Sunday, July 22, 2012

“Premature” Conclusions

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

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

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

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

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

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

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

If you define “success” as achieving an 80 percent real replacement rate from Social Security and 401(k) accumulations combined, looking at workers ages 25–29 (who will have more than 30 years of simulated eligibility for participation in a 401(k) plan), then the decrease in success resulting from the COMBINATION of cashouts, hardship withdrawals, and loans is just 6.1 percent.² The impact when you add in the impact of loan defaults is less than 1 percentage point higher (approximately 7.1 percent for all four factors combined).

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

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

A Problem to Fix?

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

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

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

- Nevin E. Adams, JD


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

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

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

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