If only fixing a leaky retirement account were as easy as repairing a leaky faucet. A new report from the Center for Retirement Research at Boston College found that money is seeping out of retirement accounts at alarming rates, causing permanent damage to future retirement account balances. The cause of these leaks is “any type of pre-retirement withdrawal that permanently removes money from retirement savings accounts.” In other words, the ability for American workers to tap retirement accounts through a variety of ways, which include: In-service withdrawals (either hardship withdrawals or for those that occur for workers over the age 59 1/2); cash outs or lump sum distributions, which occur after an employee leaves a job; and loans against 401(k) assets. While all of these events are perfectly legitimate, they can “erode assets at retirement.”
The Center worked with Vanguard Investments to determine just how much each of the methods for accessing retirement assets can reduce future retirement nest eggs. While cash outs are the most damaging, all three show a total leakage rate of 1.2 percent of retirement assets. The analysis then used that rate to project the impact on 401(k) balances at age 60 and the bottom line is startling: “Leakages reduce 401(k) wealth by 25 percent. These estimates represent the overall impact for the whole population, averaged across both those who tap their savings and those who do not.”
So how do we repair leaky retirement accounts? The research makes a series of policy recommendations to plug the holes and keep monies in the plan for retirement, including:
Altering the definition of “Hardship”: Hardship withdrawals allow plan participants to withdraw funds if they face an “immediate and heavy financial need.” Government rules allow for hardship withdrawals under six circumstances: (1) To cover medical care expenses (2) To pay for funeral expenses (3) To prevent the eviction from or foreclosure on the mortgage on the principal residence (4) To cover certain expenses to repair damage to the principal residence (5) To cover costs directly related to the purchase of a principal residence or (6) To pay for post-secondary education.
While the paper acknowledges that it probably makes sense to keep hardship withdrawals as a safety valve for families in financial trouble, it suggests that “hardship” could be limited to serious, unpredictable hardships. Those might include: total and permanent disability; Health expenses in excess of 7.5 percent of AGI (as opposed to 10 percent under current law); and job loss, as documented by the receipt of unemployment benefits.
Separately, the report argues that the age for non-penalized withdrawals from both 401(k) and IRAs be raised to at least Social Security’s Earliest Eligibility Age, which is currently 62.
Cash-Outs: When you leave a job, there are usually three choices as to what to do with your retirement assets: you can leave the funds in the plan (if the employer permits), you can roll over the balance into an IRA, or into a new employer’s 401(k), or you can take a lump-sum distribution. It’s the third option that causes leakage.
The report suggests closing down the ability to cash out of a plan altogether and instead change the allowable options to leaving the money in the prior employer’s plan (even balances under $5,000); to transfer the money to the new employer’s 401(k); or, for those leaving the labor force, to roll over the plan balance into an IRA.
Loans are the least worrisome of the three leakage events. The reason is that most borrowers continue to contribute to the plan while they have a loan; and most of the money is repaid.
Most observers believe that these fixes are unlikely to be implemented any time soon, so the best bet for plan participants is to think twice before they tap the money in retirement accounts – doing so could prevent a small leak from turning into a deluge of cash that flows out of their grasps.