Emergency savings = Better retirement?

Of all the statistics about financial anxiety, one of the most alarming is that 37% of Americans in 2024 reported that they would be unable to meet an unexpected $400 expense without borrowing or selling a personal item.¹ Alarming, yes – but what does that have to do with retirement?

A great deal, actually.

Borrowing from the DC plan

Participants who turn to their workplace retirement plan for an emergency loan may not recognize who really pays the price of their loan: their future self.

The “cost” of their loan may ultimately include lost market exposure and the opportunity to compound investment returns. If a participant reduces contributions to off-set their loan repayment, they may also be giving up the potential benefit of pre-tax deferrals, as well as a possible company match (loan repayments are after-tax). Despite these hidden costs and lost opportunities, more than 90% of large 401(k) plans have outstanding loans, according to an Employee Benefit Research Institute report.²

Even more alarming is that individuals experiencing employment gaps of four months or longer are 60% more likely to have defaulted on a loan, compared to 32% for those without such gaps, according to The Pew Charitable Trusts.³ The report concludes that the ten-year cost to future account balances based on the “cumulative effect of loan defaults upon retirement, including taxes, early-withdrawal penalties, lost earnings, and any early cash out of defaulting participants’ full plan balances,” will be a staggering $2 trillion.

Restarting the retirement clock

The impact of leakage, or cash withdrawals from one’s 401(k) retirement savings before the age of 59.5 years, carries several negative impacts for clients:

• For clients, the U.S. government imposes a 10% penalty on any amount of leakage.
• In a 2022 study, 42% of separating employees took a cash distribution, despite income tax and financial penalties for failing to roll over assets to a qualified plan.⁴
• For large companies with retirement plans, the amount of money saved in their plan has a major impact on the strength of their bargaining power in the recordkeeper and investment provider marketplace.

Let’s consider what this may look like in individual terms. In this case, we’ll examine the potential cost of the “hidden leakage” of young people who cash out their 401(k) savings when they go to a new job. In effect, they restart their retirement clock.

Since they often have saved very little before they changed jobs – in this example, we’ll assume roughly $6,500 – it may not seem like a significant issue. In effect, by giving up decades of compounded returns, however, they may reach retirement age with 24% less savings or have to work longer to make up the shortfall.

Plugging leaks, protecting savings

Should plan sponsors allow retirement plan loans? After all, prohibiting loans would seal one potential source of leakage. But it may come at a surprising cost: lower savings rates. The “Safe Box, Lock Box”⁵ experiments offer an illustration. Rural people in Kenya were given savings boxes with a slot on top for deposits and a passbook to record the savings. The boxes differed in one critical respect:

Safe Box

The saver was given a key to open the box if needed.

Lock Box

No key was provided, meaning the saver could not access the money.

What may at first glance seem surprising is that savers using the Safe Box had larger balances than Lock Box users at the end of the experiment. But perhaps that shouldn’t be a surprise: The ability to access the money if necessary may have provided the reassurance to save more.

The same is likely true for DC participants, especially younger workers who are not used to saving. Being able to borrow can create a sense of security and control, enabling them to feel more comfortable about contributing to a long-term saving plan. Closing off the ability to borrow may be counterproductive by reducing the security that being in control can provide.

Paradoxically, one of the best ways to protect retirement savings may be outside the retirement plan – or, more accurately, alongside it.

Sidecar savings, short-term stability

People want to feel in control and prepared to meet their needs. One of the ways employers can help their employees achieve this is through what is termed a “sidecar savings” – a savings account alongside the 401(k) that can be used for emergency expenses.

The idea behind sidecar savings or other non-retirement workplace savings plans is to create confidence. Even if participants never have to access the money, the positive effects may be felt, with a potentially more secure commitment to long-term savings and less financial stress affecting workplace performance.

Clearly an emergency savings account will not meet every unexpected need or prevent every form of leakage. There are other steps plan sponsors can do to consider that may also help, especially when combined with emergency savings:

• Reducing the number of loans or creating waiting periods between loans
• Simplifying rollovers to IRAs or new employer plans
• Restricting cash outs to the employee’s contributions
• Creating a hardship loan program rather than withdrawals
• Allowing former employees to continue repaying their loans

Helping participants meet short-term financial needs may not seem like a matter of concern for a retirement plan, but creating financial well-being and security is increasingly recognized as one of the goals of a robust benefits plan. And it just may be one of the keys to driving better retirements.

For more on helping people build emergency savings, please visit BlackRock’s Emergency Savings Initiative.