Leakage -- The Scourge of the 401(k)

Leakage -- it is the scourge of the 401(k). What is it? Well, it's not a really well defined term. But, in a nutshell, it's what happens to a participant's account or accounts -- their total savings -- when they have a discontinuity.

Simplified, most people are doing well until they run into some sort of hardship. Then the problems start. If they have a hardship, but they are still employed, they are likely to continue deferring, but perhaps not to the same extent. However, the news gets worse for the unemployed and the underemployed.

The Investment Company Institute (ICI) published a survey recently. They found that 63% of the unemployed who had a 401(k) account with their last employer have taken a withdrawal and 34% of the underemployed (they don't defined underemployed that I saw) have done so.

You've seen those projections. If you get your first real job when you are, say, 25 years old, and you begin deferring and you keep it at it, you'll have a wonderful nest egg by the time you reach retirement age. That's when the angels are looking down on you. But the ICI survey says that with unemployment or underemployment comes the devil known as leakage. And, these days, there just aren't that many people who will never suffer from either or from some other short-term financial hardship. It's part of the way of an extended weak economy.

Suppose we took those rosy projections starting at age 25 and running to even age 70 and looked at them. What's a reasonable rate of investment return? Many of the projections say 8% per year compounded. That means a geometric 8% rate of return. I'll bet you that you can't get a geometric 8% rate of return. If you have  gotten that this century to date, you are probably in the 99th percentile of all investors.

How do you model leakage? Consider this. Little Miss Muffet was a star student at a top school. She graduated, then got her MBA and finally took a good job at a company with a good 401(k) plan at the age of 25. She had read all the articles and began to save in earnest in her 401(k) plan. Uh, oh, Little's employer ran into some business hardships. They had to do a layoff and Little's number came up. She had a house with a mortgage. She had a car payment, and even though she had put aside a bit of a nestegg, the job market was tough. Little Miss Muffet had no alternative but to withdraw her money from her 401(k) plan.

Leakage!

Muffet was now 30 years old. Finally, she got another job, but remember those projections where you start saving at age 25. She can't go back to 25. And, while she got another job, she was desperate and it's not as good a job as she had at age 25.

So, you tell me how Little Miss Muffet is going to overcome leakage to get to a good retirement. As I asked you yesterday, has the 401(k) system failed us? Methinks it has.