(This article was originally posted on July 7, 2017, and subsequently revised.)
Workers are depleting their employer-sponsored retirement plans when they take out loans and don't pay them back, take hardship withdrawals, and fail to roll over retirement plan savings when they change jobs.
"Paternalistically, leakage means that people may not be ready for retirement when the time comes," said Geoffrey T. Sanzenbacher, a research economist at the Center for Retirement Research at Boston College. For employers, "leakage can make the plan more expensive in terms of the fees charged by the recordkeeper on a per-account or per-participant basis."
Such fees tend to be based on a retirement plan's asset size. When plans lose funds each year, the total asset size and the size of individual accounts can be reduced. Small accounts tend to be more expensive for employers to administer.
If their retirement accounts are dwindling, older employees may not be able to retire when they want to. How problematic that is depends on the employer and its workforce management philosophy.
"If the employer views its jobs only as a stopping point for employees and hopes only to get a good couple of years of work from them, they are probably not very concerned about whether these employees can retire," said John Lowell, a consultant and actuary with October Three Consulting in Chicago. However, if an employer wants workers to stay until normal retirement age, pass along their knowledge and skills, and then leave so younger workers can move up, early withdrawals become more problematic.
"How will this employer move those workers into retirement if their account balances are too small because of leakage?" Lowell asked.
[SHRM members-only toolkit:
Designing and Administering Defined Contribution Retirement Plans]
Causes of Leakage
Workers withdraw funds or take loans against their retirement plans for different reasons. Employees may tap into these assets as a last resort to pay medical expenses or to avoid eviction from their home, for example. Other employees may see these savings as an easy way to pay for weddings, cars and similar large expenses.
Loans and hardship withdrawals—or in-service withdrawals, penalty free after age 59½, that aren't rolled into an IRA—may also be a sign that people do not know how to manage their finances effectively. A
2016 survey of more than 4,000 workers conducted by Transamerica found that 25 percent of workers in small companies and 28 percent in large companies have taken some form of loan, early withdrawal or hardship withdrawal from a 401(k) plan, suggesting they lacked a family budget or were unable to keep expenses within their budget.
What makes leakage so frustrating is that employees lose a large chunk of their retirement savings to taxes if they withdraw it before they reach age 59½ or become disabled.
If an employee takes a hardship withdrawal, defaults on a 401(k) plan loan or simply cashes out a retirement plan account balance when changing jobs, that individual will walk away with far less than what was in the account because these withdrawals are subject to applicable federal, state and local income taxes on the full amount of the withdrawal and a 10 percent excise tax. As a result, an employee who withdraws $10,000 might lose up to 40 percent or more on that sum from taxes and penalties.
The deficiency becomes even greater over time, given the loss of compounded annual growth on the withdrawn amount.
Retirement plan consultants at For Us All in San Francisco
show how a small withdrawal can add up to big losses by retirement. For instance, if an employee withdrew $10,000 at the end of the fifth year of participating in the plan, her retirement nest egg would be $230,399 in the 30th year, rather than the $273,257 that would have been attained with no early withdrawals—a 16 percent loss in savings. If she withdrew $16,000, her savings would reach only $204,587 or 25 percent less.
Accumulated Retirement Savings after Withdrawals |
Funds withdrawn in year 5 |
Zero leakage (no funds withdrawn) |
$10,000 withdrawal |
$16,000 withdrawal |
Year 30 account balance |
$273,257 |
$230,399 |
$204,587 |
Assumes a salary of $40,000, 3 percent annual salary increase, 6 percent deferral rate and 6 percent investment return (annualized).
Source: For Us All. |
Addressing the Problem
There are steps employers can take to stem the outflow of retirement funds:
- Change plan design to eliminate or reduce situations where participants can take out plan loans or take a hardship withdrawal.
- Educate employees about the impact a loan or withdrawal could have on their retirement savings.
- Provide financial education to employees to help them manage their money better and avoid the need to tap retirement assets.
- Offer
emergency loans that can be repaid with a payroll deduction.
- Provide for
payroll deductions into an emergency savings fund.
- Educate departing employees about the need to roll over retirement assets into an IRA or their new employer's retirement plan.
- Implement an automatic rollover program so that employees' retirement plan assets end up in an IRA rather than being cashed out.
Before making plan changes, Lowell suggested that employers talk to employees about any concerns they may have. "Younger employees may have a fear of tying their money up for so long [and not having] access to that money, especially if they face any sort of work stoppage in their careers," he said. "All employees may benefit from education on the impact withdrawing money from a retirement plan can have on their ability to retire comfortably."
If employers, regulators and service providers want to get serious about the leakage issue, they may need to create a new system that automatically consolidates retirement assets as individuals change jobs and move through their careers. "In a perfect world, retirement plans wouldn't be employer specific," said Sanzenbacher. In such an arrangement, employees would always have control over their retirement assets and would not have to do anything or make any changes to those assets when they leave an employer. However, "such a world is still a ways off and is likely to develop through private sector initiative rather than through regulatory change."
Caution: Cashing Out When Changing Jobs
"Cashing out of an employer-sponsored retirement plan is possibly the single most harmful action—next to not contributing to a company-sponsored retirement plan at all—impeding employees' ability to save adequately for retirement," said Polly Scott, communication and deferred compensation plan manager for the Wyoming Retirement System. "Any withdrawal of funds from a defined contribution plan are subject to prevailing local, state and federal taxes, and, typically, a 10 percent early distribution penalty. Most significantly, the amount cashed out loses the potential for investment growth," added Polly, who is also the National Association of Government Defined Contribution Administrators'
2017 Security Week spokesperson. Polly identifies three options for employees changing employers or who have lost their jobs: -
Roll retirement plan assets into the new employer's plan. "This option, hands down, is the best option as having all retirement funds in one place makes it easier to track and manage assets," Polly said. To help employees through the consolidation process—"which can be 'clunky' at best"—most plan record keepers have assembled teams to help participants go through the process and assist with paperwork, she noted.
-
Leave retirement plan assets in the current employer's plan. Keeping a current employer's plan is also a good idea for those moving from a large employer to a small employer, where the large employer's plan has lower fees and more service offerings, Polly noted. "That said, leaving assets in a former employer's plan should never be viewed as a signal not to continue contributing or not to contribute to the new employer's plan," she advised.
-
Roll retirement plan assets into an individual retirement account (IRA). Sophisticated individual investors may choose an IRA to have the ability to participate in tax-deferred investments not offered by employer plans, Polly noted. However, IRAs may be more costly than employer plans, which often are able to offer lower costs, achieved with the buying power and clout of their size.
"Whatever the complexities involved, we encourage employees to stay the course and avoid a cash out," said Polly. "They'll avoid the inevitable regret of losing assets they are not able to retrieve—and their future selves will thank them profusely."
Tax Law Altered Loan Repayment Deadline Beginning in 2018, the Tax Cuts and Jobs Act extended the deadline for repaying a plan loan from 60 days post-employment to the date on which the participant can file his or her tax return for the year in which the loan amount was treated as a distribution. After a separation from service, borrowers also can avoid having their loan become a taxable withdrawal by contributing (by the tax filing deadline, including extensions) to an IRA or to another qualified employer plan an amount equal to the repayment terms of the loan. The contribution is then treated as a rollover that offsets the outstanding loan.
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Joanne Sammer is a New Jersey-based business and financial writer.
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