Has your 401(k) plan sprung a leak? If so, it’s better to patch it than just trying to paddle faster to get to shore. “Plan leakage” refers to participants allowing their account balances to shrink, because of either loans or hardship withdrawals. Plan loans don’t always result in permanent leakage when they’re repaid, but they still can have adverse long-term consequences for participants.
How do plan loans leak?
There are several basic problems participants can run into with plan loans. For example, while participants are “paying themselves” with the plan loan interest, typically there’s an opportunity cost associated with not having borrowed funds invested in financial markets, as they would otherwise be if they remained in the plan. In addition, making principal and interest payments on the loan typically constrains participants’ ability to maintain the pace of their previous salary deferrals.
Many participants ultimately default on plan loans, resulting not only in adverse tax consequences, but diminished retirement savings. Finally, from the sponsor’s perspective, plan loans increase overall plan administration costs to the ultimate detriment of plan participants.
Why allow plan loans?
None of this is to suggest that having a plan loan provision — which is entirely optional — is a bad idea. Most plans do allow loans. Why?
The fundamental reason is to encourage plan participation by the full demographic spectrum of employees who might otherwise not join the plan, fearing that they would essentially lose access to their savings without the ability to borrow from their accounts. Also, when employees encounter a financial emergency and have to borrow money, they can probably do so at a lower cost through a plan loan, particularly when factoring in the interest payments that will accrue to their own accounts. Similarly, an employee who’s carrying high interest rate loans would probably come out ahead in the long (and short) run by paying off that debt with a plan loan.
In addition, if an employee with shaky personal finances can’t access credit at a reasonable cost from other sources, a financial crunch could drive him or her to take a hardship withdrawal — a welcome form of relief during a difficult time (though a leading contributor to plan leakage).
How can you plug leaks?
How, then, to strike a balance between maximizing participation with a plan loan provision and the unintended consequence of plan leakage? Consider the following:
Incorporating preemptive education. Instead of just explaining plan loan procedures, incorporate financial education into the material that plan participants must read before requesting a loan. Such content might include a list of good (retiring higher-cost debt) and bad (discretionary purchases like expensive vacations) reasons for borrowing.
Limiting the number of allowable plan loans. IRS rules cap loan amounts at the greater of $10,000 or 50% of the participant’s vested account balance, or $50,000, whichever is less. The rules don’t, however, limit the actual number of loans participants can take out if the total amount borrowed stays within those limits. But the more loans employees can take out, the easier it might be for them to wind up hitting the aggregate debt ceiling.
Charging loan origination fees. Research confirms that the higher the loan fee, the fewer participants with an outstanding plan loan. According to an Aon Hewitt study, 28% of participants have outstanding loans when the fee is below $50, but only 20% do when the fee is $100 or more.
Setting additional plan loan limits. Employers can further limit loan amounts, for example, with a loan limit formula based entirely on employees’ accumulated deferrals, but not amounts reflecting your matching contributions. Other limits include requiring that, once a plan loan is paid off, another loan cannot be taken for a period of time; setting a minimum loan requirement; and limiting the reason for a loan to the same requirements that hardship distributions have.
Tightening things up
Another leak-plugging tactic you can employ concerns the loan principal and interest payment process. Putting it on a payroll deduction basis should help ensure loans are retired as promptly as possible. These tactics, adopted in a coordinated manner, should amount to more than a duct tape solution to plan leakage. Integrating them into a larger participant long-term financial education and retirement readiness campaign can go a long way toward tightening up participants’ accounts.