Participants' savings in 401(k) and other defined contribution plans can be eroded significantly by "leakage"—loans, hardship withdrawals and cash outs when changing jobs—leaving retirement income security in tatters, according to an August 2011 report by the nonprofit Defined Contribution Institutional Investment Association (DCIIA), Plug the Drain: 401(k) Leakage and the Impact on Retirement.
Plan leakage reduces significantly the probability that low-wage participants will be able to replace most of their income in retirement after 31 to 40 years of plan eligibility. Successful income replacement is defined as replacing at least 80 percent of income in retirement, taking into account Social Security.
The report suggests that plan sponsors reduce leakage by modifying practices involving plan loans and hardship distributions. “When it comes to American workers’ retirement income adequacy, policy-makers, plan sponsors and the industry have tended to emphasize enrolling employees in 401(k) plans at robust levels—and that’s critical to building retirement income,” said Lori Lucas, the chair of DCIIA’s research and survey committee. “Our new research underscores the importance of going a step further to encourage employees and retirees to retain assets in the plan.”
The report builds on a 2010 joint research report DCIIA produced with the Employee Benefit Research Institute (EBRI), The Impact of Auto-Enrollment and Automatic Contribution Escalation on Retirement Income Adequacy, and the DCIIA's companion report, Raising the Bar: Pumping Up Retirement Savings. The core message of these research reports is that auto enrollment and auto contribution escalation in 401(k) plans—depending on how they’re implemented and used—can result in a material improvement in retirement income replacement, especially for low-income workers.
Lucas noted that “contrary to many commonly held assumptions around the impact of loans, the DCIIA research report identifies cash outs and other pre-retirement distributions to be the most harmful elements of leakage from the defined contribution system.” The analysis finds that 401(k) plan cash outs can reduce the probability of participants replacing most of their income in retirement within the 401(k) environment by more than 5 percentage points (from an 83 percent probability without cash outs to a 78 percent probability with cash outs). For hardship withdrawals, the reduction can be as high as nearly 3 percentage points.
Most compelling, when the projected impact of cash outs, delays in participation by job changers and hardship withdrawals are combined, the projected probability of success drops by more than 14 percentage points. This outcome amounts to a potential derailment of retirement income replacement.
“Plan sponsors and policy-makers can have a big impact on the retirement outcomes of American workers," said DCIIA’s executive director, Lew Minsky. His group's recommendations for plan sponsors include:
• Encourage new employees to roll over balances from former employer's plans into their new employer's plan, possibly as part of the new-hire orientation, and encourage ways to simplify and automate this process.
• Through communication efforts and through plan design (by allowing more flexibility around partial distributions), encourage retired employees to leave assets in the plan.
• Restart contributions automatically after the statutory six-month suspension period following hardship withdrawals.
• Target communication messages to employees with hardship withdrawals to encourage restarting contributions in the plan.
• Reduce the number of loans allowed and/or restrict the available loan balance.
• Allow loan payments after termination.
DCIIA's recommendations to policy-makers include:
• Cash outs. Instead of allowing cash outs automatically on termination, restrict cash outs to those in need (similar to in-service hardship withdrawals).
• Hardship withdrawals. Eliminate the six-month contribution suspension requirement for hardship withdrawals. This action might decrease the potential impact of hardship withdrawals and retirement security, especially given possible participant inertia when it comes to reinstating plan contributions.
• Loans. Place limits on loan-taking, and allow post-termination repayment of loans.
Stephen Miller, CEBS, is an online editor/manager for SHRM.
Preretirement 401(k) Breaches on the Rise, SHRM Online Benefits, January 2013
Senate Bill Would Limit Retirement Savings 'Leakage,' SHRM Online Benefits, May 2011
401(k) Loans and Hardship Withdrawals on the Rise, SHRM Online Benefits, August 2010
GAO Recommends Revising 401(k) Hardship Withdrawal Policy, SHRM Online Benefits, October 2009
One in Four Withdraw Retirement Account Funds Early—and Pay the Price, SHRM Online Benefits, May 2008
Do’s and Don’ts of Hardship Distributions, U.S. Internal Revenue Service
401(k) Plan Loans: An Overview, 401khelpcenter.com
401(k) Hardship Withdrawals: An Overview, 401khelpcenter.com
SHRM Online Benefits Discipline
SHRM Online Retirement Plans Resource Page