More and more Americans are putting their retirements in jeopardy by taking cash out of their 401(k)s plans and IRAs and not keeping their money invested.
A study by the Center for Retirement Research at Boston College warns of the growing problem that is worsened by people tapping funds after they reach 59 ½ and is causing some to retire earlier than they should.
The research starts with the assumption that if somebody starts work at 22 and puts 6 percent of their salary into a 401(k) and get a 50 percent match and invests in a mixed stock or bond portfolio, by the time they get to 65, they will be rich, says Anthony Webb, a research economist at the center.
“The reality is when you look at a survey of consumer finances, the median 401(k) and IRA balance level of households that have those things is only $111,000,” Webb says. “The question is why is there this disconnect.”
One of the reasons is the 401(k) plan is an immature system, Webb says. There’s nobody approaching retirement who’s been in the program for a full working life.
Americans have had periods when they’re out of the labor force, but that can’t wholly explain why the program is not working as designed, Webb says, What the research shows is that leakages are a big contributor to that and the average leakage in which someone takes money out of those accounts reduces plan balances by 20 percent to 25 percent, he says.
“There are some people who never leak and would never dream of leaking and use the program as proscribed,” Webb says. “The other people are serial leakers who never accumulate significant amounts of wealth. The 20 to 25 percent is an average of both groups.”
The question remains what to do about the problem that would have to be addressed by Congress, Webb says.
The most draconian option is to ban leakages as they do in Australia but that wouldn’t be supported in a nation of rugged individualists who value freedom of choice, he says.
“The problem is for a lot of people is that leakages sound like a relatively harmless thing,” Webb says. “Maybe they accumulated $1,000 or so in their plan, and it doesn’t sound like a lot of money. They are a long way from the age of retirement. They have good things to spend the money on and they cash it in. The trouble is those few thousand could have grown to many more thousands had they been left undisturbed.”
One option to limit leakages is limit the circumstances in which individuals could leak, Webb says. Maybe, you can only leak if you are unemployed, thus stopping someone who changes jobs from using the balance for remodeling their kitchen, he says.
“If the person is down on their luck, it may be the least bad option,” Webb says. “They lost job or hit with high medical costs and the alternative is to go without food or being made bankrupt then maybe it’s better for them to leak. The suspicion is many leakages don’t fall into those categories.”
What it appears for many is an inability to live within their means, Webb says. They run up credit card bills and it seems liked an easy way to get rid of the credit card debt.
“If the credit cards stay paid off than maybe that’s a good decision but if the individual is living beyond their means, they will end up in a few years in the same situation,” Webb says. “What the person really needs is help in balancing their budget.”
None of that addresses another growing problem, Webb says. When people remove money from their 401(k) or IRA, they must pay a 10 percent penalty on that, Webb says. One of the worries is when you get to 59 ½, you’re no longer subject to the 10 percent penalty, and that’s sending out a signal that it’s the appropriate age to tap your 401(k) or IRA.
“What we ought to be telling people is 65 is the appropriate age,” Webb says.
The issue with older people who have rolled over their 401(k) balance into IRA is that it’s easier to leak from an IRA, Webb says. If you go on a Web site and click, the check is in the mail. In a 401(k), you either wait until change jobs or jump through hoops with human relation’s department, he says.
“The problem with older people is they are in the path of temptation,” Webb says. “I think the issue of older people is a question of a premature retirement. Unlike a traditional pension, the case of a 401(k) plan, there’s no designated retirement age. Older people see all this money and think it’s a lot they may prematurely retire.”
All of the issues raised by the study are manifestations of the same problem — the money is accessible and there’s not enough of an incentive to keep it investing and earning returns until age 65, Webb says.
The message is when you are looking at your plan balance, you shouldn’t think of the plan balance itself but the income it will generate, he says.
“If you are lucky enough to have one million dollars, it doesn’t mean you’re a millionaire,” Webb says. “It means you’re somebody that can generate a lifetime of income of $40,000 a year from your investment. That’s not a huge amount of money. You’re not as rich as you think you are.”
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