Unveiling the Unseen Threat Jeopardizing Retirement Savings

When it comes to studying the accumulation of 401(k) retirement savings, researchers have uncovered an alarming trend that has been overlooked by thousands of studies. Many employees, upon leaving their jobs, choose to cash out their retirement savings instead of preserving them. This issue is especially concerning considering the likelihood of individuals changing jobs multiple times before their retirement.

The research paper entitled “Cashing Out Retirement Savings at Job Separation,” authored by Yanwen Wang from the University of British Columbia, Muxin Zhai from Texas State University, and John Lynch, Jr. from the University of Colorado Boulder, sheds light on this issue. The paper, published in Marketing Science, reveals that 41.4% of employees with a 401(k) matching contribution opt to withdraw their savings upon leaving a firm, and 85% of those individuals cash out the entire amount. This means that instead of saving money for retirement, they choose to use it for short-term consumption. The ease of cashing out retirement savings in the United States contributes to this alarming behavior. By cashing out, individuals essentially reset their savings progress, hindering their ability to accumulate enough funds for a comfortable retirement.

The study analyzed data from 162,360 employees who left employers covered by 28 retirement plans between 2014 and 2016.

It’s important to note that in the United States, individuals who tap into their 401(k) savings before the age of 55 are subject to a 10% penalty in addition to income taxes. This means that by cashing out, individuals are losing a significant portion of their savings.

The research team discovered that the decision to cash out retirement savings is primarily driven by psychological factors rather than financial need. If cashing out were solely based on need, it wouldn’t matter whether the money in the 401(k) account came from the employer or the employee. However, the study found that the more the employer contributes to the account balance, the more employees treat it as a windfall that can be spent freely. The researchers refer to this phenomenon as the “account composition effect.” It leads departing employees to overlook the penalties and taxes associated with early withdrawals and choose to liquidate their 401(k) savings.

The authors attribute this behavior to both psychological and administrative factors. Employers often neglect the importance of providing financial advice to departing employees, instead relying on partner financial services firms to handle communication. These firms typically send impersonal letters outlining the options available to employees, which fails to address the account composition effect. The administrative process involved in rolling over the savings into another retirement account can be cumbersome, which further contributes to employees choosing the path of least resistance and cashing out their savings.

Ultimately, the authors suggest that employers should take a more proactive role in ensuring departing employees receive proper financial advice. By preventing employees from viewing their retirement savings as a windfall, employers can help their employees fully benefit from generous match rates and avoid setbacks in their retirement plans.

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