Plug That Leak In Your 401(k)

Here’s the problem. According to a 2019 paper by the Employee Benefit Research Institute (EBRI), the median tenure of all wage and salary workers ages 25 or older is only about five years.

Don’t blame the gig economy. EBRI says this tenure has remained relatively constant over the past 35 years. That’s well before Uber UBER , Lyft LYFT , et al appeared with such ease on your mobile device.

The short tenure does many things, some good, some not so good. Among the not so good things is the proliferation of orphaned 401(k) accounts. You leave your job but your retirement savings stays put.

Now, here’s where the really bad thing happens. Instead of ignoring it (a less than optimal choice) or rolling it over into your new company’s 401(k) or your own IRA (the optimal choice), too many people decide to cash out, especially if it’s a small amount.

That “small amount” adds up to a grotesquely large number. The U.S. Government Accountability Office (GAO) issued a report in 2019 to the Senate Special Committee on Aging. Using “the most recent nationally representative data available from three relevant federal sources focusing on individuals ages 25 to 55,” the GAO concluded, “plan participants ages 25 to 55 withdrew an aggregate $9.8 billion from their plans that they did not roll into another qualified plan or IRA.”

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So much for a small amount.

It gets worse. Much worse.

When you add in hardship withdrawals and unrepaid plan loans to this, the GAO said participants withdrew a total of $29.2 billion prematurely from their 401(k) accounts.

Are you ready for the really bad news? Those numbers were based on 2013 data. Given what Congress has done recently, the annual non-retirement withdrawal rates may be substantially higher. It has lowered or removed obstacles, allowing easier access to hardship withdrawals. It now allows each parent to take out up to $5,000 for childbirth or adoption expenses. And, last year, in the height of the Covid panic, it permitted qualified savers to withdraw up to $100,000 from their 401(k) accounts.

Financial specialists refer to these premature withdrawals from retirement accounts as “leakage.” It’s an apt term since even a deceptively small leak in your retirement savings can sink your retirement.

Leakage defeats the primary advantage of retirement saving: compounding returns over decades that yield dramatically large accumulations of assets. With each leak, another cascading stream of growth is removed from your retirement portfolio.

Just when you think things are irretrievably bad, though, comes a ray of sunshine that gives you an ounce of hope.

It turns out many more Americans had the discipline to brush aside the temptation to steal from their own future. Major brokerage and mutual fund companies have reported their shareholders and clients have been reluctant to dip into their long-term savings to satisfy short-term needs.

This may have been in part due to the stoicism of individual savers. But it might have also been the result of proactive plan sponsors.

“Some plan sponsors took action to reduce leakage–without reducing liquidity,” says long-time industry veteran Jack Towarnicky, former Executive Director of the Plan Sponsor Council of America. “Some eliminated in-service hardship withdrawals, while concurrently improving their loan processing to create liquidity without leakage along the way to and throughout retirement.”

Loans are key to reducing leakage without hampering liquidity. The fact is, sometimes people have real hardships and the only way to address that need is to access money saved in a 401(k) plan.

But “access” and “withdrawal” are not necessarily interchangeable terms. You can access your retirement money before you retire without necessarily withdrawing it. In a sense, you literally temporarily borrow from your future. You not only pay it back, but you pay yourself interest on top of that!

Utilizing a loan rather than outright withdrawing the funds offers you an advantage you’ll find most beneficial. Unlike a premature withdrawal, with a 401(k) loan you can take money out of your account (again, you will have to pay it back) without incurring taxes and penalties.

Of course, taking the money out is the easy part. It’s the paying it back part that can be a challenge. Fortunately, as Towarnicky explains, companies aided employees who borrowed from their 401(k) accounts by adding features such as electronic banking and behavioral finance “nudges.”

Electronic banking helps insure the 401(k) loan is paid back consistently and on time. This is especially critical if you leave your employer prior to paying back the loan in full.

As Towarnicky notes, “Loans are not leakage unless they are not repaid. Loan principal remains an asset in the plan. It becomes a fixed income investment in the participant’s portfolio. Where the loan interest rate is less than the rate on loans from commercial sources AND where it exceeds today’s historically low rates of return on bond investments, a plan loan can improve BOTH household wealth AND retirement preparation.” One behavioral economics “nudge” Towarnicky likes is requiring a participant to execute the loan application in two places—one as the borrower and the other as the lender. 

If you’re compelled to take money from your retirement savings, the first thing to do is to think again about doing it. If you’re left with no choice, try to access it via a loan rather than as a hardship withdrawal. Then ask your company if they can incorporate automatic loan repayments or other electronic banking tools.

You can plug any potential leaks from your 401(k) account and keep it liquid at the same time.

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