For Every Dollar Saved For Retirement, At Least 20 Cents Is Withdrawn Too Early

Americans find it hard to save: according to data from the Federal Reserve Survey of Consumer Finances, only 53% of adults have a retirement account. In 2019, the personal savings rate was under 9%, although most experts agree that workers need to save between 10% and 15% of their income for retirement to avoid making difficult pullbacks in their quality of life as seniors.

But the problem isn’t just that we don’t set aside enough money for retirement. A new study, by economists from the U.S. Department of Treasury and the U.S. Congress’ Joint Commission on Taxation, found that for every dollar that an American aged 47 or less sets aside for retirement, they withdraw 20 cents within 8 years, before they turn 55. Some estimates suggest that the percentage of retirement assets that get withdrawn early, subject to penalty, is as high as 40%.

It’s a crisis that some experts call the “leakage” problem: a 2019 report by the Government Accountability Office found that annually, individuals in their prime working years withdrew at least $69 billion from retirement accounts early.

This evidence shows our retirement security crisis can’t be solved just by helping workers set more money aside. We have also have to address the financial instability that forces workers to tap into retirement savings before reaching retirement age.

Why Does Retirement Plan “Leakage” Happen?

Job Changes

Economists Lucas Goodman, Kathleen Mackie and their co-authors found that the probability of retirement plan leakage goes up by 250% when a worker changes jobs.

Changing jobs voluntarily or involuntarily can come with added expenses. A worker changing jobs might struggle putting food on the table while she’s in between paychecks, or have to pay a security deposit for a new apartment if she’s relocating for work. Tapping into retirement savings, for some workers, is the only way to finance these added expenses.

And if you have less than $5,000 saved in your workplace 401(k) and you leave your job, your former employer isn’t obligated to hold on to that money for you. If the balance saved is less than $1,000, your former employer is allowed to send you a check for the balance. The smart choice for workers, experts say, is to roll over your 401(k) balances into an IRA if you switch jobs, but many workers end up spending the money instead.

Someone in their 20s or 30s with only $3,000 saved doesn’t always realize the value of their retirement savings, but if that $3,000 is allowed to compound at 7% for 40 years, it’ll accumulate to $44,000, enough to fund a year of retirement.

A March 2019 GAO report pointed out that workers may be confused by the letter they get upon job separation that explains what they can do with their 401(k) balances. Workers don’t always understand how to roll over a 401(k) from one employer to another employer. The Department of Labor has tried to address this “accidental” leakage by allowing an organization called the Retirement Clearinghouse to roll over 401(k) accounts on behalf of workers. The Retirement Clearinghouse would be allowed to move workers’ retirement assets into the 401(k) of a new employer. According to reporting by Brian Croce of Pensions & Investments , the Retirement Clearinghouse is scheduled to pilot this “auto-portability” system in late 2020, launching the program with a subset of retirement plan record-keepers; it’s expected to cover between 25% and 40% of the market.

Lack of Emergency Savings

Consider a working-class family whose household income is somewhere between the 20th and 40th percentile. According to data from the 2016 Federal Reserve Survey of Consumer Finances, those families have an average of $45,380 saved in financial assets, which includes money they have in checking accounts, savings accounts, retirement accounts, and cash-value life insurance policies, but doesn’t include the value of their home or car. Of that $45,380, typically, more than a third of those assets, or $15,681, are tied up in retirement accounts.

When Americans are stretched thin, they’re often unsure of which savings goals to prioritize, forced to pick and choose between putting away money for retirement, emergency savings, their kids’ college funds, and goals like buying a home.

It’s not surprising, then, that emergency savings sometimes gets the short end of the stick, even though most experts recommend that workers make sure they have a “safety net” that covers their expenses for at least 3 months before starting to save for retirement.

And employers can unintentionally encourage this mistake, by steering workers into 401(k) payroll deductions in lieu of emergency savings.

That’s why many financial health advocates have called on Congress and employers to explicitly encourage workers to set aside money for emergencies like a job loss or unexpected illnesses or injuries.

How To Stop The “Leakage”

Helping workers build their emergency funds is one way to make sure they don’t need to tap their retirement accounts when an emergency strikes. A 401(k) “sidecar” can encourage workers to build up those rainy day funds.

Although there are some variations on how “sidecars” work, commonly, the worker sets a goal for an emergency fund, which they contribute to via payroll deduction. Once the worker has hit their emergency savings goal, the employer automatically starts “filling up” the worker’s 401(k) instead of the emergency fund. If the worker needs to deplete their sidecar, the payroll deductions would again be used to “refill” that emergency fund. Many salaried workers find it easier to save when they “pay themselves first” by setting aside a fixed amount with every paycheck — a 401(k) sidecar lets workers adopt that same approach for both retirement savings and emergency savings.

Today, these sidecars have to be funded with after-tax deductions, without special tax benefits, although Congress has considered legislation that would make sure workers who have to prioritize emergency savings (and who are often lower-income) don’t miss out on the advantages that higher-income workers get when they save for retirement. One proposal to expand use of sidecar accounts, the “Strengthening Financial Security Through Short-Term Savings Accounts Act of 2019,” had bipartisan support in the Senate, but stalled before it could reach a vote.

When people choose to cash out a 401(k) early, they often make an “all or nothing” decision, rather than just withdrawing a specific dollar amount. That’s why helping workers build even modest amount of emergency savings can help them preserve their retirement accounts.

But rainy-day funds on their own aren’t a substitute for a real safety net. When Americans are hit with financial catastrophes — like a natural disaster that destroys their home and car, or the onset of an illness that renders them unable to work for more than a year — they’re often surprised to find out that “safety net” programs they’ve heard about on the news are less generous than the expected, come with long waiting periods, or they get hit with unexpected or confusing denial letters.

To build retirement security for Americans, we need to encourage workers to save when they can, and provide greater support when workers can’t.

This article was written by Elena Botella from Forbes and was legally licensed by AdvisorStream through the NewsCred publisher network.