Draining Your Retirement

“It’s my money—why shouldn’t I use it?” and “What difference could $5,000.00 possibly make?” These are precisely the kinds of questions plan sponsors and advisers need to address if they’re going to free participants of the notion that a plan loan or hardship withdrawal is the best place to turn for the extra cash many so sorely need in the current financial environment. More than ever, plan advisers must make sure their clients are armed with educational tools that show participants what they stand to lose by cashing in today on assets designed to make ends meet tomorrow.

Plan sponsors and advisers have to make employees understand the economics of what happens to their retirement account when a hardship withdrawal or loan is taken. Participants have to understand, says Beth Almeida, executive of the National Institute on Retirement Security in Washington, that “even a fairly modest amount can have a really significant effect because of the loss of compound interest.”

“It’s almost like a truth-in-lending disclosure [that’s required],” says Almeida. “Something saying: “Here is basically what you’ll pay over time.””

Loans Versus Hardship Withdrawals

A report released this past summer by the Center for American Progress, entitled “Robbing Tomorrow To Pay for Today, looks at defined contribution plan loans made from 1989 to 2004 and finds, even going back to 2003 and 2004, participants took such loans because demands on their incomes had increased due to a spell of unemployment, bad health, or, to a lesser extent, the purchase of a home.

Now, experts observe, the home-ownership issue driving pre-retirement 401(k) distribution is more likely to be one of avoiding foreclosure on an existing structure, rather than the yen for a newer and better place for the family to live that spurred most of the loan activity in the late 1990s. As a result, hardship withdrawals are rising at a much quicker rate than 401(k) loans.

A retirement plan may, but is not required to, provide for hardship distributions, which, according to IRS regulations, must be made only on account of immediate and heavy financial need: specifically for things like medical expenses; costs relating to the purchase of a principal residence; tuition and related educational fees and expenses; payments needed to prevent eviction from, or foreclosure on, a principal residence; burial and funeral expenses; and needed repairs to one’s home. Hardship withdrawals must be limited to the amount of money that a participant needs, and must be taken after a participant has exhausted all distribution options or nontaxable loans otherwise available. If a participant is not 59 1/2 years old, there is a 10% withdrawal penalty assessed on the distribution, in addition to regular income taxes (see “Outward “Bound”“).

Loan availability varies from plan to plan but, for those that offer them, loans generally are permitted for the same kinds of reasons associated with a hardship withdrawal: to cover educational expenses, to purchase a first home, to prevent home eviction, or to pay for medical expenses. Loans for purposes other than those associated with a residential home purchase must be paid back in five years. Generally, participants are allowed to borrow 50% of their vested account balance, up to $50,000.

Mercer, the New York-based global consulting and outsourcing firm, finds a formidable 21% increase in the number of 401(k) and other defined contribution plan participants taking hardship withdrawals on their accounts during the first six months of 2008, compared with the same period last year—while the number of new loans taken out by plan participants increased 4.5%. Overall, however, only a 2% share of Mercer’s participant base took hardship withdrawals in early 2008, with the average withdrawal for Mercer participants coming in at $9,400 during the first six months of this year. The figures cover 1.5 million participants in retirement plans Mercer administers, running the gamut from small plans with as few as 100 participants and large plans representing giants like CBS Corp. and Thompson Reuters says Eric Levy, worldwide partner and retirement business leader for the outsourcing practice at Mercer.

Bruce Gsell, First Vice President, Investments, at Merrill Lynch, says the hardship withdrawal figures jibe with those from Merrill. Participants on the Merrill Lynch II Platform, representing 1,700 plans with 2.7 million participants and roughly $100 billion in assets, reflected a 22.7% increase in the number of hardship withdrawals from June 2007 through June 2008, with a 21.7% increase in actual dollars withdrawn. On the other hand, he says, general-purpose 401(k) loan activity dropped 3.8% for participants on the Merrill platform, and loan activity for home purchases declined a whopping 19.8%.

Gsell says the numbers are in “direct correlation” with the economic situation, reflecting the slowdown in real estate purchases. Levy, meanwhile, suggests that, given the categories of financial distress under which the IRS allows hardship withdrawals, participants are most likely taking the cash because of medical problems, their children’s educational needs, or the threat of home-loan foreclosure.

Vanguard data released in May said withdrawals from plans for which the company provides recordkeeping services shot up 17.1% in 2006 and 8.6% in 2007 after normalizing for overall growth in Vanguard’s participant base. December 2007 hardship withdrawals were up 22% from a year earlier.

Although some observers have linked the withdrawal trend to financial stresses on households with shaky finances related to the nation’s housing crisis, William E. Nessmith and Stephen P. Utkus of the Vanguard Center for Retirement Research also suggest the hardship withdrawal data are affected by a seasonal trend with such transactions typically peaking in July or August—a development that might be connected to tuition expenses.

Hardship Withdrawal Considerations

“A lot of people who don’t know what to do, do the wrong thing,” explains Sri Reddy, Head of Retirement Income Strategies at ING.

Although it may be that participants have no other recourse than to take the hardship withdrawal, “we want them to understand the consequences,” Gsell says. A handout Merrill uses with participants gives the example of someone who takes a $10,000 hardship withdrawal at age 40. Assuming he is in the 28% tax bracket and that the money will grow at a 6% rate until he reaches age 65, the funds would have had the chance to grow to $42,919, had he left them in the plan. On the other hand, due to the impact of penalties and taxes, the same $10,000 will only net the participant $6,200 in actual proceeds.

Participants also should understand that, if there really is no alternative source of cash, a 401(k) loan is a better choice than a hardship withdrawal. Opting for the latter means the money likely never gets put back into the plan and, as stated earlier, the distribution raises one’s taxable income—often significantly—in the year it is taken. “You have to be prepared to pay that tax bill on April 15th!” Levy explains.

As Levy notes, a withdrawal affects the long-term picture in terms of forfeiting the compounding of investment income over time. In the short term, meanwhile, participants need to know that a hardship withdrawal brings with it a larger tax bill that will cut down on net proceeds. Usually participants are not permitted to contribute to their plan for six months after the withdrawal, which means no employee match for that period of time. With a 401(k) loan, however, one may continue contributing to the plan without disruption.

Communication Points

By all means, Reddy says, if the choice is between a hardship withdrawal and a 401(k) loan, go for the latter. “The biggest benefit is that you are not actually taking money out of the plan.”

What other kinds of things should advisers be communicating to plan participants? The most important points to get across to participants about taking a loan, according to Reddy, are the following:

It is true that you pay interest back into your own account. However, you are paying yourself back with money you have already paid taxes on, and need to come up with interest as well. Moreover, at retirement, you will have to pay taxes on your retirement savings again, since defined contribution funds only delay tax payments—they are taxable at retirement.

The second thing that participants need to understand, says Reddy, is that, if you separate from your employer or lose your job, you may have to pay back all the money you have borrowed right away. These terms are established by the plan and, though most employers prefer to add the provision to treat termination as a triggering event for the repayment of the loan, not all do. “All outstanding loans may have to be repaid within a short timeline, 60 days or so, or the outstanding loans will be treated as a cash distribution.” That means taxes and penalties for those younger than 59 1/2, just like a hardship distribution. That is not the best situation to get caught in at a time when one is losing his primary source of income. Fortunately, he comments, “If you do pay back the loan, the monies remain in the retirement plan.”

The net effect of taking the loan is that you have less money invested. The money you borrow from your retirement plan no longer appreciates in value from interest, dividends, and/or capital gains in conjunction with the rest of your investment portfolio.

Gsell advocates a three-pronged approach for advisers dealing with often-confused 401(k) participants. Newsletters, group meetings, and phone contact allowing participants access to a registered representative anytime they need wish are all part of the package Merrill utilizes to convey its message.

Sometimes the message needs to be hammered home a little harder. Last year, for instance, Merrill’s retirement group sent out a communication asking, “Thinking about taking a loan from your retirement plan?” The flyer reminded participants to “compare all of the costs” between available lending strategies, explaining that “even if you borrow to purchase your primary home, you may not get a tax break, whereas you usually can deduct the interest you pay on a home equity loan.” The piece also encouraged participants to consider service and application fees that might apply to the loan, and to consider the potential implications of leaving their jobs, given the payback requirements. If you do decide to borrow, Merrill’s mailing added at the bottom, look carefully at which investment category you tap for the loan, assuming the plan allows you to choose. “If your plan reduces all of your investments proportionally, you may need to rebalance in order to maintain your desired investment strategy,” Merrill explained. Otherwise, advisers say it is best to withdraw funds from your fixed-income investments.

“Selling off equities to fund a loan will change the overall asset mix and that is often a bad idea,” says Bert Carmody, Fiduciary Consulting Director at Fiduciary Risk Management, LLC, in Atlanta.

Almeida of the National Institute on Retirement Security is quick to note also that, at a time when the Dow has fallen fast to new lows, participants will only lock in losses by taking money out of their 401(k)s. “You will basically be taking paper losses (unrealized losses) and making them realized losses,” she says.

Beyond that, the essential “don’ts” that advisers must communicate to plan participants include the following, says Dave Young, Director of Reserve Solutions, Inc., which offers participants a debit card to access loan monies as needed: Don’t borrow for everyday living expenses; don’t reduce ongoing contribution amounts when you take a 401(k) loan; don’t borrow if you’re unsure of continued employment with your company; don’t default on payments; and don’t borrow more than your immediate need.

“It’s not your rainy day fund,” says Reddy. “Given that it’s a long-term asset, any impact you make today will have an exponential impact in the long run.”

Illustration by Harry Campbell