Broken Piggy Bank: 'Leaky' 401(k)s Worry Congress

May 20, 2011 -- Americans in record numbers are raiding their 401(k)s, depleting their retirement savings to compensate for paychecks and mortgage equity lost to the recession. As employers and savings plan providers struggle to stem the outflow of money, two senators have introduced legislation that would make it both harder for employees to dip into company-sponsored retirement savings and easier to repay their borrowings.

The SEAL Act (Savings Enhancement by Alleviating leakage in 401(k) Savings) introduced by Sens. Herb Kohl, D-Wis., and Mike Enzi, R-Wyo., would reduce to three the number of loans an employee could take against a 401(k). Savers currently can take as many loans as they think they can handle -- or as many as their employer may permit.

The bill would ban products that promote savings depletion, such as debit cards linked to 401(k)s, and it would make it easier for consumers to repay monies borrowed. According to a new study by consultants Aon Hewitt, some 28 percent of active participants in 401(k) plans had an outstanding loan in 2010, up from 22 percent in 2005.

"Loans are at an all-time high," says Pam Hess, director of Retirement Research for Aon. Withdrawal of money for reasons of hardship has been "up significantly, since the downturn," she reports. She thinks savers "are permanently impairing their retirement."

Persons who borrow against their 401(k) and manage to return the money, she says, aren't doing themselves any long-term harm. But those who default, after taking a cashout or making a withdrawal, pay penalties and taxes that can amount to 30 percent.

Kohl, in a statement accompanying his legislation, says that as the frequency of retirement fund loans has gone up, the amount of money people are saving for their retirement has gone down.

"The gap between what Americans will need in retirement and what they will actually have saved is estimated to be a staggering $6.6 trillion," he says. While acknowledging that having the ability to borrow against a 401(k) in an emergency is "an important feature," he stresses that such accounts were never intended to be used "as a piggy bank."

The Aon report found that 7 percent of plan participants had withdrawn money in 2010 (versus 5 percent in 2005). The percentage who, after losing a job, cashed out entirely was 42 percent. These depletions, taken together, are referred to by the savings industry as "leakage."

Hess calls cashouts the "most disturbing" part of the problem. They're "long-term scary," she says, in the case of younger workers, who won't be able to rely on pensions. Employers, she thinks, have been doing a good job getting these workers to participate in 401(k)s. "But cashouts are undoing all that good behavior, unwinding all that positive momentum."

Joe Bonfiglio, spokesman for the Kohl's Committee on Aging, says savers' ability to borrow is not the problem. Over the years, he believes, "Most folks have used their retirement savings for exactly the right reasons," such as buying a home.

Ann Combs, head of strategic retirement consulting for Vanguard, says that when 401(k) plans were first introduced, the inclusion of a borrowing option was deemed essential to making them attractive. "The thinking was that if you didn't offer access to the money, people would be reluctant to contribute."

The problem is payback. Says Bonfiglio, "The chance for people in tough economic times to pay the money back isn't good, and it's getting worse. I was most struck by the default rate in their [the Aon] report. After people who've borrowed lose their job, the default rate is huge -- around 70 percent."

Under present rules, a borrower who loses his job must repay the entire loan, typically within 60 days, or else default and pay tax penalties. The Kohl-Enzi bill would give such borrowers longer to repay. They would have up until they filed their federal taxes to pay down their debt, by putting money into an IRA. The details, says Bonfiglio, would have to be worked out by the IRS and the Treasury Department.

Debit cards linked to 401(k)s aren't in wide use right now, says Bonfiglio, but have been marketed in the past. "The companies come and go," he says. Using such a card, a consumer can pay for something as small as a supermarket purchase by tapping into his retirement savings, which Bonfiglio calls folly.

"That's not what 401(k)s were created for," he says. The Kohl-Enzi bill explicitly prohibits employer plans from making such loans through cards.

Hess says that employers could do much more to reduce leakage, including adding to their programs online tools that savers could use to see, in advance, the long-term harm done their retirement savings by making a withdrawal. Aon is currently developing such tools.