Financial Planning, Retirement

The Persistent Problem Of Plan Leakage

11/18/20 12:00 PM

Recently we have highlighted how the rise of automatic enrollment has helped millions of Americans participate in 401(k) plans, but too many of these individuals could still wind up hindering their ability to retire comfortably by dipping into the funds early. Indeed, as a review 401(k) “leakage” can take many forms (see below), and even prior to the economic disruptions of the coronavirus result in roughly 1.5 percent of retirement assets exiting the system each year, according to a well-known study by Boston College’s Center for Retirement Research (CRR). That might not seem particularly large at first glance but the report’s authors estimate that aggregate retirement wealth is at least 20 percent lower than it would have been without the current level of allowed plan leakage. Similarly, Federal Reserve Board calculations suggest that 40 cents of every dollar savers under the age of 55 contribute to defined contribution accounts will eventually leak out of the system prior to retirement.


The CRR researchers argue that roughly a 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, updated data from the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI) show that a majority of 401(k) plans in America offer a loan provision to participants, and roughly 1 in 7 eligible participants have such a loan outstanding. The decision to borrow from their 401(k)s might not have seemed like a particularly bad idea at the time to these participants because they simply view such loans as money they will eventually pay themselves back. Unfortunately things do not always go as planned, and research has shown that many 401(k) loans are never repaid, and that some participants are even susceptible to “serial borrowing.” “Cashing out” one’s 401(k) after a change in employment is responsible for another 10 percent of retirement account leakage, according to the CRR study, a figure which could increase if the rate of labor turnover in the U.S. rises.


Moreover, an earlier survey conducted by the Defined Contribution Institutional Investment Association (DCIIA) found that almost one in four Baby Boomers 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. What is worse is that 42 percent of surveyed Millennials said that they spent their retirement plan cash outs on non-emergency items like weddings and cars, and a quarter of Gen-X respondents said that they used their early cash outs for similar outlays. 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 typically offer.



Sources: CRR, FRBG, ICI, EBRI, NBER, Fidelity Investments, DCIIA

Post author: Charles Couch