Retirement Insights

Emergency Savings = Better Retirement?

Nov 11, 2020
  • BlackRock
Key points
01

Cost of DC loans

Loss of market exposure and compounded returns are some of the cost of borrowing from DC plans.

02

Sidecar Savings for emergency expenses

A “sidecar savings” account may help build short-term stability, giving participants the confidence to commit to long-term retirement goals.

03

Support from plan sponsors

Plan sponsors could help participants meet short-term financial needs by taking steps to help reduce defaults.

Of all the statistics about financial anxiety, one of the most alarming is that 41% of Americans in 2017 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. There are two ways a financial emergency can undermine retirement – and why plan sponsors may want to consider taking action. The first is the direct damage that emergency withdrawals or loans can do to retirement savings. We will illustrate this below.

The second is more subtle. At the recent BlackRock Retirement Summit, Rachel Schneider of the Aspen Institute Financial Security Program explained that if participants have confidence about near-term stability through access to emergency cash, it may improve long-term behavior. “If they have more security today,” she said, “It should translate into more long-term savings.”

Conversely, she said, “If people don’t establish financial security early enough, they are also highly unlikely to have saved enough for retirement.”

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.

Their “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, 90% of large 401(k) plans have outstanding loans, according to a BrightScope report.2

Even more alarming is that 10% of borrowers default on their loans when they leave their job, according to Deloitte.3 Deloitte 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

A recent Government Accountability Office (GAO) report4 broke down the sources of leakage in 2013 as follows:

  • $18.5 billion in hardship withdrawals
  • $9.8 billion in cash outs at job separations that were not rolled over
  • At least $800 million in loan defaults (The report suggests the actual figure is much higher.)

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.

Restarting the retirement clock: the cost of cashing out $6,000 for a young job hopper

Restarting the retirement clock

Source: *Based on BlackRock’s Future in Focus® tool. Based on BlackRock’s Future in Focus® tool. Please see Assumptions and Methodologies for more information about the inputs used and for the tool’s assumptions and methodology. The projections or other information generated by the Future in Focus App (“App”) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Actual participant outcomes may vary with each use and over time. For a related study, see Best Intentions: The unintended consequences of plan design.

Since they often have saved very little before they changed jobs – in this example, we’ll project the balance to be $6,000 at age 25 — it may not seem like a significant issue. In effect, by giving up decades of compounded returns, however, they may reach retirement age with 20% less savings or have to work longer to make up the shortfall.

Plugging leaks, protecting savings

Should plan sponsors allow 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 Lock Box
The saver was given a key to open the box if needed. 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

Rachel Schneider believes that a focus on long-term security can grow from short-term stability. People want to feel in control and prepared to meet their needs. One of the ways she believes 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 proposals such as 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 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 a number of other steps plan sponsors may wish to consider that may also help, especially when combined with emergency savings, including:

  • 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.