Knowledge. Experience. Integrity.

Leakageintheretirementcyclehasasubstantialimpactonsavings,potentiallyresultinginsignificant

reductions in retirement income adequacy.

Definedcontribution(DC)plan leakage includescashouts,hardshipwithdrawals,delayedparticipa-

tion,andloans.Onaverage,workerswhoengageinthesepracticesexperiencethesamefinancial

impactasiftheyhaddelayedplanparticipationbyfiveyears.1

The purpose of this paper is to help plan sponsors prioritize the causes of negative impact on retire-

ment income replacement. Through plan design and proactive communication, plan sponsors can

stem considerable damage caused by leakage.2

IntroductionThemoderndefinedcontribution(DC)planwasconceivedin2006withthepassageofthePensionPro-

tectionAct(PPA).Thisplanbearsverylittleresemblancetothesupplementalsavingsplansofthe1990s.

ProvisionswithinthePPAhastenedashiftbycorporateplansponsorsawayfromdefinedbenefitplans,

whileatthesametimebolsteringusageoffeaturesinDCplanssuchasautomaticenrollmentandauto-

maticcontributionescalation.DCplansarenowcommonlypositionedastheprimaryemployer-sponsored

retirementincomevehicleforAmericanworkers.However,whilethePPAmadegreatstridesinenhancing

workers’abilitytosavemoneyintheirDCplans,itdidlittletoaddressplanleakage,whichmanifestsinthe

formofloans,cashouts,andwithdrawals.

Inthispaper,Callanexploreshowleakageinfluencespotentialsavingsoutcomesandrecommendssteps

plan sponsors can take to reduce plan leakage. This paper includes empirical research by Jack VanDerhei,

ResearchDirectoroftheEmployeeBenefitResearchInstitute(EBRI),andLoriLucas,CFA,ExecutiveVice

PresidentandDefinedContributionPracticeLeaderforCallan,aswellasExecutiveCommitteeMemberof

theDefinedContributionInstitutionalInvestmentAssociation(DCIIA).

CALLANINVESTMENTSINSTITUTE

Research

January 2013

Sealing Leaks

Addressing401(k)LeakageandItsImpactonRetirement

1 Analysis applies only to plans with auto-enrollment and auto-escalation, and to employees with at least 30 years of eligibility.

2 While the research for this paper is confined to 401(k) plan behavior, its findings can be extrapolated to other plan types.

2

The (Limited) Power of Conservative Auto-EnrollmentStartingin2010,DCIIAandEBRIengagedinaseriesof jointstudiesonprojectedDCplanretirement

incomereplacementratesbasedonEBRI’sSecurityProjectionModel.3Themodelstartedbyexamining

theincomereplacementpotentialofthelowestincomequartileofcurrentDCparticipantsinplanswith

automaticenrollmentandautomaticcontributionescalation.Inthissimulation,“retirementsuccess”was

definedastheabilitytoreplace80%ofincomeinretirementthroughacombinationof401(k)accumula-

tionsandSocialSecurity.

EBRIandDCIIAfoundthatwhenplansimplementautofeaturesinaveryconservativeway—forexample,

witha3%deferralrateanda6%caponautomaticcontributionescalation—themodelprojectedthatfewer

thanhalf(45.7%)oflow-incomeworkerswereexpectedtosuccessfullyreplace80%oftheirincomein

retirement.

EBRIandDCIIAthenturnedtoascenarioinwhichplansimplementedautomaticfeaturesrobustly—for

example,withcontributionsautomaticallyescalatingby2%insteadof1%ofpayannually,andwithcon-

tributionescalationcappedat15%ofcompensationinsteadof6%.Underthisscenario,theprobability

oflower-wageworkersreplacingatleast80%ofrealincomeinretirementsoaredfrom45.7%to79.2%.

As the result of changing the defaults under auto-enrollment and auto-escalation, retirement income

replacementpotential (Exhibit 1)inDCplanswent frommediocre to reasonablyhealthy.4(Foranexplanationofconservativevs.robustimplementationofautofeatures,seeExhibit 2.)

Exhibit 1

Effects of Elevated Auto Features

3 The research used EBRI’s simulation model based on individual administrative records of more than 23 million DC participants.

4 The analysis also assumed certain improvements in participant behavior, such as reduced opt-outs from contribution escalation, which might be achieved through concerted communication efforts by plan sponsors.

5 “Success” is defined as achieving an 80% real replacement rate from Social Security and 401(k) accumulations combined as defined in “The Impact of Auto-Enrollment and Automatic Contribution Escalation on Retirement Income Adequacy” by Jack Van-Derhei and Lori Lucas, November 2010 EBRI Issue Brief #349. The simulated population consists of workers in the lowest-income quartile, currently aged 25–29, who will have more than 30 years of simulated eligibility for participation in a 401(k) plan. Workers are assumed to retire at age 65, and all 401(k) balances are converted into a real annuity at an annuity purchase price of 18.62.

Pro

babi

lity

of

Suc

cess

Maximum Employee Contributions

20%

40%

60%

80%

6% 9% 12% 15%

Lowest, Robust 48.9% 64.2% 73.5% 79.2% Lowest, Conservative 45.7% 56.4% 61.0% 62.1%

Source:EBRI/ERFRetirementSecurityProjectionModel,versions100810a1–100810a16.

Success5 Rates of Achieving a Combined 80% Real Replacement Rate from Social Security and 401(k) Accumulations as a Function of Maximum Employee Contributions

3Knowledge. Experience. Integrity.

This analysis demonstrates that thoughtful, customized plan design and robust implementation of au-

tomatic features in 401(k) plans can significantly alter the long-term savings levels of future retirees.

Conversely,itillustratestheharmthatlowcontributionsto401(k)planscanhaveonparticipants’abilityto

retire comfortably.

Canwethensaythatthekeytoachievingretirementincomeadequacyistheaggressiveenrollmentof

workersintogenerous401(k)plans?Theanswerisno.ToparaphraseHankWilliams,“Yourbucket’sno

goodifit’sgotaholeinit.”

Policymakersandplansponsorsarecorrect to focuson improvingplanparticipation,especiallyvia

automaticenrollmentandthedesignofnewcontributionfeatures.However,leakageinDCplanscan

be an insidious drain on retirement income over time, and should therefore also be a primary concern.

The Impact of Plan LeakageJustoverone-fifthofDCplanparticipantseligibleforloanshaveoneoutstandingagainsttheiraccounts,

withameanvalueborrowedofabout$6,846,or14%oftheaverageaccountbalance.6 In addition, among

terminatedparticipants,morethan40%takeacashdistribution,ratherthanrollingtheirbalancesintoa

newretirementaccountor leavingtheirbalances in theirexisting401(k)plan.7Theseareexamplesof

leakage,whichhasthepotentialtoeroderetirementsavingstoanalarmingdegree.

In2011,SenatorsHerbKohlofWisconsinandMikeEnziofWyomingintroducedlegislationaimedatre-

ducing401(k)planleakage.AppropriatelytitledtheSavingsEnhancementbyAlleviatingLeakage(SEAL)

in401(k)SavingsAct,itnotesthat“studyafterstudyhasshownleakagefromretirementplanscansig-

nificantlyreduceworkers’retirementsavingsandtheamountofmoneytheywillhavewhentheyretire.”

6 Jack VanDerhei, EBRI, Sarah Holden, ICI, Luis Alonso, EBRI, and Steven Bass, ICI, “401(k) Plan Asset Allocation, Account Balances and Loan Activity in 2010.”

7 AonHewitt, “Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income.” 2011.

Exhibit 2

Conservative vs. Robust

A “conservative” implementation of automatic features includes:

• Cappingautomaticcontributionescalationat6%ofcompensation.

• Implementing1%annualincreasesincontributions.

• Assuming participants opt out of contribution escalationatratessimilartopastexperience.

• Defaulting participants at current, generally lowinitialautomaticenrollmentcontributionrates.

• Noefforttoencourageemployeestomakecontributions at a level comparable to their participationinaprioremployer’s401(k)plan.

A “robust” implementation of automatic features includes:

• Cappingautomaticcontributionescalationat15%ofcompensation.

• Implementinga2%annualincreaseincontributions.

• Successfullypreventingparticipantsfromopting out of automatic contribution escalation.

• Whereapplicable,successfullyencouragingemployees to make contributions at a level comparable to their participation in a prior employer’s401(k)plan.

4

Buildingontheir initialretirementincomeadequacystudyofautomaticfeaturesinDCplans,VanDerhei

andLucasexaminedtheimpactofleakagefactorsonworkers’abilitytoretirewithsufficientsavings.Work-

ersinthisstudyhadatleast30yearsofeligibilityforDCplanswithautomaticenrollmentandautomatic

contribution escalation.

TheanalysisfoundthatwhenDCplanleakage—includingcashouts,hardshipwithdrawals,andloans—

areremovedfromtheequation,theprobabilitythatafull-careerDCparticipantcanreplaceatleast80%

ofincomeinretirementis82.9%.Cashoutsalonereducetheprobabilityofworkersreplacingthemajority

oftheirincomeby5.1%(Exhibit 3).Dependingonhowlongcontributionsaresuspendedasaresultofhardshipwithdrawals,suchwithdrawalscanbeexpectedtoreducetheprobabilityofworkersreplacing

mostoftheirincomebyasmuchas3.7%.

Interestingly,theanalysisshowsonlyamodestimpactonretirementincomereplacementattributableto

loans,whichareestimated—assumingnodefaults—toreducetheprobabilityofworkersreplacingmost

oftheirincomeinretirementbyjust1%.However,whenloans,cashouts,andhardshipwithdrawalswith

asix-monthsuspensionaretakentogether,thecombinedreductionintheprobabilityofworkersbeing

abletoreplacethemajorityoftheirincomeinretirementdeclinesby6.1%.Theanalysisfindsthistobe

similartothedeclineintheprobabilityofsuccessthatwouldcomefromafive-yeardelayinparticipation

byeligibleworkers.

Implications for Plan SponsorsIn its most recent analysis,9 EBRI found that by simply increasing the default contribution rate under

automaticenrollmentto6%,morethanonequarterofworkersinthelowest-incomequartilewhohad

originallynotbeenprojectedtosuccessfullyreplacemostof their incomeatretirement(becausethe

8 See Footnote 5 on page 2.9 Jack VanDerhei, “Increasing Default Deferral Rates in Automatic Enrollment 401(k) Plans: The Impact on Retirement Savings in Plans

with Automatic Escalation,” EBRI Notes, September 2012.

0.0%

0% 1% 2% 3% 4% 5% 6% 7% 8%

No leakage (82.9% prob. of success8)

Delay = 1 year

Loans**

Hardship withdrawals

HW and 6-month suspension

HW and 24-month suspension

Cashouts

Delay = 5 years

Cashouts, HW 6-month, Loans

Cashouts, HW* 6-month, Loans (w/defaults)

5.1%

1.9%

2.5%

3.7%

1.0%

7.1%6.1%

0.6%

5.9%

Percentage Point Decrease in Probability of Success8

Exhibit 3

Impact of Leakages For Automatic Enrollment Plans: Lowest income quartile

Source:EBRI/ERFRetirementSecurityProjectionModel,versions100810a1–100810a16.

* HW=Hardshipwithdrawals.**Assumesmoneybeingloanedcomesfromfixedincomeandnotequity,andthattherearenodefaults.

5Knowledge. Experience. Integrity.

actualinitial-contributiondefaultwastoolow)werenowexpectedtobeabletosuccessfullymeetorex-

ceedtheirretirementgoals.Tominimizeleakage,Callanrecommendsthefollowingforplansponsors:

• Activelypromotetonewemployeesthebenefitsofrollingoverexistingbalancesfromtheformerem-

ployer’splansintothatoftheirnewemployer,possiblyaspartofnew-hireorientation.

• Encourage retired employees to leave assets in the plan through communication efforts and plan design.

• Automatically restart contributions after the statutory six-month hardship suspension period. Target

communicationmessages toemployeeswithhardshipwithdrawals toencouragerestartingcontribu-

tions in the plan.

• Reducethenumberofloansallowedand/orrestricttheavailableloanbalance.

• Allowloanpaymentsaftertermination.

ConclusionPlansponsorsarewisetofocusonoptimizingtheimplementationofautofeatures,asthishasanenor-

mous impactonpotential incomereplacement inretirement.However, leakagecanalsotakeasignifi-

canttollonincomereplacement.Cashoutsandhardshipwithdrawalshavethegreatestnegativeimpact.

Seeminglysmalleffects likedelays in reinstatingcontributionsafterahardshipwithdrawalsuspension

period,aswellasdelaysinparticipation,canaddupquickly.

Loansarelessoftentheculpritwhenitcomestoinadequateretirementsavings.Researchonthistopicis

mixed,assomeareconcludingthattheavailabilityofloansattractspeopletoplansataratethatoffsets

anydamagetheymightdowhenpeopleactuallytakethem.

TheabilityofDCplanstofacilitateretirementincomeadequacydependsheavilyonplanimplementation

andusage.Whileplansponsorscanuseautomaticenrollmentandautomaticcontributionescalationto

encourage earlier participation and higher savings, they should not lose sight of the impact of leakage on

the retirement program.

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6

7Knowledge. Experience. Integrity.

Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational pur-poses only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business.

Authored by Callan Associates Inc.

If you have any questions or comments, please email institute@callan.com.

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