The persistent problem of savers pulling money from their 401(k) plan has grown worse since the financial crisis, heightening concerns about the effectiveness of these plans as a retirement tool.
One in four American workers with a 401(k) or other defined contribution plan tap their retirement account for current expenses, a new study shows. This “leakage” reached $70 billion in 2010, equal to nearly a quarter of all contributions that year.
Looking only at workers’ contributions (excluding employer matching funds), individuals are spending 40% of the money they put away for retirement, reports online financial firm HelloWallet. Among other findings:
- Penalized 401(k) withdrawals increased from $36 billion to almost $60 billion from 2004 to 2010.
- Workers in their 40s are most likely to breach their savings for nonretirement needs.
- 75% of those who cash-out their entire balance do so because of basic money-management problems.
Money leaks out of 401(k) plans before retirement in three basic ways: hardship withdrawals, loans that do not get repaid and cash-outs when workers switch jobs. All these have the effect of greatly reducing workers’ retirement security. Thirty years ago, most workers had a guaranteed pension at retirement; today, the $3.5 trillion in self-directed 401(k) and other defined-contribution plans is the primary retirement account of most Americans.
The issue is so concerning that experts are looking for reasonable alternatives to 401(k) plans. Some believe funds borrowed from a 401(k) should be insured. Workers who borrow from their plan and then lose their job must repay the loan. If they cannot, the loan is in default and treated as a distribution. This not only opens the worker to penalties, it permanently reduces their retirement account. Insurance would guarantee that a laid-off worker with such a loan would not lose their nest egg.
Fidelity found in 2010 that a record 22% of 401(k)-plan participants had a loan outstanding and that the default rate on those loans was skyrocketing. Defaults on 401(k) loans account for up to $37 billion of leakage annually, according to a study from Robert Litan at Brookings and Hal Singer at Navigant Economics.
The good news is that outstanding 401(k) loans have hit a plateau (though at a high level) as the economy has bottomed and begun to turn up, according to the Employee Benefit Research Institute. Some groups — those under age 25 and over 60 — are doing an especially good job of avoiding these loans. Most loans get repaid but those that do not remain a nagging source of money leaking from the retirement kitty.
Cash-outs are an even bigger source of leakage. Participants who take out money before age 59 and half rather than roll it into another qualified plan, are subject to a 10% penalty and immediate income tax.
All this raises even more questions about 401(k) plans, which in many ways have failed Americans as a primary retirement-savings vehicle. If so much money earmarked for retirement is going to be pulled out early, 401(k) plans would seem to be a terribly inefficient tool. The high costs of leakage point up the value of building and maintaining an emergency fund even before building a nest egg.