Planning to Tap That 401K to Get You Through? Think Twice
Many financial experts are strongly against tapping into your 401K except as a last resort. Their reasoning and logic is sound, as the vast majority of investors do not have the appropriate mindset to get their retirement investments back on track. Personally, I don’t have such a huge opposition to using 401K loans and early withdrawals to help you through tough times, but it is important to understand the real costs involved. I could write many pages on all of the issues and costs that need to be considered, but many others have covered this topic quite well in the past. A simple Google search on “costs of 401K loans” or something similar will get you the information that you need.
The topic that I actually wanted to touch on today is a new issue that has not really been seen since the rise of the 401K, that is, investors not being allow to get their money out when they need it. To the average employee who has been diligently putting money away in his or her 401K for the past 10-12 years, the thought that you might not be able to access your own money is probably difficult to understand and even more difficult to accept. Unfortunately, in these confusing times that we are in, more and more 401K plans and participants are being locked out from making withdrawals from their investments.
Over the past 8 months or so, you have probably heard about some of the widely publicized investment funds crashes like those at Bear Sterns that helped set off the inferno. Typically, before a fund completely tanks, the fund management has the ability to prohibit investors from taking money out of the plan for a certain period of time. This time period may be only a few months or the funds could be locked up for years. Up until recently, we were only seeing this “capital locks” being used only with hedge funds and other huge funds made up of large, institutional investors. Your average Joe and Jane Smith really weren’t being directly affected. That is now beginning to change.
One important thing to keep in mind is that this is not an issue of 401K plans locking up your money, it is the individual investments within those plans that can cause the trouble. If your 401K investments are diversified in several different investment funds, you are unlikely to have any major issues. Unfortunately, many 401K plans only offer a handful of investment options and plan participants sometimes choose to invest in mutual funds that diversify your investments for you. In those situations, it is not unusual to see 50% or more of an individual’s 401K balance invested in a single fund. If an investor is in this situation and that fund locks withdrawals for some reason, you could have a serious problem getting your money out, should you need it.
If there is anything that this market crisis has taught us, it is the importance of liquidity. Investment funds that put their money into less liquid assets (i.e. real estate) are more likely to run into issues that require the control of withdrawals. As crazy as it sounds for someone to be able to keep YOUR hard-earned money away from you, there is a reason that managers are allowed to freeze cash withdrawals. Real estate funds are an easy example to use to show this. When a fund has its capital tied up in say, high-rise office buildings, it cannot easily tap into that money on short notice. So, if 20% of the investors decided to pull their money from the fund, the cash would not be there. The only option would be for the fund to sell assets, which for a high-rise office building worth a couple hundred million dollars, is not a quick task. If the fund were forced to sell that asset as quickly as possible, it would result in significantly lower sales proceeds than if more time is allowed to market the property and go through the standard sales process. If the fund is indeed forced to sell assets below their market value, this impacts everyone invested in the fund, not just those trying to get out. Therefore, it is deemed to be in the best interest of fund investors “as a whole” to freeze withdrawals.
Does this power get abused? Absolutely! Fund managers get paid based on assets in the fund, so allowing withdrawals that will lower the total value of the fund as a whole, lowers their fees. It is one of those dis-alignment of interests between managers and investors. I just wanted to explain the thought process behind the decision to allow for managers to freeze withdrawals.
There is one other category of funds that is especially at risk for an asset freeze, those that participate in securities lending. The issues and technicalities behind securities lending and the freezing of investment funds is much more complex and more difficult to understand than my previous real estate example. I’m sure most of you don’t care about all of the minute details here, so I’ll try to hit the “big-picture” issue.
Many 401K plans invest in funds that “lend” their portfolio holdings to other investors in exchange for collateral (typically valued at around 102% of what is being lent) that the funds invest in normally safe, liquid holdings. The reason that funds do this is that the exchange can result in small, yet (relatively) reliable returns that can be used to offset fund expenses. In the past, this practice has worked fine because of the safe, liquid nature of the assets being invested in. As we all know by now, what was once thought to be a very safe, liquid investment may not be either in today’s market. Many of these investments were made in assets like Lehman Brothers (we know how that worked out) and other investments that have quickly tanked. This has thrown the entire lending practice out of whack and has forced some managers to freeze withdrawals to be able to maintain the fund’s obligations in the lending exchanges.
I realize that the last paragraph was probably a little confusing for most readers, but hopefully you get the general idea. I’m not advocating that you pull all of your 401K money out of real estate or out of any fund that practices portfolio lending, but I do think it is very important to be aware of the risks that are developing today. I know a handful of people who are out of work and are counting on access to their 401K to survive if they do not find work soon. If you haven’t looked at your 401K investments recently, now might be a good time to make sure you are properly diversified. If you have a large percentage of investments tied up in one or two funds, be sure to take a closer look at their practices and be sure that you know if you could run into a similar issue down the road.
I realize that I got a little complex with this article, so please feel free to comment and ask any questions that you have or let me know if there is anything that I can clear up for you. Also, if you would be interested in a future post on the considerations and costs of tapping into your 401K plan, let me know that also and I’ll be happy to write something up on that topic also.