What Constitutes Retirement Plan Leakage, Really?

Previous studies substantially overestimate leakage from retirement accounts, according to new analysis of tax data by Investment Company Institute (ICI) economists Peter Brady and Steven Bass. The economists define “leakage” as early withdrawals from retirement accounts used for nonretirement purposes.

While this is good news, the analysis still reveals that retirement account leakage is a big problem. And the types of retirement plan distributions weeded out for the economists’ definition of leakage raise a question.

The economists compared taxpayers’ reports of retirement distributions on tax returns for 2010 with information reported to the IRS by the payers of those distributions, including pension plans and financial institutions, to determine which distributions were penalized. Distributions from an employer-sponsored retirement plan, annuity or individual retirement account (IRA) to individuals younger than age 59.5 are generally subject to a 10% penalty under the income tax code. The economists took out exceptions to the penalty such as regular pension benefits paid to retired military, police and firefighters, as well as retirement plan distributions made after a worker dies or becomes disabled.

They also disregarded the return of excess retirement contributions either above the statutory limit or due to failed nondiscrimination testing by qualified retirement plans. While some may not consider this “leakage,” it certainly represents lost retirement savings. Though it is mostly highly paid employees who receive returns of excess contributions, retirement plan sponsors recognize that these employees may have greater savings needs to support their lifestyles in retirement and to make up for getting a smaller replacement income from Social Security. Many plan sponsors offer nonqualified plans to help these participants accumulate more savings, and some may use a cross-tested, or new comparability, plan.

Using penalized distributions as a proxy for leakage, the economists found that, in 2010, the year for which the data were analyzed, taxpayers younger than age 55 received $93 billion in taxable distributions, of which only $48 billion (51%) was penalized. Again, good news, but $48 billion is a huge amount of lost savings.

According to a report from the Savings Preservation Working Group, “Cashing Out: The Systemic Impact of Withdrawing Savings Before Retirement,” which analyzed a variety of research and data, cash-outs from plans when people switch jobs are the most prolific form of leakage. This surpasses hardship withdrawals by eight times and loan defaults by 130 times. The Working Group found that at least 33% and as many as 47% of plan participants withdraw part or all of their retirement savings when switching jobs.

Plan sponsors can work on effective communications to let participants know how cashing out will hurt their retirement outcomes. Participants should also understand how to rollover balances to another employer’s retirement plan or individual retirement account. Research done by the Government Accountability Office (GAO) showed that stakeholders identified difficulties transferring balances to a new plan as a factor in early withdrawals. Some legislators and retirement industry providers are advocating for automatic rollover solutions.

Defaulting on loans from defined contribution (DC) plan accounts is also a big source of leakage. An analysis from Deloitte finds that more than $2 trillion in potential future account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years.

This figure includes the cumulative effect of loan defaults upon retirement, including taxes, early withdrawal penalties, lost earnings and any early cash-out of defaulting participants’ full plan balances. For a typical defaulting borrower, this represents approximately $300,000 in lost retirement savings over a career.

The Deloitte report suggests ways plan sponsors can help prevent leakage caused by defaulted loans, including by facilitating emergency savings accounts and post-separation repayment opportunities.