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Is It Time for a Hands-Off 401(k)?

Six analysts say today's lax rules endanger Americans' retirement

By Richard Eisenberg

Lately, I’ve noticed quite a few articles referring to 401(k)s as Americans’ piggy banks, because they’re so easy to break into — and so many people do just that.
But six retirement experts at Harvard, Yale and Cambridge just released research saying it might be time for a new type of 401(k): one that wouldn’t let you get your mitts on your money until retirement.
“We should be asking ourselves: ‘Are we serving the American public with the 401(k) system we have or have we placed too much emphasis on liquidity and not enough on locking money away for retirement?’” said David Laibson, a Harvard economics professor and one of the study’s authors.

(MORE: 8 Ways to Derail Your Retirement)
Laibson’s colleagues presented their provocative idea at the Retirement Research Consortium meeting I attended in Washington, D.C. recently (run by the Center for Retirement Research at Boston College, the Michigan Retirement Research Center and the National Bureau of Economic Research).
It's Easy to Tap a 401(k) Before Retirement

You might think investing for retirement is the whole point of having a 401(k). But actually, no.
There are three ways you can tap your account for other purposes: You can generally take out a loan against your 401(k) for any reason; take a cash distribution (known as a cashout) when you leave your employer or make an early withdrawal while you’re at your employer if you can prove what the IRS calls “an immediate and heavy financial need.”
Retirement pros call such withdrawals “leakage,” and boy, are people leaking — especially pre-retirees in their 50s and 60s.
It’s easy to understand why: most Americans don’t have necessary emergency funds. According to a new Federal Reserve study, 64 percent of people 45 to 59 say they haven’t set aside emergency funds to cover their expenses for three months.

(MORE: Is Borrowing From Your 401k A Good Idea?)
How 401(k)s Are Leaking Badly

Here’s the drip drip drip happening to Americans’ 401(k)s:

  • According to a new Schwab report, roughly one in four 401(k) participants (24 percent) have taken out 401(k) loans — mostly to pay bills, make a down payment, or do home improvements or repairs.
  • Wharton’s Pension Research Council says that 86 percent of people with 401(k) loans who leave their companies don’t repay the money. The IRS treats this as a distribution and the borrowers owe taxes plus, if they’re under 59 ½, a 10 percent tax penalty. On a $20,000 loan, you could be socked with a $7,600 tax bill. 
  • About 25 percent of people age 50 to 64 in the 401(k)s Fidelity administers — one in three of all ages — cashed out of their plans when they left their employers (using the money for whatever they wanted rather than rolling the money into an IRA or keeping the cash in their former employer’s plan). An AON Hewitt survey says cash distributions are even more common; it says 33 percent of “terminated participants” age 50 to 59 cashed out of their 401(k)s in 2013.
  • The Employee Benefit Research Institute (EBRI) estimates that people who cash out could see their retirement income cut by 11 to 67 percent as a result. EBRI calls cashouts the most significant risk to successful retirement outcomes in 401(k)s.

“There’s a lot of leakage when people leave their employers and take cash distributions,” said Laibson. “Our proposal would help plug that hole.”
(MORE: The 4 Biggest 401k Mistakes People Make)

The Freedom and Savers Accounts

So here’s what Laibson & Co. propose: There’d be two types of 401(k)s. Think of them, Laibson said, as the Freedom account and the Savers account. The Freedom account would be your “rainy day” account and the Savers account would be your retirement account.
The Freedom account would be like what we have now, allowing employees to take out loans, make hardship withdrawals and get cash distributions when they leave.
But the hands-off Savers account (Laibson also calls it the “Goal” account) would be exclusively for retirement. It wouldn’t allow loans and, when you left the company, you’d be required to either rollover the money into an IRA or keep it in your ex-employer’s plan.
You could only withdraw money from the Savers account while an employee if you became disabled or proved you had a financial emergency.
“There might be a slightly higher employer match in the Savers account,” Laibson said, to encourage employees to lock up some retirement money. “Or I could imagine that the employer’s match would only go into the Savers account.”
As you can see, the idea is just at an early stage. “We haven’t resolved all the issues, but our research suggests some of our retirement savings should be in highly illiquid assets and some should be liquid, if we have an emergency,” said Laibson.
Unlike in the United States, Laibson told me, the workplace savings plans in most developed countries are completely hands-off. “We’re the outlier,” he said.
Other retirement analysts also think it’s time to make 401(k)s more restrictive, so employees don’t find their savings diminished when they retire.
Outgoing House Ways and Means Chairman Dave Camp (R, Mich.) called for banning 401(k) hardship withdrawals for college or first-time purchases. EBRI has suggested looking at tightening the rules, but fears it might lead employees to contribute less to their 401(k)s or stop contributing altogether. And Wharton’s Olivia Mitchell has said it might be time to tighten the vise on 401(k) loans, so you couldn’t borrow more than 25 percent of your plan balance (under current law, you can borrow up to 50 percent or $50,000, whichever is less).


Prospects for the Proposal

I find the two-tier 401(k) idea intriguing. But it left me with two questions:

1. What would it take for the professors’ 401(k) proposal to happen?

Laibson said any employer could “do it tomorrow” and he’d love if one did. “We’re interested in finding companies that would try this,” he added.

2. Will we ever see 401(k)s with Freedom and Savers accounts?
“I’m not exactly sure where this research takes us, but whether it’s firms starting to experiment with ideas like this or new regulations or legislation, there are lots of ways to affect the course of retirement policy. I’m hoping we’re starting a conversation,” said Laibson.

Me, too.

Photograph of Richard Eisenberg
Richard Eisenberg is the former Senior Web Editor of the Money & Security and Work & Purpose channels of Next Avenue and former Managing Editor for the site. He is the author of "How to Avoid a Mid-Life Financial Crisis" and has been a personal finance editor at Money, Yahoo, Good Housekeeping, and CBS MoneyWatch. Read More
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