Guest Article

Best Practices for Reducing Loans, Hardship Withdrawals, and Impulsive Investment Decisions

By Liz Davidson, founder and CEO of Financial Finesse.

Negative behaviors such as using the 401k plan as an emergency fund instead of a long-term retirement savings account and taking excessive loans and hardship withdrawals is a symptom of a bigger problem among the employee population. The same is true for impulsive investment decisions that could ultimately delay employees' retirement. When employees try to time the market instead of sticking with time tested investment strategies such as asset allocation, rebalancing, and dollar cost averaging, their investment performance suffers. Effective employer solutions treat the root cause of the problem rather than focusing on the symptoms.

Employees who take 401k plan loans contribute less for retirement. According to the Aon Hewitt study Leakage of Participants' DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income, employees with loans have an average contribution rate of 6.2% while employees without loans contribute on average 8.1% to their defined contribution plans. This difference in contribution rates could mean tens of thousands of dollars to participants in retirement. The study also noted that withdrawals (including those due to hardship ) have a great impact on retirement income as well, noting that full-career contributors who take withdrawals and stop contributing for two years thereafter reduce their retirement income by 7% to 25% depending on income and enrollment methodology.

Investment timing can negatively affect investment performance, but many employees don't know what else to do when they don't understand basic investment strategies. A recent study by Fidelity Investments® showed employees that moved all of their funds out of equities during the recession of 2008 - 2009 experienced an average increase in account balance of only 2% through June 30, 2011 while those who maintained their investment strategy realized an average account balance increase of 50% during the same period. Reducing impulsive investment decision making and encouraging strategic decision making will improve retirement preparedness along with employees' investment confidence.

This is a problem that could come back to haunt employers. There is a growing concern that lawsuits from employees who claim they weren't given enough information on how loans, hardship withdrawals, and poor investment choices could severely impact their retirement may increase. The claim may be that employees shouldn't have been allowed to take loans or hardship withdrawals, or that they should have been given more information on asset allocation.

Employers that offer a well designed plan that includes financial education as a level benefit with easy access for all employees can reduce these negative behaviors, can help their employees to have a more secure retirement, and can reduce the likelihood of lawsuits in the future. Excessive loans and hardship withdrawals are caused by employees' poor cash management and excessive debt. If an employer attempts to use only plan design to solve the problem, the employees may perceive the plan as too harsh and the company as "big brother" trying to steer their behavior. Education alone may be effective for the employees who make full use of the education but may miss the employees who don't utilize the education. A combination of plan design and financial education works well to improve employees' financial wellness by casting a wider net in order to help employees help themselves without feeling pushed.

Best practices to reduce excessive loans:

• Plan design - reduce the number of loans an employee may have outstanding at one time. This way it forces the employee to consider how serious the need for the loan is since taking the loan reduces or eliminates the possibility of taking another one until this loan is paid off.
• Plan design - limit loans to employee contributions and gains on those contributions only. This way the employer is sending a message that employer contributions are earmarked for retirement only.
• Education - require the employee to speak with a financial counselor before taking a loan. Many employees are not aware of the potential pitfalls associated with taking a 401k loan. Talking to a financial counselor can help them avoid unintended consequences while offering possible alternatives to the loan. Requiring employees to speak to a financial counselor before taking a loan also reduces the possibility of a lawsuit stemming from an employee who declares they did not understand the ramifications of taking a loan.

Best practices to reduce hardship withdrawals:

• Plan design - have tight criteria for withdrawals. It is standard for many employers to match the IRS guidelines for taking early withdrawals including disability, threat of eviction or foreclosure, and to purchase a primary residence. Some employers, however, have a less restrictive definition that includes "heavy financial need."
• Plan design - automatically restart contributions after the six-month period following a hardship withdrawal. In their recent research report called Plug the Drain: 401k Leakage and the Impact on Retirement, the Defined Contribution Institutional Investment Association (DCIIA) recommends that policy makers suspend the mandatory six-month waiting period on contributions after a hardship distribution. In lieu of that change, plan sponsors may want to restart the participant's contributions after the six-month suspension period ends.
• Education - require employees to speak with a financial counselor before taking a hardship withdrawal. Many employees don't realize the negative tax consequences of a hardship withdrawal, or the more severe consequence of not having enough funds for a comfortable retirement. Requiring them to speak to a financial counselor forces them to acknowledge the reality of the situation and to explore alternatives, and provides the employer with documentation stating that the employee understood the consequences.
• Education - assess your workforce and provide financial education to those employees with the highest risk. Assess your employees' financial vulnerabilities using a financial wellness assessment. Indentify and isolate those who are high risk before they take their first hardship withdrawal and help others to prevent hardship withdrawal recidivism. Provide multi-faceted education - workshops, webcasts, and online tools - to employees around cash management, budgeting, establishing an emergency fund, and debt management, to address the problem of excessive hardship withdrawals.

Best practices for reducing impulsive financial decisions:

• Plan design - restrict the timing and number of investment changes an employee can make in their 401k plan. It is rare, but there are companies that restrict any investment choice changes in the 401k to once a year during annual enrollment. This seems extreme, but it forces employees to put more rational thought into their investment decisions and reduces (or virtually eliminates) reactive behaviors. Market timing is taken out of the equation.
• Education - provide the opportunity to speak to a financial coach when making an investment change. Employees like the convenience of making their own investment choices online but that limits their personal contact with a financial planner. Consider having a pop-up window or a default check box where the employee is offered a financial consultation with a financial planner over the phone or in person for a financial planning session before they make a decision to reallocate.

They can also be offered an online asset allocation tool to determine their risk tolerance and be provided sample allocations prior to making their investment change. Make this benefit easily accessible and do not bury it so deep that it takes nine clicks on the company intranet to find it. Making this easily accessible benefits the employee today and the employer in the long run since the employer can document that the education was available.

• Education - offer financial education that is specific to current market trends. Today's employees need more sophisticated content to keep up with a changing economy. Instead of offering evergreen financial workshops and webcasts, provide topics such as "Investing in Today's Market." Provide employees with the ability to write their own investment strategy that they can review before making any impulsive investment decisions.

There is a delicate balance that must be struck. Employers that put too many constraints on plan design may have employees who feel their employers are too involved in their decision making and resent it. At the same time, plan design can be very effective at shaping employee behavior. Pairing appropriate plan design with financial education can strike the right balance by encouraging good behavior in employees while protecting the company at the same time.

About Financial Finesse

Financial Finesse was founded with a single mission: Provide people with the information they need to become financially independent and secure. Today, we are the leading provider of unbiased financial education for large companies and municipalities. Our financial education services are fully integrated programs designed to address the strategic goals of the organizations we service and are delivered by on-staff Certified Financial Planner™ professionals as an employee benefit. If you are interested in learning more about workplace financial education programs, contact one of our education consultants at AskFF@financialfinesse.com.

The Ask Financial Finesse Q&A service is designed to provide general information on trends and developments in workplace financial education programs and participant education strategies. Due to the complex nature of financial benefits and/or workplace financial issues, the information contained in this document is not to be construed as advice.

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