Financial Planning, Retirement

401(k) Plan Leakage: A Serious Problem

8/29/19 12:00 PM

/iStock-462756183.jpgAutomatic enrollment and auto-escalation are among the many innovations that resulted from the Pension Protection Act of 2006. The rapid adoption of these plan enhancements has helped significantly boost participation in tax-advantaged 401(k)s and ensured that more working Americans regularly set aside enough money to take full advantage of employer-provided matching contributions. In fact, a new ICI analysis estimated that nearly two in every three workers aged 26 to 64 now participate in a retirement plan either directly or through a spouse. The sharp uptick in participation has been especially beneficial for younger workers who typically have more than three decades of 401(k) plan eligibility ahead of them.

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Such an early start can significantly increase the likelihood of achieving a target income replacement rate in retirement, according to the Employee Benefits Research Institute. 401(k)s, though, are not without room for improvement, and the various ways that plan “leakage” can still occur is arguably the biggest problem limiting the effectiveness of these tax-advantaged tools. Indeed, leakage can take many forms, and hardship withdrawals and loans are perhaps the most well-known examples. These plan features can be useful in the event of an economic setback, but problems arise when participants abuse the ability to tap into their retirement assets early, in turn treating their 401(k) like a short-term emergency fund instead of a long-term savings vehicle. The situation is made worse when accompanied by a temporary suspension in contributions and/or when the “borrowed” funds are never returned, a far too common occurrence.

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“Cashing out” one’s 401(k) after a change in employment is also responsible for billions of dollars in retirement account leakage each year. Specifically, under current law, workers have several options regarding what to do with their 401(k) balances when they leave a job but an alarming number of people simply withdraw all the funds and exit the retirement system completely. Alight Solutions, for instance, estimated that four in ten terminated 401(k) participants make the decision to cash out prematurely. These individuals only account for roughly 15 percent of all terminated participants’ plan assets but this is likely because people with smaller 401(k) balances tend to cash out much more frequently. Moreover, Alight researchers found that 80 percent of job-switchers with sub-$1,000 accounts cashed out their entire balance, and the cash out rate did not drop below 50 percent until balances surpassed $10,000.

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Similarly, an earlier DCIIA poll found that almost one in four Baby Boomers had cashed out their retirement savings at least once while changing jobs, and a third of younger respondents admitted to doing the same. What is worse is that 42 percent of surveyed Millennials and a quarter of Gen-X respondents said that they spent their retirement plan cash outs on weddings, cars, and other non-emergency items. This behavior is counterproductive because 401(k) plans are intended to help participants amass a significant retirement nest egg through routine contributions and the return generated from properly investing those savings. Tapping into these assets early can therefore have a negative impact on a person’s financial future by lowering the amount of money that can be invested and potentially diminishing the various tax advantages that 401(k) plans offer.

  


 

Sources: ICI, EBRI, Alight Solutions, DCIIA

Post author: Charles Couch