Understanding Retirement Plan Leakage Triggers and Costs

Participants have numerous reasons for taking a pre-retirement distribution.

The biggest triggers for retirement plan leakage are participants taking pre-retirement distributions, loan defaults and hardship withdrawals, according to an industry expert.

Asset leakage is an important issue for plan sponsors because larger retirement plans are better positioned to negotiate with recordkeepers and investment providers to secure institutionally priced investment products and lower fees by trading on their size and bargaining power.

A report issued by the Congressional Joint Committee on Taxation in 2021 showed that 22% of net contributions made by individuals age 50 and younger left retirement plans between 2010 to 2015. The research was authored by U.S. Department of the Treasury personnel at the Office of Tax Analysis and Joint Committee on Taxation.

The research report published by the Social Science Research Network, “Leakage from Retirement Savings Accounts in the U.S.” says, “Understanding the magnitude and contributing factors to leakage is important for evaluating the efficiency of the U.S. retirement savings system.” It finds that about 25% of contributions by pre-retirement-age individuals leaked between 2003 and 2005, and that this increased to roughly one-third in 2010. Following the Great Recession, there was a gradual return to pre-2008 levels, with a leakage share of 28% in 2015.

Sherri Painter, senior vice president, Retirement Plan Services, at Newport Group, says participants have numerous reasons for taking a pre-retirement distribution.

After a participant has changed jobs and neglected to move their retirement plan balance to a new plan rather than taking a distribution, they often believe they have time to make up the difference. Participants often need the money to pay bills and say it’s too complicated to roll over the account balance, Painter explains. “This results in leakage from the retirement plan and in workers that are not properly prepared for retirement,” she says.

Additionally, the same participants “frequently” have outstanding loans in their retirement account, which causes more leakage from not paying off the loan in full before receiving a distribution, she adds.

Costs to Participants

The U.S. Government Accountability Office issued a report to the Senate Special Committee on Aging in 2021 that showed plan participants ages 25 to 55 withdrew $9.8 billion from retirement plans and did not roll over into another qualified plan or individual retirement account.

Costs to participants from cash distributions include tax ramifications. Despite participants being given the tax information when taking a withdrawal, the tax impacts—withholding and tax penalty—are often misunderstood, and only become clear when tax time comes, Painter says. 

“If they are younger than 59.5, the withdrawal costs them 30% in taxes—mandatory 20% federal withholding, plus an additional 10% early distribution penalty—in addition to state and local taxes,” Painter says. “That short windfall of cash is already spent, and they are starting over with retirement savings and potentially having a tax liability they had not planned.”

Ultimately, participants mulling a pre-retirement distribution or loan must consider how desperately the retirement money is needed because taking a withdrawal is “defeating one of the primary advantages of retirement savings, that of compounding investment returns over decades,” adds Painter.

“Those who start saving early and do not borrow against, or withdraw from, their retirement plan are much more likely to be in a better financial position at retirement age,” she says.

Retirement plan sponsors and advisers can act to lessen pre-retirement withdrawal frequency by offering participants help with simplifying rollovers to a new plan or IRA. Plan sponsors and advisers can institute electronic transfers to minimize paperwork and simplify the investment process, adds Painter.

Painter suggests the following:

  • Modification of the plan’s loan policy: Many plans offer a loan provision where participants can repay through payroll deductions. Plan sponsors can add automatic/electronic banking for loan payments after participants leave the plan.
  • Restructuring the plan’s hardship withdrawal provisions: Plan sponsors and advisers should encourage participants to use a loan feature before taking a hardship withdrawal from their account, by restricting the hardship withdrawal only to certain savings in the plan and limiting the reasoning for a hardship withdrawal to one of the IRS safe-harbor reasons.
  • Adding employee education: Employees need to be educated on the financial impact to their retirement plan when taking a loan or hardship withdrawal. An adviser can provide participants help in navigating the features of their retirement account, understanding the financial impact of withdrawing from their account, and examining the impact of sacrificing the benefits of long-term investing.