By Cyril Tuohy
While lawmakers are quick to tout initiatives aimed at boosting retirement plans, none of the bills in Congress proposes shutting down retirement plan “leakage.”
Leakage — how people drain assets from their defined contribution retirement plans through borrowing, early withdrawals and cash-outs — is costing investors dearly, according to studies and surveys of retirement plans.
John C. Bogle, founder of the Vanguard Group index mutual funds, said that under the defined contribution model in use today, early withdrawals are granted too easily, loan qualifications are not strict enough and repayment terms are too lenient.
“A major part of the problem is that corporate defined contribution plans were designed as thrift plans, not retirement plans,” Bogle said before a Senate Finance Committee hearing on retirement savings and tax reform. “To a greater or lesser degree, corporate defined contribution plans simply (and paradoxically) give their beneficiaries and owners too much flexibility.”
No doubt, once investors interrupt putting money away for tomorrow, it’s even more difficult for them to restart their savings habit.
Loans are particularly costly. Within five years of taking a loan from their 401(k), 40 percent of borrowers decreased their savings rate and more than one-third of those who took a loan stopped saving altogether, a recent Fidelity Investments survey found.
A 401(k) investor who begins saving 10 percent of a $50,000 salary at age 25, but then reduces savings to zero for 10 years beginning at age 35, can expect monthly retirement income of only $1,960 from a 401(k), according to Fidelity. That same investor who maintains a 10 percent savings level for 10 years beginning at age 35 can expect to receive $2,650 in estimated monthly retirement income from his 401(k), Fidelity said.
“The number of investors borrowing from their 401(k) has trended upwards in recent years, with more than 2 million investors now having an outstanding loan,” said Doug Fisher, senior vice president of thought leadership and policy development at Fidelity Investments.
Financial advisors generally don’t encourage borrowing against savings, although there may be times when a 401(k) home loan is an option.
Loans against retirement accounts rose in the wake of the 2008 financial crisis, particularly among workers earning between $40,000 and $60,000 annually, according to a 2011 survey by Aon Hewitt on how loans, withdrawals and cash-outs erode retirement savings.
The Aon Hewitt survey also found that withdrawals rose in the wake of the financial crisis.
In 2010, 6.9 percent of defined contribution plan participants took a withdrawal, and 20 percent of the withdrawals were related to hardship, with an average amount of $5,510, the survey found. The remaining 80 percent were withdrawals by investors who were eligible to take out the funds since they had reached the required age of 59.5 years. The average withdrawal amount for those investors was $15,480, the survey found.
Cash-outs, the “take the money and run” equivalent when an employee leaves an employer plan through termination or early retirement, are the most “injurious” forms of leakage, according to the Aon Hewitt survey.
Among workers who terminated employment in 2010, 42 percent took a cash distribution, the survey found.
Retirement plan participants who cash out benefits can expect to see their retirement income reduced from 11 percent to 67 percent, Aon Hewitt said. Cash-outs cost retirees dearly because of taxes and penalties.
With "outs" like these, critics of the nation’s defined contribution system aren’t surprised that so many working Americans are falling short of their retirement goals.
Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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