Out-of-plan emergency savings accounts: The real key to retirement security?

While auto enrollment is set to significantly boost retirement participation, it comes with a critical caveat: an anticipated surge in retirement leakage. As workers unexpectedly discover accumulated funds in their retirement accounts, many are likely to withdraw prematurely, especially those living paycheck to paycheck.

“This trend underscores a crucial gap in financial wellness strategies – the absence of accessible emergency savings,” said Sid Pailla, CEO, Sunny Day Fund. “Despite SECURE Act 2.0′s in-plan PLESA provisions, plan sponsors overwhelmingly prefer out-of-plan Emergency Savings Accounts (ESAs) for their flexibility, ERISA independence, and alignment with holistic financial health practices.”

The rising popularity of ESAs reflects a shift towards liquid wealth accumulation, addressing immediate financial needs while simultaneously strengthening retirement planning. “Our data shows that ESAs serve as a steppingstone to increased retirement savings, with both contributions and participation in retirement accounts rising post-ESA implementation,” said Pailla. “This symbiotic relationship between emergency savings and retirement planning is particularly impactful for paycheck-to-paycheck workers, making the prospect of long-term savings less daunting. As the first federal legislation to address workplace emergency savings, SECURE Act 2.0 has spotlighted the critical role of ESAs in fortifying retirement plans, paving the way for more comprehensive financial wellness solutions in the workplace.”

We further discussed the benefits of out-of-plan emergency savings account with Pailla, as employers look to ease financial stress for employees.

Q: Why is emergency savings the real key to retirement security?

A: Two reasons: emergency savings 1) shields retirement assets from depletion and 2) activates financial confidence to nudge participation and greater contributions towards retirement.

In our current approach to 401(k)-driven retirement security, we make a critical assumption: that savers have a separate pile of cash to count on when needed so that they don’t touch their retirement savings. This assumption is built into everything from tax law to plan administration to benefits education.

Nearly three-quarters of American workers (72%) said they do not have cash buffers or liquid savings or that their cash buffers or liquid savings add up to less than $5,000, and the typical emergency costs even more than that, so workers are unfortunately raiding their retirement savings.

We can only achieve security in retirement when those 401(k) dollars are gone and can compound and grow. Emergency savings provide the immediate, no-cost alternative, and research has consistently shown that $1,000 in savings cuts the likelihood of retirement loans and withdrawals in half.

But there’s more—when people have the safety net of emergency savings, their emotional response to money begins to change. They develop greater confidence in longer-horizon planning, like saving for retirement.

That’s why emergency savings are the real key – they provide the solid foundation upon which the house of retirement security can be built.

Q: Why do plan sponsors prefer out-of-plan Emergency Savings Accounts?

A: First of all, kudos to the policymakers who undertook this first innovation – it signaled to the market that workplace emergency savings is a crucial component of retirement security.

Now, let’s briefly understand the current alternative: pension-linked emergency savings accounts (PLESAs) have very limited tax benefit to employees, have balance or contribution limits based on income that’s difficult to communicate, require more regulatory overhead, and require liquidity that the current retirement world just can’t support well. It’s overwhelming to employees, employers, and others in the ecosystem – however they most notably unlocked auto-enrollment.

The whole point of emergency savings is to start simple. You can’t have the first step towards financial well-being be something that feels like yet another complex, inaccessible option – even with auto-enrollment.

Out of plan provided the simplicity, eligibility and match flexibility, and administrative ease and economics that both employers and employees wanted in the first place. It’s a market-driven solution that works, and can become even more powerful with its own auto-enrollment policy.

Q: How do ESAs pave the way for more comprehensive financial wellness solutions?

A: Emergency savings is famously the first step towards overall financial well-being. It serves as the on-ramp for just about everything else, like financial education, affordable credit, tax-advantaged savings and loan actions, housing and medical expense planning and more.

Behaviorally, this concept of an easy on-ramp with appropriate horizon mapping matters. Alternative starting paths have showed some success, but not yet broad-based success. For example, saving towards retirement has always been about “set it and forget it” and financial education has a perceived starting cost of time and emotion that’s hard to overcome. Well-designed ESAs on the other hand automatically start more people off with something they should already be doing, layering micro-doses of financial confidence and thus nudging and readying the Saver towards the next best financial wellness action, potentially leveraging AI.

Q: Why does auto enrollment pose a threat to a surge in retirement leakage?

A: Auto-enrollment into retirement savings is a fantastic idea if and only if auto-enrollment into simple emergency savings also exists. Without ESAs, auto-enrollment predictably has caused employees of lesser means to rely on costly 401(k) loans and hardship withdrawals, and for some they’ve also converted employer matches into unintended emergency cash grants rather than down-payments of future retirement security.

The data is clear: over a third of plan participants have taken loans and early withdrawals, and large recordkeepers like Vanguard continue to report double-digit percentage increases in a number of loans and early withdrawals. We also know, thanks to DCIIA, Aspen FSP, and Morningstar, that the leakage is more pervasive among Black Americans, Hispanics, and women, controlling for income. Over the same period, cost of living has grown substantially and income hasn’t kept pace, more than 60%  of employers use auto enrollment, according to the Plan Sponsor Council of America.

Interestingly, we have found through our design thinking research as we built Sunny Day Fund that employees who received matches developed new habits after auto-enrollment, which run counter to the policy’s intent. For example, at an employer leveraging a SIMPLE IRA with a 3% match and auto-enrollment, we heard from employees who withdrew their contributions and match every pay cycle, effectively treating it as immediate additional income even at the expense of penalties. So we need to think through whether these policies – by themselves – are creating the outcomes we want.

Q: How can employers ease the gap in accessible emergency savings?

A: Empowering emergency savings behavior is much easier than what employers imagine. Employers play a crucial role in making it happen while standing to gain through better retention, productivity, and health equity.

Consider the current situation: when employees want to save for an emergency or anything else, they have to find a no-fee or low-fee option without monthly minimums and ideally with a decent interest rate, spend at least 20 to 30 minutes to open the digital bank account or credit union membership (far longer for brick and mortar, far less secure for saving in cash under the mattress), endure credit checks or checks systems that may lead to denials, take the new bank account number and routing number and set up auto payments from their checking account or add to their payroll direct deposit themselves, and hope they don’t touch that emergency fund for anything but an emergency.

Related: ‘Rainy day funds’: A top priority for 70% of employees

People don’t have the time or energy to do all that.

What if you can bundle all of that into a single action at the time the employee elects their benefits: how much would you like to save for emergencies?

ESAs powerfully close the intention-action gap by simplifying the otherwise convoluted, unrewarding process of saving. And when employers contribute as well, the solution leaps into a great retention and well-being strategy.