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.

Kohl and Enzi Introduce Bill to Prevent 401(k) Leakage

In a rare bipartisan moment, Senators Herb Kohl (D-WI) and Mike Enzi (R-WY) have introduced the "Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011", also to be known according to the language in the bill as the "SEAL 401(k) Savings Act." Who thinks this stuff up? Hopefully, if it does become law, the SEAL Act will do a better job of sealing 401(k) leakage than the JOBS Act did of creating jobs. You can read the bill language here if you feel so inclined. If not, I'm going to summarize it for you below, adding commentary on the key provisions.

First, though, we need some context. When we look at 401(k) plan designs and retirement adequacy, the true champions of a DC-only world (only defined contribution retirement plans, no defined benefit plans) perform projections assuming that an individual enters the workforce at some age in their early 20s, participates in a 401(k) plan with a generous match for their whole career at one company never deferring less than the amount required to get the full match, never takes a loan or a hardship withdrawal, never has a work interruption, and gets a constant return on their investment of, say, 7% per year.

Thank you for your visit to Dreamland. Now, back to reality.

In reality, based on current trends, a person entering the workforce today and working relatively continuously until about age 65 will probably hold about 10 different jobs (don't ask me for a citation on this one because I admit that I just made it up and it is based on my powers of observation). At least some of those times, there will be discontinuities. Some of those jobs will provide 401(k) plans that are not so generous. Some will provide no retirement plan at all. Our hero(ine) will go through some times of economic hardship and not contribute enough to get the full match throughout their career. They will take plan loans from time to time and maybe even a hardship withdrawal or two. Like it or not, our new worker is going to have a lot of turmoil in their grand retirement plan. It is this combination of bad stuff that is sometimes referred to as leakage.

So, how is the SEAL Act going to stop this? Well, it's not a very long bill. It has five sections including the ridiculously silly Section 1 that seems to live in all bills and is called the Short Title (it seems to me that this could go in the bill header, but what do I know?). Each of the remaining sections has a purpose and we'll refer to them by number.

Section 2. This section would increase the rollover period for plan loans when a participant with an outstanding loan changes employment. It would allow the participant to wait until they file their federal income tax return for the year in question before having to repay the loan to their rollover account without suffering the penalties of a defaulted plan loan, and therefore, a deemed distribution. Senators Kohl and Enzi think that participants are not repaying these loans currently because they don't have enough time to make the decision. Do you know what? They are wrong. People are not repaying the loans because they don't have the money or even access to the money to do it. You can't repay a plan loan with hope or with a credit card, you need actual money.

Section 3. This would allow participants to take a hardship withdrawal, but still make deferrals to the plan during the six months immediately following the hardship withdrawal. Let's think about this. A participant jumps through all the hoops necessary to take a hardship withdrawal (including that they have no other sources of the money that they need) and Senators Kohl and Enzi expect them, or even want them, to continue deferring to the 401(k) plan. Either Kohl and Enzi don't get it or I don't get it, and at least in this case, my nod goes to them not getting it. According to his own Senate disclosures, Mr. Kohl's net worth has recently been in the vicinity of $250 million. Mr. Enzi's net worth, on the other hand, has only been in the range of $1 million to about $2.5 million. Even Mr. Enzi probably doesn't quite know the plight of someone dealing with a hardship withdrawal, and we can be sure that Mr. Kohl does not run in those circles.

By the way, if you want to check out the finances of a US Congressman, you can find their disclosures at opensecrets.org

Section 4. This would reduce the number of plan loans that a participant can have outstanding at any point in time to three. Perhaps I am missing something here, but a person who has three plan loans outstanding is probably not in a position to be making large deferrals.

Section 5. This would prohibit products like the 401(k) debit card that encourage participants to raid (self-leakage) their 401(k) accounts before retirement. In a press release, the bill's co-sponsors admit that such products are not prevalent.

So, there you have it, a summary of the bill named after either a strange looking mammal or Heidi Klum's husband. What do you think?