How to Overcome 'Income Shocks' that Wreck Retirement Security

Household income shocks from job loss, job change, marital change or sudden illness are becoming more common, and these disruptions are taking a massive toll on the retirement security of millions of Americans, new research shows.

The trend is most unnerving for low-income households—a segment that is expanding as the middle class erodes. But this is a growing issue for moderate- and high-income households too. These income shocks—and their fallout—are part of a bigger retirement insecurity story that Warren Buffet and others have begun to discuss: capitalism itself may be failing.

There can be no doubt that the haves and the have-nots are growing further apart. The middle class has shrunk to the point where it may no longer be the economic majority in the U.S., a new report from Pew Research concludes. The share of adults in lower-income households rose in 160 of 229 metropolitan areas from 2000 to 2014, Pew found.

Low-income alone makes saving for retirement difficult. But such households are also more likely to experience income shocks—and to raid their retirement savings in order to get by, according to a paper from researchers led by Teresa Ghilarducci at New School Schwartz Center for Economic Policy Analysis.

The paper looks at two-year period during the financial crisis and found that 51% of U.S. households with a 401(k) plan experienced at least one income shock. Some 21% were classified as low income; 17% as moderate income; and 13% as upper income. Low-income households experience a higher rate of all four kinds of income shocks in the study.

Low-income households were significantly more likely to take money from retirement accounts. Over two years, 11% of low-income households raided their 401(k), vs. 9% of moderate-income households and 5% of upper-income households. Linking that to income shocks, the study found that a low-income household is more than twice as likely as a moderate-income household and three times as likely as an upper-income household to raid retirement accounts after a shock. Roughly a third of withdrawals from low-income households were the result of an income shock.

Money leaking out of 401(k) plans and IRAs through early withdrawals and loans that go unpaid has been a key issue for the retirement industry and policymakers. Tens of billions of dollars of retirement savings are lost every year. Ghilarducci and others have called for extreme measures, including mandatory savings accounts with no early access.

Don’t wait for marching orders from the government. Early distributions and 401(k) plan loans should be seen as a last resort. You may pay a penalty to get the money, and at the very least you lose years of compound growth even if you eventually pay the money back.

With income shocks becoming more common, you might consider private wage insurance through a product like IncomeAssure. It is also more important than ever to have an emergency fund. Start with $300—enough to, say, fix the refrigerator. Then add to it monthly until you have at least three months of living expenses. Job loss and other shocks afflict low-income households the most, but they occur at all income levels.