There’s no shortage of things that can help keep retirement savings on track. Bear market. Panic sale. Market timing.
However, there is a 401(k) withdrawal rule: 401(k) withdrawal rule that automatically redeems other investment funds when a retiree decides to withdraw money.
A drawback? Retireers who own multiple funds in their retirement accounts, such as large equity funds, bond funds, and interest financial markets, can be injured if the 401(k) plan withdraws money from one of the funds they don’t own.
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This built-in, often private sales protocol can knock portfolio assets allocations from bangs, leading to a more risky profile for the portfolio.
It is called a “hierarchical trap.”
401(k) withdrawal Snafu – Less-known hierarchical trap
This obscure withdrawal protocol relates to retirement planning rules, which specify the order in which 401(k) plans to withdraw processes when retirees place a sell order.
“We’ve seen a lot of experience in our client experiences,” said Marci Stewart, Client Experience Director at Charles Schwab Workplace Financial Services.
In many cases, a 401(k) plan allows account holders to specify the fund or fund they wish to withdraw. However, retirement plans also have other rules that determine more stringent sales procedures.
One common practice is proportional distribution, or proportional withdrawal. This liquidation strategy is relatively benign as equal amounts are drawn from each fund held in the 401(k) and maintains the retirement asset allocation intact. Of course, even the Pro-Rata Sell rules won’t achieve your goals if your goal is to adjust the weights of your holdings up and down in sales.
However, recent Wall Street Journal stories (burned by the 401(k) “hierarchical trap”) revealed an unprecedented, relatively unknown, hierarchical approach used in unprecedented 401(k) plans.
This method of handling 401(k) redemptions has received little attention and is a mystery to many of the financial advisors we have spoken about. In many cases, there is no disclosure of this type of redemption rules in the overview of a 401(k) plan. Sales rules are often buried in record managerial procedures or custody agreements rather than clearly spelled out in material aimed at participants.
“The hierarchical method is a matter of fine printing and disclosure,” said Jonathan Lee, senior portfolio manager for private wealth management at a US bank. “At least, that’s something investors need to ask, knowing that it’s a possibility.”
Without a doubt, understanding how a 401(k) handles withdrawals is an important part of your retirement plan.
What is a “hierarchical trap”?
First conservative investment
In a hierarchical-based system, 401(k) plans make withdrawals in a specific order.
Typically, tiered protocols start with the sale of the most conservative or low-risk investments, such as money market accounts. If the initial fund is completely exhausted and more money needs to be withdrawn, the next fund or investment in a given tier will be sold.
This sales system is designed to maintain the growth portion of your portfolio, but comes with a downside. You can withdraw funds from funds from retired portfolios that you are not planning to sell. This could knock your portfolio’s asset mix out of the bang and change the portfolio’s risk profile.
Poor disclosure
“This is the problem. If you’re intentionally trying to reduce your inventory exposure, a tiered system can work against you and pull out the very funds you want to keep untouched,” says a blog post from investment management company Hanover Advisors. “What’s worse, many plans don’t clearly disclose these rules in participants’ summary. You may not know how money will be withdrawn until it’s too late.”
According to the FA (Financial Advisor) magazine, if a retiree wishes to withdraw from a retirement account, they must request that certain funds be sold, not just a specific dollar amount. FA Magazine notes that client withdrawal restrictions are often imposed by plan record managers, not by plan sponsors. Employers may not notice them.
The portfolio’s risk profile may change without you realizing it.
In many cases, the unintended consequence of hierarchical sales protocols is contrary to one of the key pillars of financial planning. This means that the retainer’s holdings are consistent with risk tolerance.
“If you have the option to request a withdrawal from your retirement plan and choose where your money comes from, it’s all under your control, whether it’s a bond fund, an equity fund or a money market fund (this is fine),” Lee said. The Pro-Rata sales system does not change the weight of your portfolio holdings, so it does not destroy your portfolio.
“If the portfolio is 50% equity and 50% bonds, half of the withdrawal will come from the bond fund and half from the equity fund,” Lee said.
In contrast, if, for example, a larger distribution is drawn from a more conservative bond fund via hierarchical methods, retirees leave a greater weighting of riskier equity holdings, Lee says.
For example, a retiree with $100,000 nest eggs and 50% equity/50% bond asset allocation will withdraw $10,000 and a tiered sales system will begin.
Of course, the risk is that if retirees do not re-summon the portfolio to return their assets in line with their financial plans, the risky skin of the portfolio will undergo a dramatic change.
“If this happens in a row, you can see the risk profile change very significantly within your retirement account,” Lee said. “That’s why it’s important to understand the outcome.”
How to avoid hierarchical traps
Make sure you know the rules.
Before you sell, contact your 401(k) Planning Manager to determine how your withdrawals are handled and whether you want to use a hierarchical sales protocol. If so, you can ask for a copy of the liquidation rules, understand it and take proactive steps to avoid portfolio disruption if you need to withdraw it from your retirement account.
“Investors should read detailed printing and disclosures when presented,” Lee said.
It is important to have proper due diligence.
“The best approach to ensuring your withdrawal is to specifically request the investment fund you want, or to request and confirm that the withdrawal is proportionalized if it’s your preference,” Schwab’s Stewart said.
“Also, if you have investments through multiple sources of 401(k), make sure to ask which source you want to tap,” she said (for example, if you have both traditional tax deferred contributions and Roth 401(k) contributions in your plan).
How to avoid “hierarchical traps”
There is a way to withdraw money from your 401(k) without compromising your set asset allocation.
actively. For example, if you want to reduce your exposure to stocks, consider redistributing your stock funds to the funds at the top of the withdrawal tier before redemption.
For example, if you know that your plan is using a money market fund first, then transfer the stock funds to your cash account before withdrawing the funds.
Please keep this in mind when withdrawing 401(k) funds
Conclusion? “We understand how to implement withdrawals and the withdrawal or reimbursement protocols will maintain alignment between target asset allocation and risk tolerance (certainly),” Lee said.
“Consult your plan provider about options and then run options that control asset allocation based on the options. You can also ask about workaround options if you don’t have the option to withdraw from Prorata or a specific fund.”
