Enrollees Continue Banking on DC Plans for Loans and Withdrawals
401(k) plan participants have been pulling out funds more in the past two years than before. What does this mean for plan sponsors, plan participants and the future of retirement savings?
Two years ago, Eric Perkins wanted to start up his own law firm but didn’t have the cash. It was a tough economy, and Perkins said many lenders weren’t interested in approving a loan at a reasonable interest rate.
Instead of racking up credit card debt, Perkins decided to leave his large law firm and roll his 401(k) assets into a new, self-employed 401(k), which allows users to take either $50,000 or half of the account balance, whichever is less. He loaned himself nearly half of the $70,000 in his 401(k) account to start up his Glen Allen, Virginia-based law firm. By law, he has five years to pay off the loan, set at the prime rate plus 1 percent.
“For a self-employed individual, this is a great financing option,” Perkins says. “I don’t feel like I’m losing out on any significant retirement savings, compared to the interest expenses I’d have using a credit card.”
While Perkins was able to leverage his retirement savings to successfully start his business, others aren’t so fortunate. An alarming number of people continue to pull money set aside for the future just to make ends meet now.
Meanwhile, the retirement industry is determined to get workers to save enough annually so they can retire on time. Recently introduced federal legislation may aid their cause.
Despite employers adopting features like auto enrollment and automatic increases to employee contribution rates, a new report from consulting firm Aon Hewitt shows more participants are taking loans, making withdrawals or completely cashing out of their 401(k) plans when they move to a new job.
“We think it’s a quiet, looming problem that has the potential to undermine what the retirement industry is doing,” says Pam Hess, director of retirement research for Lincolnshire, Illinois-based Aon Hewitt.
About 28 percent of active 401(k) participants had outstanding loans in 2010, Aon Hewitt reported May 18. The average loan amount was $7,860 last year, and the number of people taking out loans has steadily climbed from the low point of 21.8 percent in 2006.
Meanwhile, Aon Hewitt data for 1.8 million employees in 110 large defined contribution plans show a slight dip in withdrawals to 6.9 percent in 2010, down from 7.1 percent in 2009. About 20 percent were hardship withdrawals, which are subject to taxes and a 10 percent penalty, with the average amount being $5,510. Nonhardship withdrawals, which are also subject to taxes but have the 10 percent penalty waived, averaged $15,480.
In 2010, nearly 42 percent of workers who left their jobs took a cash distribution, while 29 percent left the assets in the plan, and 29 percent rolled assets into a qualified plan.
“People have more financial constraints today than they did a few years ago,” Hess says. “Our concern is once you stop saving it becomes a difficult thing to start up again.”
By law, employers don’t have to offer loans from their plans. The vast majority do, mostly because not having loans might stop employees from participating, according to retirement plan experts. Unless a participant defaults or terminates employment without paying the loan immediately, the loans are not subject to taxes, but fees for setup are generally standard, as well as a five-year payback, which includes a set interest expense, says Rick Meigs, president of the 401(k) Help Center in Portland, Oregon.
In its report, Aon Hewitt recommends employers use plan design features to limit loan or withdrawal activity. Adding or increasing loan application fees, reducing the number of loans allowed, restricting the amount available for loans, having a waiting period between loans, and allowing longer repayment options after termination are ways employers can influence participant behavior, Hess says.
In an effort to limit workers from taking money from their defined contribution accounts, Sens. Herb Kohl, D-Wisconsin, and Mike Enzi, R-Wyoming, introduced legislation in May intended to limit plan participants to having a total of three loans from their 401(k) plans.
But Mike Skinner, vice president of client experience and research for investment firm T. Rowe Price in Baltimore says that while the rate of loans is increasing, it’s not alarming considering the tough economy.
“You don’t read the headline that the majority of people did nothing,” Skinner says. “Through communication and plan design, plan sponsors are doing all they can to encourage the right behaviors.”
Loan activity tends to climb in the wake of financial stresses, says Sarah Holden, senior director of retirement and investor research for the Investment Company Institute, a Washington, D.C.-based association for investment companies. The institute’s latest study showed an increase in loans in 2010, but also a strong commitment from participants to save. ICI found only 2.4 percent of plan participants stopped contributing to their plan compared with 3.4 percent in 2009.
“It shows the resilience of our participants in preserving assets for retirement,” Holden says. “Still fewer than 1 in 5 participants are borrowing money.”
While Fidelity Investments reported 22.1 percent of participants taking an average loan of $9,060 in the first quarter this year, it also saw average 401(k) balances grow to $74,900, an all-time high since the company started tracking account balances in 1998.
Donna Norwood, senior vice president for workplace solutions and customer service for in Fidelity’s Smithfield, Rhode Island, office, says the company works closely with its clients to track participant behavior. More than half of plans that explained distribution options to departing employees saw a 2 percentage point decrease in cash-outs; plans that didn’t explain options saw a 5 percentage point increase in cash-outs, Norwood says.
“You want to have participants educated in terms of what [a loan, withdrawal or cash-out] does to that ultimate retirement number,” Norwood says.
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