401(k) plans—the primary retirement vehicle for most Americans—sets people up for financial failure. It’s not just that Americans often don’t save enough, but that they use the money that they’ve saved too early, leaving them with little for retirement.
This is a problem particularly for lower-income workers who might dip into those accounts early out of need, and, as a result, exacerbate already-bad inequality, according to a recent study from National Conference on Public Employee Retirement Systems (NCPERS).
Part of the problem is the flexibility that is built into self-managed plans: There are lots of opportunities to withdraw from these accounts. For instance, anytime you switch jobs, you can choose to pull money out, roll your savings into an Individual Retirement Account (IRA), or put your funds into the plan of a new employer. And if you choose to use an IRA for retirement savings, you can pull funds out for virtually any reason and face only a 10 percent penalty, which can seem appealing when compared to pricier loan and credit options. A recent NBER working paper from from John Beshears, David Laibson, and Brigitte Madrian of Harvard, James Choi of Yale, and Joshua Hurwitz of NBER, found that for every dollar that enters the defined-contribution market, about 40 cents leak out in the form of premature withdrawals.
This flexibility is often framed as a feature of these plans, allowing people to mitigate current pain at the expense of future security. But would fewer options actually mean better financial health?
That’s the case in a handful of countries abroad, where although they have similar “defined-contribution” accounts to help people save for retirement, tapping into funds early is much harder, according to the NBER paper. Germany and the United Kingdom don’t allow for early withdrawal, except in the case of disability or terminal illness (a qualifying factor in all countries studied). In Singapore, home purchase, medical bills, and education allow for withdrawal of a portion of funds. In Canada and Australia, serious financial hardship, like income which falls below a certain threshold or unemployment that lasts for longer than a specific period of time, may allow a person to pull a portion of their funds early.
Compared with these five countries, the U.S., far and away, has the most lenient policies toward retirement withdrawals and also the largest problem with overall wealth inequality.
This is bad news for Americans. Slim savings heading into retirement can mean an increased likelihood of poverty in later years. In fact, seniors without pensions were nine times more likely to live in poverty than those who have them, the NCPERS study noted. According to Public Finance Management, a financial-advising firm, retirees account for more than $800 billion in annual spending, and that spending accounts for more than 5 percent of the annual Gross Domestic Product.
So what’s the solution? The NCPERS suggests focusing on efforts that can buoy budgets without cutting funds slated for pensions. The group argues that closing corporate tax loopholes—which give businesses breaks and credits for things like overseas income or research and development—would help bring in revenue while not risking retirement funds. But even if the march toward 401(k) and other defined-contribution plans continues, the U.S. might be able to learn a lesson from other countries’ defined-contribution rules about how much flexibility is helpful versus how much flexibility is harmful.