Just when I thought I'd seen it all - including 401(k) plans that allow participants to obtain multiple loans from the plan year after year and actually encourage employees to borrow against their retirement - I'm horrified to discover the newest trend might become 401(k) credit cards.
Banc One Corp., based in Columbus, Ohio, has devised a credit card that will allow 401(k) participants to tap into their 401(k) plan more easily. The idea was conceived by Franco Modigliani, Nobel Prize-winning economist, and Francis M. Vitagliano, a pension industry compliance officer. The card will become widely available in 1997 and will offer credit as high as the lesser of $10,000 or 40% of vested retirement savings. The interest rate will be pegged to the prime rate plus 3.9 points.
This credit card's "purpose" is veiled as a way to "encourage savings." Did I miss something? The explanation is that many workers, especially younger ones, fail to participate in 401(k) plans available to them because they feel they can't access it when necessary. Exactly.
As a large provider of investment management consulting to 401(k) participants, I can tell you that employees know how to take 401(k) loans and they do it in droves. Is this what we want to encourage?
Keep in mind, after all, this is a retirement plan we are talking about. I see many employees who sacrifice their long-term security for relatively short-term and often foolish reasons. Few of these employees fully understand the ramifications of borrowing from their 401(k) plan.
The opportunity cost of these loans is a concept that often goes unexplained by plan sponsors and is misunderstood by plan participants. Many participants believe the first place they should go for a loan is their 401(k) plan, reasoning, "Why pay the bank interest when I can pay myself the interest?" Wrong. First, they need to understand that no one can make money paying himself interest. If a bank charges interest on a loan, the bank profits from the interest received. If individuals pay themselves interest, they do not profit; they are simply transferring money from one account to another. A loan from a 401(k) plan is an interest-free loan because the interest is credited to the 401(k) account, but the participant is not "making money."
In a 401(k) credit card arrangement, a portion of the interest goes to the bank, not into the 401(k) account. In the Banc One example, the 3.9% goes to the bank, not to the 401(k) plan. Regardless of where the interest goes, the most important point to keep in mind is that a loan from the 401(k) plan can cost a participant many times more than a traditional loan from a bank.
Opportunity cost is what I call the expense associated with the lost opportunity that a 401(k) loan causes. These assets are no longer in the 401(k) plan and therefore do not have the opportunity to grow at the rate other plan assets do.
For example, suppose a participant borrows $20,000 from his plan. If during that year the market is up 30%, the participant's opportunity cost for the money borrowed from the plan could be up to 30% as compared to a more standard 9% personal loan expense from a bank. Of course, the opposite is also true. In a down market, the participant actually benefits from protecting the loan assets from market decline.
Another little known fact about the more traditional (non-credit card type) 401(k) loan is that loan payments, principal and interest are made with after-tax dollars, but when a participant withdraws these assets from the plan at some point, say, for a loan, he or she will pay taxes again on the interest portion because it is considered 401(k) earnings. Taxes are bad enough the first time around. Why pay twice?
Admittedly, a 401(k) plan loan is an alternative in a pinch, but I would venture to say 401(k) loans and 401(k) credit cards are simply an attempt to reverse the 1986 tax law that was put in place purposely to convert 401(k)s from savings plans to retirement plans. This law restricts employee access to 401(k) assets in order to encourage them to save. Human nature is such that if people have money available to them, they will tap into it without regard for the long-term detriment to their retirement.
Since 401(k) credit cards offer little value to anyone other than the banks, I don't believe many plan sponsors will jump on the credit card bandwagon. Banc One claims the flexibility of a 401(k) credit card will encourage participation by attracting younger participants who might not participate in a 401(k) plan otherwise. This is not my view. The majority of 401(k) plans already have loan provisions that offer participants a less expensive alternative.
The Banc One credit card requires that the money in the "loan pool" be transferred into a money market account in order to make withdrawals (i.e., loans). A money market fund is a non-performing asset in a retirement plan. Therefore, many participants stand to suffer from poor returns even if they never actually draw on the monies with the 401(k) credit card. For these reasons, I fail to see how many plan sponsors would view the credit card options as a benefit to employees or to the success of the plans themselves in promoting retirement saving.
The 401(k) credit card encourages employees to move in the wrong direction. Consumer credit is at record levels, and now this new device encourages employees to borrow from one of the few retirement savings vehicles they have. True, some employees may not contribute to their 401(k) plan because they view it as illiquid. Many employees participate in their 401(k) plan simply to reap the company match but fail to understand the value of a long-term tax-deferred savings vehicle and are the first to borrow from a 401(k) plan or use a 401(k) credit card. They just don't get it.
My life's work has been spent explaining to employees how critical it is to save for retirement in spite of the "need" for a new car, house, or college education. Ideally, these expenses should be paid for from savings outside of 401(k) plans. It all comes down to the fact many employees just can't seem to live off 90% of their salary. That's their perception and perception becomes reality. In truth, few would miss 6% or 10% of their salary and their sacrifice could be compensated for by matching contributions and a reduction in annual taxes. These individuals are also the most likely to have high consumer debt and borrow from their 401(k) plan.
There's no justification for a 401(k) credit card. A credit card is just what it sounds like - easy access debt - and a 401(k) credit card will prove to be a detriment to employees and 401(k) plans.
J. Michael Scarborough is president and chief executive officer of The Scarborough Group Inc., Annapolis, Md.