The why and how of workplace emergency savings funds

The unprecedented economic and financial impacts of an emergency event like the Covid-19 pandemic have created a poignant, teachable moment for many Americans; a time when understanding and learning about a particular concept or idea becomes easier because interest in the concept or idea is high.

For decades, financial advisors and personal finance publications have communicated the importance of emergency savings funds (ESFs). The relatively limited impact of these messages was revealed by the Federal Reserve in 2019, when it reported that many adults are not well prepared to withstand even small financial disruptions; 4 in 10 Americans did not have the financial wherewithal to easily pay an unexpected $400 expense.

Since then, coronavirus lockdowns, economic disruptions, and rising unemployment have raised awareness about the importance of emergency savings in a way that only an emergency can. More than 40 million people across the United States have found themselves, or their partners, unemployed or furloughed. According to a June Bankrate survey, one of Americans’ biggest financial regrets is not having enough emergency savings.

The change in Americans’ mindset and attitudes about saving can be measured by the change in the United States personal savings rate over time, as documented by the Bureau of Economic  Analysis. In 2019, the average personal saving rate as a percentage of disposable personal income was 7.5%. This year, through July of 2020, the average personal saving rate averaged 17.7%.

In 2020, the only months that Americans have saved less than 10 percent of their disposable personal income were January and February, pre-pandemic.  The numbers show those who can afford to save are saving as much as they can – and they may keep saving at an increased rate, until a vaccine becomes a reality.

Today, it appears that saving money for emergencies is top-of-mind for Americans. Many are more receptive to messages about saving and opportunities to save than they have been in the past. In this environment, workplace emergency savings funds have tremendous appeal.

In addition to helping build employees’ financial confidence, emergency savings funds have the potential to improve retirement outcomes by reducing the need for ESF participants to take plan loans and/or early distributions from qualified retirement plan accounts to cover unexpected expenses.

Structuring emergency savings fund programs

There are a number of different ways to structure ESFs and the options that plan advisers choose to present to their clients will reflect the needs of the companies they serve, the capabilities of recordkeepers, and other factors.

Possible ESF structures include the following:

Payroll deduction emergency savings. This is one of the simpler approaches to ESFs. Employers give employees the opportunity to direct a portion of each paycheck to a checking or savings account the employee has established through a financial institution. Stored value cards also are an option.

This option offers several advantages: 1) Checking and savings accounts are controlled by employees; 2) There are no contribution minimums or limits, and 3) The accounts are protected by the Federal Deposit Insurance Corporation (FDIC).

The primary disadvantage of payroll deducted savings accounts is a lack of deterrent to withdrawals for non-emergency purposes. There is no hurdle to cross or consequence to make employees think twice about using the money saved for a non-emergency purpose.

One possible solution to the lack of deterrent disadvantage for this type of account is for plan sponsors to educate employees about mental accounting. The theory of mental accounting holds that “…people treat money differently, depending on factors such as the money’s origin and intended use…Examples include banks offering multiple accounts with savings goal labels, which make mental accounting more explicit,…”

Theoretically, if employees give ESFs a goal label of “emergency savings,” and companies refer to ESFs as “emergency savings” in benefits communications, then the likelihood that employees will use the money for non-emergencies, such as vacations, new smartphones, gaming accessories, and other non-emergency expenditures, is reduced.

Payroll deduction Roth IRAs. Like payroll deduction savings accounts, payroll deduction Roth IRAs are a relatively simple ESF solution to implement. Employers give employees the opportunity to direct a portion of each paycheck to a Roth IRA the employee has opened through a financial institution.

Roth IRA ESFs offer several advantages: 1) The accounts are controlled by employees; and 2) Contributions made to Roth IRAs can be distributed tax-free and penalty-free, if certain requirements are met, so savings are available to employees in the case of an emergency.

The primary disadvantage of a payroll-deducted Roth IRA is that Roth IRAs have contribution limits and income limits for participation. These features may make the option less valuable, or completely unavailable, to high income earners.

It should be noted that any tax-deferred earnings are subject to income taxes and early withdrawal penalties, unless certain requirements are met.  In addition, since distributions must be requested in advance and processed, savings may not be immediately available. Some see these features as disadvantages. Others believe these features will act as a deterrent to arbitrary withdrawal and ensure employees will think carefully before using their savings for non-emergency purposes.

Repurposed retirement accounts. Companies that have qualified employer retirement plans may be able to repurpose certain types of contributions as emergency savings. These include the following:

• Voluntary after-tax contributions. Often, after-tax contributions are subject to different rules and restrictions, and are not subject to qualified plan rules, so assets can be distributed without taxes or penalties.
• Deemed IRAs. Typically, these accounts are accounted for separately (just like after tax accounts are), are not subject to qualified plan rules, and are treated like regular IRAs,  subject to the same contribution and income limits. However, similar to Roth IRAs, deemed IRA contributions may be withdrawn tax- and penalty-free at any time and for any purpose, while distributions of earnings may be subject to taxes and penalties.

One advantage of this option is that automatic enrollment and matching contributions may be possible. A disadvantage is that the accounts have the potential to increase fiduciary and administrative complexity.

Help build financial security

Workplace emergency savings funds can help Americans build or re-build financial security. They also can help employers meet the needs of a rapidly changing workforce that often includes employees, freelancers, and/or gig workers. Depending on how these programs are structured, employers may be able to offer these benefits across worker groups.

If you haven’t been talking with your clients about emergency savings funds as a benefit option, it’s a good – and unprecedented – time to start.

Kevin Clark is senior vice president and business development director of Retirement Services at Millennium Trust Company, LLC. Mr. Clark has over 30 years of experience with employee benefits and retirement services. Millennium Trust Company performs the duties of a directed custodian, and as such does not offer or sell investments or provide investment, legal or tax advice.