While most retirement plan advisers and sponsors focus on ways to inspire participants to save more, on the flip side, leakage from retirement plans is a serious issue they also need to address.
According to a report from the Savings Preservation Working Group, “Cashing Out: The Systemic Impact of Withdrawing Savings Before Retirement,” which analyzed a variety of recent research and data, cash-outs from plans when people switch jobs are the most prolific form of leakage. This surpasses hardship withdrawals by eight-times and loan defaults by 130-times.
The Working Group found that at least 33% and as many as 47% of plan participants withdraw part or all of their retirement savings when switching jobs. This leakage runs between $60 billion and $105 billion a year.
The first thing advisers and sponsors need to do to help prevent leakage is to educate participants about the downsides of cashing out, taking out a loan that they might not repay in full, or resorting to a hardship withdrawal, says Mike Lynch, vice president, strategic markets, at Hartford Funds.
Participants need to know that cashing out of their retirement plan could jeopardize their retirement security, says Ric Edelman, co-founder and chairman of financial education and client experience at Edelman Financial Services. Participants also need to know they will have to pay ordinary taxes on the money and, if they are under the age of 59 ½, the IRS will charge them a 10% penalty, Edelman says.
“From a retirement planning perspective, this is the worst choice that they can make,” he says.
Furthermore, if a participant cashes out and immediately spends all or most of the money, they may not have adequate cash on hand to pay the upcoming taxes, warns Larry Steinberg, chief investment officer at Financial Architects, Inc.
When a participant cashes out of a plan, investment firms are required to withhold 20% of their balance in order to cover taxes, but this is just an estimate, Steinberg says. “In California, you can owe as much as 53% of a distribution, because that is the marginal federal and state tax rate for someone in the top tax bracket,” he says.
To prevent participants from taking out loans or hardship withdrawals or cashing out, employers can consider setting up automatic emergency savings accounts for them, says Mike Webb, vice president at Cammack Retirement. While these are offered by only a handful of employers, Webb is hopeful they will gain traction.
Another thing employers can do to get in front of leakage is to offer additional benefits that employees can tap into, says Tom Foster, national spokesperson for MassMutual’s workplace solutions unit. “This could include health savings accounts, 529 college savings plans, student loan programs, critical illness insurance, accident insurance, life insurance, and access to low-cost loans,” Foster says. “Sponsors can offer many alternatives, and it doesn’t cost them additional money.”
Advisers can play a critical role in this effort by “explaining to sponsors that it would be a disadvantage to them if they don’t have the right benefits to attract and retain employees,” he says.
Another thing that advisers and sponsors can do is to “offer financial wellness programs and seminars and tutorials on the basics of budgeting and setting up an emergency fund,” Foster says. And if the sponsor has decided to offer additional benefits, this is an opportunity for advisers to educate them about these various options and to help participants prioritize their dollars into these benefits, he says.
“And if the employer doesn’t offer these additional benefits, advisers can work with employees to see what financial resources they might have other than their 401(k)—be it other savings, insurance or help from relatives,” Foster says.
Foster reminds advisers and sponsors that providers have many educational tools and calculators that they can use in their efforts to combat leakage.