David I Gensler, MSPA, MAAA, EA
“Leakage” sounds like something seniors need to worry about. It is certainly not a term that one would associate with a 401(k) plan. But leakage can come in many different forms. And in a recent article in the Wall Street Journal, it is leakage from their 401(k) plans that has many American companies concerned.
Leakage is a term from the retirement plan industry that is used when participants tap into or pocket retirement funds early. The article stated that this practice can cause an employee’s ultimate retirement nest egg to shrink by up to 25%.
Many employers have taken some aggressive steps (like auto-enrollment and auto-escalation) to encourage their employees to save in 401(k) plans. But like a bucket with a hole in it, while those savings find their way into a company’s 401(k) plan, there is a growing awareness that the money is not staying there. If older workers cannot afford to retire, it can create a logjam at the top, leaving little room for younger, less-expensive hires.
Leakage primarily takes two forms: loans and distributions that are not rolled over. Let’s look at each one and see how some companies have found some ways to, if not solve the problem, at least slow it down.
Assuming that a retirement plan has a loan provision, a participant can borrow the lesser of 50% of their vested interest up to $50,000. In 2009, 401(k) plans had assets of about $4.2 trillion. A rising stock market and new contributions from employees and employers has driven that number up to about $7 trillion. For many participants, other than their home, their 401(k) account balance represents the most significant investment that they have. And unlike their home, they get a statement each quarter showing them exactly how much it’s worth. That of course, invariably leads to the question “How can I get my hands on that money?” Taking out a loan is not, in and of itself necessarily a bad thing. If the employee remains with the same employer, the loan will ultimately be repaid and their account balance is made whole. But if the employee terminates employment, they must then repay the outstanding principal balance. If they cannot, then the unpaid principal gets characterized as a distribution. And if they are younger than 59 ½, an excise tax on top of the income taxes is also assessed. Since every time a distribution is taken from a 401(k) plan a 1099-R is generated, it is relatively easy for the IRS to identify what income taxes are due and who owes them.
Some companies are finding creative ways to make people stop and think before taking out a 401(k) loan. A mortgage company in South Carolina started requiring workers who initiate a loan to consult with a financial advisor, at the company’s expense. Home Depot recently started making employees wait at least 90 days after paying off one 401(k) loan before taking another. When Home Depot employees apply for a 401(k) loan online, they get a pop-up notice that estimates how much the loan might reduce the employee’s retirement nest egg.
Other companies are offering a low-cost loan outside of the 401(k) plan or, have partnered with their payroll vendor to offer their employees to contribute – via payroll – to an emergency savings account linked to its 401(k) plan. So if the employee goes online, they can see this other source of funds and will (hopefully) use that first before tapping their 401(k) plan for a loan. These funds represent non-401(k) after tax dollars. Still by illustrating that they have another source of funds available to them, employers are hoping that their employees use that money first.
Note – this feature is very new and not readily available to most companies and their employees.
The article states that 30% – 40% of people leaving jobs cash out their 401(k) account and pay the income taxes and the penalties, rather than rolling it over. If that statistic is accurate, I would not characterize that as leakage, it is more like a tsunami. Failure to roll that money over will have a devastating effect on an employee’s ability to save any meaningful amount of money for retirement.
Finally, the article quotes research firm Morningstar stating that in 2013 when changing jobs, between loans and distributions, employees pulled $68 billion from their 401(k) accounts. That is up from $36 billion in 2004. That is a disturbing trend. If not reversed, the log jam at the top of many companies is not going away any time soon.