By Thomas Hawkins
Cashout leakage, a long-standing problem in America’s defined contribution system, is a silent crisis that unnecessarily robs millions of Americans of a comfortable, timely or secure retirement. Plagued by misunderstanding and neglect, it’s vitally important to understand the problem and to take decisive action to curb it.
The first of a five-part series, this article addresses the fundamentals of cashout leakage.
What is Cashout Leakage?
Cashout leakage is the voluntary, premature withdrawal of tax-qualified retirement savings following a job change, and prior to normal retirement age, which results in the payment of taxes and penalties.
While the term “leakage” can carry comedic value – conjuring images of diaper-clad babies and adult undergarments – it’s a serious problem for our nation. Each year, up to 6 million participants cash out, elect to use their tax-qualified savings for purposes other than retirement and become retirement system dropouts. Just as a young adult who chooses to drop out of school could damage their chances of success in life, participants who cash out could be squandering their retirement security.
Sources of Confusion
Next, let’s clear up some common sources of confusion surrounding the problem of cashout leakage.
- Cashout Leakage vs. Other Forms of Leakage
Don’t confuse cashout leakage with its cousins, in-service hardship withdrawals and loan defaults, different forms of leakage which many – incorrectly – believe to be larger problems. According to a 2009 study by the U.S. Government Accountability Office, nearly 89% of all leakage is attributed to cashouts that occur when a participant changes jobs, and hardship withdrawals and loan defaults together account for the remaining 11%.
- Most Cashout Leakage is Avoidable
Perhaps the most egregious misconception about cashout leakage is that it’s largely driven by financial emergencies. On the contrary, a 2015 survey by Boston Research Technologies (BRT) found that only about one-third of cashout leakage is due to a true financial emergency. Almost two-thirds of cashouts are for other reasons and could be avoided. Accordingly, the same study indicated that many participants experienced high levels of regret over their cashouts, which grew over time.
- Leakage of Small Balances is a Big Problem
While large balance 401(k) cashouts occur, two-thirds of participants who cash out have balances less $5,000, based on results from the Auto Portability Simulation. What’s even more interesting is research completed in 2017 by the Employee Benefit Research Institute (EBRI), which concluded that, over a 40-year period, $2.0 trillion could be retained in the US Retirement System if cashout leakage were addressed for all balances, and $1.5 trillion, or fully three-quarters of that amount, was attributed to accounts with less than $5,000.
- “Fast” vs. “Slow” Cashout Leakage
Since 2010, multiple studies by large 401(k) plan recordkeepers have consistently shown cashout leakage in the year following a job change affects anywhere from 33% - 36% of participants, representing a phenomenon characterized as “fast leakage.” When multi-year, longitudinal studies are conducted, cashout leakage continues to occur, albeit at lower rates. The cashout leakage that occurs in the years following separation is known as “slow leakage.” When multi-year distribution decisions are considered, as they were in a 2019 Alight study, the composite cashout rate increases to around 40%.
Why Does Cashout Leakage Persist?
If cashout leakage is such a large problem, and if most of is avoidable, then why does it persist at its current, unacceptable levels?
- Cashing Out is Easy; Moving Savings Forward is Not
The real culprit driving the bulk of cashout leakage is friction. According to 2013 study by the Boston Research Group: “Participants facing…’friction’ that results from complex rollover procedures and an absence of assistance take the path of least resistance and prematurely cash out at alarming rates, depleting their retirement savings and…regretting their decisions in hindsight.”
Put simply, it’s an easy and very tempting choice for a participant to cash out following a job change, even if the decision to cash out is not in their best interests.
- Plan Sponsors, Service Providers Have Mixed Motivations
While a plan sponsor’s fiduciary duty is to act prudently and solely in the interests of their plan’s participants, small accounts of former employees don’t fare so well. Whereas large plan balances of former employees may benefit the plan, the administrative burden to maintain the growing number of small accounts left behind by separated participants outweighs the benefits of having those assets. To reduce plan costs, many sponsors automatically cash out all balances under $1,000 and force accounts with $1,000 - $5,000 balances out of the plan. Both these actions dramatically increase cashout leakage.
Also contributing to the cashout leakage problem is the indifference that small balance account owners are shown by leading IRA providers. Quick to accommodate larger balances, IRA providers are reluctant to service this population, as the median balance for accounts under $5,000, and subject to mandatory distributions is $1,679 – lower than the initial deposit required to open many IRAs. Combined with the complex and time-consuming nature of DIY plan-to-plan portability, separated participants—and especially those with less than $5,000 – find that cashing out is their easiest option, by far.
Recent developments, including the Department of Labor’s guidance on auto portability, and the creation of the new Saving Preservation Working Group, indicate that DC policymakers, providers and sponsors are interested in finding solutions to the cashout leakage problem.
In our next article, we’ll take a deeper dive into the demographics of cashout leakage and show why solving the problem is a critical retirement savings public policy goal