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How Should the 401k Fiduciary Address “Leakage”?

November 26
03:46 2013

There’s a growing concern some employees are abusing this privilege to withdraw prematurely from their 401k account for expenses other than retirement. These withdrawals can range from so-called “hardship” withdrawals to simply taking the 1235157_16765716_house_for_sale_stock_xchng_royalty_free_300money out when employment is terminated. Every such transaction has the effect of delaying retirement readiness.

Financial professionals call these transactions “leakage.” “Leakage is where assets leave a 401k plan prior to retirement – where monies are not used for post-employment income purposes,” says Jack Towarnicky, an employee benefits attorney in Grandview Heights, Ohio. “Hardship withdrawals are leakage. Post-separation distributions prior to retirement are leakage. Retirement, of course, is defined by each worker – and may include a transition to retirement (flexible or phased retirement), a second career/continued employment, or leisure. On the other hand, loans are generally NOT leakage. The average loan balance is less than $8,000, while the median loan balance is less than $4,000. Most loans are repaid prior to separation (one estimate showed less than 3% of loans are defaulted while employment continues). Most loans that are in effect at separation are NOT repaid and do become leakage (estimates are that 80% of loans at separation are not repaid). One study showed the average loan default was $6,542. However, the total leakage from loans is dwarfed by leakage due to hardship withdrawals and post-separation distributions. Leakage at separation (whether from a loan, or a distribution) is highly concentrated among younger workers and those with very modest account balances.”

Towarnicky spoke on the topic of 401k leakage at the 2013 annual meeting of the Academy of Behavioral Finance and Economics. He says that leakage occurs for “many reasons. According to the annual American Payroll Association survey, Getting Paid in America, most Americans live ‘paycheck to paycheck’ – that even a short delay in a single check would pose a financial hardship for two-thirds of survey respondents. And, for many Americans, their 401k savings is their only accumulation of cash. So, for those workers who are illiquid and have no ready access to credit, the 401k loan and hardship withdrawal provisions serve as a lifeline.”

He says, “One 2009 study showed that about half of U.S. households reported they could come up with $2,000 in 30 days – less than 33% among those with incomes less than $30,000 (50% would source a savings account, 30% would borrow from family or friends, 21% would run up the credit card balance, and 12% would use payday/pawn shop loans).”

While we know leakage can hurt retirement readiness, there could be worse things. Towarnicky acknowledges “leakage creates a hole in your accumulated account balance,” but he points out, “with apologies to Tennyson, ‘it is better to have saved and lost, than to never have saved at all.’ That is, even a 401k drained by emergency needs is better than the insignificantly higher short term standard of living where no one saves, such that payday/pawn loans must be accessed for such needs.”

What could a plan sponsor do to cut back on leakage? “Hardship withdrawals are not subject to Internal Revenue Code § 411(d)(6) anti-cutback provisions,” says Towarnicky. “As a result, a plan that previously offered hardship withdrawals can eliminate them. In-service withdrawals and post-separation withdrawals are subject to those tax code provisions – so, prospective changes are necessary. Limiting withdrawals need not create any issue so long as the plan allows loans – and specifically, loans where administration and structure are designed to prompt repayment in almost every situation. My 401k plan eliminated in service, hardship withdrawals in 1996. Participants adjusted easily.”

The precise significance of leakage ranges depending on what study you look at. Towarnicky says, “In a 2009 study of 2006 distributions, GAO confirmed that leakage after separation is significant ($74B), hardship withdrawals totaled $9B while deemed distribution loans (in service loan defaults) accounted for $670MM. At least one study puts the leakage from loans as high as $37B annually – however, those individuals were selling insurance for 401k loan defaults – insurance employers don’t want and insurance employees don’t need. One analysis of the $37B number suggests a more reasonable estimate would be $7B.”

Towarnicky reminds us that “leakage is not a ‘plan’ issue, but a ‘participant’ issue. The participant controls the vested portion of the account. So, it may or may not be a ‘problem’ – depending on the objective to be achieved. Leakage is a problem because Americans have not saved enough for retirement.” He feels leakage “ranks a very distant fourth on the list of issues with respect to retirement preparation.” Among these, he lists:

  1. “Not enough employers sponsor a plan (~80MM work for an employer that does not sponsor a retirement plan, Current Population Survey, EBRI), however, many who are ineligible are under age 21, over age 65, self-employed, part time, and low income.”
  2. “Too many fail to join when eligible (voluntary enrollment rates ~59%, Vanguard, 2012)”
  3. “Too many fail to save enough (median deferral rate 6%, median total contribution rate 9.5%, Vanguard 2012)”
  4. “Upon separation, 53% of assets remained in the plan, 39% rolled-over to IRAs, 5% was cashed out, and 3% was split between cashout and rollover (Vanguard, 2012).”

While there has been talk among some that leakage is a problem that needs solving, Towarnicky doesn’t agree. “My experience is that leakage is an issue for every plan,” he says, “particularly leakage after separation – simply because for almost all plans, the only option to access monies after separation is a taxable distribution. More plans need to adopt 21st Century loan processing, participants should be able to access funds after separation, in a tax-efficient, electronic loan process (just like electronic bill paying) – so, those who are not yet of retirement age have access without necessarily triggering leakage.”

If a choice between working longer or losing your house, which would you choose?

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

1 Comment

  1. Charles Humphrey
    Charles Humphrey November 27, 09:30

    Thank you Chris for writing about this very important issue. It is one that every plan sponsor should be very concerned about.

    The problem is that the 401(k) plan was never intended to be the retirement plan it has morphed into today. (Remember when sponsors had both true defined benefit retirement plans and a 401(k) plan.) Hence it has the features mentioned in your piece, allowing immediate access to access to funds but thwarting achievement of retirement income security objectives.

    Plan sponsors who are concerned about their employees achieving a secure retirement will want to have a discussion about leakage and what they can do about it. What good are participant education efforts and and plan sponsor contributions intended to provide retirement benefits if they are dissipated away in termination and hardship distributions.

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