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Stopping 401(k) Plan Leakage

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When 401(k) participants begin taking loans, cash outs and withdrawals from their plans, their retirement security is damaged or depleted. The Defined Contribution Institutional Investment Association reported this in August 2011 in a report titled "Leakage and the Impact on Retirement." This plan leakage lowers the likelihood that participants with low wages will be able to replenish their retirement incomes after 31 to 40 years of plan eligibility. In definition, successful income replacement is placing 80% of income in retirement while taking Social Security into consideration.

The report by the Defined Contribution Institutional Investment Association stated that plan sponsors are helpful in preventing leakage by making changes to practices in hardship distributions and plan loans. When considering the adequacy of American workers' retirement, DCIIA's research committee chair points out that both the industry and plan sponsors emphasize enrollment in 401(k) plans and higher levels, which is critical for building a secure retirement income. The committee's research defines the importance of encouraging employees and retirees to keep their assets in their plans.

This report is connected to another research report from 2010 that was completed with information from the Employee Benefit Research Institute, the DCIIA's "Raising the Bar: Pumping Up Retirement Savings" report and the Impact of Auto-Enrollment & Automatic Contribution Escalation on Retirement Income Adequacy. The main message of these reports is that automatic contribution and enrollment escalation may bring a material improvement in retirement income replacement. This fact is especially true for low-income workers. However, the effectiveness of the plan depends on how it's implemented and utilized.

Although many people have the misconception that loans and cash outs aren't extremely harmful, the committee chair points out that research shows the opposite. Pre-retirement distributions are, according to their report, the most harmful forms of plan leakage in the contribution system. Their research also shows that cash outs may lower the likelihood that participants will replace most of their income in their plans by more than five percentage points. The reduction rate for hardship withdrawals may be as high as three percentage points. When the projected impact of hardship withdrawals, cash outs and participation delays are combined, the success probability falls by more than 14 percentage points. This total presents a failure risk for retirement income replacement.

Since plan sponsors and policymakers impact the outcome of American workers' retirement funds, there are several things plan sponsors should do:

  • Encourage rollovers by offering online options.
  • Permit loan payments following termination.
  • Encourage new employees to add balances from previous employers into their new plans.
  • Lower the number of allowed loans.
  • Restrict the available loan balance.
  • Encourage retired employees to keep assets in the plan through good communication and flexible design.
  • Encourage employees using hardship withdrawals to restart contributions to the plan.
  • Automatically restart contributions after the statutory suspension period following hardship withdrawals.

The DCIIA also recommends these inclusions:

  • Instead of automatically allowing cash outs upon termination, allow them only to those who are truly in need.
  • Put limits on loans, and allow repayment of loans after termination.
  • Strike out the six-month suspension requirement for hardship withdrawals.

It's important to design a plan structure that encourages more contribution and less withdrawals from plan funds. These changes benefit both the plan sponsor and the participants who contribute.

Click here to return to Amity Insurance E-Newsletter January 16, 2012.