The Costly Mistake of Leaving Retirement Savings in Cash
How workers are missing out on Billions.
Workers often lose out on substantial investment gains by withdrawing their retirement savings from the stock market when changing jobs, frequently without intending. When people roll their 401(k) balances from their former employer's plan into an individual retirement account (IRA), the funds are typically kept in cash until they choose new investments. Many never make these selections, according to new research from Vanguard Group.
The study found that nearly a third of individuals who transferred their savings to IRAs at Vanguard in 2015 still had their balances sitting in cash seven years later.
Americans who have a lot of cash in their IRAs are missing out on over $172 billion each year in retirement wealth they could have earned by investing in stocks and bonds, the Vanguard study says.
This is a common and costly mistake. Especially for younger workers who are used to having their savings automatically invested in company plans. They risk missing out on years of potential gains that could significantly increase their retirement funds over time.
The issue is also significant for older savers, who typically need some stock exposure to ensure their funds last, according to a financial advisor. The large amounts of money unintentionally left in cash are becoming a growing concern, as IRAs have become the primary method for Americans to hold their retirement savings, noted Fiona Greig, global head of investor research and policy at Vanguard and a co-author of the study.
The Investment Company Institute reports that IRAs have $14.3 trillion in assets, while 401(k)-type plans have $11.1 trillion. Brie Pio, a financial advisor in Rockport, Maine, shared an example of a couple who hired her in 2021.
They moved over $400,000 from a 401(k) to an IRA last year but didn't realize the money was just sitting in cash. "They couldn't understand why they weren't earning any money despite the stock market's high returns," said Pio, who estimated the couple lost about $100,000 by missing out on the market rally.
Cashing Out
There are several ways to manage retirement savings when changing jobs. You can choose from three options for your 401(k) balance.
You can leave it with your old employer. You can transfer it to your new employer's plan. You can also put it into an IRA.
An IRA offers more investment options, but the money is typically not automatically invested in the market. When transferring your 401(k), the administrator typically sells your investments and then transfers the money into the IRA.
Although rollovers constitute a large part of IRA assets, some people make annual contributions. According to a Vanguard study, over half of the investors who contributed to an IRA in 2022 kept their money in cash for at least 12 months.
Andy Reed, head of investor behavior research at Vanguard and co-author of the study, explained that some account holders delay investment decisions due to the overwhelming number of options IRAs offer. Some people believe that IRA custodians like Vanguard or Fidelity will manage their savings, similar to 401(k) plans. This is not true.
IRA custodians only hold and safeguard the investments, they do not actively manage them. It is up to the individual to make investment decisions within their IRA account. It is important for individuals to be aware of this distinction when choosing an IRA custodian.
Without prompts to move the cash, "a significant number of IRA investors would remain in cash indefinitely," he said. In 2023, a survey was conducted on Vanguard IRA clients. According to the survey, 68% of clients who rolled over their accounts still had cash in June. Surprisingly, these clients didn't know how their money was invested.
Missing Out
Since the Federal Reserve began increasing interest rates in 2022, cash-like investments have seen a boost. Money-market funds currently have annual interest rates around 5%, much higher than the almost nonexistent returns in 2021.
However, historically, cash still underperforms compared to stocks. Morningstar Direct reports that U.S. large-cap stocks have had a 7.19% annualized return since 1926, adjusted for inflation. In contrast, cash has only returned 0.31%.
Laura Bovard, a 33-year-old nurse from Cincinnati, realized she missed out on thousands of dollars in gains because her IRA has been in cash since 2016. An ex-employer moved her pension to an IRA after leaving her job, a common practice for balances of $1,000 to $7,000.
Bovard only recently discovered the IRA when she received a statement. "It's not even in a high-yield money-market fund. It's earning very minimal interest even now," said Bovard, who is now transferring the money to her current 401(k)-type plan.
Her husband, John Bovard, a financial advisor, estimated that the $3,200 balance would be more than double if it had been invested in stocks over the past eight years. Vanguard data shows that customers who rolled money into an IRA in their 20s kept cash in those accounts for a median of seven years, compared to five months for those who rolled over around age 55.
A Nudge for IRAs
The amount of money transferred from 401(k) accounts to IRAs has increased significantly. In 2023, $701 billion was transferred, up from $404 billion in 2013. This increase is due to older workers retiring and younger workers changing jobs. Cerulli Associates reported these findings.
This law allows 401(k) plans to automatically enroll workers in diversified portfolios, such as target-date funds. Vanguard, the largest provider of target-date funds according to Morningstar, estimates that such a policy could add more than $100,000 to the average IRA balance by the time an investor under 55 reaches age 65.
Mark Iwry, a former Treasury Department official, believes that automatically enrolling IRA investors into target-date or similar funds would be a significant improvement. This change would make it easier for investors to save for retirement without having to actively choose their investments.
Iwry's suggestion aims to simplify the process and encourage more people to participate in retirement savings. He said that IRAs are different from 401(k)s and have different rules. Congress needs to think about things like fees on IRA default funds before making any changes.
Bottom Line
Many workers are losing money because they keep their retirement savings in cash instead of investing it. They do this after moving their 401(k) balances to IRAs. This mistake can cause younger workers to lose out on a lot of money by not investing in company plans.
IRAs are important for retirement savings. It's crucial to actively manage these accounts to get the most out of them and maximize returns.
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Disclosures:
This information is an overview and should not be considered as specific guidance or recommendations for any individual or business.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.
