June 30, 2011
When Matt,* a legal secretary at a large Manhattan law firm, lost his job in 2009, he quickly ran out of cash. He’d earned $75,000 a year, but after eight years at the firm he received only two-and-a-half weeks of severance pay. His unemployment benefits amounted to $430 a week, barely enough to meet his monthly rent of $1,650.
Matt found himself eyeing the $30,000 in his 401(k). He had rolled his money over into an IRA, but soon began making withdrawals. “Thank God it was there,” he says. “If not, I don’t know what I would have done — except just not eat.” Matt got a comparable job within a year, but his retirement savings were wiped out. He had to pay the mandatory 10 percent early-withdrawal fee, as well as income tax. He used the last $3,000 in the account to pay the IRS.
In the wake of the Great Recession, a record number of Americans are tapping their 401(k) retirement plans, according to a new report by Aon Hewitt, a consulting firm. Some, like Matt, are making withdrawals. Others are cashing out all together when they lose their jobs. Many more are taking loans from their accounts. Experts warn that employees weren’t saving enough to begin with and that the steady outflow of funds is putting the retirement nest eggs of millions of people at risk.
“The idea was to make the plans flexible and give people access to their money earlier,” said Barbara Hogg, a retirement expert with Aon Hewitt. “That gives people a really hard choice between trading future dollars for future spending and meeting immediate needs. With the financial crisis, we see people dipping in.”
The numbers are startling: Among employees with defined-contribution plans who lost their jobs in 2010, 42 percent cashed out entirely, while less than 30 percent rolled their assets over into an IRA. Meanwhile, about 7 percent of 401(k) holders withdrew some funds from their accounts in 2010, up from 5 percent before the recession. Of those, 20 percent of withdrawals were for financial hardship, as in Matt’s case; half the people who took hardship withdrawals said they did so because they were facing eviction.
Even more alarming, a record number of employees took loans directly from their 401(k)s in 2010 from their 401(k)s – nearly 28 percent, up from less than 22 percent before the recession. Most defined-contribution plans allow loans, and they may be a better choice than other forms of borrowing, like high-interest credit card debt. But most plans require employees to repay any outstanding balance within 60 to 90 days if they leave the company – a big risk in a weak job market. Under those circumstances, nearly 70 percent default, and must pay taxes and IRS penalties on the loan balance. “The implications are huge in terms of future retirement,” said Timothy Yee, an advisor at Green Retirement Plans in Oakland, California. “You are really hurting yourself.”
The increased borrowing comes as more Americans than ever rely on 401(k)s to fund their retirement. Since the IRS adopted regulations allowing 401(k) plans in 1981, the number of families covered by defined pension plans has dropped from 88 percent to 36 percent, while those with a 401(k)-type plan has increased from 12 percent to 63 percent, according to Demos, a liberal New York think tank. And there is growing evidence that plan holders aren’t saving enough to ensure a comfortable retirement. One in five full-career contributors in large 401(k) plans will be able to meet their needs in retirement, according to the Aon Hewitt study.
Many companies have been changing their plan structures to encourage employees to save more, according to Marina Edwards, a consultant at Towers Watson. Instead of matching 100 percent of contributions to the first 3 percent of salary, some companies have changed their plans to match 50 percent of up to 6 percent of salary. And many large companies now auto-enroll employees in 401(k) plans, which dramatically increases participation.
But as banks have tightened credit requirements, 401(k) loans have become more attractive to borrowers. With housing values dropping, home equity loans, a major source of consumer credit during the boom, are harder to come by. At the end of March, Americans had $925 billion of outstanding home equity lines, the lowest level since 2005, according to Federal Reserve data. Patrick White, an investment adviser with John White & Co. in Orland Park, Ill., has a client who recently took a $40,000 401(k) loan to make home improvements. “ In 2003, I would have said, ‘Get a home equity loan,’” White says. “But now most home equity is wiped out.”
Investment advisers say they see clients dipping into their retirement accounts for all sorts of reasons. Ilene Davis, an investment adviser in Cocoa, Fla., an area hit hard by the real-estate crisis, says she used to see people taking loans from their 401(k) plans to buy homes before the crash. Now, she says, they are often forced to dip into their plans to pay taxes they owe after short sales of their property. “It seems to me that people are using their 401(k) plans as ATMs [now that] they can’t use their house as an ATM,” she says.
Joe Skarda, a retirement specialist at Sapient Financial Group in San Antonio, Texas, has a client who borrowed $6,000 from her 401(k) when her air conditioning gave out. “She didn’t need to get credit approval and she was given a much more favorable interest rate than she would have gotten from a third-party lender,” Skarda says. Another group of borrowers are using the money to consolidate other debts. Yee of Green Retirement Plans has a client who recently took a $40,000 loan against his 401(k) to pay off his credit cards, one of which had an interest rate of 26 percent. The client was able to borrow against his 401(k) at the prime rate plus 1 percent interest, which came to about 4.5 percent.
But even if employees hang onto their jobs, borrowing from a 401(k) can permanently damage long-term savings. People often stop contributing to their accounts while they’re repaying a loan. Long-term, that interruption can have a big effect. Ceasing 401(k) contributions while repaying a loan can decrease future retirement income by 10 to 13 percent, according to the Washington-based Employee Benefits Research Institute.
Experts say the shortfall in retirement savings has created the potential for a huge crisis. “Americans seem to have no understanding of what they’re going to need,” says Skarda, the retirement specialist in San Antonio. “I’m not sure if we’ll all just be wandering the streets, like something out of the Book of Eli.”
*Matt did not want to use his last name because of the personal nature of his financial issues.
Borrowing from a 401(k) (Bankrate)
Don’t Wait For Washington. Fix Your 401(k) Now. (The Fiscal Times)
Boomers May Go Bust As 401(k)s Fall Short in Retirement (The Fiscal Times)