September 10, 2018
Well Tom, there is a new study out that highlights a challenge to retirement saving for many Americans. As you know, employer sponsored 401k accounts are the backbone of many people’s retirement saving. In recent years, many employers have embraced automatic enrollment, meaning they sign employees up for 401k plans unless workers specifically opt out. Overall, this has been positive. Auto-enrollment has boosted average 401k participation rates above 85%, compared with just 63% at companies without the feature. However, there is some unsettling news from a recent report. Increasingly, these retirement savings made possible by automatic enrollment in 401(k)-style plans are being treated as a pot of money for workers to borrow from or cash out when they leave a job. This is not a good trend.
According to the study, from the TIAA Institute, workers who were automatically enrolled in retirement accounts tend to treat their 401k accounts as convenient pools of cash, rather than money they have placed out of reach. Specifically, the researcher found that within eight years of joining a 401(k) plan, automatically enrolled workers withdraw nearly half of the extra they manage to save, compared with workers left to sign up for the retirement plan on their own. So, while automatic enrollment is increasing participation, we have not found a system that incentivizes people to leave their money alone once they have contributed.
Interestingly, this could be linked to the amount that people have managed to save. Two other studies show the connection. According to Alight Solutions LLC, many automatic enrollment plans set their default contribution for 401(k) accounts around 3% of earnings, which creates a number of accounts with small balances. And Retirement Clearinghouse LLC found that 60% of 401(k) participants with balances below $10,000 liquidate their accounts when they leave a job. According to an expert from the Employee Retirement Benefits Institute, when people do not have much money in the system, they do not believe it is worth it to them to roll it over.
First things first, Tom: people need to understand the actual costs of cashing these accounts out – partially or fully – or of taking loans from your 401k. Our listeners should know that pulling from your retirement funds early – what we in the industry refer to as leakage – will likely reduce the wealth in U.S. retirement accounts by about 25% when the lost annual savings are compounded over 30 years, according to economists at Boston College’s Center for Retirement Research. On top of lost returns over time, in the more immediate timeframe you have to pay taxes and penalties on any withdrawal you take before you are 59 ½ years old.
As an example, let’s do the math. Say you want to withdraw $1,000 from your 401k today. Assuming a 15% federal income tax rate, a 3% state income tax rate, and the 10% withdrawal penalty, you will pay $280 – 28%! – in taxes and fees. And if you assume returns of 5% annually for 20 years, you are forfeiting $1,640 in earnings.
These findings are likely to spur conversation about how to address these problems. Many retirement policy experts already are recommending automating the process of transferring money from an old employer’s plan to a new employer’s plan. Some also favor doing away with a rule that allows companies to issue checks to departing employees with 401(k) balances below $1,000, many of whom cash the checks rather than deposit in another retirement account. Finally, there have been calls for more companies to offer two different kinds of accounts - a 401k and an emergency savings account linked to it - so that fewer employees turn to their retirement savings when in tough financial straits.
Ultimately, Tom, the best things we can do is make sure people are educated about the need to save for retirement, and the actions that can jeopardize these savings.
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