401(k) Plans: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers' Retirement Savings
Published: 2009-08-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Under federal regulations, 401(k) participants may tap into their accrued retirement savings before retirement under certain circumstances, including hardship. This "leakage" from 401(k) accounts can result in a permanent loss of retirement savings. GAO was asked to analyze (1) the incidence, amount, and relative significance of the different forms of 401(k) leakage; (2) how plans inform participants about hardship withdrawal provisions, loan provisions, and options at job separation, including the short- and long-term costs of each; and (3) how various policies may affect the incidence of leakage. To address these matters, GAO analyzed federal and 401(k) industry data and interviewed federal officials, pension experts, and plan administrators responsi- ble for managing the majority of 401(k) participants and assets.
section_title: What GAO Found
paragraphs: The incidence and amount of the principal forms of leakage from 401(k) plans--that is, cashouts of account balances at job separation that are not rolled over into another retirement account, hardship withdrawals, and loans--have remained relatively steady, with cashouts having the greatest ultimate impact on participants' retirement preparedness. Approximately 15 percent of participants initiated some form of leakage from their retirement plans, according to an analysis of U.S. Census Bureau survey data collected in 1998, 2003, and 2006. In addition, the incidence and amount of hardship withdrawals and loans changed little through 2008, according to data GAO received from selected major 401(k) plan administrators. Cashouts of 401(k) accounts at job separation can result in the largest amounts of leakage and the greatest proportional loss in retirement savings. Most plans that GAO contacted used plan documents, call centers, and Web sites to inform participants of the short-term costs associated with the various forms of leakage, such as the tax and associated penalties. However, few plans provided them with information on the long-term negative implications that leakage can have on their retirement savings, such as the loss of compounded interest and earnings on the withdrawn amount over the course of a participant's career. Experts that GAO contacted said that certain provisions had all likely reduced the overall incidence and amount of leakage, including those that imposed a 10 percent tax penalty on most withdrawals taken before age 59?, required participants to exhaust their plan's loan provisions before taking a hardship withdrawal, and required plan sponsors to preserve the tax-deferred status of accounts with balances of more than $1,000 at job separation. However, experts noted that a provision requiring plans to suspend contributions to participant accounts for 6 months following a hardship withdrawal may exac-erbate the long-term effect of leakage by barring otherwise able participants from contributing to their accounts. GAO also found that some plans are not following current hardship rules, which may result in unnecessary leakage.

section_title: Letter
paragraphs: The current economic recession has caused millions of U.S. workers to  lose their homes, their jobs, and significant portions of their retirement  savings. The sudden reduction in the value of retirement savings in  response to stock market declines has reportedly led many 401(k) plan  participants to feel less confident in reaching their retirement goals and to  worry that they may never be able to retire. Moreover, the rise in  unemployment has had a detrimental impact on retirement savings. For  example, unemployed participants can no longer make tax-deferred  contributions to employer-sponsored plans and will likely have more  difficulty saving anything at all. In addition, unemployment may lead  participants to tap into their accrued retirement savings to navigate  difficult times. This “leakage,” which can result in the permanent loss of  retirement savings, has raised concerns that plan participants may be  jeopardizing their long-term retirement security through the short-term  consumption of their retirement savings. Such reductions in retirement  savings may be even more pronounced if the leakage occurs at a time  when a participant’s account balance has already experienced market  value losses.
Since they were first introduced several decades ago, 401(k) plans have  become the principal retirement savings vehicle for millions of U.S.  workers. Unlike employees with more traditional defined benefit pensions,  employees with defined contribution plans—such as 401(k) plans—choose  to participate in their employers’ plans and generally decide the amount  they want to contribute and how to invest it. Thus, they bear the  responsibility for funding and managing their investments in a way that  seeks to achieve sufficient benefits in retirement. The removal of  retirement savings prior to retirement can affect a participant’s ultimate  preparedness for retirement, especially when the amounts removed are  spent and not replaced. For example, 401(k) participants who choose to  take a lump-sum distribution, or “cash out,” from their account balance  when separating from their employer, rather than rolling the money over  to another qualified plan, may find it difficult to accrue sufficient savings  to provide adequate income in retirement.
In this report, we use a standard definition of leakage—that is, participants  tapping into their accrued retirement savings prior to retirement. We do  not take into account other events that could adversely affect participant  balances, such as participants not taking advantage of the full employer  matching contribution, participants contributing less than the annual  federal limit, or the costs associated with paying plan administrative fees.  In addition, we use the term “cashout” to refer to a lump-sum distribution  made to an employee at job separation that is not subsequently rolled over  into a qualified retirement account or an individual retirement account  (IRA).
You asked us to examine several aspects of leakage from 401(k) plans.  Specifically, we answer the following questions in this report:  1.  What are the incidence, amount, and relative significance of the  different forms of 401(k) leakage?  2.  How do 401(k) plans inform participants about hardship withdrawal  provisions, loan provisions, and options at job separation, including  the short-term and long-term costs associated with each?  3.  What is known about how various policies may affect the incidence of  401(k) leakage?
To determine the principal forms of 401(k) leakage, we interviewed  industry and academic experts, reviewed laws and regulations, and  analyzed existing studies on leakage. We then identified cashouts,  hardship withdrawals, and participant loans as the three principal forms of  leakage for the purposes of this report. To determine the incidence and  amount of leakage over time, we analyzed a cross-section of the 3 most  recent years of nationally representative survey data collected in 1998,  2003, and 2006 in the U.S. Census Bureau’s Survey of Income and Program  Participation (SIPP). We also analyzed published annual statistics from the  Department of Labor and the Internal Revenue Service (IRS), respectively,  to obtain aggregate loan default amounts and early withdrawal penalties  paid. To determine the recent prevalence of leakage, we analyzed  summary data from 2005 through 2008 that we obtained from 401(k) plan  administrators that represent about 22 million 401(k) participants and over  $1 trillion in 401(k) plan assets. To illustrate the relative significance of  leakage over time, we developed scenarios to simulate the effect that  various forms and amounts of leakage may have on retirement savings. In  developing these scenarios, we considered a range of factors, including  historical and projected rates of return, earnings, wages, contribution  rates, years until retirement, loan administration fees, and penalties  associated with leakage.
To determine how plans inform participants about leakage, we  interviewed 26 plan administrators that represented an estimated 80  percent of 401(k) participants and 65 percent of 401(k) plan assets. As part  of these efforts, we analyzed documents related to leakage from 401(k)  accounts and conducted 10 site visits during which we interviewed  representatives, reviewed relevant documentation, and toured a  participant call center. We also reviewed selected 401(k) plan sponsor and  administrator Web sites, and current pension law and regulations.  Appendix II provides a list of the 401(k) plan administrators that we  contacted.
To identify what is known about how various policy options may affect the  incidence of leakage, we identified provisions in current law, regulations,  and legislative proposals to identify policy options that are likely to affect  leakage. We then interviewed selected industry and academic experts to  determine how these provisions may affect leakage. We analyzed their  responses and identified the provisions that these experts said were likely  to affect leakage. We then developed model scenarios based on the factors  that experts identified, to illustrate the effect that certain provisions may  have on the accumulation of a participant’s retirement savings.
We conducted this performance audit from August 2008 to August 2009 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. We determined that the data that we  analyzed were sufficiently reliable for the purposes of this report.  Appendix I of this report contains a detailed description of the  methodology used in this review and its limitations.
subsections: section_title: Background
paragraphs: Private-sector pension plans are classified either as defined benefit or as  defined contribution plans. Defined benefit plans generally offer a fixed  level of monthly retirement income based upon a participant’s salary,  years of service, and age at retirement, regardless of how the plan’s  investments perform. In contrast, defined contribution plans, such as  401(k) plans, benefit levels depend on the contributions made to the plan  and the performance of the investments in individual accounts, which may  fluctuate in value. Named after section 401(k) of the Internal Revenue  Code, traditional 401(k) plans allow workers to save for retirement by  diverting a portion of their pretax income into an investment account that  can grow tax-free and be withdrawn without penalty after age 59½.  Employers and employees may make pretax contributions, up to certain  limits, to individual participant accounts. In 2009, participants may  contribute up to $16,500 per year. The 401(k) account balance is a function  of both the contributions made to the accounts over a career as well as the  investment performance of the account. As such, the declines in the  markets can have a stark effect on retirement savings, as happened in 2007  and 2008 when the financial markets declined.
About one-half of all U.S. workers participate in some form of employer- sponsored retirement plan. Participation in 401(k) plans rose steadily from  fewer than 8 million participants in the mid-1980s to over 70 million  participants in 2006—the most recent year for which data were available.  The assets in 401(k) plans also increased significantly over the same time  period, from less than $100 billion to over $3 trillion.
Current law limits participant access to their retirement savings in their  employer-sponsored retirement plans so that the favorable tax treatment  for retirement savings is limited to savings that are, in fact, used to provide  retirement income. Only under certain circumstances do federal  regulations allow 401(k) plan sponsors to provide participants with access  to their tax-deferred retirement savings before retirement. IRS, within the  Department of the Treasury, and Labor’s Employee Benefits Security  Administration (EBSA) are primarily responsible for enforcing laws that  govern defined contribution plans. IRS interprets and enforces provisions  of the Internal Revenue Code that apply to tax-qualified pension plans.  EBSA enforces the Employee Retirement Income Security Act (ERISA)  reporting and disclosure provisions and fiduciary responsibility standards,  which, among other things, concern the type and extent of information  provided to plan participants.
Plan sponsors have considerable latitude within the regulatory guidelines  to choose whether to provide this access in the form of a participant loan,  a hardship withdrawal, or a lump-sum distribution when the participant  separates from an employer. Plans may allow participants to take loans,  but may place limitations on the amounts, purpose, or number of loans  available. Plans may also allow participants who can demonstrate that  they are facing a hardship to take hardship withdrawals. In addition, when  separating from their employer, participants may elect to receive a lump- sum distribution of their account balance, or “cash out,” rather than to  preserve the tax-deferred status of their accounts by rolling over their  account into another qualified plan or IRA. Table 1 provides a summary of  the provisions related to leakage from 401(k) plans.
Plan sponsors may, but are not required to, offer loan and hardship  withdrawal provisions to participants. In providing these options, plans  offer participants a certain flexibility and short-term financial relief that  may improve a participant’s overall long-term financial standing if the  distributions are used, for example, to pay off high-interest credit card  debt, purchase a primary residence, or support a college education.  Furthermore, as we reported in October 1997, the availability of loan  provisions is associated with encouraging workers to join their employer- sponsored 401(k) plans when they otherwise might not, resulting in higher  overall participation and contribution rates. Unlike other forms of  leakage, participant loans, which are paid back to the plan with interest,  become leakage only if they are not repaid.
Early access to retirement savings may also burden participants with  short-term costs and long-term consequences. In the short term,  participants who take a distribution before reaching age 59½ generally pay  a 10 percent early withdrawal penalty and income taxes on the distribution  amount, and may face other restrictions and fees, such as loan origination  fees. In the longer term, this leakage may reduce the amounts that  participants can save prior to retirement by permanently removing assets  from their accounts and forgoing the accumulation of savings realized  through compounding.
subsections: section_title: Rules Affecting Early Distributions from Retirement Plans
paragraphs: The tax-deferred contributions in participants’ 401(k) plans can only be  distributed upon the occurrence of certain events. As shown in table 2,  each of the principal forms of 401(k) leakage that we identified is subject  to a number of specific rules. For example, to discourage the use of  pension funds for purposes other than retirement, the law imposes an  additional 10 percent tax on certain early distributions made from  qualified retirement plans, such as a 401(k) plan, before a participant  reaches age 59½. As regular income distributions, these early distributions  are subject to federal and state income tax withholding and taxed at the  marginal income tax rate. Some early distributions may not be taxable if  they are rolled over into an IRA or another qualified retirement account.  Certain other distributions have been exempted from the additional tax.
Participants tapping into their 401(k) account follow different rules and  procedures to gain access to their money, depending on whether they take  a loan, hardship withdrawal, or cashout. Figure 1 describes the process  that a participant must generally follow to withdraw money using one of  these options.
section_title: Leakage Has Remained Relatively Steady, with Cashouts Having the Greatest Impact on Retirement Savings
subsections: section_title: Leakage Has Remained Relatively Steady, Even in the Poor Economy
paragraphs: Our estimates—based on SIPP data collected in 1998, 2003, and 2006— found no statistically significant differences in the overall incidence of  leakage from 401(k) accounts in the data from the three SIPP panels that  we analyzed, with approximately 15 percent of participants between ages  15 and 60 initiating at least one form of leakage. As shown in figure 2, we  estimated that the percentage of participants experiencing each leakage  type remained steady across the 3 years, with more participants borrowing  money from their plans in the form of a loan than taking a cashout or  hardship withdrawal.
Our analysis of SIPP data found significant differences in the amounts of  leakage, by type, that participants reported taking from their 401(k) plans,  with the total cashout amounts being significantly higher than the total  amounts of either hardship withdrawals or loans. As shown in figure 3, we  estimated that the amount of leakage reported in 2006 was approximately  $108 billion, with cashouts comprising the bulk of that amount.
The median amounts of leakage also remained steady in the 3 years of  SIPP data that we analyzed. According to our estimates, the median  cashout amount was significantly higher than the median loan amount.  (See fig. 4.)
The overall incidence and amounts of leakage from loans and hardship  withdrawals also remained steady through 2008, according to data that we  obtained from selected major 401(k) administrators. While these data  were not nationally representative, they covered a wide spectrum of  401(k) plans, participants, and assets. As shown in table 3, the overall  incidence and average amounts of leakage changed little, if at all, from  2005 through 2008. Two administrators also told us that they had seen  little change in the number of hardship withdrawals and loans in the first  quarter of 2009.
Taking a cashout, hardship withdrawal, or loan can come with costs that  can amplify the detrimental effect that leakage can have on a participant’s  retirement savings. For example, early distributions from a 401(k)  account, whether in the form of a cashout, hardship withdrawal, or  defaulted loan, may be subject to a 10 percent tax penalty that must be  paid in addition to the amount of the distribution. In addition, some plans  require participants who take a loan to pay an additional loan origination  fee or periodic loan maintenance fees over the course of the loan  repayment period. Participants taking hardship withdrawals are subject to  the 10 percent penalty and must eventually pay federal and state income  taxes on the hardship withdrawal amount. In addition, the requirement  that participants suspend all contributions to their plans for 6 months  following the hardship withdrawal not only prevents participants from  continuing to make contributions but also precludes them from obtaining  any employer matching contribution. The additional costs associated with  cashouts, hardship withdrawal, and defaulted loans can compound  permanent losses of retirement income by reducing a participant’s balance  and precluding these amounts from compounding in the account over  time.
While the estimated amount of 401(k) leakage is in the billions of dollars,  it represents a relatively small proportion of the aggregate value of assets  in 401(k) plans. As shown in figure 5, in 2006, leakage resulted in marginal  losses in retirement savings in aggregate. Yet, at the level of the individual  participant, leakage can create considerable displacement of retirement  savings.
section_title: Cashouts Can Have the Greatest Impact on Retirement Savings
paragraphs: Cashouts at job separation can have the greatest impact of the principal  forms of leakage on an individual participant’s savings, according to the  results of our analysis. We simulated a range of leakage scenarios that  took into account the age, earnings, and job tenure of participants as well  as a range of leakage amounts. We found that cashouts of any amount at  job separation—whether taken in part or in full—can have a greater effect  on a participant’s account balance at age 65 than comparable amounts  taken in the form of a hardship withdrawal or loan. As shown in table 4,  cashouts resulted in a greater proportional loss of retirement savings  among low-wage earners, especially those who took a partial cashout  earlier in their working careers.
Participants who voluntarily cashed out their entire 401(k) account  balance at job separation experienced the largest reductions in the amount  of retirement savings that accumulate over their working careers. As  shown in table 5, unlike partial cashouts, which leave some assets in the  plan to grow over time, total cashouts can significantly reduce a  participant’s retirement savings, even when the participant experiences no  interruption of 401(k) contributions. Cashouts can be especially damaging  if taken later in a career when a participant has less time to recover the  losses. For example, table 5 also shows that if a participant were to cash  out their plan at age 35, their account balance at age 65 would be $404,431,  or $183,618 less than had they left the money in their account.
section_title: Hardship Withdrawals Can Result in Large Reductions in Retirement Savings
paragraphs: Participants who initiated hardship withdrawals also experienced large  reductions in their retirement savings over their careers. While slightly less  than the amounts lost due to cashouts, hardship withdrawals can result in  permanent loss of retirement income and may affect participants at a time  when they face greater difficulty in recouping the losses. In our analysis of  various leakage scenarios, we found that among all age and income levels,  hardship withdrawals had the greatest impact on low-income and younger  participants. For example, our simulation showed that a low-earning 35- year-old participant taking a $5,000 hardship withdrawal would forgo 12  percent in retirement savings resulting from the hardship, whereas a high- earning participant of the same age would forgo less than 5 percent due to  higher contribution amounts. Larger hardship withdrawal amounts taken  earlier in a participant’s career had the greatest proportional impact on  participants who earned lower incomes.
section_title: Loans Have the Least Damaging Effect on Retirement Savings
paragraphs: Of the three principal forms of leakage that experts identified, loans paid  back to the plan in regular installments are the least damaging, because  participants are able to recover most of their losses, regardless of their age  or earnings level. While the overall amount of participant loans has  increased since 1996, as shown in figure 6, this rise roughly paced the  overall growth in the number of 401(k) participants.
Experts told us that participant loans constitute limited leakage only when  they are not paid back to the plan, even though there may be costs, such as  paying loan fees, which could reduce participant balances. Like cashouts,  the outstanding balance of a defaulted loan is distributed to the participant  as income and is subject to the 10 percent penalty and various taxes.  According to the most recent data available from Labor, the amount of  loan defaults from 401(k) plans ranged from a low of $359 million to a high  of $666 million in the period of 1999 through 2006. (See fig. 7.)
Plans have some security against default on a participant loan because  loan repayments are automatically deducted from a participant’s paycheck  as long as the participant is employed. However, under current rules,  participants who separate from their employer and have an outstanding  loan balance generally must repay the loan balance in full shortly after  their separation. For participants who face involuntary job separation,  such as a layoff, the requirement to repay the loan in full may create a  burden. Like cashouts, the larger the loan balance when the participant  defaults, the greater the impact the loan default can have on a participant’s  retirement savings. Table 6 illustrates the effect of a loan default on a  participant’s retirement savings at age 65.
Loan defaults may affect participants differently, depending on whether  job separation is voluntary or involuntary. For example, loan defaults can  adversely affect participants who, after securing a loan from their account,  suddenly find themselves laid off by their employers. These participants  will typically be required to repay the amount of the loan back to the plan  in full within a short time frame. Participants who cannot or do not repay  their loan balance in full must generally pay the 10 percent penalty and  income taxes on the outstanding amount that is distributed to them as  income, resulting in a loss of retirement savings.
section_title: Plans Used Various Means to Inform Participants about Withdrawal Provisions, but Few Alerted Them to the Negative Long-term Implications
subsections: section_title: Plans Used Various Means to Inform Participants about Leakage Provisions
paragraphs: Federal law requires plans to provide several mandatory written  communications to participants that contain information on the various  provisions affecting cashouts, hardship withdrawals, and loans. As shown  in table 7, for each document, the law defines the type of information to be  included and the timing of the delivery.
Plan officials we contacted told us that one way participants could learn  about their plans’ loan and withdrawal provisions is through the summary  plan description (SPD). Some plan officials told us that they developed  reader-friendly highlights of the SPD to communicate the plan procedures  to participants. For example, the SPD highlights from one plan explained  the following provisions on one page: participant eligibility, contribution  amount, rollover contributions, the employer match, vesting, the  investment choices, loans, and withdrawals. Officials that we contacted  told us that the highlights documents are kept intentionally vague out of  concern that participants might rely on these documents, rather than the  actual SPD. However, one plan official and one expert stated that the  extent to which participants understand the information and use it to  make informed choices about their accounts remains unknown.
Plans that we contacted provided participants with information on leakage  at three distinct points determined by federal requirements: at enrollment,  when a loan or hardship withdrawal is requested, and at job termination.  Some plans that we contacted provided participants with information  about loans and hardship withdrawals in the participant’s initial  enrollment package. Other plans that we contacted provided participants  with information beyond federally required notices at the participant’s  request. Another plan sent out a termination package when a plan sponsor  sent notification of a participant’s termination date, while another plan  waited for the participant to contact the plan upon job termination.  According to some plan officials, participants inquire about plan  provisions when a triggering event occurs, such as when the participants  need access to money in their account or when they are separating from  their job. Participants, however, may request information about  withdrawing money from their accounts at any time.
Apart from meeting federal requirements, plans have varying levels of  involvement with participants, ranging from plans seeking to protect  participants from making poor decisions with respect to cashouts,  hardship withdrawals, or loans, to plans giving participants little advice on  how leakage would affect their retirement accounts. Some plans we  contacted provided participants with detailed information that went  beyond the legally mandated disclosures about the implications of  cashouts, hardship withdrawals, and loans. Some plan officials we  contacted stated that they gave no information to participants about the  effects of cashouts, hardship withdrawals, and loans on retirement  account balances to participants for fear of being perceived as offering  advice and potentially violating their fiduciary duty to the plan. According  to EBSA officials, providing investment advice is not a per se violation of  fiduciary duty. Other plan officials that we contacted told us that while  they wanted to make sure that participants understood the impact of  withdrawing money from their accounts, they did not want to tell  participants that they should not take a distribution.
Some plans that we contacted also staffed call centers to answer  participants’ questions about their accounts, which they said also included  topics related to the principal forms of leakage. Call center representatives  had immediate access to participant account information, could inform  participants about their range of options for withdrawing money from  their accounts, and could discuss the mandatory federal disclosures with  the participants. At one participant call center, plan officials demonstrated  how the representatives would respond to a participant requesting  information about acquiring a loan, about a hardship withdrawal, or about  the management of their account balance at job termination. Some plan  officials said that they trained call center representatives to inform  participants of the available options, while other plans told us that they  sought to dissuade participants from taking a hardship withdrawal. One  plan that we contacted required participants to contact the call center at  job termination, so that the representative could counsel the participant  on the best option for that individual.
Plan officials told us that younger participants preferred to use the plan  Web sites to locate the information they needed. Some plans that we  contacted had plan documents available online, such as hardship  withdrawal applications and procedures, providing participants with  immediate access to information about the processes and impacts of  withdrawing money from their account. Plan officials told us that some  Web-based communications often provided the same information available  to plan participants in print, while other Web-based communications were  less comprehensive than the written information available to participants.  Some plans that we contacted also utilized plan Web sites to notify  participants of the amount of money available for a cashout, hardship  withdrawal, or loan. One plan also provided a 5- to 10-minute online  course outlining the impact of leakage on the participant’s long-term  savings. Two plans that we contacted included information on leakage in  articles on plan Web sites to educate participants about the consequences  of borrowing from their 401(k) accounts. However, few plans that we  contacted had tools on their Web sites for participants to project the  potential impact of cashouts, hardship withdrawals, and loans on their  future retirement savings.
Some plan officials told us that plans had begun providing just-in-time  information on 401(k) leakage to participants entering certain life phases  to better meet the participants’ needs. Regarding cashouts, for example,  one plan provided each separating participant with a worksheet that  contained a personalized projection of their current 401(k) account  balance, comparing dollar-for-dollar the advantages of keeping the  account tax-deferred by rolling it over into a qualified plan or IRA with the  consequences of cashing the balance out and paying the associated  penalties and taxes. Officials at another plan told us that when an  employer notified them that a large number of employees were facing an  imminent layoff, they would create a campaign to educate participants  about the steps they needed to take to preserve their account balances  after the layoff. Regarding hardship withdrawals, some plans told us that  they contacted participants after the 6-month suspension period to inform  them that they could reenroll in the 401(k) plan. Another plan  automatically reenrolled participants in their 401(k) plan after the 6-month  suspension period. Officials at one plan told us that they sought to  intercept participants requesting a disbursement from their retirement  account, discussing with the participant on the telephone the  consequences of withdrawing the money. Regarding loans, some plans  request that the plan administrator set up on-site seminars to cover  various topics, such as the consequences of job termination on a  participant’s outstanding loan.
section_title: Most Plans Informed Participants about the Short-term Costs of Leakage, but Few Informed Participants about the Long-term Implications
paragraphs: Almost all of the plans contacted told us that they sent a termination  package to participants at job separation that outlined the available  options for their account balance, but that these documents did not  contain information on the long-term implications of choosing to take a  cashout. These options included leaving the balance in the plan, rolling the  balance over into another employer-sponsored plan or IRA, or cashing out  their account balance. For example, one plan’s standard termination  package included a document with information on the options available to  participants at termination, and on whom to call for more information, and  included a one-page summary illustrating the short-term effects of cashing  out of the plan. Few plans that we contacted told us that they had tools on  their Web sites, such as calculators, for participants to project the  potential effect on their future retirement savings of taking a cashout.
Plan officials told us that they included information on the short-term  costs of hardship withdrawals, as required, whenever a participant  requested the hardship withdrawal. Hardship withdrawals come with a  number of short-term costs, including the 10 percent early withdrawal  penalty, the 6-month contribution suspension period, the inability to return  the withdrawn sum back to the plan, and the participant’s potential  personal tax liability resulting from the withdrawal. Many of the plans  that we contacted required participants to send a hard-copy of the  hardship withdrawal application to the plan, and some plans required  participants to contact their plan administrator or sponsor to request a  hardship withdrawal. While participants received information on the short- term costs associated with a hardship withdrawal, the plans that we  contacted provided little information on the long-term implications of a  hardship withdrawal on retirement savings. Some plan officials told us  that they did not provide participants with any information on the long- term effects on retirement of taking a hardship withdrawal.
Plan officials told us that plans informed participants about the short-term  costs of loans—including the loan amount, repayment schedule, and tax  consequences—through the plans’ call centers, Web sites, or publications.  Some plan officials told us that even though they informed participants of  the short-term costs associated with taking a loan, information about the  long-term implications was largely omitted because as long as the loan is  repaid, it has a small overall impact on account balances. Some plan  officials that we contacted said that the loan check sent to the participant  also included a loan repayment schedule, information on the tax  consequences of taking the loan, and the effects of defaulting on the loan.  Plans that we contacted also told us that plan Web sites offered  participants loan calculators to help the participant determine how much  the loan repayment would cost per pay period, and also offered articles  designed to educate participants about the consequences of borrowing  from their account. Some plans that we contacted offered loan modeling  tools that allowed participants to estimate the short-term impact of the  loan on their retirement balance. For example, one plan provided  participants with an online calculator tool that allows participants to  determine what effect a loan and its associated tax implications might  have on their future retirement benefit. However, few plans that we  contacted provided participants with information on the long-term  consequences of taking loans from their accounts.
section_title: Experts Said That Some Statutory Provisions Have Helped Reduce Leakage
subsections: section_title: Three Statutory Provisions Are Said to Have Helped Reduce Leakage
subsections: section_title: Early Withdrawal Penalty Provision
paragraphs: The experts that we contacted said that the 10 percent penalty on early  withdrawals had likely reduced the incidence and amount of leakage  among 401(k) participants, but that its function as a disincentive could be  strengthened. One expert told us that he believed that the penalty had  significantly reduced the number of cashouts being taken from 401(k)  plans. Other experts noted that the penalty served as a deterrent because  participants were generally reluctant to pay penalties, regardless of the  amount. A plan administrator told us that many participants contacting the  call center to inquire about a hardship withdrawal had reacted negatively  to the information that they would be required to pay a 10 percent penalty.  Some experts questioned whether the 10 percent penalty’s power as a  disincentive needed to be strengthened to further discourage participants  from removing money from their accounts. Some felt that the percentage  was too low to have any major impact as a deterrent and suggested that  the penalty needed to be increased to further discourage participants from  taking early withdrawals. For example, one expert noted that young  workers who receive a distribution after leaving their first job may regard  the distribution as free money, and the penalty would only reduce the  amount of free money they received. Another expert said that the penalty  served more as a speed bump than as a deterrent for participants earning  higher incomes. Other experts noted that the provision did not deter  participants who were facing true hardships and needed money from their  accounts, regardless of the penalty assessed.
Because the incidence and amount of leakage from 401(k) accounts have  remained relatively steady, the 10 percent penalty has continued to  provide a steady source of revenue to IRS. Officials told us that the penalty  serves a dual purpose: it deters participants from tapping into their 401(k)  account when they have other sources of money available, and it allows  the federal government to recoup a portion of the subsidy provided to  keep the money tax-deferred. According to published IRS data on early  withdrawals from qualified retirement plans, including 401(k) plans and  IRAs, more than 5 million tax filers paid $4.6 billion in early withdrawal  penalties in tax year 2006. As shown in figure 8, the amount of early  withdrawal penalties paid has increased since 1996, while the average  penalty paid per tax return has stayed about the same.
Experts said that the provision that lowered the threshold for plan  sponsors to cash out the accounts of separating participants automatically  has likely reduced the overall incidence of leakage. Prior to this provision,  employers could compel mandatory cashouts for separating participants  with account balances under $5,000. The change reduced the threshold for  an automatic cashout to account balances valued at less than $1,000. For  account balances valued at between $1,000 and $5,000, employers were  required to preserve the tax-deferred status of the accounts, either by  keeping the assets in the plan or rolling the balances over into an IRA.  Several experts noted that the provision had dramatically reduced the  incidence of leakage for participants with balances of between $1,000 and  $5,000, but the overall effect was marginal because this group represents a  small proportion of the participant population.
We developed an illustration to show the maximum savings that could be  preserved over the course of a participant’s working career under the  automatic cashout provision. Our illustration showed that the reduction in  the maximum cashout amount could result in greater savings over time.  (See table 8.)
Experts said that the provision requiring participants in 401(k) plans to  exhaust their plan’s loan provisions before taking a hardship withdrawal  had likely reduced leakage by promoting the use of loans that are  generally repaid and returned to the plan. Experts said that the provision,  which reduces hardship withdrawals, was a good rule and made financial  sense. One expert said that because loans remain in the plan as an  investment and retain assets when repaid, they resulted in minimal  leakage. In contrast, hardship withdrawals result in the permanent  removal of assets from the plan and cannot be returned to a tax-deferred  account. Thus, taking a loan prior to a hardship withdrawal would  preserve more assets for retirement. One expert told us that it was  important for participants to exhaust their loans to reaffirm that the  hardship exists and is long-term in nature, and the expert emphasized that  it was the responsibility of the plan administrator to demonstrate that the  hardship withdrawal was the participant’s loan of last resort. Another  expert noted that while the rule made financial sense, plan sponsors  needed to more actively encourage this practice, and not simply allow  participants to take a hardship withdrawal each time they faced a situation  that fell within the IRS definition of a hardship.
In January 2009, as a result of its compliance monitoring examinations,  IRS reported the failure of plans to meet hardship distribution  requirements as one of the top 10 issues facing 401(k) plans. Among other  things, IRS found that administrators of plans that offer participant loans  and hardship withdrawals are allowing participants to take hardship  withdrawals without first exhausting the plan’s loan provisions, as is  currently required. Plan administrators that we contacted said that most  of their plans strictly adhered to this provision; however, others stated that  some plans were not enforcing the provision. Several plan administrators  told us that some plans took participants at their word that they were  facing a hardship or believed that it was the plan sponsor’s decision  whether to fulfill this requirement. For example, officials at one plan told  us that they asked participants whether they had taken a loan before  granting a hardship withdrawal, but that they did not verify the  participants’ responses. Other plan administrators told us that they  believed that the requirement applied to some but not all 401(k) plans.  Under current rules, the loan exhaustion provision applies to all plans that  offer loans and hardship withdrawals, but there is no requirement for  plans to document compliance with this provision.
Our illustration shows the amount of retirement savings that could be  preserved by adhering to this provision. Specifically, we calculated the  effect on the growth in retirement savings for a medium-income  participant who obtained a combination of a $2,500 loan and a $2,500  hardship withdrawal, rather than taking a $5,000 hardship withdrawal. As  shown in figure 9, participants obtaining even a portion of the needed  amount in the form of a loan could result in additional retirement savings  over the course of a working career.
section_title: Experts Said That the Provision Requiring Suspension of Contributions May Exacerbate the Long-term Effects of Leakage
paragraphs: Experts noted that the statutory provision requiring a 6-month suspension  of participant contributions following a hardship withdrawal may increase  the amount of leakage by prohibiting those participants who can  contribute to their 401(k) accounts from doing so. Treasury officials told  us that the suspension period was intended to serve as a test to ensure that  the hardship was real, and that the participant did not have other assets  available to address the hardship. Many of the experts noted that the  provision did little to deter participants from taking hardship withdrawals.  For example, one expert told us that while the provision may have had  some effect as a deterrent to taking a hardship in theory; in practice, it  only affected people already experiencing a hardship.
Other experts noted that the provision seemed to contradict the goal of  creating retirement income. One expert said that the provision  unnecessarily kept able participants from making contributions, such as  an employee who needed an infusion of cash for a discrete, one-time  event, such as a home purchase. Other experts characterized the  suspension period as excessive and more of an inconvenience than an  effective deterrent. For example, one expert noted, participants who need  money and initiate hardship withdrawals must pay taxes and penalties and  are prevented from making contributions, leaving them with 50 percent or  less of the money they had withdrawn. Several experts suggested  remedies, such as shortening or repealing the suspension period, or  allowing participants to at least keep their employer match during the  suspension period to begin making up lost ground.
Our illustration shows the effect of the 6-month suspension on the  accumulation of retirement income. As shown in table 9, the suspension  period would have the greatest impact on the retirement savings of  midcareer participants earning a medium income.
Finally, several experts noted that the 401(k) hardship withdrawal  definition was too broad and gave participants access to money for  circumstances that were both voluntary and foreseeable. For example,  under current rules, participants may take a hardship withdrawal for  purchasing their primary residence, which some experts said did not  constitute an immediate and heavy financial need. Moreover, the 401(k)  definition of hardship differs from hardship equivalents under other  qualified plans, such as 457(b) retirement plans. Under a 457(b) plan, for  example, a participant may take a hardship distribution only when faced  with an unforeseeable emergency, which the regulations define as a severe  financial hardship resulting from an illness or accident, loss of property  due to casualty, or other similar extraordinary and unforeseeable  circumstances arising as a result of events beyond the control of the  participant or beneficiary. In addition, the regulations also state that the  purchase of a home and the payment of college tuition are generally not  unforeseeable emergencies.
section_title: Conclusions
paragraphs: There are many reasons why participants may choose to use their  retirement savings prior to retirement, and some of these choices may  involve a rational trade-off between immediate financial emergencies and  future retirement needs. U.S. workers continue to feel the effects of the  current economic downturn in the form of job losses, home foreclosures,  and the depreciation of 401(k) retirement savings. With home values down  and lending sometimes difficult to obtain, some workers may see their  accrued 401(k) savings as their last protection against financial hardship.  Yet, even small amounts of leakage can have a significant impact on the  retirement savings of some plan participants.
While tapping into a 401(k) account to meet short-term needs may be  rational under certain circumstances, some leakage could be mitigated if  participants had adequate information on the long-term implications of  their actions. Cashouts can be the most damaging form of 401(k) leakage,  are the least regulated, and appear to run counter to the goal of retirement  savings. However, many participants continue to take this option when  separating from their employer, in part because the option is often  presented to them with little or no information on its long-term  consequences. With better information on the consequences of the various  forms of leakage, participants may choose to preserve their retirement  savings, resulting in a better retirement outcome.
Participants facing sudden and unanticipated hardships would also benefit  from the assurance that they are using the most appropriate and least  damaging option, thereby minimizing the negative impacts on their overall  retirement preparedness. For example, to avoid unnecessary leakage,  employers should not approve participants for hardship withdrawals until  they are certain that participants have exhausted the plans’ loan  provisions. In addition, under current hardship rules, participants who  could continue making retirement contributions after taking a hardship  withdrawal are barred from doing so. This suspension of contributions  also prevents participants from receiving employer matching contributions  and will likely leave them with a lower account balance at retirement.  Ensuring that participants choose the path that causes the least harm to  their retirement accounts and continue to make retirement contributions  whenever possible may help mitigate the adverse impacts of leakage that  otherwise will linger into retirement.
section_title: Matter for Congressional Consideration
paragraphs: To help participants recover more quickly from a hardship situation,  Congress should consider changing the requirement for the 6-month  contribution suspension following a hardship withdrawal.
section_title: Recommendations for Executive Action
paragraphs: To support the goal of providing plan participants with understandable  and useful information about their employer-provided retirement plan  benefits, we recommend that the Secretary of Labor promote industry best  practices by encouraging plans to take the following actions:  Include on their participant Web sites information on their plan loan,  hardship withdrawal, and cashout provisions, including examples of the  long-term consequences of each provision. For example, plans could place  a copy of the summary plan description in an electronic form that  participants could reference as needed, or provide modeling tools.
Provide separating participants with a projection of their account balance  under different scenarios, such as when assets are left in a tax-deferred  retirement account compared with those assets cashed out in the form of a  lump-sum distribution.
To prevent unnecessary leakage and increase compliance with existing  regulatory requirements, we recommend that the Secretary of the Treasury  clarify that the loan exhaustion provision applies to all plans that permit  both participant loans and hardship withdrawals, and require plans to  document that participants have exhausted available plan loans before  allowing a hardship withdrawal.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Secretary of Labor and the  Secretary of the Treasury for review and comment. In comments on a draft  of this report (which are reprinted in app. III), the Department of Labor  agreed to consider our recommendations as it developed regulations and  other guidance to assist plan participants and beneficiaries in  understanding their benefits and distribution options. Labor also provided  technical comments on a draft of this report, which we incorporated as  appropriate. In its comments (reprinted in app. IV), the Department of the  Treasury agreed to publish an article highlighting the requirements of the  hardship withdrawal provisions, giving special attention to the scope of  the loan exhaustion requirement and the need for plans to document  compliance.
As agreed with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from its  issue date. At that time, we will send copies of this report to relevant  congressional committees, the Secretary of Labor, the Secretary of the  Treasury, and other interested parties. In addition, the report will be made  available at no charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-7215 or bovbjergb@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made contributions to this report are listed  in appendix V.
section_title: Appendix I: Scope and Methodology
paragraphs: The objectives of this study were to identify (1) the incidence, amount,  and relative significance of the different forms of 401(k) leakage; (2) how  401(k) plans inform participants about hardship withdrawal provisions,  loan provisions, and options at job separation, including the short-term  and long-term costs associated with each; and (3) what is known about  how various policies may affect the incidence of 401(k) leakage. We  conducted this performance audit from August 2008 to August 2009 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. We determined that the data that we  analyzed were sufficiently reliable for the purposes of this report.
subsections: section_title: Incidence and Amount of 401(k) Leakage
paragraphs: To determine the principal forms of 401(k) leakage, we interviewed  industry and academic experts, reviewed laws and regulations, and  analyzed existing studies on leakage. We then identified cashouts at job  change, hardship withdrawals, and participant loans as the three principal  forms of leakage.
To determine the incidence and amount of these principal forms of  leakage over time, we analyzed data from the 1996, 2001, and 2004 panels  of the U.S. Census Bureau’s Survey of Income and Program Participation  (SIPP), using the data from survey respondents on their participation in  401(k) plans contained in the Pension and Retirement Topical Module  (collected in 1998, 2003, and 2006). We excluded SIPP participants who  were younger than age 15 or older than age 60 at the time of the interview,  and used this subset of the SIPP data to develop estimates of the number  of 401(k) plan participants who reported taking a cashout, hardship  withdrawal, or loan from their account prior to retirement. Because SIPP  is based upon a probability sample, we followed the Census Bureau  technical documentation in deriving all percentage and dollar-value  estimates and the 95 percent confidence intervals that correspond to these  estimates.
To determine the aggregate loan default amounts over time, we analyzed  published annual statistics from 1996 through 2006 the Department of  Labor’s Private Pension Plan Bulletins Abstract of Form 5500 Annual  Reports and tabulated the amount of loan defaults that plan sponsors  reported releasing to participants. To determine the amount of early  withdrawal penalties on qualified retirement accounts that plan  participants paid, we analyzed published annual Internal Revenue Service  (IRS) statistics from 1996 through 2006 on estimated individual income tax  liabilities, credits, and payments. Because IRS reports the penalty amounts  in aggregate for all qualified plans, including individual retirement  accounts (IRA) and 401(k) plans, we were unable to isolate the penalties  paid only by 401(k) participants.
To determine the recent prevalence of leakage, we analyzed summary data  on the incidence and amount of hardship withdrawals and loans from 2005  through 2008 that we obtained from major 401(k) plan administrators,  which represented about 22 million 401(k) participants and over $1 trillion  in 401(k) plan assets. We were not able to acquire similar year-to-year data  on cashouts from 401(k) plans. While the data that we received were not  nationally representative, they provided a snapshot of the incidence and  amount of the two forms of leakage in recent years at several of the largest  401(k) plan administrators.
subsections: section_title: Relative Significance of Leakage Forms
paragraphs: To illustrate the relative significance of leakage over time, we developed a  model to tabulate 401(k) account balances for various hypothetical  individuals at age 65 that differed depending on when and whether these  individuals tapped into their 401(k) account prior to retirement. We ran a  range of scenarios to simulate the effect that various forms and amounts  of leakage would have on a participant’s retirement savings. In developing  these scenarios, we considered such factors as the participant’s age,  earnings, wages, contribution rates, years until retirement, as well as  historical and projected interest rates and earnings levels, loan  administration fees, and penalties associated with leakage. We based our  illustrations on an individual who was born at the beginning of 1970, began  participating in a 401(k) plan at age 21 in 1991, and will retire at age 65 in  2035. We used historical values and future projections for interest rate and  rate-of-return assumptions as reported in past and projected under the  intermediate cost assumptions in Social Security’s The 2009 Annual  Reports of the Board of Trustees of the Federal Old-Age and Survivors  Insurance and Federal Disability Insurance Trust Funds (also known as  the 2009 OASDI Trustees’ Report). Also, we used scaled earnings for low,  medium, and high annual earners as reported in past and projected in the  2009 OASDI Trustees’ Report. We assumed that employee contributions  to the 401(k) are 6 percent of the individual’s wages and received a 3  percent employer matching contribution. Loans taken from the 401(k)  incur a $100 fee that is deducted from the account balance, were taken out  at the beginning of the year that the individual reached the age indicated in  our analyses, and were repaid over a 5-year period at a fixed interest rate  equal to the rate of return at the time that the loan was made. Hardship  withdrawals from the 401(k) incur a 10 percent tax penalty for early  withdrawal and are taken out at the beginning of the year that the  individual reaches the age indicated in our analyses, and participant  contributions and employer matching contributions are suspended for the  subsequent 6-month period. Partial and full cashouts also incur a 10  percent tax penalty for early withdrawal and are taken out at the  beginning of the year that the individual reaches the age indicated in our  analysis. We generally assume (except where otherwise specified in the  report) that the individual does not resume his or her own and employer  matching contributions to a 401(k) account for 12 months. Finally, we  calculated the amount of forgone retirement savings at age 65 for an  individual who took a loan, hardship withdrawal, or partial cashout in the  amount of $5,000.
section_title: Participant Information
paragraphs: To determine how plans inform participants about leakage, we  interviewed 26 plan administrators representing at least 80 percent of  401(k) participants and 65 percent of 401(k) assets. We selected our  sample of administrators using industry rankings of the leading firms that  were based on the number of plans and participants, the value of the plan  assets, and the quality of their participant services. To ensure a range of  views, we contacted 401(k) plan recordkeepers, plan sponsors, and third- party administrators representing large and small 401(k) plans. As part of  these efforts, we conducted 10 site visits during which we interviewed  representatives and toured a participant call center. The documents that  we reviewed included plans’ mandatory tax notices, summary plan  descriptions, plan brochures, loan and hardship withdrawal forms, and  prototype plan documents. We also reviewed selected 401(k) plan sponsor  and administrator Web sites, current law, and regulations. To learn about  industry standards and practices, we interviewed 401(k) plan  administrators; plan sponsors; industry and academic experts; and Labor,  Department of the Treasury, and IRS officials and reviewed relevant  literature.
section_title: Policy Provisions Affecting 401(k) Leakage
paragraphs: To identify what is known about how various policy options may affect the  incidence of leakage, we reviewed provisions in current law, regulations,  and legislative proposals and identified nine policy options likely to affect  leakage. Next, we interviewed selected industry and academic experts to  gather their opinions on which of these policy provisions would likely  affect leakage. We selected experts who were cited in the literature on  retirement leakage, were referred to us during interviews, and are known  in the pension and retirement field. To ensure that we had a range of  views, we included experts from academic, practitioner, participant  advocacy, and industry backgrounds. We analyzed the experts’ responses  and identified the provisions that they indicated were likely to affect  leakage. We then used our illustration model to simulate the effect that  each of the identified provisions may have on a hypothetical 401(k)  participant’s retirement savings at age 65. These illustrations are based on  an individual who is born at the beginning of 1970, begins to participate in  a 401(k) plan at age 21 in 1991, and retires at age 65 in 2035. We use  historical values and future projections for interest rate and rate-of-return  assumptions as reported in past and projected in Social Security’s most  recent 2009 OASDI Trustees’ Report under the intermediate cost  assumptions. We used scaled earnings for low, medium, and high annual  earners as reported in past and projected in the 2009 OASDI Trustees’  Report. In each scenario, we assumed that employee contributions of 6  percent of the participant’s earnings to the 401(k) and received a 3 percent  employer matching contribution. We used the following assumptions to  distinguish each form of leakage:    Loans taken from the 401(k) incurred a $100 fee that is deducted from the  account balance. We assumed that loans were taken out at the beginning  of the year that the individual reached the age indicated in our analyses,  and that loans were repaid over a 5-year period at a fixed interest rate  equal to the rate of return at the time that the loan is made.
Hardship withdrawals from the 401(k) incurred a 10 percent tax penalty  for early withdrawal and were taken out at the beginning of the year that  the individual reached the age indicated in our analyses. Participant  contributions and employer matching contributions were suspended for  the subsequent 6-month period.
Partial and full cashouts incurred a 10 percent tax penalty for early  withdrawal and were taken out at the beginning of the year that the  individual reached the age indicated by in our analyses. We generally  assumed (except where otherwise specified in the report) that the  individuals taking a cashout did not resume their elective or employer  matching contributions to their 401(k) accounts for 12 months.
Next, we ran five separate scenarios to simulate the effect of selected  provisions on our hypothetical individual’s retirement savings at age 65.  Specifically, we simulated the effect of each of the following scenarios:    effect of a total cashout of an entire 401(k) account at various ages;    effect of a loan default on a $5,000 loan after 1-year repayment;    effect of reducing the involuntary automatic cashout from $5,000 to $1,000;    effect of exhausting a plan’s loan provision before taking a hardship    effect of a 6-month contribution suspension following a hardship  withdrawal.
section_title: Appendix II: 401(k) Administrators That GAO Contacted
section_title: Appendix III: Comments from the Department of Labor
section_title: Appendix IV: Comments from the Department of the Treasury
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual listed above, David Lehrer, Assistant Director;  Jonathan S. McMurray, Analyst-in-Charge; Nicole Harkin; and Gene  Kuehneman made key contributions to this report. Carl Barden, Susannah  Compton, Cathy Hurley, Ed Nannenhorn, Roger Thomas, and Walter  Vance also made important contributions.