Prevent employees from paying out their 401ks when they leave a job

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Sstatistically, you will probably change jobs several times before you retire. In fact, one Pew Research survey estimated that 30% of US workers will have changed jobs by 2022 alone, most of them at higher wages. But this can be treacherous to your ability to retire when you want and with the lifestyle you want. Why? Because too many people pay out their 401(k)s in full, they leave a job — and employers do little to prevent it.

According to Vanguard data from 2021, the median 401(k) bill for a 55- to 64-year-old was $89,716. That won’t get a middle class very far, even with partner pension savings, social security and other sources of retirement income. These low balances come despite an increased emphasis by employers, the financial services industry and personal finance gurus on helping employees build retirement savings through employer-sponsored retirement plans. Many companies now have generous match rates aimed at attracting and retaining the best employees and ensuring financial security in retirement.

However, the focus on building savings during employment overlooks an important fact: in the US, employees can pay out at any time when they are on the job or when they leave their job. Of the developed economies, only the US allows companies to present this option to a departing employee. Employees also pay income tax and for withdrawals before age 59.5 they pay 10% in penalties.

Too often, departing employees cash in their 401(k)s when they change jobs, losing everything they’ve saved on the job. Few employers see this as a problem, but hardly any decision an employee makes can so undermine preparation for retirement.

Why and when people cash out their 401(k)s

To better understand how widespread 401(k) payouts are when someone quits their job, our recent research studied 162,360 U.S. outgoing workers covered by 28 retirement plans. They left their company in a three-year period before Covid-19, from 2014 to 2016.

Shockingly, 41.4% of employees cashed in 401(k) savings on their way out. Equally surprising was that 85% of those who did cash out cleared the entire balance.

Did they need that? It’s hard to know for sure, but it’s by no means a logical conclusion that cashing out is a good or necessary response to leaving or losing a job. We see this both in our research and in more recent data. For example, we estimate that only 27.3% of the employees we studied had lost their job (as opposed to leaving voluntarily). And other countries require many months of unemployment and evidence of clear adversity before someone is allowed to tap into defined contribution retirement savings.

Furthermore, industry studies in the US show that payouts remained flat or fell slightly during the Covid pandemic, despite the massive increase in job losses. How have all these new waves of unemployed coped? They relied on a combination of temporary lifestyle changes, performances and government benefits, heeding such calls from Carrie Schwab-Pomerantz, president of the Charles Schwab Foundation, who advised people not to relax under the CARES Act during the pandemic. to use for recordings. :

“Even if it is possible to borrow from your 401(k) or make a distribution… consider this a last resort. While current circumstances may be difficult, I advise everyone not to jeopardize their future retirement. unless absolutely necessary. You may not appreciate the full consequences until much later.”

The 41.4% payout rate at layoff in our data also eclipsed the number of payouts during their years of service. While at work, people had ample opportunities to lose money due to circumstances such as the loss of their spouse, medical emergencies, weddings to be planned, and looming college bills, and faced the same early retirement taxes and penalties. Yet only 7% was paid out through hardship and 3% through 401(k) loans that were not repaid on time. We calculated that dollar losses from job change payouts were 12.4 times what these 162,360 employees paid during their average 6.6 years with their company.

So why do so many people specifically pay on a job change and undermine their retirement security? Why not roll their 401(k) balance into an IRA or Roth IRA, keep money in their employers’ plans, or transfer assets to new employers’ plans, if available?

The problems stem from bureaucracy and psychology. Employers delegate all communication when an employee leaves to financial services companies such as Fidelity, Vanguard, TIAA or Alight, who manage their plans. These plans send anonymous form letters to employees with facts about what their options are, but no advice. In addition, the form letter legally allows employers to offer less attractive options to departing employees if they have lower balances. For example:

• Most employees with balances under $1,000 will automatically receive a check for their savings minus income tax and 10% penalties, with no other options offered.
• Most employees with balances between $1,000 and $5,000 are given two other options for paying out: to transfer assets to a qualified IRA or to transfer to a new employer’s plan.
• Most employees with balances greater than $5,000 are given three options for cashing out: to keep their money in the current plan, transfer assets to a qualified IRA, or transfer them to a new employer’s plan.

Crucially, these form letters bring to mind the option of making money far more than years of employment. They turn psychologically illiquid retirement savings into a source of cash. When departing employees are urged to consider the option to cash out, it becomes very attractive to spend what was previously seen as an unassailable source of retirement security. No wonder so much more money is spent changing jobs than working.

We also find that people respond more strongly to the temptation to cash out when they have contributed proportionally less to their total 401(k) balance, while holding balance size and other employee characteristics constant. We call this pattern the ‘account composition effect’.

The pattern we observed was the same for employees with higher or lower 401(k) balances, higher or lower incomes, men or women, older or younger employees, and those who left the company in months with high or low turnover. All told, the more the balance came from the employer, the more people treat their savings as “house money” or “free money” when asked to consider the option of cashing out when changing jobs.

How employers can help departing employees

The lesson from our findings is not that employers should contribute less to employer matches. The lesson is that a socially responsible employer must also pay attention to employees when they leave the company. Companies with more generous retirement plans clearly intend to ensure the financial well-being of employees years down the road. And most know that many of their current employees will change jobs – several times – before finally retiring. Employers’ indifference to payouts undermines their investment in the future of their employees. At this point, cashing out is the path of least resistance. People choose what is easy, not what is wise.

Employers could take measures to dramatically improve employees’ pension security at a very low cost to them. For example, it is increasingly recognized that cashing out is more likely when people don’t have emergency savings. The new Secure Act 2.0 that went into effect in December allows employees to automatically allocate up to $2,500 a year to pay for emergency expenses without plundering their retirement fund. When onboarding new employees and explaining retirement benefits, employers could encourage the use of these accounts and warn new employees of the danger of being paid out if they later change jobs.

Employers could also contract with their financial services providers to provide web-enabled “just-in-time financial education” on how to maintain retirement balances during a job change, or pay for a session with a financial advisor. Similarly, employers could pay financial services companies to hold an exit meeting to help individual employees evaluate whether they should keep their assets in their current plan, transfer assets to their new employer’s plan, or whether their 401(k) balance should be automatically transferred to very low-cost Roth IRA index funds. All of these options preserve employee retirement security and avoid 10% penalties – and all of these options should be easier than cashing out.

Along the same lines, we recommend that companies stop automatically paying employees with low balances. There are some new ways to make this easier; for example, a new “auto-portability” initiative from Retirement Clearinghouse automates the process of transferring balances less than $5,000 from the current employer to the new employer’s plan if both employer plan sponsors are served by a major financial services company .

If the industry doesn’t fix this problem of running out of retirement savings when changing jobs, neither employers nor financial services companies will be happy with what comes next. Governments could step in to create new systems more similar to those in other parts of the world, such as Australia. There, all companies must contribute the same amount, all employees must contribute the same amount, and the account remains with employees when they change jobs – and employees can only access their balance after long-term unemployment.

We think the more likely scenario is for companies to solve the problem, with employers working with financial services companies to make small changes with dramatic potential to change employee retirement readiness. There are major benefits for employers in a competitive talent market and for financial services companies leading the way in solving this pressing societal problem.

John G. Lynch is University of Colorado Distinguished Professor at the Leeds School of Business, University of Colorado-Boulder and Executive Director of the Marketing Science Institute. From 2017-2020 he was a member of the Academic Research Council of the US Consumer Financial Protection Bureau. Yanwen Wang is Associate Professor and Chair of the Department of Marketing and Behavioral Sciences and Canada Research Chair in Marketing Analytics. Muxin Zhai is an assistant professor in the Department of Finance and Economics at Texas State University’s McCoy College of Business.

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