When 401(k) participants begin taking loans, cash outs and withdrawals from their plans, their retirement security can be damaged or depleted. The Defined Contribution Institutional Investment Association reported this in a report titled "Leakage and the Impact on Retirement." Plan leakage lowers the likelihood that participants with low wages will be able to replenish retirement income after many years of plan eligibility.
In the report, successful income replacement is defined as replacing about 80% of pre-retirement income in retirement, taking Social Security into consideration. The DCIIA noted that plan sponsors can help prevent leakage by updating practices around hardship distributions and plan loans.
According to the DCIIA research committee chair, both the retirement industry and plan sponsors should emphasize enrollment and higher contribution levels to build secure retirement income. The committee also highlights the importance of encouraging employees and retirees to keep assets in their plans.
Related research combined DCIIA work with information from other organizations and concluded that automatic enrollment and automatic escalation of contributions can materially improve retirement income replacement, especially for lower-income workers. Related resources include Importance of Retirement Financial Planning and Health Insurance Awareness.
Many people assume loans and cash outs are not highly harmful, but the committee's research shows the opposite. Pre-retirement distributions are among the most harmful forms of plan leakage.
The report finds that cash outs may lower the likelihood that participants will replace most of their income by more than five percentage points, while hardship withdrawals can reduce replacement rates by up to three percentage points. When the projected impacts of hardship withdrawals, cash outs and participation delays are combined, the probability of success falls by more than 14 percentage points, creating a substantial failure risk for retirement income replacement.
Recommendations
- 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 clear 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.
Additional recommendations
- 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.
Designing plan structures that encourage more contributions and fewer withdrawals benefits both plan sponsors and participants. For broader context on retirement plan trends and employer-sponsored coverage, see The Decline of Employer-Sponsored Pension Plans.
Frequently Asked Questions
How do plan loans and cash outs affect retirement savings?
Loans and cash outs reduce the balance growing in the plan, which can significantly lower the chance of reaching a target replacement rate in retirement.
What can plan sponsors do to reduce leakage?
Plan sponsors can encourage rollovers, limit loan features, allow loan repayment after termination, and promote automatic enrollment and escalation.
Are hardship withdrawals always necessary?
Hardship withdrawals should be limited to true emergencies, and plans can be designed to encourage participants to restart contributions afterward.
Why is automatic enrollment effective?
Automatic enrollment and automatic escalation increase participation and contribution rates, which improves long-term retirement income adequacy for many workers.