Sunday, August 22, 2010

Double Dipping?

Last week, Fidelity published some data from their quarterly analysis of participant activity.

For the very most part, the data (see Fidelity Finds Q2 Uptick in 401(k) Withdrawals) revealed what we have come to expect from such reviews: Participants continue to stay the course, deferral rates are largely unchanged (average was 8%), and more increased their rate of deferral (5.3%) than decreased it (2.9%) in the most recent quarter. Additionally, the balance recovery continues apace, with the average account balance up 15% (though for this good news, you have to reach for a year-over-year comparison, because Q2 figures to be a pretty rough one for participant accounts—down 7.6% in Fidelity’s database).

However, this report drew more than the customary amount of coverage for its finding that rates of hardship withdrawals and loans were higher—and by some measures, significantly higher—than they were a year ago.1

My initial reaction was that this latter finding was something of an outlier; after all, in recent weeks we have seen other, similar reports from other providers that indicate that withdrawal volumes were down, certainly compared with the dark early days of 2009. But then, this was more recent data, and with the report of weekly jobless claims back up to half a million, well, let’s just say that it didn’t require much imagination to see a link between more people out of work and an uptick in “premature” distributions.

But later, as I considered the data, the findings didn’t seem so out of line. While the Fidelity survey found that 11% of participants took out a loan this quarter (9% did a quarter earlier), neither the average initial loan amount ($8,650) nor the loan term (3.5 years) seemed out of line. The report did, however, contain at least two alarming statistics. First, 22% of participants recordkept by Fidelity now have an outstanding loan, and while that isn’t much beyond the one in five that did a year ago, it nonetheless represented a decade-long record for Fidelity’s database. Indeed, this was the item that most media outlets qravitated toward (based on the calls I got).

In fact, IMHO, a more troubling trend lies in the fact that nearly half (45%) of participants who took hardship withdrawals one year prior also took a hardship withdrawal in the 12-month period ending in the second quarter of this year.

While participant loans are (too) frequently touted as borrowing from yourself, they put the participant in the position of having to replace—on an after-tax basis—the contributions you’ve withdrawn and a rate of “return” in the form of interest on the loan. Still, at least you’re on a schedule to replace the money you’ve withdrawn.

Now, properly administered, it’s not easy to obtain a hardship withdrawal. You actually have to be experiencing a financial hardship, for one thing, and you often not only have to prove that, but also that you have exhausted other sources. Worse, that hardship withdrawal is reduced not only by the need to pay taxes on the pre-tax monies you’ve now tapped, you have to fork over another 10% as a penalty to Uncle Sam (unless, of course, you’re older than 59 ½). What that means, of course, is that what you think you are seeing isn’t exactly what you are going to “get.”2 In fact, it could easily be just half what the requesting participant might be expecting.

The reality is that people are surely hurting, and if the money they have set aside in their 401(k) helps them through this period, puts food on the table, or keeps the family in their home, that’s, IMHO, a good thing. After all, there’s not much point in taking out a loan when you don’t have a source of income to repay it.

But what concerns me about the trends in the Fidelity report, aside from the implications that so many are struggling financially, is that, in my experience, hardship withdrawals, unlike loans, are not only gone for a while, they are savings that are often “gone” forever.

—Nevin E. Adams, JD

1Loans initiated over the past 12 months grew to 11% of total active participants from about 9% one year prior. The portion of participants with loans outstanding also increased two full percentage points in the second quarter to 22%. The average initial loan amount as of the end of the second quarter was $8,650, with an average loan duration of three and half years, according to Fidelity.

According to Fidelity’s data, 62,000 of the participants recordkept by the firm initiated a hardship withdrawal in the second quarter, compared with 45,000 participants who did so the quarter before. As of the end of Q2, 2.2% of Fidelity’s active participants took a hardship withdrawal, compared with 2.0% a year earlier.

2 Those taxes aren’t always obvious at the point of distribution, unfortunately, but due at the individual’s next tax filing.

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