The wake of the pandemic draws attention to emergency savings accounts

Illustrated by Bill Mayer

A myriad of financial lessons can be learned from the COVID-19 pandemic, but one of the most important lessons concerns the value of an emergency savings account alongside a retirement account.

It’s no surprise that a growing number of pension plan archivists are offering their plan sponsor clients the ability to directly link employee emergency savings accounts to payroll-deferred retirement plans. ‘company.

“The pandemic has heightened awareness of the importance of emergency savings accounts for individuals and employers,” says Rachel Weker, chief retirement officer at T. Rowe Price.

Weker says there wasn’t as widespread use of pandemic-related distributions among attendees as many feared. However, few of those who received distributions have repaid them, Weker says, and those people will feel the impact of those distributions on reduced retirement account balances.

Weker adds that plan sponsors have gained a better understanding of emergency savings challenges during the pandemic. She believes employers are now more likely to prioritize emergency savings as part of their financial wellness programs.

According to David John, senior strategic policy adviser at the AARP Public Policy Institute, one of the results of the pandemic has been that individuals now understand that they need emergency savings.

“People who had emergency savings generally fared much better than those who didn’t,” he points out. “As a result, it’s now a much higher priority than it would have been in 2018 or 2019.”

Automation and simplification are key

For plan sponsors who want to offer an emergency savings option, it’s important to automate and simplify the process, Weker says. Otherwise, employees may struggle to get started in terms of opening an account and knowing how much they need or how much they can afford to save. She also warns that many employees struggle to recognize that they can save more than they currently do and that it’s important for them to look at spending habits with an honest eye.

According to Weker, pension plan emergency savings considerations should include the speed at which funds could be accessed, as same-day access to funds is generally not available, and the taxation of contributions and distributions. She also says it’s important to consider the potential for further leakage from the pension plan, as participants could be more likely to dip into pension plan assets if the emergency fund doesn’t really meet their needs. emergency.

In March, a group led by the AARP Public Policy Institute and the nonprofit Aspen Institute released a set of principles for effective emergency savings policies. The group has developed the following five design principles which they believe should be followed by policy makers when implementing an emergency savings policy:

  • Allow automatic enrollment in workplace emergency savings;
  • Ensure that emergency savings are their own savings “bucket”;
  • Allow a wide range of options, especially for low to moderate income households;
  • Design emergency savings to meet household needs; and
  • Preserve retirement savings.

The importance of automatic registration

A growing body of research shows that automatic enrollment in employer-sponsored 401(k) savings plans has had a dramatic impact on how millions of Americans save for retirement. Inertia seems to prevent many workers from enrolling in company pension plans, as the desire to save is not always translated into action.

“As seen with pension plan experience over the years, auto-enrollment can be an effective way to encourage savings by harnessing inertia and removing traditional barriers to getting started on the way of savings,” says Weker.

However, research also shows that auto-enrollment is more effective at increasing participation than increasing overall savings levels. An analysis by T. Rowe Price and Taha Choukhmane, assistant professor of finance at MIT Sloan School of Management, indicates that auto-enrollment programs implemented without automatic escalation of deferrals tend not to have a large positive impact on financial results. Indeed, employees who are automatically enrolled tend to contribute less than those who are not.

Separating emergency accounts from retirement plans

According to John, behavioral studies of investment habits show that people are much less likely to dip into their emergency savings for other things if they’re in a separate account.

“There’s a study that’s been widely cited that talks about what’s called the ‘envelope theory’, and what it basically shows is that people are less likely to hit assets when ‘they are held in an account with a particular, stated purpose,’ says John. . “The takeaway is that people need an emergency savings account and a separate account from their general savings.”

According to a National Bureau of Economic Research research paper, 39% of American adults said in a survey that they could not afford an emergency expense of $400 in cash or its equivalent.

“With limited cash, many working-age households are spending savings intended to finance the consumption of the elderly well before they reach retirement,” the document warns.

The analysis attributes these spending patterns to several behavioral biases, including what is known as the present bias, which is the tendency to overweight the present over the future.

“People with current biases tend to act impatiently in the present while wanting to act patiently in the future,” the report explains. “Households with a current bias hold too little liquid wealth and will deplete their partially liquid retirement savings (for example, through 401(k) loans or pre-retirement distributions) in the face of adverse shocks.”

Provide a range of options to ensure needs are met

According to the set of principles of an effective emergency savings policy, supporting only one type of emergency savings account could exclude some households that desperately need it. Simply put, the needs of different groups will vary greatly.

Additionally, emergency savings should be sufficient to meet a wide range of financial needs when income alone is insufficient. Some research indicates that the minimum cash cushion required by the average low-income household is just under $2,500 and can reach upwards of $3,000.

According to the Aspen Institute, households with at least $1,000 in emergency savings were half as likely to withdraw from their workplace retirement savings accounts during the pandemic. Such an account can replace the need to use retirement withdrawals or loans and can reduce the number of people who regularly withdraw their retirement savings early.

“A significant number of employers now recognize that this is something their employees want,” says John. “We’re still seeing a relatively small number of employers offering emergency savings accounts, but we’re seeing that number increase. And that should drive innovation even more in the future.

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