The Fiduciary Underpinnings of Plan Loans
Prudence. We often seem so focused on this one particular ERISA standard at times that it seems we do it to the exclusion of what is really ERISA’s own “prime directive”: “A fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries.”
Sure, prudence is critical when dealing with plan investments, as is diversifying investments to minimize loss, as is administering a plan in accordance with its documents (these are each a specific fiduciary standard contained in ERISA Section 404(a)) These rules, however, do not exist in a vacuum.
It is easy to forget that the fiduciary’s exclusive obligation is to provide retirement income from these plans. ERISA is pretty clear that even defined contribution plans are actually meant to provide retirement income. They are “employee pension benefit plans” under ERISA Section 3(2)(A) which each “provides retirement income to employees, or results in a deferral of income by employees for periods extending to the termination of covered employment or beyond.”
We spend much of our time focusing on the minutiae of fiduciary investments making sure compensation is reasonable; finding ways to comply with variable compensation under the fiduciary rule; drafting compliant 404a-5 and 408b2 documents; documenting procedures; evaluating cost and fees related to investments; and all manner of plan financial issues. In doing so, however, we cannot lose sight of the proverbial forest for all the trees.
This point becomes very real when dealing with plan loans. Yes, plan loans are investments subject to prudence. But they are also critical plan rules which have can have a major impact on the ability of the plan to provide retirement benefits which implicate that “prime directive.” The DOL recognized that loans secured by participants’ account balances can, and do, undermine the plan’s provision of retirement benefits when they default and plans offset the retirement benefit (which data shows they regularly do). The ERISA regs’ 50% rule is NOT designed to co-ordinate with the IRS’ statutory limit on loans. As a matter of fact, Title 1 is silent on the matter. The DOL specifically imposed this limitation by virtue of regulation in order to minimize the risk that defaulting loans cause to retirement benefits (if you are curious, the preamble to the ERISA loan regs at 54 Fed Reg. 30520
are an interesting read). The Department of Labor (DOL) was clearly concerned about the exclusive purpose rule.
The DOL really laid it out well when it issued Advisory Opinion 95-17, giving its opinions on 401(k) credit cards. There it laid out the exclusive purpose standard when setting the terms and conditions of a loan: “it should be emphasized that the purpose of section 408(b)(1) and the regulations thereunder is not to encourage borrowing from retirement plans, but rather to permit it in circumstances that are not likely to diminish the borrower’s retirement income or cause loss to the plan.”
In the day-to-day operation of a plan (without plan credit cards!), this raises a troubling issue- particularly when a plan design forces a loan default offset of a participants accrued benefit following involuntary employment (such as a layoff, death or disability), where the retirement benefit is lost under difficult circumstances where there is little chance to recover. To add to the difficulties, a significant number of these offsets result in a 10% tax penalty being impose at a time it is most difficult to bear- a fundamental unfairness of which I have blogged in the past.
Employers do the best they can, even as loan defaults serve to undermine one of the fundamental reasons employers provide a retirement plan. Short of not offering loans, all that really is left to do is to engage in an effort to notify plan participants of default; and often send collection letters following default. This is why the IRS asks questions about collection efforts. This is also why policymakers often propose eliminating loans from plans, because of this problem.
Loans, however, are really a necessary part of retirement plans. Without that sort of access, many employees would shy away from making deferrals, which also undermines retirement readiness. But there remains this tension between the exclusive obligation to protect the ability to provide the retirement benefit, and the practical demand to have a loan program.
There is a potential solution in the wings, as I have been working with Custodia Financial and a number of leading practitioners throughout the country to develop a program under which plans will have the ability to protect the benefit.
Robert J. Toth, Jr. is principal in the Law Office of Robert J. Toth, Jr., LLC.
Opinions expressed are those of the author, and do not necessarily reflect the views of ASPPA, or its members.