401(k) Leakage

A good advisor can help plug 401(k) leaks

A 401(k) is a great way for you and your employees to stay on the road to a successful retirement. In fact, a hefty retirement savings is essential in an era where few families can rely on a traditional pension plan. Further, retirees should expect Social Security to provide no more than 40% of their working wages. Yet, the Social Security Administration’s financial experts say retirees will need something closer to 70% of their earnings to live comfortably. 401(k) plans are greatly increasing the odds that more employees will reach that 70% figure.

The odds are even better if your company’s plan has a high participation rate and employees are deferring a significant portion of their earnings. But employees with a leaky 401(k) account could have a tougher time accumulating sufficient retirement assets.

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What is 401(k) leakage?

“Leakage” is 401(k)-speak for when participants withdraw retirement funds from their 401(k) account before retirement. While leakage may sound like something that could be quickly fixed with a patch and some glue, 401(k) withdrawals can have long term implications.

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Types of 401(k) withdrawals

Leakage occurs in three ways.

1. In-service withdrawals. These include “hardship withdrawals” before the age of 59 ½. Here participants take out retirement money to pay for emergency medical expenses, education, or to buy a home. Such withdrawals come with a 10% penalty tax. The other type of in-service withdrawal is any withdrawal after age 59 ½. This type of leakage includes withdrawals by those actually retired, by those not yet retired, and by those rolling over 401(k) money into an IRA. Although there is no penalty for this type of withdrawal, taking out funds for living expenses too early can adversely affect long term retirement planning.
2. Cashouts. A cashout is when an employee takes a lump-sum distribution from a retirement plan upon leaving a job rather than leaving the money in the plan or rolling it into an IRA. There is a 10% penalty tax on such distributions.
3. Loans. Loans generally must be repaid, so they typically have a limited impact on retirement savings. However, some loans are never repaid, causing the 401(k) balance to take a permanent hit. Loan defaults trigger the 10% penalty tax.

It’s difficult to determine to what degree leakages are making saving for retirement more challenging. Comprehensive data is simply lacking, but researchers at the Center for Retirement Research of Boston College have given it a go. They examined data from Vanguard retirement plans, which account for about 10% of total retirement plan assets.

Of the three types of leakage from Vanguard plans, cashouts were the largest, followed by hardship withdrawals. From a macro perspective, these leakages represent a small portion of retirement funds. For example, cashouts represented just 0.5% of total Vanguard assets. But it’s at the individual employee level where the impact can be meaningful.

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Why 401(k) leakage matters

For an individual, leakages are a problem if the nest egg at retirement is meaningfully smaller than it would have been otherwise. Leakages early in the asset accumulation phase are especially harmful because those funds would otherwise be compounding returns for years and years.

To better understand the impact of a leak, let’s consider the case of an employee earning $40,000 a year who gets a 3% raise each and every year. Let’s say this employee defers 6% of her earnings into her 401(k). Let’s further assume these contributions are made for 30 years. We’ll also assume that these 401(k) investments earn a 6% return. At the end of 30 years, our hypothetical employee will have retirement savings of $273,257.

But what if some of those savings leak out? As the accompanying table illustrates, a little withdrawal can have a huge impact. If our employee withdrew $10,000 at the end of the fifth year, her retirement nest egg would be 16% less in Year 30, or $230,399, rather than the $273,257 attained with no leakage. If she withdrew $16,000, her savings would reach only $204,587 or 25% less. What may seem like a small withdrawal can add up to big numbers by retirement:

Accumulated Retirement Savings vs. Leakage

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As it turns out, the employee described above may be more real than hypothetical. According to a 2015 study by PWC, it is not unusual for employees to struggle with competing priorities. The researchers found that 35% of those surveyed believed they would one day have to use retirement savings to pay for non-retirement expenses. That figure is up from 27% the past two years.

Because of the importance of 401(k) savings and the relative ease of making withdrawals, some big companies are taking steps to make employees think twice before withdrawing retirement funds. But even if your company’s plan isn’t giant-sized, a good advisor can ensure that your employees get plenty of help when it comes to weighty financial decisions.

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