Employers frequently use matching contributions as an incentive to encourage employees to participate in defined contribution plans with the hope of improving retirement financial security, but while matching contributions are successful at increasing participation, they could also be having an unintended adverse impact on retirement security.
A study of about 15% of the U.S. workforce serviced by one of the nation’s largest recordkeepers revealed that matching contributions correspond with a higher rate of pre-retirement “leakage.” According to the study compiled by UBC Sauder Associate Professor Yanwen Wang, who co-authored the study with Muxin Zhai of Texas State University and John G. Lynch Jr. of the University of Colorado, this leakage happens frequently at job separation. Around 41% of employees who were voluntarily or involuntarily leaving their job cashed out their 401(k) savings, most of whom drained their entire accounts. This is despite a 10% penalty imposed by the U.S. government for withdrawing 401(k) funds before age 59.5, the study found.
Approximately 64% of those who depleted their entire account took a one-time total cash-out, whereas another 21% depleted their 401(k) balances in two or more withdrawals within eight months, according to the study. Furthermore, the study found that a 50% increase in an employer’s matching rate would be associated with an increase of 6.3% in leakage probability at job termination.
Employees do have the option to avoid penalties by rolling their balance to an individual retirement account, keeping the money in their employer’s plan or transferring assets to the new employer’s plan. Despite these options, employees are still opting to cash out in large numbers.
“The nature of exchanges at job separation seems to unintentionally nudge employees to take the cash, suffering penalties and taxes, leaving them in a position to have to restart 401(k) retirement savings at their next jobs,” the report said.
The study examined whether financial hardships associated with job changes could account for the increase in 401(k) leakage but noted financial shocks, such as the COVID-19 pandemic, did not lead to people having a higher tendency to withdraw funds from their retirement accounts even when penalties were eliminated. Instead, studies showed that people tended to address financial challenges during the pandemic by reducing living expenses rather than liquidating retirement accounts.
The study posits that the out-of-sight, out-of-mind nature of retirement savings changes when it becomes available at the time of job transition, transforming a perceptually illiquid source of long-term retirement security into a psychologically liquid pile of cash.
The report outlines four theories about why a higher employer contribution match rate might lead to greater leakage:
- Employees with a higher match rate might be opportunistic and plan to leak, viewing it as ‘free money’ for use at job separation, especially if the 10% penalty is lower than other borrowing costs.
- Employees might perceive a higher matching rate as a sign of job security, which could prompt them to overspend during employment necessitating the need for cash at job separation to maintain their spending habits.
- The separation of employee and employer contributions on 401(k) statements might create separate ‘mental accounts’ that encourage employees to treat the employer-contributed funds as a liquid windfall and their own contributed funds as a sacred source of retirement income.
- On the other hand, employees may not create separate mental accounts and therefore view their entire account as either a liquid windfall or an untouchable source of retirement security.
Employers have an important role to play in mitigating pre-retirement leakage at the point of job change, the report said. The first way employers can help is to intervene at the point of separation with departing employees to show the effects of leakage on future retirement assets if they drain them and have to start over. On the other side, employers hiring employees can provide ‘roll-in’ support for consolidating assets from prior employer retirement plans.
Another way employers can address this trend is to weaken the account composition effect on leakage. In other words, if employers sponsor separate emergency savings accounts for employees to accumulate a chunk of liquid funds that don’t incur withdrawal penalties, they will be more likely to view funds held in a retirement account as untouchable except for retirement.
The study also noted growing support within the industry for auto-portability policies, which would allow employers to automatically roll small-balance accounts of a terminating employee into the new employer’s plan.
Kristen Beckman is a freelance writer based in Colorado. She previously was a writer and editor for ALM’s Retirement Advisor magazine and LifeHealthPro online channel.