In 2014, the Bipartisan Policy Center (BPC) launched the Commission on Retirement Security and Personal Savings, led by former Senator Kent Conrad and WL Ross & Co. Vice Chairman Jim Lockhart. The commission will consider and make recommendations regarding Social Security, pensions, defined contribution (DC) savings vehicles, strategies to generate lifetime income and other factors that affect retirement security.
This BPC-staff authored post is the third in a series that will outline the state of retirement in America and provide a sense of the challenges that the commission seeks to address in its 2015 report.
For Americans who have access to workplace retirement plans and contribute early and often, the current defined contribution system enables significant accumulation of savings for retirement. But as we have discussed, many employers don’t sponsor plans, and ones that do but lack automatic features too often result in workers failing to participate.
An important risk in the defined contribution system is pre-retirement withdrawals from 401(k) plans and Individual Retirement Arrangements (IRAs), which can significantly decrease the likelihood that workers will be ready for retirement. These withdrawals take several forms: loans by workers from their 401(k) balances; hardship withdrawals by workers from their 401(k)s; early distributions from IRAs; and, most problematic, cash-outs of retirement accounts at job changes.
Leakage, especially cash-outs, negatively impact retirement readiness. Recent research by the Employee Benefit Research Institute (EBRI) estimates that workers across the income spectrum who participate in automatic enrollment plans are between 6 and 10 percentage points less likely to be able to replace 70, 80, or 90 percent of their pre-retirement income in retirement because of the impact of leakage.
Cash-Outs at Job Turnover Are the Most Harmful Form of Leakage
When leaving an employer, employees can typically choose from four options for what to do with funds in their 401(k) plans: 1) leave the funds in the old employer’s plan; 2) roll the balance over into their new employer’s plan (if one is offered); 3) roll the balance over into an IRA; or 4) cash out by taking a taxable distribution. Departing workers often face significant pressures that lead them to the last option, despite the fact that it is likely to hurt them in the long run. Cash-outs at job change account for about two-thirds of the negative impact of all leakages on retirement readiness.
Because rolling money over into a new plan can be a hassle, taking a cash-out may seem like the best option, especially for workers with low balances. If the worker leaves their job without another lined up, they may feel the need to cash out in order to help cover expenses during an unemployment spell. Additionally, we know from behavioral economics research that individuals are generally predisposed to options that give them immediate access to their balances.
Finally, some employees don’t have all four options: some may not be starting a new job immediately or may find that their new employer does not offer a retirement plan to roll the money into, while employees may also not have the option of leaving the funds with their current employer if the account balance is less than $5,000.
Hardship Withdrawals and 401(k) Loans
In addition to leakage from cash-outs, many defined contribution plans allow individuals to take tax-free loans from their 401(k)s or to withdraw their funds in the event of demonstrated financial hardship (like an impending eviction) provided that they both pay taxes and an extra 10-percent penalty on the withdrawal.1
Hardship withdrawals, which are typically accompanied by a six-month suspension of contributions, have a modest negative impact on retirement security. The average effect depends on the account holder’s income level, but EBRI finds that (all else equal) those who take the withdrawals face a reduction of one to two percentage points in the likelihood of achieving an 80-percent replacement rate after retirement.
The evidence is more mixed, however, when examining 401(k) loans. A significant proportion of workers take these loans at some point – about 40 percent will over a five-year period. Recent research suggests that 401(k) loans may actually have a somewhat positive effect on retirement savings, as workers may be more likely to participate in 401(k) plans or make greater contributions if they know that the plans carry the option of a loan to access their savings before retirement if necessary. Typically, these loans are paid back, with interest, and participants continue contributing to the plan while the loan is outstanding.
Conversely, if an employee with an outstanding loan leaves an employer, the entire balance of the loan generally becomes due immediately. If the employee cannot pay back the loan, it is treated as a taxable distribution and the worker owes income taxes and the 10-percent penalty on the balance of the loan. Although overall default rates on 401(k) loans are relatively low (about 15 percent), the vast majority (about 80 percent) of those who leave their employer with a loan default.
Leakage: IRAs vs. 401(k) plans
The vast majority of retirement assets are accumulated in employer plans. Those individuals who do not have access to an employer plan, however, do have the option of contributing to an IRA. Additionally, workers who are departing employers (especially those transitioning into retirement) often roll plan assets over to an IRA.
Generally, withdrawing funds from an IRA is far easier than from an employer plan. In 401(k) and similar plans, plan sponsors may determine allowable reasons for hardship withdrawals, and the 10-percent penalty (in addition to income taxes) is never waived for individuals below age 59 ½. For traditional IRAs, no hardship is necessary; early distributions may be taken for any reason, and the 10-percent penalty is waived if the distribution is for a variety of pre-approved purposes, such as higher education costs or expenses related to the first-time purchase of a home. For Roth IRAs, contributions can be withdrawn at any time without penalty. The ease of tapping these funds may pose a risk to retirement readiness in particular cases.
The Bottom Line
For some Americans, cashing out their retirement accounts in between jobs is undoubtedly hurting their retirement prospects. Other forms of early access to funds from employer plans, such as 401(k) loans, do not appear to be problematic in most circumstances. There is less comprehensive data on the impact of leakage from IRAs on retirement security, but given the more lenient rules on accessing those funds before retirement, the area is one worth exploring. BPC’s commission will be analyzing these issues further and considering ways to reduce the harmful leakages out of the system.
Alex Gold contributed to this post.
View all posts in BPC’s Retirement in America series under Related Stories below.
1 The 10-percent penalty is waived if the account holder is aged 59 ½ or older.