Reducing leakage to keep participants on track for retirement.
Part 2: Distributions
In part 1 we discussed how generous loan programs might be acting as cracks, slowly draining your participants’ pool of retirement savings over time. In this part, we will address two additional ways participants might empty the pool and steps that you, as a plan sponsor, can take to help prevent your participants from negatively affecting their retirement readiness. The two ways are:
- hardship distributions and
- distributions after a participant separates from employment.
Currently 88.3%1 of plans allow for hardship distributions. Hardship distributions can limit the reasons a participant to take a distribution. However, if the participant qualifies for the distribution, the participant should understand there could be tax consequences as well as the 10% additional tax for cashing out before age 59½. Generally to qualify for a hardship, a participant must show a need for the distribution, such as to prevent foreclosure or eviction from primary residence, pay for tuition, cover funeral expenses, purchase of primary residence, or cover repairs to a principle residence2. It is important that participants realize that hardship distributions also limit their ability to contribute for up to six months. In a hardship distribution case, it is a “lose/lose” situation – the account balance is being depleted and cannot be replenished because the participant is restricted from adding contributions for a period of time.
In order to qualify for a hardship a participant might also be required to utilize a loan provision. This helps prevent tax consequences by potentially keeping the needed distribution amount lower. However, adding a loan payment during this time can complicate the issue even more if the participant is already having cash flow or budgeting issues.
Although we do not recommend allowing for hardship distributions or loans, if you would like to provide participants with some sort of access to their account, consider only allowing loans. You can even make the loan itself contingent upon showing a need for hardship.
Separation of Service Distributions
As a plan sponsor, you can consider some action steps to help keep participants from cashing out when they leave employment. Look at your automatic cash-out features and adjust them to promote positive saving behavior. You might consider reducing or eliminating plan features that automatically cash out low balances. According to a recent survey3, 75% of participants with account balances under $1,000 take cash distributions. If you automatically cash out your participants’ low balances, consider having the low balances automatically rolled into an IRA, or offer education to help your participants understand the importance of saving and the time value of money. This is especially important for younger participants. For example if you assume a 7.2% return, based on the rule of 724, the account balance doubles every 10 years. If a participant is in his/her late 20s/early 30s, the participant may have an additional four decades for his/her account to grow. With the power of compounding, a $1,000 cash out distribution today could potentially cost the participant $15,000 worth of savings 40 years from now. With education, participants can better understand they could be losing $15,000 by cashing out $1,000 now. When participants discover they will only get a portion of the $1000 due to taxes and penalties, the idea of rolling money into an IRA or a new employer plan becomes even more appealing.
As account balances grow, fewer participants take distributions, meaning more is being rolled over or kept in their plans. In the previously mentioned survey3, only 24% of participants with account balances between $30k-50K took cash. When the account balances were $100k or more, only 10% cashed out.
This addresses how a plan sponsor might help its participants that leave its employment. A plan sponsor can also help new hires by accepting rollovers from other qualified plans and by relaxing eligibility requirements so participants can move money as quickly as possible. The longer a participant has to wait, the more chances are they will find a reason to take distributions. You can learn more in our previous blog post about relaxing eligibility requirements and the impact to retirement readiness.
Concerned about the effects hardship or separation of services distributions might have on your participants? A member of the RetireAdvisers® Team can help you analyze your current plan design features, and create a results focused education program to help your participants reduce the leakage. For more information, contact Pension Consultants’ RetireAdvisers® Team at 417-889-4918.