Like a nagging cold, leakage from defined contribution plans continues to bedevil plan sponsors and their providers.
Defined contribution plan industry players view leakage as causing lost opportunities for participants to build a stronger foundation for retirement. It represents a persistent challenge to plan executives who include features — ranging from matches to auto-enrollment to auto-escalation — that encourage greater participation, but then see the maximum potential benefit eroded when employees remove some or all of their money prematurely.
Another challenge is defining leakage.
The most common definition includes hardship withdrawals, defaulted loans and cash-outs when employees change jobs and take their money without rolling it over into an individual retirement account or their next employer's plan. But some in the industry more broadly define leakage to include loans, even if repaid, as well as assets removed from the plan and put into an IRA. Leakage also can apply to plans that offer non-hardship withdrawals.
“Leakage is the price you pay for allowing flexibility” such as hardship withdrawals and loans, said Mark Herman, manager of retirement and wealth programs at Sprint Nextel Corp., Overland Park, Kan., and manager of the company's $2.2 billion 401(k) plan.
“Numerous studies have shown that there is a significant impact of sporadic withdrawals on a (participant's) balance at age 65 vs. no withdrawals,” said Marina Edwards, a Chicago-based consultant at Towers Watson & Co. “But some savings, even if a participant takes a withdrawal, is better than no savings at all.”
Some experts focus on the movement into IRAs because the participant loses the benefits of economies of scale, such as institutional pricing, when moving assets to a retail environment.
“The IRA rollover industry has been very successful in saying, "Your money is safer with us when you retire than in your employer's plan,'” said Georgette Gestely, director of tax-favored and citywide programs for New York City's Office of Labor Relations. Ms. Gestely is director of the New York City Deferred Compensation Plan, which has $9 billion in 457 assets and another $1 billion in 401(k) assets. “Going from group pricing to individual pricing is not a good move.”
Because there are so many definitions, it's hard to assess the overall financial impact.
A 2009 Government Accountability Office report said leakage due to cash-outs from job changes ($74 billion), hardship withdrawals ($9 billion) and loan defaults ($561 million) represented about 3% of the $2.7 trillion in 401(k) assets based on 2006 census data.
Soon-to-be published research by The Vanguard Group Inc., Malvern, Pa., shows the percentage of withdrawals — hardship plus non-hardship — is growing slowly, but steadily, to 3.7% at the end of last year from 2.9% at the end of 2005 in plans for which Vanguard is the record keeper. The company defines leakage as cash-outs, defaulted loans, and hardship and non-hardship withdrawals.
Vanguard also says that from 2006 through 2010, the percentage of participants with outstanding loans has hovered in the mid- to high teens, reaching 18% in 2010. Among participants earning less than $30,000 a year, the loan rate was 23% last year. In aggregate terms, outstanding loans represented 2% of Vanguard's total record-keeping assets in each of the five years.
“I'm less worried about the 20% who borrow,” said Jean Young, senior research analyst at the Vanguard Center for Retirement Research. “I'm more concerned about the 30% who don't participate.”
Fidelity Investments, Boston, also considers loans as leakage even if they are repaid. “The loan is not working for you in the same way as if the money were still in the plan, due to compounding,” said Beth McHugh, vice president of market insights for Fidelity.
Fidelity has found that participants with outstanding loans also have consistently lower deferral rates over time than participants without outstanding loans.
According to research of plans for which Fidelity is record keeper, the aggregate cash-out rate among participants has been creeping up. During the 12 months ended June 30, Fidelity said 33% of participants cashed out all or some of their account balances, a rate that has been increasing every 12 months since the period ended June 30, 2006.
Fidelity also has found that cash-outs are most common among younger, lower-paid participants with lower account balances.
To reduce the effects of leakage, many defined contribution plan executives constantly review plan designs and features.
Executives at Paychex Inc., Rochester, N.Y., count loans, defaulted loans, hardship withdrawals and cash-outs as leakage.
“Active employees who regularly take money out of the account, including loans, are missing out on a growth opportunity,” said Rick Amering, compensation & benefits services manager.
Still, officials at the $542 million 401(k) plan began allowing hardship withdrawals. “Philosophically, we felt this (401(k)) money was for retirement, but after the economy started going south, we heard from a lot of employees,” Mr. Amering said.
“Hardship withdrawals may seem like an easy way out. The more you can educate (employees), the more you can explain the impact.”
Hardship withdrawals hit participants' long-term savings in three ways: Money removed from the plan cannot be replaced; federal law says participants who make hardship withdrawals cannot resume deferrals for six months; and, if a plan has a corporate match, participants lose the benefit of the match for the six months, too.
The Home Depot Inc., Atlanta, offers loans and hardship withdrawals in its $3 billion-plus 401(k) plan, and the company educates employees on the pros and cons of both, said Brant Suddath, director of benefits. “We discuss the advantages of keeping money in the plan,” he said. “Loans are better than hardships.”
Since December 2009, the company has limited hardship withdrawals per participant to two within a 12-month rolling period. Previously, there was no limit.
Participants can work with a hardship specialist through record keeper Aon Hewitt once they request such a withdrawal. “We started looking at the concept of a hardship specialist because our withdrawal requests were up — similar to other employers during the down economy — and our denial rates were high,” said Mr. Suddath. “The No. 1 reason for hardship denials was that documentation did not meet plan requirements.”
Mr. Suddath said the program has been successful. “At a minimum, we feel more comfortable that we have more educated employees,” he said.
United Parcel Service Inc., Atlanta, takes a broad view of leakage that includes rollovers into IRAs, and it has taken steps to encourage participants in the $4.5 billion 401(k) plan for salaried employees to stay in the plan even after retirement.
“We want to make sure they know what their choices are when they retire,” said Justine Peddle, corporate retirement and portfolio manager. “Our plan has greater bargaining power and institutional pricing. We want to make sure participants could leverage that as long as possible.”
To reflect this philosophy, plan executives have added installment options so when employees retire, they can keep their money in the plan and remove funds in monthly, quarterly or other installments. In addition, UPS retirees may keep their money in the plan as long as they wish, although they have to take IRS-mandated distributions beginning at age 70½. Previously, retirees had to remove all of their money from the plan by that age.
The New York City Deferred Compensation Plan views rollovers into IRAs as leakage, and it has responded by choosing a rarely used design called a “deemed IRA,” allowed by Section 408(q) of the Internal Revenue Code.
Participants may roll over money into an IRA administered by the city plan that benefits from institutional buying power and pricing, Ms. Gestely said.
She noted that after a federal law was enacted in 2002 allowing rollovers into IRAs for 457 plan participants, “money started leaving our plan at the rate of $5 million to $10 million a month.” The “deemed IRA,” initiated in 2006, had $68 million in assets at the end of 2010.
Rollovers into retail IRAs are still occurring at a rate of about $4 million to $6 million per month, “but we're a much bigger plan than we were before we started the deemed IRA,” Ms. Gestely said. “Relatively speaking, when we look at those numbers, we're doing better.”