“Breaching” Out?

By Nevin Adams, EBRI

Adams

Adams

“401(k) breaches undermining retirement security for millions,” was the headline of a recent article in the Washington Post.(1) No, we’re not talking about some kind of data hacking scandal, nor some new identity theft breach. Rather, those “breaches” are loans and withdrawals from 401(k)s.

Providing the impetus for the article is a new report by HelloWallet(2) that indicates that “more than one in four workers dip into retirement funds to pay their mortgages, credit card debt or other bills.”

While the article primarily deals with the potentially negative aspects of loans and withdrawals, it also touches on some broader concerns—and does so with some factual inaccuracies. For example, the article incorrectly states that “in 1980, four out of five private-sector workers were covered by traditional pensions;” in fact, only about half that many actually were at that point (a correct statement would be that 4 out of 5 covered by a plan at that time were in a traditional pension, which works out to about 2 in 5 of all private-sector workers—which puts the article’s “now, just one in five workers has a pension” statement in a far more accurate context).

The article notes that the “most common way Americans tap their retirement funds is through loans,” although U.S. Department of Labor data indicate that loan amounts tend to be a negligible portion of plan assets and that very little is converted into deemed distributions in any given year. That finding is supported by hard data from the EBRI/ICI 401(k) database, the largest micro-database of its kind: Among participants with outstanding 401(k) loans in the EBRI/ICI database at the end of 2011, the average unpaid balance was $7,027, while the median loan balance outstanding was $3,785.(3) The Washington Post article cautions that these loans “must be repaid with interest,” but fails to mention that the 401(k) participant is paying interest to his/her own account: Those repayments represent a restoration of the retirement account balance by the participant, as well as a return on that investment. Sure, that interest payment is coming from the participant’s own pocket, but it’s generally being deposited into their own retirement account, and (if it was being used to pay down debt) likely at a much more favorable rate of interest.

The article also notes that those who withdraw money from their 401(k) early (before the authorized age) face “hefty” penalties, and certainly there is a financial price. However, those penalties consist of the 10 percent early withdrawal penalty (that was put in place long ago to discourage casual withdrawals by those under age 59 -½), and the income taxes they would be expected to pay on the receipt of money on which they had not yet paid taxes (which they would likely pay eventually).(4)

The HelloWallet report describes defined contribution (DC) retirement plans as a “marginal contributor to the actual retirement needs of U.S. workers.” However, an EBRI analysis of the Federal Reserve’s Survey of Consumer Finance (SCF) data, looking at workers who are already retired, finds that DC balances plus IRAs—which for many retired individuals were funded by rollovers from their DC/401(k) plans when they left work—represent nearly 15 percent of their total assets (which includes things like houses, but does not include Social Security and defined benefit annuity payments, although DB rollovers are included), and nearly a third of their total financial assets, as defined in the SCF.

The dictionary describes a “breach” as an “infraction or violation of a law, obligation, tie, or standard.” The article quotes the HelloWallet author as noting that “What you have is 401(k) participants voting with their wallets saying they would much rather use this money for other purposes.” However, these reports can’t always know, and thus don’t consider, how many participants and their families have been spared true financial hardship in the “here-and-now” by virtue of access to funds they set aside in these programs(5) (an AonHewitt study,(6) cited both in the article and in the HelloWallet report, notes that just over half of the hardship withdrawal requests were to avoid home eviction or foreclosure).

It’s hard to know how many of these “breachers” would have committed to saving at the amounts they chose, or to saving at all, if they (particularly the young with decades to go until retirement) had to balance that choice against a realization that the funds they set aside now would be unavailable until retirement. We don’t know that individuals who chose to save in their 401(k) plan did so specifically for retirement, rather than for interim (but important) savings goals—such as home ownership or college tuition—that, sooner or later, make their own contributions to retirement security. Indeed, what appears to a be a short-term decision that might adversely affect retirement preparation may actually be a long-term decision to enhance retirement security with a mortgage paid off or higher earnings potential.

In sum, we don’t know that these decisions represent a “breach” of retirement security—or a down payment.

Notes

(1) The Washington Post article is online here. 

(2) You can request a copy of the HelloWallet report here.

(3) For an updated report on participant loan activity from the EBRI/ICI database, see “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2011,” online here. 

(4) While the Post article states that these taxes would be paid at capital gains rates, in fact, withdrawals are taxed as ordinary income.

(5) See “’Premature’ Conclusions,” online here. 

(6) See “Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income 2011,” online here. 

401(k) Investors Continued to Diversify in 2011

IB.Dec12.380.K-Update.Pg1401(k) savers continued to seek diversified portfolios in 2011, with 61 percent of 401(k) participants’ assets invested in equity securities and 34 percent in fixed-income securities, on average, according to the annual update of a joint study released by the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI).

The study, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2011,also finds target-date funds are playing an increasingly important role in that diversification with 72 percent of 401(k) plans offering target-date funds in their investment lineup at year-end 2011, compared with 70 percent at year-end 2010 and 57 percent at year-end 2006. At year-end 2011, 13 percent of the assets in the EBRI/ICI 401(k) database was invested in target-date funds, up from 11 percent in 2010 and 5 percent in 2006. In addition, 39 percent of 401(k) participants held target-date funds at year-end 2011, compared with 36 percent in 2010 and 19 percent in 2006.

IB.Dec12.K-update.PR-Fig

“When planning their retirement savings strategy, participants increasingly use tools such as target-date funds, which are designed to offer a mixed investment portfolio of equity and fixed-income securities that automatically rebalances to be more focused on income over time, to get diversification,” said Sarah Holden, senior director of retirement and investor research at ICI and coauthor of the study. “The study’s findings highlight that 401(k) participants, particularly recent hires, are opting to diversify their account balances, either actively or as a result of plan design.”

The study finds that more new or recent hires invested their 401(k) assets in balanced funds, including target-date funds. For example, 51 percent of the account balances of recently hired participants in their 20s was invested in balanced funds at year-end 2011, up from 44 percent in 2010 and 24 percent in 2006. At year-end 2011, 40 percent of the account balances of recently hired participants in their 20s was invested in target-date funds, compared with 35 percent in 2010 and 16 percent in 2006.

“A growing number of employers have taken advantage of plan design enhancements such as automatic enrollment, contribution acceleration, and qualified default investment alternatives, including target-date funds, that can help participants make better savings decisions,” noted Jack VanDerhei, EBRI research director and coauthor of the study. “That impact is particularly noticeable in the data regarding new hires and younger workers.”

The full analysis is being published in the December 2012 EBRI Issue Brief and ICI Research Perspective, online at www.ebri.org and www.ici.org/research/perspective It was written by ICI’s Holden; EBRI’s VanDerhei; Luis Alonso, EBRI director of information technology and research databases; and Steven Bass, ICI associate economist, based on the EBRI/ICI database of employer-sponsored 401(k) plans, the largest of its kind and a collaborative research project undertaken by the two organizations since 1996. The 2011 EBRI/ICI database includes statistical information on about 24 million 401(k) plan participants, in 64,141 plans, holding  $1.415 trillion in assets, covering nearly half of the universe of 401(k) participants.

“Premature” Conclusions

By Nevin Adams, EBRI

Adams

A couple of months back, my wife noticed a water spot on the ceiling of our dining room. Now, it didn’t look fresh, but considering that that ceiling was directly underneath the master bath, she had the good sense to call a plumber. Sure enough, there was a leaky gasket—and from the look of it, one that had been there for some time before we took ownership. Fortunately, the leak was small, and the damage was minimal. Even more fortunately, we took the time to have the plumber check out the other bathrooms, and found the makings of similar, future problems well before the “leakage” became serious.

Homes aren’t the only place with the potential for problems with leakage. A recent report on 401(k) loan defaults suggests that “leakage”—the money being drawn out of retirement plans prior to retirement —is a lot larger than a number of industry and government reports have indicated. In fact, the report (online here)  claims that “the leakage could be as high as $37 billion per year,” although it completes that sentence by acknowledging that the estimate depends “…on the source of the data on loans outstanding and the assumed default rate.”

The paper promotes a recommendation that ERISA be amended so that plans could choose to allow those who take out 401(k) loans to be defaulted into insurance that would repay those loans on default. It looks at a number of different sources to conclude that the available data do not really capture all the loan leakage (because some of it is obscured as part of distribution upon termination/separation from service), and that the available data do not (yet) capture the impact of the prolonged economic slowdown that is evidenced in other, non-401(k) loan trends.

Setting aside the validity of those conclusions, and the scale of their impact on the analysis, the issue of “leakage” remains a focus for many in our industry.

Late last year, an EBRI Issue Brief examined the status of 401(k) loans, noting that in the 2010 EBRI/ICI 401(k) database, 87 percent of participants in that database¹ were in plans offering loans, although as “has been the case for the 15 years that the database has tracked 401(k) plan participants, relatively few participants made use of this borrowing privilege.”

Indeed, from 1996 through 2008, on average, less than one-fifth of 401(k) participants with access to loans had loans outstanding. At year-end 2009, the percentage of participants who were offered loans with loans outstanding ticked up to 21 percent, but it remained at that level at year-end 2010 (see the full report, online here).  This hard data, by the way, measuring activity by more than 23 million 401(k) participants.

If loan levels and amounts outstanding have remained relatively constant during this period (which included the “Great Recession”), one might nonetheless wonder about the overall impact on retirement readiness.

If you define “success” as achieving an 80 percent real replacement rate from Social Security and 401(k) accumulations combined, looking at workers ages 25–29 (who will have more than 30 years of simulated eligibility for participation in a 401(k) plan), then the decrease in success resulting from the COMBINATION of cashouts, hardship withdrawals, and loans is just 6.1 percent², according to more recent EBRI research.  The impact when you add in the impact of loan defaults is less than 1 percentage point higher (approximately 7.1 percent for all four factors combined).

Looking at the overall impact another way, more than three-fifths of those in the lowest-income quartile³ with more than 30 years of remaining 401(k) eligibility will still be able to retire at age 65 with savings and Social Security equal to 80 percent of their real pre-retirement income levels, even when factoring in actual rates of cashout, hardship withdrawals, and loans—INCLUDING the impact of loan defaults.

The impact at an individual level can, of course, be more severe—something that will be explored by future EBRI research.

A Problem to Fix?

There is, however, a potentially larger philosophical issue: whether the utilization of these funds prior to retirement constitutes a “leakage” crisis that cries out for a remedy. We don’t know how many participants and their families have been spared true financial hardship in the “here-and-now” by virtue of access to funds they set aside in these programs. Nor do we know that individuals chose to defer the receipt of current compensation specifically for retirement, rather than for interim (but important) savings goals—such as home ownership or college tuition—that make their own contributions to retirement security. It’s hard to know how many of these participants would have committed to saving at all, or to saving at the amounts they chose, if they (particularly the young with decades of work ahead of them) had to balance that against a realization that those monies would be unavailable until retirement.

In fixing the recent leakage problem in our home, the plumber replaced the worn gaskets, but at the same time sought to improve on things by tightening (as it turns out, over-tightening) some of the connections further up the line. That extra step produced an unanticipated outcome that didn’t show up until the next day, in dramatic fashion. Like my plumbing problem, retirement plan “leakage,” unminded, has the potential to cause damage—to deplete and undermine retirement savings. However, a view that all pre-retirement distributions from these programs are a problem that requires redress not only ignores the law and regulations as written, it also has the potential to create unanticipated changes in savings behaviors.

And the data—based on hard data from actual participant balances and activity—indicate that such concerns are at least somewhat premature.

Notes

¹ The EBRI/ICI Participant-Directed Retirement Plan Data Collection Project is the largest, most representative repository of information about individual 401(k) plan participant accounts in the world. As of December 31, 2010, the EBRI/ICI database included statistical information about 23.4 million 401(k) plan participants, in 64,455 employer-sponsored 401(k) plans, representing $1.414 trillion in assets. The 2010 EBRI/ICI database covered 46 percent of the universe of 401(k) plan participants.

² Workers are assumed to retire at age 65 and all 401(k) balances are converted into a real annuity at an annuity purchase price of 18.62. Additionally, the projections assume no break in contributions occurs with a change in employers, that the maximum employee contribution is 6 percent of compensation.

³ Those in the higher income quartile have more trouble reaching the success threshold, given the PIA formula in Social Security. Cashouts, loans and hardship withdrawals have approximately the same impact as for those in the lowest income quartile.

Latest EBRI/ICI 401(k) Database Update

The average 401(k) retirement account balance rose 31.9 percent in 2009, according to a report released today by the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI) analyzing a group of consistent participants. The rise in 2009 was in line with the 2003–2007 pattern of steady increase in account balances and in contrast to the 27.8 percent decline in 2008.

The EBRI/ICI report, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2009, is based on the largest database of its kind, with records on 20.7 million participants at year-end 2009, including 4.3 million consistent participants—those who have had 401(k) accounts with the same 401(k) plan each year from year-end 2003 through year-end 2009.

The full report is being published simultaneously by EBRI and ICI and is on their websites (EBRI’s is here, ICI’s is here).

The joint press release is here.

The Nov. 29 webinar where co-authors Jack VanDerhei (EBRI) and Sarah Holden (ICI) presented the results is online here.

Some initial media coverage of the report:
* Bloomberg/ Business Week
* Reuters
* Minneapolis Star-Tribune
* Financial Planning