Pandemic’s Wake Draws Emergency Savings Accounts Into Focus

Art by Bill Mayer

Myriad 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.

Not surprisingly, a growing number of retirement plan recordkeepers are offering their plan sponsor clients the ability to directly link emergency savings accounts for employees with the company’s payroll deferral retirement plans.

“The pandemic increased awareness of the importance of emergency savings accounts for both individuals and employers,” says Rachel Weker, a senior retirement manager at T. Rowe Price.

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

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

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

“Individuals who had emergency savings tended to fare much better than those who didn’t,” he points out. “As a result, this is 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 is important to automate and simplify the process, Weker says. Otherwise, employees may struggle with getting started in terms of establishing an account and knowing how much they need—or how much they can afford to save. She also warns that many employees are struggling to recognize that they can save more than they currently are, and that it is important for them to look at spending patterns with an honest eye.

According to Weker, retirement plan emergency savings considerations should include the speed at which funds could be accessed, as same-day access to funds typically isn’t available, and the taxation of contributions and distributions. She also says it is important to consider the potential for additional leakage from the retirement plan, as participants might be more likely to tap into retirement plan assets if the emergency fund doesn’t truly meet their emergency needs.

In March, a group led by the AARP Public Policy Institute and the nonprofit Aspen Institute published a set of principles for effective emergency savings policies. The group developed the following five design principles they believe policymakers should follow when implementing emergency savings policy:

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

The Importance of Automatic Enrollment

A growing body of research shows that automatic enrollment in employer‑sponsored 401(k) savings plans has had a huge impact on the way millions of Americans save for retirement. Inertia seems to be stopping many workers from signing up for company retirement plans, as a desire to save doesn’t always translate into action.

“As seen with the retirement 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 a savings path,” Weker says.

However, research also shows that auto-enrollment is better at increasing participation than it is at increasing overall levels of savings. An analysis from T. Rowe Price and Taha Choukhmane, an assistant professor of finance at the MIT Sloan School of Management, indicates that auto-enrollment programs set up without automatic deferral escalations tend not to have a strong positive impact on financial outcomes. This is because employees who are auto-enrolled tend to contribute less than those who are not.

Separating Emergency Accounts From Retirement Plans

According to John, behavioral studies on investing habits show that people are far less likely to dip into their emergency savings for other things if they are in a separate account.

“There is a study that has been widely quoted which addresses something called ‘envelope theory,’ and what it basically shows is that people are less likely to touch assets when they are held in an account with a stated, particular purpose,” John says. “The takeaway is that people need an emergency savings account and one that is different from their general savings.”

According to a research paper from the National Bureau of Economic Research, 39% of U.S. adults said in a survey that they could not pay for a $400 emergency expense using cash or its equivalent.

“With limited liquidity, many working-age households spend savings intended to finance old-age consumption well before reaching retirement,” the paper warns.

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

“Individuals with present bias tend to act impatiently in the present while wanting to act patiently in the future,” the report explains. “Households with present bias hold too little liquid wealth and will deplete their partially liquid retirement savings (e.g., through 401(k) loans or pre-retirement distributions) when adverse shocks arise.”

Provide a Range of Options to Ensure Needs are Met

According to the set of principles for effective emergency savings policy, supporting only one type of emergency savings account could exclude certain households that are in desperate need. Put simply, the needs of different groups are going to vary widely.

Additionally, emergency savings should be enough to meet a wide range of financial needs when income alone is insufficient. Some research indicates that the minimum liquidity buffer needed by the average low-income household is just under $2,500, and can be as high as more than $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 may reduce the number of people who regularly withdraw early from retirement savings.

“A significant number of employers are now recognizing that this is something that their employees want,” says John. “We are still seeing a relatively small number of employers actually offer emergency savings accounts, but we are seeing that this number is growing. And that is likely to spur even more innovation going forward.”