Easy Come, Easy Go?

Earlier this year, I commented that it would be interesting to see how expanded access to hardship withdrawals might impact that activity. Now we have some answers.

There’s more than a little irony in a legislative body that has long bemoaned both the paucity of retirement savings and the nefarious impact of “leakage” (pre-retirement withdrawal of retirement savings) opening those floodgates a little wider – but mostly the new law, and clarifying regulations[i] seemed to provide plan sponsors a bit more flexibility in administering these programs, some welcome latitude in helping their workforce navigate choppy financial waters.

What remained unknown was – would participants take advantage – or, more precisely, would they abuse the privilege.

The first sign – and it was a bit of an eye-opener – came from Fidelity who, in a white paper, claimed to have seen a shift in participant behavior. Not in the percentage of participants taking loans and hardships overall, but - at least among Fidelity-recordkept plans, there were fewer loans and more hardships. Less than 6 months after the law took effect, based on the evidenced trends, they predicted that the annual loan rate for 2019 would dip slightly to 9.2%, while the annual hardship rate would rise to 4.4% – up from about 3% in 2018 and an average rate of 2.2% since 2009, according to their data.

Intrigued, I posed the question to NAPA-Net readers in early October – and the responses indicated that while the move to embrace the option was underway, it was – well, it was still underway. Just over a third (35%) said the rules were already in place at most of their clients, and nearly a quarter (24%) said they were already in place at all of their clients, while another 23% said they were in place at “some” of their clients. The rest were in “not yet” territory. The most surprising aspect (to me, anyway) was the lack of plan sponsor response to the impact of the changes (at least in earshot of their advisors).

Now we have a direct response from plan sponsors, courtesy of a “snapshot” survey on the subject by the Plan Sponsor Council of America. The PSCA found that nearly two-thirds (65%) of respondents already have adopted the new hardship provisions. However, most (73%) reported no change in the number of hardship withdrawals since the new provisions were implemented. Fewer than one in five (17.8%) noted an uptick in hardship withdrawals in 2019 – but even among those that did, the vast majority (92%) are not considering any changes to their provisions at this time. Indeed, most plan sponsors amended their plans even where change was not mandatory; 65.1% eliminated the requirement to take plan loans before taking any hardship withdrawal, and 59.6% expanded the assets available for hardship withdrawals to include earnings on 401(k) contributions. More than half (52.3%) voluntarily expanded the list of reasons that qualify for a hardship distribution.

It's still early to assess the long-term impact of these changes, of course, though plan sponsors appear to have embraced them without much hesitation. And if the recent take up rates have been pretty much status quo – well, the markets and unemployment numbers have been good, and the natural disasters that often produce upticks in financial hardships have been muted of late. Yes, it’s early to evaluate the impact – to see if greater access will mean more access, to see if removing barriers does, indeed open floodgates, or if knowing that it will be easier to access the money, individuals are less inclined to do so.

In sum, to see if addressing the hardships of today wind up creating hardships down the road.

- Nevin E. Adams, JD

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[i]The expanded access, of course, came courtesy of the Bipartisan Budget Act of 2018, which, among other things, set aside or made optional several of the penalties and restrictions that had long been in place to discourage usage, and/or to ensure that the request was “serious.” This included aspects like the requirement to take a plan loan first (it’s now optional), and more significantly, the suspension of contributions. The changes not only broadened not only the categories of contributions eligible for hardship (it now includes matching contributions and non-elective contributions, as well as earnings on those accounts), but also included changes in the ability to qualify for a hardship distribution in the case of casualty losses and losses associated with federal disaster areas. The IRS also loosened the rules for determining the status of a hardship – arguably lessening the burden of both requesting and approving these distributions (final regulations were published in September).

'Hidden' Costs

Valentine's Day was this week, and you have perhaps seen those increasingly ubiquitous advertisements for a certain online florist.

Now, I’ve used that particular service on many an occasion over the past several years; they are not only convenient, they deliver a quality product, and on time. In sum, I’ve used them before, have, in fact, used them this year, and will doubtless use them again.

The ads tout the ability to get a dozen roses for $24.99. That’s in red only (but hey, it’s Valentine’s Day), and you do actually get a glass vase included in that price (with options to “upgrade,” of course).

That said, “standard” delivery is another $12.99, and – at least at this (late) date, it’ll cost you $9.99 to guarantee Valentine’s Day delivery, another $14.99 if you want it there in the morning, and there’s a “care & handling charge” of $2.99, regardless of delivery date or time.

In fact, by the time you add in taxes those $24.99 roses will run you… well, quite a bit more than $24.99.

Not that you’ll see that all presented in one place – well, until the very last screen, anyway.

Hardship Costs

I wonder sometimes if that isn’t how those who request a hardship withdrawal feel – though, disclosures notwithstanding, it’s not like they can see what it’s actually going to cost at the point they make the request.

Oh, they know the amount they need, and presumably request. But then there’s the 20% withholding that comes off the top, but then, come tax time, they’ll find out if that 20% withholding was “enough.” At the same time, they’ll likely discover the 10% penalty (for those who aren’t yet 59½). Less obvious is the retirement savings “ground” they’ve lost to the customary 6-month suspension of contributions (and match). And that’s not considering the 401(k) loan they likely had to take first because, after all, we have to make really, really sure that you absolutely have no other way to get to that money.

Still – and though the 61st Annual Survey of Profit Sharing and 401(k) Plans from the Plan Sponsor Council of America (PSCA) indicates that more than 80% of plans offer a hardship withdrawal option – only 2.3% of workers who have access to them take them. Data from the nonpartisan Employee Benefit Research Institute puts that at fewer than 2%, and Vanguard’s “How America Saves” study says that only about 3% of participants do.

Expanded Access

Then late last year, Congress passed the Bipartisan Budget Act of 2018, which, among other things, set aside several of these “hidden” costs, notably the requirement to take a plan loan first (it’s now optional), and more significantly, the suspension of contributions. They broadened not only the categories of contributions eligible for hardship (it now includes matching contributions and non-elective contributions, as well as earnings on those accounts), but also included changes in the ability to qualify for a hardship distribution in the case of casualty losses and losses associated with federal disaster areas. The IRS also loosened the rules for determining the status of a hardship – which should lessen the burden of both requesting and approving these distributions.

Now, despite the retirement focus of these savings, I’ve always thought that it was important to provide emergency access. After all, if you thought that there was no way you could ever tap into those funds in a dire situation no matter what, wouldn’t you hold back on savings? And while there are almost certainly abuses, the relatively low take-up rates despite the widespread availability suggest that those are the exception, not the rule. The new rules, while they certainly open the door to pre-retirement withdrawals a bit wider, seem, for the most part, a thoughtful extension of potential relief to individuals that surely need it.

What remains to be seen – the new provisions were only just effective for plan years beginning on or after Jan. 1, 2019, after all – is how that expanded access will influence the historically low take-up rates on hardships.

And what the ultimate cost will be.

- Nevin E. Adams, JD

The Impact of Assumptions on the Impact of Leakage

It has become something of an article of faith in our industry that “leakage,” the distribution of money from retirement accounts prior to retirement, is bad.

Bad, of course, in the sense that those “premature” withdrawals, via hardship withdrawals, loans or the so-called “deemed distributions” that result when a termination occurs when a loan is outstanding, reduce individual retirement savings.

So when the Center for Retirement Research at Boston College published a paper last week entitled “The Impact of Leakages on 401(k)/IRA Assets,” it really wasn’t a question of “if” there was an impact, it was a question of how much. The answer, according to the paper: a reduction in wealth at retirement of a jaw-dropping 25%.

Now by any measure, a 25% reduction in retirement wealth is a massive problem — and one that would, if valid, call for the kind of countermeasures touted by the Boston College researchers.

But consider the findings published recently by the non-partisan Employee Benefit Research Institute (EBRI) based on its massive participant database of actual participant balances and activity. Among participants with outstanding 401(k) loans at the end of 2013, the average unpaid balance was a mere $7,421, and the median loan balance outstanding was $3,973.

Moreover, the report notes — as it has for a number of years examining trend analysis in that database — that overall, loans from 401(k) plans tended to be small, with a sizable majority of 401(k) participants in all age groups having no loan outstanding at all: 88% of participants in their 20s, 73% of participants in their 40s, and 86% of participants in their 60s had no loans outstanding at year-end 2013.

So, how did the Boston College researchers manage to come up with a 25% reduction in retirement wealth? Quite simply, they started by deriving an estimate based on a “host of simplifying assumptions” — their words, not mine.

What are those simplifying assumptions? It starts with a hypothetical participant who initially makes $40,000/year, gets a 1.1% annual pay increase in real terms, assumes that he/she defers 6% of pay, is matched at a rate of 50 cents on the dollar, and whose investments gain a 4.5% real annual return. But the key assumption — and the one that arguably creates the conclusion of the paper — is their further assumption that 1.5% of assets leak out each year!

Under these assumptions, the leakages result in accumulated 401(k) wealth of $203,000 at age 60 compared with $272,000 with no leakage. So their math (and assumptions) lead to a conclusion that these leakages reduce 401(k) wealth by 25%. To “prove” the point, they provide a simple chart of the numbers they just produced, and direct the reader to it as though it provides some sort of independent corroboration.

They go on to clarify: “This estimate represents the overall impact for the whole population, averaged across both those who tap their savings before retirement and those who do not.” That’s right — averaged across everyone, not just those who actually dip into those savings prior to retirement.

Now at that point, it’s arguably just math, not so much a quantification of the impact of leakages as the mathematical impact of a series of simplifying assumptions. As for the so-called impact of leakages? It might more accurately be described as the impact of assumptions.

- Nevin E. Adams, JD

That’s not to say that leakages don’t have an impact on retirement accumulations, and doubtless for some, that impact is significant. EBRI’s analysis found that among loan defaults, hardships and cashouts at job change, cashouts were found to have a much more serious impact on 401(k) accumulation than either plan loan defaults or hardship withdrawals (even with the impact of a six-month suspension of contributions included). The leakages from cashouts resulted in a decrease in the probability of reaching an 80% real replacement rate of 5.9 percentage points for the lowest-income quartile and 4.5 percentage points for those in the highest-income quartile. In fact, the effect from cashouts (by themselves) — not loans or hardship withdrawals — turns out to be approximately two-thirds of the leakage impact.  

It’s also worth noting that it’s one thing to quantify the impact of not allowing early access to these funds — and something else altogether to assume that participants and plan sponsors would not respond in any way to those changes, perhaps by reducing their contribution levels, or by either deciding to continue to participate or to participate in the first place.

"Out" Takes

My first car wasn’t anything special, other than it was my first car. It was an older model Ford, ran reasonably well, with one small problem— it went through oil almost as quickly as it did gasoline. At first I attributed that to being a function of the car’s age, but as the leakage grew, I eventually dealt with it by keeping a couple of quarts of oil in the trunk “just in case.” Eventually, I took the car to a dealership—but by the time they finished estimating the cost of a head gasket repair, let’s just say that, even on my limited budget, I could buy a LOT of oil by the quart, over a long period of time, and still be ahead financially.

“Leakage”—the withdrawal of retirement savings via loan or distribution prior to retirement— is a matter of ongoing discussion among employers, regulators, and policy makers alike. In fact, EBRI Research Director Jack VanDerhei was recently asked to present findings on “The Impact of Leakages on 401(k) Accumulations at Retirement Age” to the ERISA Advisory Council in Washington.[1]

EBRI’s analysis considered the impact on young employees with more than 30 years of 401(k) eligibility by age 65 if cashouts at job turnover, hardship withdrawals (and the accompanying six-month suspension of contributions) and plan loan defaults were substantially reduced or eliminated. The analysis assumed automatic enrollment and (as explicitly noted) no behavioral response on the part of participants or plan sponsors if that access to plan balances was eliminated.

Looked at together, EBRI found that there was a decrease in the probability of reaching an 80 percent real income replacement rate (combining 401(k) accumulations and Social Security benefits) of 8.8 percentage points for the lowest-income quartile and 7.0 percentage points for those in the highest-income quartile. Said another way, 27.3 percent of those in the lowest-income quartile (and 15.2 percent of those in the highest-income quartile) who would have come up short of an 80 percent real replacement rate under current assumptions WOULD reach that level if no leakages are assumed.

The EBRI analysis also looked at the impact of the various types of “leakage” individually. Of loan defaults, hardships, and cashouts at job change, cashouts at job change were found to have a much more serious impact on 401(k) accumulation than either plan loan defaults or hardship withdrawals (even with the impact of a six-month suspension of contributions included). The leakages from cashouts resulted in a decrease in the probability of reaching an 80 percent real replacement rate of 5.9 percentage points for the lowest-income quartile and 4.5 percentage points for those in the highest-income quartile. That effect from cashouts—not loans or hardship withdrawals—turns out to be approximately two-thirds of the leakage impact.

However, and as the testimony makes clear, it’s one thing to quantify the impact of not allowing early access to these funds—and something else altogether to assume that participants and plan sponsors would not respond in any way to those changes, perhaps by reducing contributions,[2] potentially offsetting some or all of the prospective gains from restricting access to those funds.

Because ultimately, whether you’re dealing with an old car or your retirement savings account, what matters isn’t how much “leaks” out—it’s how much you put in, and how much you have to “run” on.

Nevin E. Adams, JD

[1] EBRI’s testimony for the ERISA Advisory Council, U.S. Department of Labor Hearing on Lifetime Participation in plans is available online here.  

[2] An EBRI/ICI analysis published in the October 2001 EBRI Issue Brief found that, “[o]n average, a participant in a plan offering loans appeared to contribute 0.6 percentage point more of his or her salary to the plan than a participant in a plan with no loan provision.” Testimony provided to the ERISA Advisory Council testimony notes that it’s likely that a similar relationship exists with respect to the availability of hardship withdrawals. See “Contribution Behavior of 401(k) Plan Participants,” online here.

Double Dipping?

Last week, Fidelity published some data from their quarterly analysis of participant activity.

For the very most part, the data (see Fidelity Finds Q2 Uptick in 401(k) Withdrawals) revealed what we have come to expect from such reviews: Participants continue to stay the course, deferral rates are largely unchanged (average was 8%), and more increased their rate of deferral (5.3%) than decreased it (2.9%) in the most recent quarter. Additionally, the balance recovery continues apace, with the average account balance up 15% (though for this good news, you have to reach for a year-over-year comparison, because Q2 figures to be a pretty rough one for participant accounts—down 7.6% in Fidelity’s database).

However, this report drew more than the customary amount of coverage for its finding that rates of hardship withdrawals and loans were higher—and by some measures, significantly higher—than they were a year ago.1

My initial reaction was that this latter finding was something of an outlier; after all, in recent weeks we have seen other, similar reports from other providers that indicate that withdrawal volumes were down, certainly compared with the dark early days of 2009. But then, this was more recent data, and with the report of weekly jobless claims back up to half a million, well, let’s just say that it didn’t require much imagination to see a link between more people out of work and an uptick in “premature” distributions.

But later, as I considered the data, the findings didn’t seem so out of line. While the Fidelity survey found that 11% of participants took out a loan this quarter (9% did a quarter earlier), neither the average initial loan amount ($8,650) nor the loan term (3.5 years) seemed out of line. The report did, however, contain at least two alarming statistics. First, 22% of participants recordkept by Fidelity now have an outstanding loan, and while that isn’t much beyond the one in five that did a year ago, it nonetheless represented a decade-long record for Fidelity’s database. Indeed, this was the item that most media outlets qravitated toward (based on the calls I got).

In fact, IMHO, a more troubling trend lies in the fact that nearly half (45%) of participants who took hardship withdrawals one year prior also took a hardship withdrawal in the 12-month period ending in the second quarter of this year.

While participant loans are (too) frequently touted as borrowing from yourself, they put the participant in the position of having to replace—on an after-tax basis—the contributions you’ve withdrawn and a rate of “return” in the form of interest on the loan. Still, at least you’re on a schedule to replace the money you’ve withdrawn.

Now, properly administered, it’s not easy to obtain a hardship withdrawal. You actually have to be experiencing a financial hardship, for one thing, and you often not only have to prove that, but also that you have exhausted other sources. Worse, that hardship withdrawal is reduced not only by the need to pay taxes on the pre-tax monies you’ve now tapped, you have to fork over another 10% as a penalty to Uncle Sam (unless, of course, you’re older than 59 ½). What that means, of course, is that what you think you are seeing isn’t exactly what you are going to “get.”2 In fact, it could easily be just half what the requesting participant might be expecting.

The reality is that people are surely hurting, and if the money they have set aside in their 401(k) helps them through this period, puts food on the table, or keeps the family in their home, that’s, IMHO, a good thing. After all, there’s not much point in taking out a loan when you don’t have a source of income to repay it.

But what concerns me about the trends in the Fidelity report, aside from the implications that so many are struggling financially, is that, in my experience, hardship withdrawals, unlike loans, are not only gone for a while, they are savings that are often “gone” forever.

—Nevin E. Adams, JD

1Loans initiated over the past 12 months grew to 11% of total active participants from about 9% one year prior. The portion of participants with loans outstanding also increased two full percentage points in the second quarter to 22%. The average initial loan amount as of the end of the second quarter was $8,650, with an average loan duration of three and half years, according to Fidelity.

According to Fidelity’s data, 62,000 of the participants recordkept by the firm initiated a hardship withdrawal in the second quarter, compared with 45,000 participants who did so the quarter before. As of the end of Q2, 2.2% of Fidelity’s active participants took a hardship withdrawal, compared with 2.0% a year earlier.

2 Those taxes aren’t always obvious at the point of distribution, unfortunately, but due at the individual’s next tax filing.