401(k) Plans: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers' Retirement Savings
Released: 2009-09-25T00:00:00

Letter

Background

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for retirement by diverting a portion of their pretax income into an investment account that can grow tax-free and be withdrawn without penalty after age 59½.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.

Rules Affecting Early Distributions from Retirement Plans

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.

Leakage Has Remained Relatively Steady, with Cashouts Having the Greatest Impact on Retirement Savings

Leakage Has Remained Relatively Steady, Even in the Poor Economy

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.

Cashouts Can Have the Greatest Impact on Retirement Savings

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.

Hardship Withdrawals Can Result in Large Reductions in Retirement Savings

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.

Loans Have the Least Damaging Effect on Retirement Savings

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.

Plans Used Various Means to Inform Participants about Withdrawal Provisions, but Few Alerted Them to the Negative Long-term Implications

Plans Used Various Means to Inform Participants about Leakage Provisions

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.

Most Plans Informed Participants about the Short-term Costs of Leakage, but Few Informed Participants about the Long-term Implications

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.

Experts Said That Some Statutory Provisions Have Helped Reduce Leakage

Three Statutory Provisions Are Said to Have Helped Reduce Leakage

Early Withdrawal Penalty Provision

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.

Experts Said That the Provision Requiring Suspension of Contributions May Exacerbate the Long-term Effects of Leakage

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.

Conclusions

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.

Matter for Congressional Consideration

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.

Recommendations for Executive Action

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.

Agency Comments

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.

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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.

Appendix I: Scope and Methodology

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.

Incidence and Amount 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 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.

Relative Significance of Leakage Forms

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.

Participant Information

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.

Policy Provisions Affecting 401(k) Leakage

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.

Appendix II: 401(k) Administrators That GAO Contacted

Appendix III: Comments from the Department of Labor

Appendix IV: Comments from the Department of the Treasury

Appendix V: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.