Leak-Proofing Your 401k Plan

By Robert C. Lawton, AIF, CRPS, President, Lawton Retirement Plan Consultants, LLC

In 2013 Time Magazine reported that one in four Americans tapped into their 401k account. Research from Fidelity indicates that 22% of participants in plans they administer have an outstanding loan. This is troubling because the high rate of 401k plan loan defaults results in annual leakage of around $6 billion per year. Boston Research Group reports that 45% of 401k participants who leave a job take a distribution of their account balance. Significant amounts of participant balances are leaking out of 401k plans and not being replenished, with potentially disastrous results.

What is leakage?

Leakage occurs in 401k plans when account balances permanently leave plans. Typically these amounts are never restored leaving participants with 401k balances at retirement well short of their needs. There are three types of 401k plan leakage:

Defaulted loans. Loan defaults occur when a participant leaves a job and, rather than paying back a plan loan, decides to have the outstanding balance deducted from his/her account. Of all the types of leakage, most experts agree this is most preventable.
Hardship withdrawals. Limited to a short list of eligible criteria, hardship withdrawals are taken by participants who run into financial difficulties. This is the most valid type of leakage and least manageable.
Cash-outs due to separation from service. Many participants, rather than rolling their account balance into an IRA or leaving it in their former employer's plan, decide to take a cash distribution of their account balance. This is the largest and most difficult type of leakage to manage.

Leak-proofing your 401k plan

Most experts believe that the following plan design elements can limit leakage:

Eliminating participant loans or limiting eligibility for loans to hardship criteria.
If eliminating loans is not possible, limiting the number of loans participants can take to one and continuing to accept loan payments from terminated participants.
Limiting loans and withdrawals to participant contributions only.
Automatically re-starting participant contributions after completion of the required hardship withdrawal suspension period.

In addition, the best way to reduce cash-outs is to educate your participants about the perils of leakage in your annual employee education sessions. Consider adding these plan design features today to address leakage in your 401k plan.

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton has over 30 years of retirement plan consulting and administration experience and has provided consulting services to many Fortune 500 companies including: Apple Inc., AT&T, Florida Power & Light, General Dynamics, IBM, John Deere, Mazda Motor Car Company, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at 414.828.4015 or bob@lawtonrpc.com.

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