Investors have increasingly taken hardship withdrawals from their 401(k) accounts at indexing giant Vanguard, putting pressure on passive flows.

Emergency Vanguard 401(k) Hardship Withdrawals Hit a Record High in 2023

Vanguard 401(k) Hardship Withdrawals Increase to 3.6% of Client Base in 2023

Signs of economic distress are building, even though the initial jobless claims report released by the U.S. Department of Labor still shows that layoffs are subdued. However, there is significant debate over whether this data accurately captures the state of the labor market, given the very low unemployment benefits paid by states and the availability of better side-hustle money in the gig economy. In fact, many observers have pointed out significant labor market distress using other metrics:


In any event, consumers are showing difficulty keeping up with the extreme price increases in essential goods and services after years of high inflation. In 2023, Vanguard reported that 3.6% of their clients took 401(k) hardship withdrawals, which is a significant increase from the 2.8% that took these distributions in 2022. According to the indexing giant, this is the highest level in the 19 years that this metric has been tracked. Notably, 19 years means the data goes back to 2005, so this period includes the financial crisis of 2008 and the high unemployment levels that persisted in the aftermath of that recession. At Passive Parabellum, we watch index fund flows very carefully because net withdrawals from Vanguard and the other indexing giants will bring about the passive investing endgame.

Under 401(k) rules, investors are typically assessed a 10% penalty for withdrawing money before they reach age 59.5 years-old. However, if certain criteria are met, this penalty is waived. Among the hardships allowed are medical expenses, the purchase of a a primary residence, certain educational expenses, payments to avoid foreclosure, and funeral expenses.

Why This Metric Is Crucial to Watch

Recent rule changes have made it easier to raid a 401(k) without paying the penalty, in addition to the fact that more and more employees have been automatically enrolled in these retirement plans and set up with default investment options. If the economy deteriorates further, this trend could accelerate and create further pressure on passive flows. The younger generations like Millennials and Generation Z are the heavy buyers of index funds through their regular paycheck contributions to 401(k) accounts, which (for now) balances the selling by retired Boomers to finance their living expenses. If the balance tips and enough young workers stop contributing and perhaps even sell, markets will have a major dearth of buyers.

Watch this space closely.

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