When it comes to sealing the leaks from 401(k) plans, the question we ought to ask isn't just how to prevent loans and withdrawals — but why do participants pull cash prematurely from their plans in the first place.
That question kept surfacing during a hearing on Tuesday afternoon held by the Senate Committee on Health, Education, Labor and Pensions.
Indeed, Sen. Bill Nelson, D-Fla., and Sen. Mike Enzi, R-Wyo., have proposed a bill that would let workers who have left their job and borrowed from their 401(k)s wait until they file their next federal taxes to repay money they've taken from the plan. Currently, employees face a 10% penalty if they fail to repay their withdrawals and loans within 60 days of leaving their job.
Evidence shows that workers aren't dipping into their 401(k)s to cover frivolous purchases. Data from Aon Hewitt found that last year, only 2% of participants took a hardship withdrawal and the great majority of those workers did so for sound reasons: In 54% of the cases, workers were trying to avert eviction or foreclosure. Medical expenses were the second most common reason for the withdrawals (15%), while paying educational expenses came in third.
Permanent withdrawals and cash-outs are the most harmful distributions from 401(k) plans, according to panelist Alison Borland, vice president of retirement income solutions and strategies at Aon Hewitt.
A worker earning a starting salary of $50,000 and contributing 8% into his or her retirement plan, plus a 5% company match, could end up with $872,000 in 401(k) savings over the course of 30 years, assuming the money remains in the plan even through job changes, Ms. Borland said.
However, if the employee were to change jobs three times over those 30 years and took a plan cash-out each time, the account would end up with just $189,000.
“Cash-outs receive the least attention despite the magnitude of the damage,” Ms. Borland said.
Further, data from Hello Wallet shows that 25 cents of each dollar contributed toward a 401(k) will be used for non-retirement-related purposes.
To stop plan leakage, plan sponsors and service providers need to get to the cause. Matt Fellowes, chief executive officer of Hello Wallet and a panelist at the Senate hearing, agreed that the 401(k) plan is becoming a savings account rather than a retirement account.
“I like to use a stepladder as a metaphor,” he said. While many workers strive to reach the top rung of retirement savings, they're missing the lower rungs they need in order to get there.
“There are missing rungs that are fundamental to retirement security,” Mr. Fellowes added. “Few people have budgets, emergency savings, and vacation and college savings. Those are just as critical to retirement security.”
Indeed, participants' debt levels are an obstacle to effective savings in their 401(k)s. A study of 1,003 employees by the Employee Benefit Research Institute and Greenwald & Associates showed that 55% of workers report having a problem with their debt and only half of all workers said they could come up with $2,000 in a pinch.
Though plan sponsors are slammed with their own day-to-day responsibilities, financial advisers who work with retirement plans are poised to encourage workers to take a more holistic view of their overall finances.
“There are a growing number of employers who are talking about financial wellness as a topic,” said Nevin E. Adams, a co-director at EBRI's center for research on retirement income.
Because advisers have a bird's eye view of workers' savings rates, they are in a position to place workers on a path to get their finances in order and build a financial cushion that will keep them from dipping into their retirement savings.
“It's important to have that short-term reserve that you can tap because inevitably, your car will break down or you'll be involved in an accident, and there are better places to go for that money than to your 401(k),” Mr. Adams said.
He added that employees typically forget about the tax whammy that's awaiting them when they take withdrawals after leaving their jobs. Plan advisers are also in a position to educate those workers about the negative implications of taking those dollars out of the 401(k) — both in terms of the short-term tax hit and the long-term damage it can do to retirement savings.
“If you have a loan outstanding, it needs to be settled up, and there are ways to do it without triggering taxes,” Mr. Adams said. “That's a part of the discussion.”