401(k) Loans: Considerations for a Plan
That retirement account is sacrosanct… until it isn’t. Sometimes a rainy day arrives before retirement, and the seemingly untouchable is a tempting source of short-term support and relief. Recent discussions about 401(k) loans look at the scale of the practice, the consequences and what a plan may consider concerning a policy for them.
Plan size appears to be related to plan loans, but in interesting ways. The Employee Benefit Research Institute (EBRI) in a study of 401(k) activity in 2015 found that the larger a plan was, the more likely it was that it made plan loans available: 90% of plans with more than 1,000 participants did so, while only 30% of those with 10 or fewer participants did. In “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” a National Bureau of Economic Research (NBER) working paper, authors Timothy Lu, Olivia Mitchell, Stephen Utkus and Jean Young reached similar findings, reporting that 90% of the 900 plans they studied over a five-year period made 401(k) loans available.
But also in 2015 year, EBRI found that while larger plans are more likely to make plan loans available, the converse was true regarding the likelihood of outstanding plan loans: 23% of participants in plans with 10 or fewer participants had them, while roughly 18% of those in plans with 1,000 or more participants had outstanding balances. The overall numbers, however — around or just below 20% of plan participants — have held steady for 20 years. Similarly, NBER researchers reported that approximately 20% of the active participants in the plans they studied had an outstanding loan.
The prevalence of plan loans was highest among participants in their 40s in every year EBRI has measured since 1996, ranging between 20% and 25%. Next most likely were those in their 30s, followed by participants in their 50s. So found the NBER researchers, writing, “Participants ages 35 to 44 are more likely to borrow than their younger or older peers.”
On the average, plan loan balances amounted to an average of 14% of 401(k) balance since 1996, EBRI says. Not surprisingly, loans have consistently been a higher percentage of the balances of the participants who are the youngest and who have the shortest tenure. The NBER study showed similar results.
Loans from 401(k) balances obviously have consequences for plan participants. They can help in meeting a serious and/or sudden financial need, but that comes at a cost — plan loans reduce balances, must be repaid and could affect financial security in retirement.
But could loans enhance employees’ inclination to participate in the plan? At least one analysis suggests that making it possible for participants to take loans can have that result. In a 401(k) Blog post, “401(k) Loan Policy Best Practices,” Alex Goldberg suggests that at least the knowledge that one can take a loan may be an incentive to save. He writes that “knowing that their savings could be accessed in an emergency may make the idea of saving for retirement a bit easier.” Goldberg goes on to say that “the ability to borrow may actually encourage reluctant employees to participate in the company plan, and even prod them to defer a larger portion of their salary into the 401(k).”
And while it is the employee that experiences the direct effects of a plan loan, a plan nonetheless can feel effects as well; for instance, if employees who take plan loans delay retirement in order to refresh their retirement accounts, and because of any administrative complications that result.
Tips for Employers and Plan Sponsors
A plan can help address or even ameliorate the effects it experiences as a result of plan loans, as well as the effects on participants, by approaching plan loans in way that encourages participants to act responsibly and that helps them remain on a course to save for the future.
In “Top 5 Tips for 401(k) Loan Program Design,”a post on the International Foundation of Employee Benefit Plans’ “Word on Benefits” blog, Jenny Lucey offers some ideas by which plan sponsors and employers may accomplish that.
Educate employees. Lucey suggests employers educated employees about the consequences of taking a plan loan. For instance, she says, an employer can:
- encourage employees to be mindful of possible future circumstances they may face;
- remind employees if any financial counseling options are available; and
Put limitations in place.
- explain the consequences of changing jobs while there is a loan balance.
Lucey argues that it is possible that employees could interpret the ability to take a plan loan as encouragement to do so. She suggests that a plan can inhibit such a perception if it limits:
- the availability of loans to only one per account;
- loan access to only contributions an employee made to her/his account;
- the dollar amount or percentage of vested balance available for a loan; and
Impose service fees.
- the reasons that are acceptable for taking a loan.
Lucey reports that just over three-quarters of plan sponsors require their plan participants to pay a loan origination fee; the most common, she says, is $50, followed by $75. And Lucey cites a study by Aon Hewitt
that found that plans that charged higher plan loan origination fees had smaller outstanding plan loan balances.Make it easy to repay a plan loan.
An employer can accomplish this, Lucey suggests, by setting up a system by which plan participants can repay a plan loan directly from their own bank accounts. This has an added advantage over payroll deductions to repay a loan, she argues, since direct payments from a participant’s own account will be unaffected if the participant changes jobs.Protect employee savings.
Lucey suggests that an employer can help accomplish this by making sure that employee contributions to the retirement account continue, unchanged, during the period in which the employee repays the loan.