Millions of Americans participate in employer-sponsored 401(k) plans, and many more will eventually join in as the shift from defined benefit plans to defined contribution plans continues. Although it is encouraging that a growing number of U.S. workers are utilizing these tax-advantaged saving vehicles, too many participants wind up hindering their ability to retire comfortably by dipping into the funds early. Indeed, 401(k) "leakage" can take many forms, e.g. loans and hardship withdrawals, and result in roughly 1.5 percent of retirement assets exiting the system each year, according to a study from the Center for Retirement Research (CRR) at Boston College.
The report’s authors also found that roughly one quarter of retirement account leakage can be explained by adverse life events, such as job loss and the onset of poor health, and another 8 percent is attributable to people tapping into their retirement assets early to help with a down payment on a home. One of the most common ways of accessing a 401(k) prior to retirement is through the use of a plan loan. In fact, a joint study from the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI) found that 54 percent of 401(k) plans in America offered a loan provision to participants in 2014 (most recent data available), and 20 percent of eligible participants had loans outstanding.
Borrowing from their 401(k)s might not have seemed like a particularly bad idea at the time to these participants because they simply viewed such loans as money they will eventually pay themselves back. Unfortunately, things do not always go as planned, as evidenced by research out last year from the Pension Research Council at the Wharton School which found that 10 percent of 401(k) loans are never repaid, and many participants are susceptible to “serial borrowing.” However, even if a plan loan is paid back in full, the tax-deferred growth the borrowed funds would have generated while in a traditional 401(k) are lost forever, and the loan itself is repaid with after-tax dollars.
Changes in a person's employment situation are also partially responsible for plan leakage in America because separating 401(k) participants generally have up to four options for their savings:
- Leave the funds in the previous employer’s plan.
- Roll over the funds to the new employer’s plan.
- Roll over the funds to an IRA
- Cash out.
The last option (cashing out) is responsible for 10 percent of retirement account leakage, according to the CRR study mentioned earlier, a figure which could increase if the rate of labor turnover in the U.S. rises. Moreover, a report from the Defined Contribution Institutional Investment Association (DCIIA) found that a quarter of surveyed Baby Boomers said that they had “cashed out” their retirement savings at least once while changing jobs, and a third of Millennials and Gen X respondents reported doing the same. Ideally the money would be kept in a 401(k) because sponsors are responsible for regularly monitoring a plan’s investment options, and many employers even provide education or guidance on investing for participants.
The automated and presumptive plan-to-plan transfer of retirement savings as workers change jobs is a potential way to address the problem of plan leakage related to employment changes, according to a new EBRI report. However, J. Spencer Williams, president and CEO of the Retirement Clearinghouse, told the EBRI that one of the current hurdles in the way of such an “auto-portability” initiative is “getting the U.S. Department of Labor to agree with the ‘negative consent’ provision, under which the transfer of funds is presumed to be chosen unless a participant actively chooses to withdraw the funds.”
Sources: Boston College (CRR), ICI, EBRI, Fidelity Investments, DCIIA, Boston Research GroupPost author: Charles Couch