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Protection from 401(k) leakage

By Barbara Whelehan · Bankrate.com
Friday, July 20, 2012
Posted: 5 pm ET

A couple of studies about 401(k) leakage were leaked to the press this week, so to speak.

A 401(k) leakage refers to money that seeps out of a retirement plan through the actions of the account owner. It occurs when you take a hardship withdrawal, cash out of the plan when you switch jobs, or borrow from the plan with the intention of paying it back but then default on the loan, usually because of involuntary job loss.

In its report, "The Cracked Nest Egg," Transamerica Center for Retirement Studies found that 35 percent of its survey respondents with retirement accounts have taken a withdrawal from their 401(k) or similar type plan since becoming unemployed or underemployed.

A separate study by Navigant Economics estimates annual leakage of about $37 billion from defaulted loans of 401(k) plans between mid-2008 and mid-2012.

The cost to the account holder is huge. If you take out a loan for $10,000 and then default, you can lose an additional $2,500 in federal taxes, assuming you're in the 25 percent tax bracket, in addition to state taxes. Lop on another 10 percent penalty, and this loan gets very expensive.

An insurance solution

But the solution could be expensive, too.

The paper by Navigant Economics recommends that 401(k) loan applicants get access to insurance that would pay the unpaid loan balance in the event of death, disability or involuntary job loss. Such a change would require an amendment to the law. "In particular, the law should be amended so that plans may choose to allow 401(k) borrowers to be automatically enrolled into insurance coverage unless they opt to decline such protection," the paper's authors suggest.

Automatic enrollment has been greatly successful in getting new hires to contribute to their retirement plans because it involves no action on their part to sign up. They have to take action to opt out. So the study wants the same kind of arrangement for this insurance product in the event someone wants to take out a 401(k) loan.

I asked the paper's co-author, Hal Singer, who is a managing director at Navigant Economics, how much this insurance would cost.

"I estimate that the annual premium payments associated with insuring a balance of $8,700 would be between $43 and $522, depending on an interest rate between 0.5 and 6.0 percent, in line with the rates of private mortgage insurance."

That's a big range. I pay $275 annually for a life insurance policy with a payout of $100,000 to beneficiaries. Paying $43 a year might be worth insuring a loan amount of $8,700. But $522? I don't think so.

Then I got another estimate from Kevin Smart, CFO of Custodia Financial, which as it happens, was cited as a source in the paper by Navigant Economics.

"According to Custodia Financial, a provider of debt protection for 401(k) loans, the cost would average 2.1 percent of the original loan balance on an annual basis," Smart says. "The cost of protection could be offset by a reduced interest rate to reflect the reduced risk of the loan. The interest rate reduction would allow the borrower to have a protected loan at about the same cost as an unprotected loan and still earn an attractive return."

The ability to borrow from a 401(k) plan is important, even if the funds are used for something other than retirement -- such as survival in a recession. Insurance might be a good way to remove the risk of default in case you lose your job through no fault of your own. But I think it should be a deliberate decision, not something you're automatically paying unless you elect to do otherwise.

It would be a boon for the insurance industry to get the rules changed, though, and it is working behind the scenes to do just that. In April, Custodia Financial submitted a statement to the House & Ways Committee arguing for automatic enrollment into insurance coverage for 401(k) loans.

And this paper by Navigant Economics, which made a big splash in the press, was financially supported by Americans for Retirement Protection. That organization has a website, ProtectMyRetirementBenefits.com, but no "about us" link. It does give you the opportunity to sign a petition demanding protection of retirement funds through insurance. Take a look at it, and see if you think the website was created by average Americans or by the insurance industry.

At least we have some consolation knowing that, beginning next month, all 401(k) fees will finally come to light.

What do you think about this insurance product?

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Follow me on Twitter: BWhelehan.

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