Commentary: In 2013 Time magazine reported that one in four Americans tapped into their 401(k) account. Research from Fidelity indicates that 22% of participants in plans they administer have an outstanding loan. This is troubling because the high rate of 401(k) plan loan defaults results in annual leakage of around $6 billion per year. Boston Research Group reports that 45% of 401(k) participants who leave a job take a distribution of their account balance. Significant amounts of participant balances are leaking out of 401(k) plans and not being replenished, with potentially disastrous results.
What is leakage?
Leakage occurs in 401(k) plans when account balances permanently leave plans. Typically these amounts are never restored, leaving participants with 401(k) balances at retirement well short of their needs. There are three types of 401(k) plan leakage:
- Defaulted loans. Loan defaults occur when a participant leaves a job and, rather than paying back a plan loan, decides to have the outstanding balance deducted from his/her account. Of all the types of leakage, most experts agree this is most preventable.
- Hardship withdrawals. Limited to a short list of eligible criteria, hardship withdrawals are taken by participants who run into financial difficulties. This is the most valid type of leakage and least manageable.
- Cash-outs due to separation from service. Many participants, rather than rolling their account balance into an IRA or leaving it in their former employer's plan, decide to take a cash distribution of their account balance. This is the largest and most difficult type of leakage to manage.
Most experts believe that the following plan design elements can limit leakage:
- If eliminating loans is not possible, limiting the number of loans participants can take to one and continuing to accept loan payments from terminated participants.
- Limiting loans and withdrawals to participant contributions only.
- Automatically re-starting participant contributions after completion of the required hardship withdrawal suspension period.
In addition, the best way to reduce cash-outs is to educate your participants about the perils of leakage in your annual employee education sessions. Consider adding these plan design features to address leakage in your 401(k) plan.
Robert C. Lawton, AIF, CRPS is president of Lawton Retirement Plan Consultants, LLC, a RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be reached at firstname.lastname@example.org or 414.828.4015.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice.
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