By Beth Pinsker
Investors are losing out on millions of dollars in growth because IRA rollovers and contributions are too hard to understand
When Andy Reed was 17, his dad told him to start making IRA contributions with his summer earnings. He did so diligently for the next five summers. Then he checked his balance and saw the account hadn’t grown much. “My dad told me to save, but he didn’t tell me to invest,” Reed said.
Flash-forward a couple of decades, and Reed is now the head of investor behavior research at Vanguard, where he just co-authored a study that shows a large percentage of people do the same thing, leaving their IRAs in cash. In particular, 28% of those who did a rollover to a Vanguard IRA from a 401(k) after leaving a job left the funds uninvested for at least seven years.
This billions of dollars in lost growth potential is usually framed as an investor mistake, as it was in Anne Tergesen’s recent Wall Street Journal article that unveiled the Vanguard research. The Vanguard study actually came about because Reed had held onto that shame of missing out for all these years. One day he asked Vanguard’s head of wealth planning, Maria Bruno, what he thought was a flippant question: Why can’t people just be defaulted to target-date funds instead of cash in their IRAs?
That would seem to be a simple solution: It’s what most 401(k) plans do now, and people are used to it. But Bruno’s answer was that the law doesn’t work that way for individual retirement accounts, and so Vanguard researchers embarked on a research study to see if they could get at what was hampering the process – and come up with a solution.
The problem with in-kind transfers
Reed thought it would be a simple study, but he found it was like peeling back the layers of an onion. Before you can get to the question of what the default option should be, you need to address why there even needs to be a default when you transfer funds that are already invested. And this is where it emerges that the mistake is mostly on the industry side.
Financial adviser Andy Panko, who practices in New Jersey and runs a popular Facebook group focused on retirement planning, often hears from clients and posters who have trouble with what are called in-kind transfers. That’s when you move money between accounts but keep it invested the same way: There’s no buying or selling, and everything stays the same.
Sometimes you can do that, and sometimes you can’t.
Panko had one client recently who was able to seamlessly do a 401(k) transfer to an IRA, keeping everything at the same brokerage house. Another client, however, had to sell everything in their 401(k) and port it to a new account at the same brokerage.
“The industry is more manual and inefficient than you think it should be,” said Panko, noting that IRA custodians have little financial incentive to move clients out of low-interest cash accounts, because they can turn around and lend that money out at higher rates.
The biggest issue he sees with in-kind transfers is that investments in a 401(k) don’t match what’s available in an IRA in terms of share class or exact funds. “Sometimes people assume they have a standard S&P 500 mutual fund and they can just transfer it over, but it might actually be a sort of collective trust that exists only in that 401(k), and it’s not portable,” he said.
Others can’t do in-kind transfers either because their 401(k) plan specifically does not allow them or because there are issues when transferring between different custodians.
Another adviser, Chelsea Ransom-Cooper, said the in-kind transfer problem is at the root of the issue of funds sitting in cash – and the No. 1 problem she sees with new clients and people she talks to at events. She said that she had not seen any of her clients be able to do in-kind transfers; they have all had to cash out completely and then reinvest in the new accounts. And that, she said, often does not happen.
“It’s not fair to say that’s their fault because they should have educated themselves more,” she said. “In their 401(k)s, they only need to decide how much to contribute.”
Reed agrees that pinning the process on investor knowledge of things like unit investment trusts and institutional share classes is a big ask.
“It does feel at times that you have to be an expert, and even experts who study this stuff can fall prey to the same inertia,” he said. That’s why he added in more questions in a survey last month to try to get at why people were not investing their rollovers.
Only 35% said it was intentional – that they didn’t trust the market and preferred to be in cash. That requires its own kind of financial education about risk tolerance, diversification and historical market growth to debunk.
Of the 60% who were in cash unintentionally, the most common reason was that they simply didn’t know. Most had no idea that they needed to actively do something to invest the funds, because they assumed that an IRA worked the same way as their 401(k) and defaulted to a position.
Some had decision fatigue and walked away from the process. That subset said the ideal number of investment choices would have been 10, rather than the 300 funds you can typically pick from in an IRA.
Overall, the process was too complicated.
Industry solutions
This investor behavior with IRAs happens across the board, not just at Vanguard. Fidelity has similarly found that a consistent 40% of those who contribute to an IRA leave the funds in cash. Susan Hirshman, director of wealth management at Schwab Wealth Advisory, said she sees people having trouble with in-kind transfers and then having to sort out what to do with the cash. But she mostly deals with clients who have advisers, which is what she recommends so that the funds get invested right away.
“It’s a lot for a person to understand without guidance,” she said. “It’s almost like you can buy IKEA furniture and put it together, or you can get somebody to help you. With a rollover, it might be your biggest asset, so are you going to choose to do it on your own, or should you have the help of an experienced adviser to help guide you and help explain the intricacies of it?”
Vanguard’s report advocated for a different approach, which is to call on legislators to add a default option to IRAs the way they allow for it in 401(k)s under Erisa retirement statutes.
“We could fix this, if we could fix the law,” Reed said.
Ransom-Cooper and Panko suggested another route, which is that IRA custodians could make it more clear during a transaction – whether it’s a rollover or a direct contribution – that the funds need to be invested. Robinhood, for one, changed its system to do this when it launched an IRA-rollover service.
“They should say something like, do you want option 1, 2 or 3 – cash, transition to the same target-date fund or pick a new investment,” Ransom-Cooper said. “That’s an easier decision they can make.”
The industry is working on it. “We are developing ways to simplify the choice,” Reed said. “But this population of investors is not very engaged. Reaching them at time of rollover is the best-case scenario.”
Until there’s better messaging and new laws, investors need to know this: Contributing to an IRA is always a two-step process that involves depositing the funds and then investing them. It’s not your fault that this is how it works – but you still have to do it yourself.
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-Beth Pinsker
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