How to create a state-of-the-art 401(k) loan program
For employers, a significant factor in helping 401(k) plan participants achieve retirement readiness is protecting them from themselves. In other words, it’s about helping participants avoid making bad decisions. An important component of that process is minimizing the loss of participant account balances from loan defaults.
Also called leakage, defaulted loan balances are typically removed from participant retirement accounts forever. This account leakage can be reduced by a well-designed 401(k) loan program. A state-of-the-art loan program has the following characteristics:
Loans limited to hardship criteria. Plan loans are horrible investments. Opportunity costs are often high, interest payments are not tax deductible and participants often reduce their 401(k) contributions in order to make loan payments. Then there is the issue of taxes. State and federal taxes apply to defaults, as do state and federal penalty taxes.
Many participants use access to 401(k) loans as their emergency cash fund. That’s bad financial planning. Rather than allowing employees to borrow to meet emergency or non-emergency needs (e.g., buying a boat or, snowmobile or paying for a vacation) many employers choose to limit participant loans to hardship withdrawal criteria.
Remember that your 401(k) plan is often the lender of last resort for many participants. As a result, a high percentage of plan loans are made to participants who are poor financial managers or have accumulated excessive debt. Since you as the lender can’t say no to someone who applies (absent hardship criteria) loans are often made to participants who aren’t credit worthy. Additional debt often isn’t helpful to these participants’ financial situation.
Using hardship criteria to qualify loan applications helps employers manage the application process. Valid hardship reasons include: preventing eviction or foreclosure, paying medical or funeral expenses, purchasing or repairing a primary residence, and paying educational expenses.
Only one loan allowed at a time. Many 401(k) plans were set up to permit multiple loans. Studies indicate that participants who take more than one loan are more likely to default. Defaults often occur when a participant moves on to another job or loses a job and is unable to continue making loan payments. Some participants also take as many loans as possible if it appears that they may be facing a layoff or moving on to a different employer, as a way of advancing a distribution from the plan.
Mandatory referral to the EAP. Whether or not hardship criteria are used to determine loan eligibility, many plan sponsors refer potential borrowers to their employee assistance program for financial counseling before they are allowed to apply for a loan. If your company does not offer an EAP, require potential borrowers to talk with the investment adviser who works with your plan.
Information shared about the impact of loans on retirement savings. Many experts feel that the participant loan area is ripe for lawsuit activity from participants who feel they weren't given enough information about the potential negative impact of participant loans. Remember, Truth-in-Lending disclosures are not required for 401(k) loans. Many participants have said to me, “Bob, if taking a participant loan is a bad decision, why would the company let me do it?” You should be aware that by offering the availability of 401(k) loans your company is indirectly implying that it is OK to take them.
Ashley Micciche shared an excellent example about the impact of participant loans on retirement savings in a recent “401k Specialist” article. In her example, she points out that a $10,000, three-year loan at 5% for a 30-year-old participant with a $30,000 balance who stops contributing while making loan payments results in a loss in retirement savings of $407,630.
Loans limited to participant accounts. Many plan sponsors have decided to limit 401(k) loans to participant contribution accounts and the earnings in those accounts. Excluded are all employer accounts including matching, nonelective and profit-sharing.
Emergency loan program option. A number of employers have decided to offer emergency loan programs to their employees. Not only does this reduce the number of 401(k) loans taken, but it can help employees avoid taking payday loans at high interest rates.
Higher loan fees to participants. Higher loan fees tend to dissuade participants from taking a loan and often reduce the average loan amount requested. Studies have shown that an increase from $50 to $100 in loan fees is often enough to reduce participant loans significantly and loan balances by nearly 50%.
Pop-up screen warnings. Many participants reduce their 401(k) contributions when taking participant loans. Some reduce their contributions below the maximum matching contribution level. Losing matching contributions is one of the worst decisions participants can make. Make sure your recordkeeper has a pop-up screen that displays a warning message when participants reduce their 401(k) contributions below the maximum matching contribution level.
Tighter participant loan programs are becoming commonplace at companies committed to retirement readiness. Plan sponsors who have successfully migrated to more stringent loan programs have done so as a result of effective participant education sessions that outline the pitfalls of participant loans in detail.
Robert C. Lawton, AIF, CRPS is president of Lawton Retirement Plan Consultants, LLC, a RIA firm helping 401(k) plan sponsors with their investment, fiduciary, employee education and compliance responsibilities.