Insights at UBC Sauder

Americans are cashing out their retirement savings at an alarming rate: study

Retirement savings
Posted 2023-04-04

From a young age people are told to save for retirement, and every year, millions of Americans dutifully sock away money in workplace 401K retirement funds, with many employers matching their contributions.

But according to a new study from the UBC Sauder School of Business, there’s a key problem: when they switch jobs, 41.4% employees are cashing out those funds — even though the U.S. Internal Revenue Service (IRS) imposes a 10 per cent penalty on anyone younger than 59.5 years old.

For the study, titled Cashing Out Retirement Savings at Job Separation, researchers looked at the files of 162,360 employees who left their jobs at 28 U.S. companies. The data included their ages, genders, when they were hired, their income, how much they contributed to their 401Ks and more. This study is also featured in the Harvard Business Review article Too Many Employees Cash Out Their 401(k)s When Leaving a Job.

The study authors also looked at the rate of “pre-retirement leakage” — that is, when people cash in their 401Ks before they reach retirement age. There are a few ways this leakage occurs: people borrow against their 401K then default on the loan; they make withdrawals when they are actively employed; or they cash out their 401K when they leave a job.

According to the study, a tiny percentage of people do the first two, but a remarkable 41.4 per cent withdraw funds from their 401K upon job separation — and of those, nearly 90 per cent take out all the funds.

“They take every penny out. Roughly two thirds take it all out at once, and the rest make multiple withdrawals,” says UBC Sauder Associate Professor Yanwen Wang (she, her, hers), who co-authored the study with Muxin Zhai of Texas State University and John G. Lynch, Jr. of the University of Colorado. “But on average, within eight months, they take everything.”

While some people face unexpected job losses and may need the funds for day-to-day expenses, it doesn’t fully explain the phenomenon: of the 41.4 per cent of people who withdrew funds, only 27.3 per cent had experienced involuntary job separations such as layoffs or terminations — and it’s unlikely that all of them needed emergency funds.

People also experience financial shocks while they’re still employed, adds Professor Wang, and yet only a tiny proportion withdraw any 401K funds, even though they technically can at any point. “Whatever benchmark you try to find,” she says, “it cannot completely explain why such a significant number of people would touch their 401K at job separation.”

Even more surprising, the more generous employers are with their matching, the more likely the employee is to cash in the 401K when they leave.

So what’s driving these mass withdrawals? Professor Wang says it likely boils down to system design, economics, psychology, or a combination. Especially when employers help to substantially grow the funds, she adds, workers seem to treat it like a lottery win.

“For example, if the employer does a one-to-two match, where for every $1 you contribute your employer will match $2, it can change the psychological sense of ownership of those 401K accounts,” says Professor Wang. “So instead of your own saved money, it’s like a windfall. And then it feels more touchable, and more legitimate to spend it when you change jobs.”

The researchers found the pattern was relatively consistent among people of different ages, genders, incomes and levels of 401K savings — and it’s happening at a time when contributions have been steadily increasing.

“Sixty percent of their accrued assets will leak out of the 401K system when people change jobs. If you consider how often people change jobs, on average every two to five years, it means they’re only left with the 401K balance of their last job,” she says. “So people aren’t saving enough for retirement.”

Previous studies have looked at Americans’ 401K contribution rates, but little attention has been paid to 401K leakage.

It’s a problem for individuals, because they lose out on the benefits of compound interest and may not accumulate enough to retire, says Professor Wang, but it also creates a larger systemic issue, because the money people pay into 401Ks is used to fund people who are currently retired — and if it leaks out of the system, that money isn’t there.

Professor Wang says there are several steps employers and governments can take to try and stem the outgoing tide. First, companies should provide education and guidance to people leaving a company, so they understand the importance of 401Ks and the consequences of cashing them.

Policymakers could also adopt “auto-portability” — that is, rather than employees being offered the option to cash out when they leave, their 401Ks would be automatically moved over to their new employer or to an Individual Retirement Account, or IRA.

Professor Wang also says employers could allocate a certain portion of employee contributions to emergency funds that act like a “sidecar” on their 401Ks, so they can take that money out as needed without being tempted to cash in their retirement savings.

“If there is no assistance for quitting employees, there’s an unintended nudging for people to take the money out, especially if there is a large match,” says Professor Wang. “Something has to be done — not to control people’s 401Ks, but to provide enough knowledge so they’re aware of the consequences of their actions.”

Interview language: English