One sure way to drain a 401(k) savings plan is through “leakage” — cashing out savings early, taking a hardship withdrawal for medical or other expenses, or taking out a loan from the account.
Defaults on those loans could lead to more than a $2 trillion hole in total retirement savings over the next decade, according to a just-released report from Deloitte Consulting, which works with retirement-plan sponsors and administrators.
Often, when someone defaults on a 401(k) loan, they end up cashing out their entire plan. Deloitte’s shortfall estimate assumes two-thirds of those who default on their loan follow this path. The estimate also incorporates penalties and taxes, as well as the loss of the compounded returns the money could have earned if invested, assuming an average return of 6% over the remainder of a career.
Nearly 40% of plan participants have taken advantage of a loan from their 401(k) plan, with about 10% of those loans defaulting each year, according to Deloitte. The trouble tends to arise when people change jobs, with 86% of workers who change jobs with a loan defaulting on the outstanding balance. Many of these defaults have gone unreported, but a new Internal Revenue Service rule could bring more attention to the issue as it requires defaults to be reported separately, says Stacy Sandler, a principal at Deloitte.
The report comes as the job market is heating up — enticing people to switch jobs — a nine-year bull market has fattened up retirement savings balances, and people are approaching retirement with more debt, all of which could make 401(k) loans more alluring.
“People say their money has grown, why not take advantage of it?” says Gursh Jhuty, a senior manager at Deloitte who worked on the research. “You’d be surprised by the people who take loans out, including a pension actuary I know that is on his fourth or fifth loan.”
It’s the cashing out of a 401(k) plan when people switch or lose jobs that can be more detrimental to retirement security, with the Center for Retirement Research at Boston College estimating that outright withdrawals and cash-outs when changing jobs takes a 25% bite, on average, out of eventual retirement wealth.
The problem of 401(k) leakage is especially pronounced among minorities, with African-Americans cashing out their retirement plans at double the rate of the average retirement savings participant, according to the Retirement Clearinghouse, a fintech company that caters to plan sponsors. African-Americans have far less saved than their white counterparts, and one reason for higher cash-out rates may be lower levels of emergency savings. While a typical white household has more than one month’s worth of income in liquid savings, a typical African-American household has just five days, according to Pew Charitable Trusts.
While offering loans in a retirement savings plan increases participation, Sandler says plan sponsors should also offer alternatives. That includes offering other ways of saving to cover expenses, such as health savings accounts, a 529 plan for college savings, or a flex-spending account, as well as preapproved emergency loan options that let employers deduct money from a paycheck for a rainy-day fund to avoid having to tap retirement savings in case of emergency.
Recent lawsuits related to retirement-account loans could cause plan sponsors and administrators to take a closer look at such options. Sandler says plan sponsors and administrators’ fiduciary responsibility extends to loans.