Combating a Flood of Early 401(k) Withdrawals

This week, the Internal Revenue Service announced that people under age 50 in 401(k) and similar workplace retirement plans will be able to deposit up to $18,000 in 2015, an increase of $500 from this year. Those 50 and over can toss in as much as $24,000, a $1,000 increase.

Which is all fine and dandy for the well-heeled and the frugal. But one of the biggest problems with these accounts has nothing to do with how much we can put in. Instead, it’s the amount that so many people take out long before they retire.

Over a quarter of households that use one of these plans take out money for purposes other than retirement expenses at some point. In 2010, 9.3 percent of households who save in this way paid a penalty to take money out. They pulled out $60 billion in the process; a significant chunk of the $294 billion in employee contributions and employer matches that went into the accounts.

These staggering numbers come from an examination of federal and other data by Matt Fellowes, a former Georgetown public policy professor who now runs a software company called HelloWallet, which aims to help employers help their workers manage their money better.

In a paper he wrote with a colleague, he noted that industry veterans tend to refer to these retirement withdrawals as “leakage.” But as the two of them wrote, it’s really more like a breach. And while that term has grown more loaded since their treatise appeared last year and people’s debit card information started showing up on hacker websites, it’s still appropriate. Millions of people are clearly not using 401(k) plans as retirement accounts at all, and it’s a threat to their financial health.

“It’s not a system of retirement accounts,” said Stephen P. Utkus, the director of retirement research at Vanguard. “In effect, they have become dual-purpose systems for retirement and short-term consumption needs.”

How did this happen? Early on in the history of these accounts, there was concern that if there wasn’t some way for people to get the money out, they wouldn’t deposit any in the first place. Now, account holders may be able to take what are known as hardship withdrawals if they’re in financial trouble. Moreover, job changers often choose to pull out some or all of the money and pay income tax on it plus a 10 percent penalty.

The breach tends to be especially big when people are between jobs. Earlier this year, Fidelity revealed that 35 percent of its participants took out part or all of the money in their workplace retirement plans when leaving a job in 2013. Among those from ages 20 to 39, 41 percent took the money.

The big question is why, and the answer is that leading plan administrators like Fidelity and Vanguard don’t know for sure. They don’t do formal polls when people withdraw the money. In fact, it was obvious talking to people in the industry this week and reading the complaints from academics in the field that the lack of good data on these breaches is a real problem.

Fidelity does pick up some intelligence via its phone representatives and their conversations with customers. “Some people see a withdrawal as an opportunity to pay off debt,” said Jeanne Thompson, a Fidelity vice president. “They don’t see the balance as being big enough to matter.”

Or their long-term retirement savings matter less when the 401(k) balance is dwarfed by their current loans. Andrea Sease, who lives in Somerville, Mass., is about to start a new job as an analytical scientist for a pharmaceutical company. She was tempted to pull money from her old 401(k) to pay down her student loan debt, which is more than twice the size of her balance in the retirement account. “It almost seems like they encourage you,” she said, noting that the materials she received from her last retirement account administrator made it plain that pulling out the money was an option. “It’s an emotional thing when you look at your loan balance and ask yourself whether you really want to commit to 15 more years of paying it, and a large sum of 401(k) cash is just sitting there.” So far, she’s keeping her savings intact.

Another big reason that people pull their money: Their former employer makes them. The employers have the right to kick out former employees with small 401(k) balances, given the hassle of tracking small balances and the whereabouts of the people who leave them behind. According to Fidelity, among the plans that don’t have the kick-them-out rule, 35 percent of the people with less than $1,000 cashed out when they left a job. But at employers that do eject the low-balance account holders, 72 percent took the cash instead of rolling the money over into an individual retirement account.

This is unconscionable. Employers may meekly complain about the difficulty of finding the owners of orphan accounts, but it just isn’t that hard to track people down these days. Whatever the expense, they should bear it, given its contribution to the greater good. Let people leave their retirement money in their retirement accounts, for crying out loud.

Account holder ignorance may also contribute to the decision to withdraw money. “There is a complete lack of understanding of the tax implications,” said Shlomo Benartzi, a professor at the University of California, Los Angeles, and chief behavioral economist at Allianz Global Investors, who has done pioneering research on getting people to save more. “And given that we’re generally myopic, I don’t think people understand the long-term implications in terms of what it would cost in terms of retirement.”

In fact, young adults who spend their balance today will lose part of it to taxes and penalties and would have seen that balance increase many times over, as the chart accompanying this column shows.

But Mr. Fellowes of HelloWallet, interpreting the limited federal survey data that exists, says he believes that people raid their workplace retirement accounts most often because they have to. They are facing piles of unpaid bills or basic failures of day-to-day money management. Only 8 percent grab the money because of job loss and less than 6 percent do so for frivolous pursuits like vacations.

What can be done to change all of this? Mr. Benartzi thinks a personalized video might be even more effective than a boldly worded infographic showing people the money they stand to lose. He advises a company called Idomoo that has a clever one on its website aimed at people with pensions. If you want to see the damage that an early withdrawal could do, Wells Fargo has a tool on its site.

Fidelity has recently begun calling account holders to talk to them about cashing out, and it has found that people who get on the phone are a third as likely to remove some of their money as they are if they receive written communication. Here’s hoping more people will get such calls when they leave for another job.

Mr. Fellowes has a bigger idea. Given that so many people are pulling money from retirement savings accounts for nonretirement purposes, perhaps employers should make people put away money in an emergency savings account before letting them save in a retirement account. It’s a paternalistic solution, but some of the large employers he works with are considering it.

It’s surprising that regulators haven’t taken more notice of the breaches here. The numbers aren’t improving, but more and more people are relying on accounts like this as their primary source of retirement savings. “This is a problem that industry should solve,” said Mr. Benartzi, pointing to the unsustainability of tens of billions of dollars each year leaving retirement accounts for nonretirement purposes.

He says he thinks that there’s a chance that a company from outside the financial services industry could come in and solve the problem in an unexpected way before regulators take action. “If we don’t solve it, someone is going to eat our lunch, breakfast and dinner and drink our wine too.”