Because of the power of compound interest, seemingly small amounts that leak out of tax-advantaged retirement accounts when people change jobs can lead to major erosion of their nest egg down the line, a study says. The research aims to examine what people do with their 401(k) balances when they leave an employer and examines the demographics of people who transfer balances to their new employer.
Citing previous research, the study by Alight Solutions notes that four out of 10 people cashed out their post-termination balance within 10 years. Not surprisingly, says Alight, the group most likely to cash out was those with the smallest balances, such that 80% of people with accounts under $1,000 cashed out, while 62% of those with balances between $1,000 and $5,000 cashed out.
The study suggests that age and income have an impact on arrival behavior. Workers in their 20s are the least likely to transfer money from a previous account to a new account, followed closely by those in their 60s. Workers in their thirties are the most likely to receive sales. People with higher earnings were also much more likely to hit sales. New hires earning at least $80,000 were more than eight times more likely to accumulate balances than new hires earning less than $40,000.
There’s a serious leakage problem when workers change employers, especially with small accounts, which means they have to start all over again when it comes to saving for retirement, says Spencer Williams, founder , President and CEO of Retirement Clearinghouse. Using technology to save time and resources, he notes that automatic portability seeks to limit leakage by automatically moving retirement accounts from the old employer to the new employer.
For its version of self-portability to work, the Retirement Clearinghouse follows guidelines issued by the Department of Labor that outline the conditions that must exist for the company to be allowed to transfer a worker’s account, Williams says. Both employers must be registered with the service, the worker must be notified at least twice that a transfer will take place, and the worker must be given the opportunity to opt out at any time.
To illustrate the impact withdrawals can have on the future retirement accounts of those who have chosen not to transfer their assets to a new account, Alight made projections using a new employee.
For the purposes of these projections, the company has assumed that a 22-year-old starts saving in a retirement plan at 3% and increases that amount by 1% each year, up to 6%. The plan matches 50 cents on the dollar on employee contributions. Interest was assumed to be 5% per annum. The individual’s initial compensation was $25,000 and increased by 2% each year. It was assumed that retirement was at age 67.
If there is no leak, the employee’s projected balance at age 67 could be close to $500,000, in this particular example. The study found that a single early withdrawal can have detrimental consequences, while three small post-termination withdrawals over the course of one’s working years can result in a nearly 20% reduction in expected pension balance. age 67, depending on when the cash-outs take place.
In the example, a withdrawal of $3,000 at age 24 results in a loss of $23,000 (5%) of the projected balance at age 67, which is equivalent to approximately half a year of additional working wages. An additional withdrawal of $4,500 at age 26 results in an overall loss of $56,000 (12%) in the projected age balance, or approximately one year of additional working wages. A third withdrawal at age 28 of $5,000 results in an overall loss of $91,000 (19%) – about 1.5 years of extra working pay.
Alight warns that this stark example may, in fact, paint an overly optimistic picture of the situation. First, the projections assume a modest return net of fees of 5% per year. Alight’s 2020 universe benchmarks show that, for the decade of the 2010s, the median return achieved by participants was nearly double. Higher yields would make the impact of early withdrawals even deeper. Assuming a worker earned 7% each year, Alight found that the impact of the three withdrawals would be almost $200,000, or a 25% reduction in projected retirement income.
In addition, the amounts shown for receipts do not reflect the impact of taxes or withholding taxes. Withdrawals from 401(k) balances are generally treated as income and can result in substantial federal and state taxes, says Alight. In most cases, people who withdraw money before retirement must also pay a 10% penalty tax.
“So if anything, the amounts shown for withdrawals in the projection may be considered an overestimate of the money the person would receive,” says Alight’s analysis.
According to Renée Wilder Guerin, executive vice president of public policy for the Retirement Clearinghouse, leaks are most visible among black, Hispanic, female and other minority workers. Research shows there’s a “huge payoff” to keeping people’s money in the tax-efficient retirement planning system, and automatic portability helps keep the playing field level and close the gap in wealth by ensuring that there is no leakage of money when someone moves to a new employer.
“In today’s world where interest in diversity, equity and inclusion continues to grow, autoportability is a measurable solution: you can measure a person’s impact on maintaining from his retirement account,” says Wilder Guerin.
She notes that, thanks to Retirement Clearinghouse’s efforts to address the inequities and economic challenges faced by many minority workers, self-portability has won the endorsement of two civil rights organizations, the National Urban League and the NAACP.