Are You Sailing Into Retirement on a Leaky Boat?

March 31, 2015

If you are plotting a financial course that will smoothly take you from your income earning years through to a secure retirement, you may be relying upon a 401(k) account or an IRA account to supplement your retirement income. These defined contribution accounts have become a popular tax shelter for retirement savings over the past thirty years and are especially important for those who do not have access to an employer-sponsored defined contribution retirement plan.

A recent study by the Center for Retirement Research at Boston College found that in aggregate, 401(k)s and IRAs were being impaired by asset leakages. These leakages can be any type of pre-retirement withdrawal that permanently removes money from your retirement account. About 1.5% of assets leak out of 401(k) and IRA plans every year, which may not seem like much, but compounded over time the slow leak takes at least 20% from the final retirement value of these plans.

Where the leaks occur

The three main sources of asset losses in retirement plans are withdrawals, cash-out at job change, and loans. One of the benefits of the 401(k) and IRA plans is that they allow savers to withdraw some of their funds if they have unexpected events that cause financial hardship. Funds can be drawn to pay for medical care expenses, funeral expenses, to avoid foreclosures, and to pay for post-secondary education. These are necessary expenses and may be well justified, but drawing upon the retirement savings has a large cost to the saver in terms of lower final wealth.

When workers change jobs they are given the opportunity to roll over their savings into a new employer’s 401(k) plan, into an IRA plan, or to cash out the balance. Often younger workers look at the small nominal balance in their plans and decide to take the cash. This has a most devastating effect on their final values of their saving plans. The effect of compound interest over long careers means that those dollars are not available to grow over time. Finally, many 401(k)s allow participants to take out loans from their plans. These loans reduce the return on assets from the plan and, if they are not paid back, become outright withdrawals.

What do leaks cost?

The study found that leaks in aggregate cost total retirement saving about 20% of final wealth, but what is the cost of withdrawals to an individual?

To illustrate the cost to your plan use the calculator from the PERA website. Here’s an example:

Suppose you are a young person just entering your professional career and have just accepted your first permanent position. Your are offered a starting salary of $35,000 per year and you plan to save 5% of that annually in your 401(k) plan with a monthly contribution of $150.00. You’ve already worked for a couple of years in intern and training positions and you’ve accumulated $5,000.00 in your previous 401(k) plan. Do you roll the funds over or do you cash out and take a trip before you start your new job?

In the grand scheme of things, that $5,000 doesn’t seem like such a big amount. Plug some numbers into the calculator and see what a difference it makes. With no initial deposit working for 40 years and investing $150 per month at a conservative 5%, the account will grow to $222,378 for retirement. Roll the $5,000 into the plan at the start date and the total will grow to $257,578 at retirement. The initial $5,000 increases the final value by  $35,199 at retirement. That’s a 16% increase in final wealth. A small leakage in the early years would have resulted in a significantly lower final wealth.

The cost of taking out hardship withdrawals and not paying back loans has a similar effect on your retirement wealth. Even small amounts compounded over time can cause a significant reduction in final wealth.

Fix the leaks and sail happily into retirement

The slow leaks in our retirement plans are making a large reduction in our final retirement wealth. The costs of withdrawals, cash-outs, and loans add up over time to reduce our final retirement wealth by over 20%. Individually the ability to tap into our retirement funds may be a life saver during periods of extreme financial stress, but the ultimate cost can be a drastically reduced final wealth in our retirement. Reducing the withdrawals and maximizing our savings when compounded over time yields a much higher total value in our plans when we reach retirement.