Based on 30+ years of plan sponsor experience, I believe negative press about 401(k) loans are aimed at the wrong target. Rather, hardship withdrawals should be in the crosshairs, not loans.
Articles about 401(k) loans tend toward the negative - using terms like "erode" or "raid" when characterizing loans' effect on employees' retirement savings. Many recordkeeping/mutual fund firms tend to cast loans in either an ambivalent or negative light, as these tend to remove monies from "assets under management" for fee purposes.
On the other hand, less frequently cited academic studies show participants may not be borrowing enough from their 401(k) - that financial status can be improved if more borrowing came from 401(k)s instead of commercial sources.
Research also can debunk other myths about 401(k) loans that have given them an undeserved bad rap:
1. 401(k) loans are a substantial source of leakage.
Leakage occurs where money saved in a 401(k) is not used for retirement. Leakage from loans is miniscule. A 2010 study by the Pension Research Council shows that loans are almost always repaid while employment continues. In a 2009 Government Accountability Office study, 89% of leakage was from distributions after separation, and 10% resulted from in-service hardship withdrawals, while less than 1% came from loan defaults.
So, without a change in behavior, most post-separation loan leakage would have occurred anyway - as studies show nearly 50% of 401(k) participants cash out at separation.
To minimize leakage, eliminate hardship withdrawals. To further reduce leakage, ensure participants confirm that they could have borrowed from a commercial source and that they secured a line of credit, etc., for contingencies.
2. Retirement accumulations are down due to 401(k) loans.
Americans' 401(k) account balances have been shown to be higher where a plan offers reasonable access to funds prior to retirement.
Research from the Boston College Center for Retirement Research shows 401(k) participation declines where access to funds is limited. Americans' retirement preparation is inadequate due to three main causes:
* Half of Americans do not have access to a savings plan at work;
* Too many don't participate even where they do have access; and
* Those who do participate often don't save enough.
The goal should be to encourage workers to save more than they believe they can afford to earmark for retirement.
Remember, people who are disciplined enough to save in the first place are more likely to be circumspect about borrowing.
Bottom line, those who save more than they believe they can afford to set aside for retirement are likely better prepared for retirement - even if they ultimately default on a loan. Better to save and default than never to save at all. Save, get the match, accumulate earnings, borrow, continue contributions, repay the loan, rebuild the account for a future need. Repeat over and over as needed until retirement.
3. Loans reduce contributions.
Some studies show workers with 401(k) loans contribute less than workers without 401(k) loans. However, no known study suggests this pattern is different in situations when a loan comes from a commercial source.
4. Participatant investments are negatively affected by loans.
Many criticize 401(k) loans as removing assets from the market. Since loans are limited to 50% of vested assets, the remainder can easily be used to maintain a 50+% market exposure - if a participant so elects. The loan simply becomes a fixed income investment.
5. Loan interest is "double taxed."
Interest paid on 401(k) loans is no more taxable than interest received from other debt investments. Further, loan interest may be tax- advantaged. A 401(k) residential loan secured with a mortgage offers a tax-deduction on interest paid to a 401(k) account. Interest on loans secured with Roth 401(k) assets may qualify for favorable tax treatment.
Changing 401(k) plans to change loan perception
Simply, loans are not withdrawals; they are not leakage unless they are not repaid. 401(k) loans can improve retirement preparation, where workers save more than they would otherwise earmark for retirement. Well-structured loans can reduce leakage if positioned as an attractive, "penalty-tax-free" alternative to in-service or post-separation withdrawals.
Plan sponsors can accomplish this by updating loan processing to include 21st-century capabilities (similar to electronic bill paying) that will not only facilitate repayment after separation, but enable participants to initiate a loan after separation and before retirement - actions designed to increase asset retention and reduce leakage after separation. Wouldn't a loan always be preferable than a taxable premature distribution - where federal, state and penalty taxes would apply?
Many plans allow post-employment repayment. Some plans even allow participants to initiate a loan after termination. It is more of a lifetime financial instrument. Post-separation access is more important than may be obvious at first pass. Americans typically change employers six or more times during their working careers, where access is limited to a taxable distribution. Consider a 35-year-old participant - what reduction in leakage would occur if she had access to assets via a post-separation loan, instead of a distribution?
Differentiate between loans and withdrawals
I suggest legislation to increase the differentiation between loans and premature withdrawals, ensure loans are more attractive than withdrawals and update loan processing to 21st century standards to foster repayment after separation.
In addition, we need to recast the 401(k) so that it can serve not only as a retirement asset accumulator, but also as a lifetime financial instrument.
Here are some suggestions:
* Update the 50%/$50,000 loan limit, unchanged for 40 years, back when 90+% of account balances were less than $50,000.
* Allow for increased loan portability, potentially including loan "transfers" to individual retirement accounts.
* Lengthen the period for repayment, or provide for a suspension of repayment, upon involuntary termination of employment (situations where the individual qualifies for unemployment benefits).
Let's write legislation that improves, not hinders, workers' efforts at saving for retirement.
Jack Towarnicky is an employee benefits attorney at Willis in Columbus, Ohio.
