the labor force due to disability had lower income, higher poverty rates, and fewer assets than those who retired, despite 80% reporting that they received Social Security benefits. The effects can cause ripples beyond a disabled employee and his family, into society at large, which must pick up the tab when disability casts workers into poverty, forcing them to rely on public assistance programs.
Protecting workers’ financial future
In our view and those of Rappaport, the new IRS regulations present a clear opportunity to address the problem, and encourage employers to consider how important it is to them to help their employees deal with disability risk.
More attention should be given to how disability impacts retirement security, and both public and private benefit programs need to integrate coverage for retirement and disability. Employer-paid and voluntary plans are available to ensure their workers’ retirement is protected, even if they are unable to work, but educating employees about the risk is vital.
Since the 2014 change in regulations, a disability insurance policy can now fund ongoing contributions to the employee’s retirement plan if certain requirements are met, without adverse tax consequences. By offering an insurance policy under which the workers’ DC plans, including 401(k)s, are the named beneficiary, employers can provide coverage equivalent to each participant’s total annual plan contributions during disability. This allows the worker’s account to continue receiving contributions during periods of long-term disability. These contributions are not taxable, protecting both the immediate and long-term financial security of the disabled worker (though of course, like all distributions at retirement, income is eventually subject to income tax).
Also see: “Employers urged to tap automatic 401(k)s.”
At least two insurance products are currently on the market offering DC benefit protections. One is a non-contributory insurance program covering all employees. Under this approach premiums are paid by the employer external to the plan. Because coverage is provided outside of the plan, however, it does not comply with the IRS TD 9665. This means that benefits paid by the insurer during a period of disability cannot be contributed to the 401(k) plan, necessitating careful tax planning outside the retirement plan.
The other plan is based on using an investment option in the DC plan. In the event of disability, the plan’s benefits replace the contributions that would otherwise be lost.
For example, if a worker’s 401(k) received $10,000 in employee contributions and $5,000 in employer contributions, under this approach $15,000 per year would be paid into the employee’s 401(k) account during the disability. This also allows the plan to continue to earn investment income on contributions just like any other plan assets. Employers have several options for making this coverage available: paying premiums themselves, sharing the cost with employees, or making it available on a 100% voluntary basis, with employees choosing whether to buy coverage.
With this second, TD 9665 compliant approach, benefits paid to a participant’s 401(k) plan account would be invested like regular contributions, continuing to earn investment income, and growing the employee’s retirement account as though she were still contributing normally.
A third option for employers is to self-insure the risk by amending the 401(k) plan to state the employer will continue contributions on behalf of disabled employees. The major drawback of this approach is that in order to qualify for continuing contributions employees must meet the Social Security definition of disability—far more severe than the definition used by most private disability insurance. This means that an employee could qualify for the employer’s group long-term disability insurance, yet fail to receive employer contributions to the 401(k) plan.
We agree with Rappaport and other experts that the first step is for employers to address their primary disability coverage, and consider how their disability decisions relate to other benefits, such as medical and life insurance.
We note that recent regulatory changes alone do not solve the problem of this gap in disability coverage; rather, they only make it possible for employers to finally address the situation.
Employers still must decide how much they are willing to invest both in educating employees about the risks disability can pose to retirement, and in taking action to protect against those risks. Employers, 401(k) plan administrators, and employees all must be involved in implementing changes in disability coverage to include DC plan coverage.